Ethiopian Civil Service University

College of finance, management and development department of accounting

and finance

Challenges and opportunities of interest free banking

In the case of Dashen Bank

Yordanos Zena

ECSU1703433

Advisor Abdu Muhammed (Ph.D) Assist. professor of public finance management

Research Proposal Submitted to department of accounting and finance in partial fulfillment for
the award of degree in master of accounting and finance

May 2020
Addis Ababa, Ethiopia
Contents
CHAPTER ONE----------------------------------------------------------------------------------------------------------------- 1
1. INTRODUCTION-------------------------------------------------------------------------------------------------------- 1
1.1. Background of the Study------------------------------------------------------------------------------------------ 1
1.2. Background of the Organization---------------------------------------------------------------------------------3
1.3. Statement of the Problem----------------------------------------------------------------------------------------- 4
1.4. Research Questions------------------------------------------------------------------------------------------------- 6
1.5. Objectives of the Study-------------------------------------------------------------------------------------------- 7
1.5.1. General Objective-------------------------------------------------------------------------------------------- 7
1.5.2. Specific Objectives------------------------------------------------------------------------------------------- 7
1.6. Significance of the Study------------------------------------------------------------------------------------------ 7
1.7. Scope of the Study-------------------------------------------------------------------------------------------------- 8
1.8. Limitation of the Study-------------------------------------------------------------------------------------------- 8
1.9. Organization of the Study----------------------------------------------------------------------------------------- 8
CHAPTER TWO---------------------------------------------------------------------------------------------------------------- 9
2. REVIEW OF RELATED LITERATURE---------------------------------------------------------------------------9
2.1. Theoretical Literature Review-----------------------------------------------------------------------------------9
2.1.1. General Concepts and Definition-------------------------------------------------------------------------9
2.1.2. Riba (Interest)------------------------------------------------------------------------------------------------ 10
2.1.3. Interest Free Banking Service Model-------------------------------------------------------------------11
2.1.3.1. Interest Free Banking – Window Service-------------------------------------------------------11
2.1.3.2. Interest Free Banking Subsidiaries---------------------------------------------------------------11
2.1.3.3. Interest Free Banking Services – Full Fledged------------------------------------------------11
2.1.4. Funds of Interest Free Banking--------------------------------------------------------------------------12
2.1.4.1. Saving Accounts-------------------------------------------------------------------------------------- 12
2.1.4.2. Investment Accounts-------------------------------------------------------------------------------- 12
2.1.4.3. Joint or General Investment Account------------------------------------------------------------13
2.1.4.4. Limited-Period Investment Deposits-------------------------------------------------------------13
 2.1.4.5. Unlimited-Period Investment Deposits----------------------------------------------------------13
2.1.4.6. Specified Investment Deposits--------------------------------------------------------------------13
2.1.5. Uses of Funds by Interest Free Banking---------------------------------------------------------------14
2.1.5.1. Murabaha (Mark-Up or Cost-Plus-Based Financing)----------------------------------------14
2.1.5.2. Musharakah (Partnership)--------------------------------------------------------------------------15
2.1.5.3. Mudarba (Profit-Sharing)---------------------------------------------------------------------------17
2.1.5.4. I Jar All (Leasing)------------------------------------------------------------------------------------ 17
2.1.5.5. Loans with Service Charge-------------------------------------------------------------------------18
2.1.5.6. Qard-E-Hasan (Interest-Free Loans)-------------------------------------------------------------18
2.2. Empirical Review------------------------------------------------------------------------------------------------- 19
2.3. Conceptual Framework of Interest Free Banking----------------------------------------------------------20
2.3.1. Principles of Interest Free Banking---------------------------------------------------------------------20
2.3.1.1. Profit And Loss Sharing----------------------------------------------------------------------------21
2.3.1.2. Shared Risk-------------------------------------------------------------------------------------------- 21
2.3.1.3. Riba------------------------------------------------------------------------------------------------------ 21
2.3.1.4. Gharar--------------------------------------------------------------------------------------------------- 21
2.3.1.5. Gambling----------------------------------------------------------------------------------------------- 21
2.3.1.6. No Investment In Prohibited Industries---------------------------------------------------------21
2.3.1.7. Zakat---------------------------------------------------------------------------------------------------- 22
2.3.2. The Role of Interest Free Banking----------------------------------------------------------------------22
2.3.2.1. Role of the Bank as Guarantor--------------------------------------------------------------------23
2.3.2.2. Advisory Services------------------------------------------------------------------------------------ 23
2.3.2.3. Other allowed Islamic financial services & products----------------------------------------23
CHAPTER THREE------------------------------------------------------------------------------------------------------------ 25
3. RESEARCH DESIGN AND METHODOLOGY----------------------------------------------------------------25
3.1. Research Design--------------------------------------------------------------------------------------------------- 25
3.2. Sampling Technique---------------------------------------------------------------------------------------------- 25
3.3. Sources of Data---------------------------------------------------------------------------------------------------- 26
3.4. Data Collection Methods---------------------------------------------------------------------------------------- 26
3.5. Data Analysis Method-------------------------------------------------------------------------------------------- 26
 CHAPTER ONE
1. INTRODUCTION
1.1. Background of the Study
Islamic economics should be seen as part of a dynamic, universal way of life that promotes
social interaction at the highest possible level. Islam is a submission to the Will of God (Allah),
obeying His laws. The Qur’an, considered the word of Allah by Muslims, lays forth the
injunctions that govern the life of a Muslim. This includes acts of worship, laws on marriage,
inheritance and the basis of Islamic economics and finance.

Islam has clearly defined the area of economics and has demarcated parameters in methods of
earning, paying, utilizing and donating wealth. Accumulation or the hoarding of wealth has no
place in Islam. Islamic economics promotes socio-economic upliftment and development
through the permissible use of funds that have been provided by the creator of those funds, Allah
Himself. While ownership is recognized in Islam, the essence of ownership is a responsibility
provided by Almighty God. Wealth must be distributed in ways that earn the pleasure of the One
who provides it. This means that prohibited earnings like the return of interest or the sale of
immoral products and services are devoid of all blessing and in fact invoke the anger of
Almighty God.

Now a day Islamic banking business is growing at a faster rate because of the interest free
system and money developed countries have started to look at it as the alternative from their
conventional banking system (Abduljelil and Khalilur, 2014).Islamic bank is an institution that
mobilizes financial resources and invests them in an attempt to achieve predetermined Islamic
ally-acceptable social and financial objectives. In addition to this Islamic banking is a system
that mobilizes savings on the basis of profit /loss sharing that is considered to be fairer and more
conducive to investment and development (Hassen& Lewis, 2007). Each bank competes to
attract the customers by providing various types of services to retain those potential customers
and attract the new ones to work with them. These competitions lead the existing banks as well
as new entrants innovative to provide new type of services to the public. The main reason to do
this is attract and meet the resource they lack liquid funds to their basic requirements.

Interest Free Banking Page 1

Recently Islamic banking services come into existence in Ethiopia to play an important
intermediary role in attracting savings, especially from customers, and channel the collected fund
into productive investments. The banking service mainly focuses on financing primarily based
on profit-and-loss sharing, trading, leasing. Both mobilization and investment of funds should be
conducted in accordance with the principles of Islamic Shari'a" (www.albarakah.com, 2014).In
Islamic banking service unlike conventional banking service, they are not allowed to charge
interest by lending money to their customers, because, under Islamic commercial law, making
money from money is strictly prohibited (Chintaman, 2014 p. 5).In contrast to this the
conventional banking business charges an interest from the loans made to customers and pay
interest to the deposits made by customers‟.

In order to attract and retain the specific needs of the Islamic banking service of the market some
commercial banks start the Islamic banking service in one segregate window with the
conventional banking service as per the requirement of the NBE directive. There are more than
18 private and government owned banks operate in the country. Among these Commercial bank
of Ethiopia, United bank S.C and Oromia international bank S.C. start Islamic banking service as
per the requirement. (www.nbe.gov.et).

In order to attract and retain the specific needs of the Islamic banking service of the market some
commercial banks start the Islamic banking service in one segregate window with the
conventional banking service as per the requirement of the NBE directive. There are more than
18 private and government owned banks operate in the country. Among these Commercial bank
of Ethiopia, Dashen Bank, United bank S.C and Oromia international bank S.C. start Islamic
banking service as per the requirement. (www.nbe.gov.et).

One of the services these banks offer includes that profits/losses sharing banking service. This
needs careful screening because of the danger of adverse selection, and careful monitoring
because of the dangers of asymmetric information and moral hazard. One factor contributing to
adverse selection is that in a mixed financial system with both Islamic and conventional banks,
entrepreneurs may not like the idea of profit sharing if they have rosy expectations of the success
of their ventures whereas they may prefer profit-sharing finance from Islamic banks if they are
less sure of a positive outcome. This might burden Islamic banks with a disproportional share of
bad debts. (Khan, 2010).

Interest Free Banking Page 2

In implementing this banking business the bank should also to note how the customer should be
served and who answers client questions. Everyone who works inside an Islamic bank should
understand Islamic finance principles. The bank training of the staffs is not only about religious
concepts, the product knowledge that leads the staffs to understand how Islamic banking is
different from conventional banking.

1.2. Background of the Organization

Dashen Bank was founded by eleven visionary shareholders and veteran bankers with initial
capital of Birr 14.9 million in September 1995. Upon securing license from the National Bank of
Ethiopia, Dashen opened its doors for service on the 1 st of January 1996 with eleven fully-
fledged branches.

Dashen Bank coined its name from the highest peak in Ethiopia, mount Dashen, and aspires to be
unparalleled in banking services. RasDashen is Part of the Simien Mountains National Park, an
exotic setting with unique wildlife and breath-taking views on a landscape shaped by nature and
traditional agriculture.The Simien Mountains is home to endemic wild life including the Walia
Ibex, Simien Fox or Ethiopian Wolf and the Gelada Baboon. Dashen aspires to set new heights
in banking services through the delivery of unique value propositions second to none.

Headquartered in Addis Ababa, the Bank is among the biggest private Banks in Ethiopia. It
operates through a network of more than 400+ Branches, ten dedicated Forex Bureaus, 350+
ATMs and 850 plus Point-of-Sale (POS) terminals spread across the length and breadth of the
nation. It has established correspondent banking relationship with 462 banks covering 70
countries and 170 cities across the world. Wherever business takes customers around the world,
Dashen Bank is already there.

Dashen is the most reputable brand in the domestic banking market; a reputation earned through
consistent delivery of values and preeminence unmatched by its competitors. Apart from the
conventional banking, Dashen Bank also offers Sharia Compliant Interest Free Banking dubbed
“SHARIK”. The Bank also works in partnership with leading brands in the electronic payments
industry (AMEX, VISA, MasterCard &UnionPay) and prominent money transfer operators
(Western Union, MoneyGram, Express Money &Dahabshiil, Ezremit, Transfast, WorldRemitand

Interest Free Banking Page 3

Ria).Dashen Bank and its technology partner Moneta Technologies introduced “Amole” Digital
Omni channel payment platform that offers subscribers digital payment capacity and access to
aggregated digital product and service from Retailers, Entertainment Industries, Airtime Dealers,
Bill Payment Points, Airlines, Social Media Players and Third-Party Service providers.

Following the finalization of its headquarters, Dashen Bank is to embark on interest-free banking
(IFB) services after getting approval from the National Bank of Ethiopia (NBE) on October 25,
2017. The service involves payments without interest and will be available on separate counters
at the bank’s branches. It aims to grab the attention of individuals, companies, enterprises and
non-governmental institutions. IFB was announced concurrently with the inauguration of the
Bank’s newly constructed 24-storey headquarters, costing a little over a billion Birr. Sprawled on
3,495sqm of land, the finishing works of the building were executed by MIDROC Construction.
IFB service is an option similar to conventional banking systems except differing on the concepts
of interest rates and exclusion of businesses engaged in gambling, sales or production of
pork and alcohol.

Dashen’s IFB service, known as Sharik, will be implemented in one-third of the Bank’s
branches, which has reached 400+ to date, unlike Bank of Abyssinia that got the green light from
the central bank to execute the service in all of its branches. The services of the Bank under IFB
are four: Amanah- keeping money safe on trust, Qerd- a current account that allows transactions
with cheques, Mudaraba- an investment account, and Mudaraba Time Deposit Account- where
the customer saves money for a fixed period and withdrawal is done on notice, not on demand.

1.3. Statement of the Problem

Banks are a very important part of the economy because they provide vital services for both
consumers and businesses. As financial services providers, they give you a safe place to store
your cash. Through a variety of account types such as checking and savings accounts,
and certificates of deposit (CDs), you can conduct routine banking transactions like deposits,
withdrawals, check writing, and bill payments. You can also save your money and earn interest
on your investment. The money stored in most bank accounts is federally insured by the Federal
Deposit Insurance Corporation (FDIC)

Interest Free Banking Page 4

Banks also provide credit opportunities for people and corporations. The money you deposit at
the bank—short-term cash—is used to lend to others for long-term debt such as car loans, credit
cards, mortgages, and other debt vehicles. This process helps create liquidity in the market—
which creates money and keeps the supply going.

Just like any other business, the goal of a bank is to earn a profit for its owners. For most banks,
the owners are their shareholders. Banks do this by charging more interest on the loans and other
debt they issue to borrowers than what they pay to people who use their savings vehicles. Using
a simple example, a bank that pays 1% interest on savings accounts and charges 6% interest for
loans earns a profit of 5% for its owners.

The empirical evidence shows that Interest free banking have rapidly spreading and developing
across the world. Some factors appear to be correlated with the diffusion of IFB, namely the
principles of risk-sharing that underlie financing, the growth of oil-rich economies, the presence
of Muslims in the population, an enabling legal framework, and economic integration with
Middle Eastern countries or proximity to Islamic financial centers (Alam, et al 2011). Wherever
there is a sizable Muslim community and is not restricted to Muslim countries, the probability for
Islamic banking to spread in a given country rises with the share of the Muslim population.
According to Ibrahim (2012), trading with the Middle East and economic stability are also
conducive to the diffusion of Islamic banking.

Almost half of Ethiopian banking commercial industry out of eighteen banks has commenced
Interest free banking service within less than three years while some others banks are also
showed initiation to commence it. The rapid diffusion of interest free banking adoption by
banking organization reflects their understanding of the importance and untapped demand it is as
an alternative financing intermediary in stiff banking competition. In return, banking sectors
investigation of factors influencing customers’ behavioral intention to adopt interest free banking
product and service, identifying resistance to adoption for product modification and frequently
collecting feedback can help banks to mobilize significant amount of deposit thereby divert to
financing that can create active economic circulation. Besides, interest-free banking deposit
market share is very low compared to conventional banks deposit & Customer Base; banks are
increasingly making an effort to attract customers by through awareness campaign to attract

Interest Free Banking Page 5

potential customers .Islamic banking studies are largely conducted in Muslim ccountiries and to
a smaller extent among non-Muslims countries. Studies in Ethiopia on IFB have been very few
due to the infancy of the industry. Studies in Ethiopia include; Mohammed (2012) has identified
the potential challenges of IFB before commencement of the service. This study was undertaken
before the practical introduction of the IFB in the country. Therefore, it was not based on actual
observation of facts on the ground. While, Teferi (2015) has identified that introduction of IFB
does not only create inclusive financial system for the Muslim population but also has a potential
to influence and enhance the economic development of the country through resource
mobilization and employment creation by encouraging people to use the banking system. It is
only limited to IFB’s contribution and prospects. On the other hand, there is a work on
Customer’s Intention (Debebe A., 2015), but the study was based on the model of Decomposed
Theory of Planned Behavior (DTPB).

The Ethiopian banking institutions starting these Interest Free Banking services and as based on
the above facts will face many challenges in their operational activity of resource mobilization.
Beyond this there is also growth prospect. In an attempt to contribute in bridging the above
stated problems, the study will focus on assessing challenges and opportunities of Interest Free
Banking service in resource mobilization efforts in the case of Dashen Bank.

1.4. Research Questions

The research attempts to come up with answers for the following research questions.

 What are the various types of services offered by interest free banking in accordance
with Islamic law?
 How interest free banking service will have an effect on resource mobilization efforts of
the bank?
 What are the basic challenges the Dashen Bank faces by starting Islamic banking
service?
 Is the product offered by interest free banking sections of the commercial banks are
sufficient enough to attract potential customers and having a potential to grow and
contribute in the economy of Ethiopia?

Interest Free Banking Page 6

 1.5. Objectives of the Study
1.5.1. General Objective
The general objective of the study was to investigate the challenges and opportunities of interest
free banking and finance in the efforts of resource mobilization of Ethiopian commercial banks.

1.5.2. Specific Objectives

Based on the general objectives and the research questions, the research would have the following
specific objectives.

 To discuss the various types of service of interest free banking possesses and their
consistency with Islamic law.
 To identify the effects of starting interest free banking service in resource mobilization
efforts of the banks.
 To identify the challenges faced by Dashen Bank when starting interest free banking
service.
 To explore the opportunities and growth prospects of interest free banking service in
resource mobilization.

1.6. Significance of the Study

IFB is a relatively new business model in Ethiopian banking system. It is also growing in its
applicability among Muslim as well as non-Muslim countries to accommodate the Muslim
population, who otherwise, are excluded from financial services due to religion factor. It is
believed that including this section of the population into financial service provision will expand
the financial frontier and bring about economic benefit both to the country and the beneficiaries.
It is, therefore, the results of this study will be significantly practical and helpful for:

 Policy Makers: It will give significant direction to review the current policy for the
development of IFB activities in Ethiopia.

 Practical: It will provide a road map for the Interest free banking and financial
institutions by studying what criteria that significantly affecting the implementation on
Interest free banking. Thus, the interest free banking and financial institutions will come
out with a new strategy and strengthen their institutions.

Interest Free Banking Page 7

  Further Study: The study would lay a ground work for further studies as well.

1.7. Scope of the Study

This study specifically was focus on the challenges and opportunities of interest free banking
service in resource mobilization efforts in the case of Dashe Bank. While starting the banking
service the testing, training of staffs, launching of the service and procedures development for
the service made at the head office and big branches and hence the scope of the study considered
in the study are head office branches and departments. Additionally the data will be collected
from employees, managers, and supervisors of Dashen Bank.

1.8. Limitation of the Study

The research will explore using employees (customer officers and managers) of Dashen Bank.
Due to the current pandemic, it will be probably be difficult to get adequate data from the
materials published in Ethiopia. As result of this, the study was only considers from published
materials by various scholars abroad and employees point of about challenges and opportunities
of Islamic banking service in resource mobilization of Dashen Bank.

1.9. Organization of the Study

This research will be organized into five chapters. Chapter one contained background of the
study, statement of the problem, research objectives, hypothesis of the study, significance of the
study, justification of the study, limitations and scope of the study. Chapter two provide a
literature review informing the reader of what is already known in this area of study. Chapter
three discussed the methodology employed in this study, including, research design, sample size
and sampling technique, data source and collection method, procedure of data collection and
method of data analysis. Chapter four will present data analysis and discussion of results.
Finally, chapter five will include summary, conclusions and recommendations.

Interest Free Banking Page 8

 CHAPTER TWO
2. REVIEW OF RELATED LITERATURE
2.1. Theoretical Literature Review
2.1.1. General Concepts and Definition
The origin of Islamic banking dates back to the beginning of Islam in the seventh century. The
Prophet Muhammad's first wife, Khadija, was a merchant. He acted as an agent for her business,
using many of the same principles used in contemporary Islamic banking.

In the Middle Ages, trade and business activity in the Muslim world relied on Islamic banking
principles. These banking principles spread throughout Spain, the Mediterranean, and the Baltic
states, arguably providing some of the basis for western banking principles. From the 1960s to
the 1970s, Islamic banking resurfaced in the modern world.

Islamic banking, also known as non-interest banking, is a banking system that is based on the
principles of Islamic or Sharia law and guided by Islamic economics. Two fundamental
principles of Islamic banking are the sharing of profit and loss, and the prohibition of the
collection and payment of interest by lenders and investors. Islamic law prohibits collecting
interest or "riba."

Islamic banking is grounded in Sharia, or Islamic, principles and all bank undertakings follow
those Islamic morals. Islamic rules on transactions are called Fiqh al-Muamalat. Typically,
financial transactions within Islamic banking are a culturally distinct form of ethical investing.
For example, investments involving alcohol, gambling, pork, and other forbidden items are
prohibited. There are over 300 Islamic banks in over 51 countries, including the United States.

The principles of Islamic banking follow Sharia law, which is based on the Quran and the
Hadith, the recorded sayings, and actions of the Prophet Muhammad. When more information or
guidance is necessary, Islamic bankers turn to learned scholars or use independent reasoning
based on scholarship and customs. The bankers also ensure their ideas do not deviate from the
fundamental principles of the Quran.

Interest Free Banking Page 9

Islamic banking is a system of banking that mobilizes saving on the basis of profit and loss
sharing that is considered to be fairer and more conducive to measurement and development.
Owing to the growing demand by the Muslim population in Western countries and also to the
increasing interest of Islamic investors to diversify geographically their portfolios, conventional
banks are increasingly becoming interested in entering the market of Islamic financial products.
(Hassen and Lewis, 2007).

2.1.2. Riba (Interest)

Riba is a concept in Islamic banking that refers to charged interest. It has also been
referred to as usury, or the charging of unreasonably high-interest rates. There is also
another form of riba, according to most Islamic jurists, which refers to the simultaneous
exchange of goods of unequal quantities or qualities. Though, here, we will be referring
to the practice of charged interest.

It is forbidden under Sharia Law (Islamic religious law) because it is thought to be

exploitative. Though Muslims agree that riba is prohibited, there is much debate over
what constitutes riba, whether it is against Sharia law, or only discouraged, and whether
or not it should be punished by people or by Allah. Depending on the interpretation, riba
may only refer to excessive interest; however, to others, the whole concept of interest is
riba and thus is unlawful. For example, even though there is a wide spectrum of
interpretation on the point at which interest becomes exploitative, many modern scholars
believe that interest should be allowed up to the value of inflation, to compensate lenders
for the time value of their money, without creating excessive profit. Nevertheless,
riba was largely taken as law and formed the basis of the Islamic banking industry.

The Muslim world has struggled with riba for quite some time, religiously, morally, and
legally, and eventually, economic pressures did allow for a loosening of religious and
legal regulation, at least for a period. In his book, Jihad: The Trail of Political Islam,
Giles Kepel wrote that "since modern economies function on the basis of interest rates
and insurance as preconditions for productive investment, many Islamic jurists racked
their brains to find ways of resorting to them without appearing to bend the rules laid

Interest Free Banking Page 10

down by the Koran," and "the problem loomed ever larger as more and more Muslim
states entered the world economy in the 1960s." This loosening of economic policy lasted
until the 1970s when a "total ban on lending with interest was reactivated."

Riba is prohibited under Sharia law for a couple of reasons. It is meant to ensure equity in
exchange. It is meant to ensure that people can protect their wealth by making unjust and
unequal exchanges illegal. Islam aims to promote charity and helping others through
kindness. To remove sentiments of selfishness and self-centeredness, this can create
social antipathy, distrust, and resentment. By making riba illegal, Sharia law creates
opportunities and contexts in which people are encouraged to act charitably—loaning
money without interest.

2.1.3. Interest Free Banking Service Model

2.1.3.1. Interest Free Banking – Window Service
According to Juan Sole, (2007) An Islamic banking window is simply a window with a
conventional bank via which customer can conduct business utilizing only sharia compatible
instruments. Sanusi (2011) defines Islamic banking window as a business model in which
conventional banks offer Islamic banking products and services from their existing branch
network. In short, Islamic banking window refers to a situation whereby a conventional banking
system provides some of the Islamic banking products or services. In other words, it can be seen
as a banking system that meets up only the profit, loss, and risk sharing principle of Islamic
banking for some of its products. (Audu and Mika, 2014).

2.1.3.2. Interest Free Banking Subsidiaries

The commercial banking unit, which offers shariah compliant products and services only in the
specific branch. It is a semi-independent office of a bank engaging in banking activities such as
accepting deposits or making loans at facilities away from a bank's home office. This branch
banking established when the main bank feels there is a potential of concentrated customers are
found in the area want to serve these customers.

2.1.3.3. Interest Free Banking Services – Full Fledged

Interest Free Banking Page 11

Once a conventional bank has operated an Islamic window for some time and has gathered a
sizeable customer base for its Islamic banking service activities, it may decide to establish an
Islamic subsidiary, or even fully convert into a full-fledged Islamic bank. By following either of
these two routes, the bank may benefit from economies of scope and concentration of knowledge
and expertise. The bank will be able to offer a wider range of Shariah-compliant banking
products than through the Islamic window alone. For example, it may be better equipped to fully
engage in Islamic investment banking activities, such as underwriting sukuk (bond) issuances or
managing Shariah-compliant investment and hedge funds, or to manage its own treasury and
money market operations.(Sole, 2007).

2.1.4. Funds of Interest Free Banking

All interest free banks operate current accounts for their customers as traditional banks do. These
accounts govern what is known as demand deposits, i.e. these deposits are payable on demand
without a notice being given to the bank. The bank guarantees full return of these deposits on
demand. The bank may use these funds in its business operations at its own risk. Since all risk is
borne by the bank, the depositors are not entitled to any share in profits earned by the bank.

2.1.4.1. Saving Accounts

Islamic banks also accept saving deposits from individuals. Four different methods of operating
saving accounts by Islamic banks have emerged: (i) accepting saving deposits on the principle of
al wadia requesting the depositors to give the bank permission to use the funds at its own risk,
but guaranteeing full return of the deposits and sharing any profits voluntarily; (ii) accepting
saving deposits with an authorization to invest and share profits in an agreed manner for the
period in which a required minimum balance is maintained; (iii) treating saving deposits as qard-
e- hasan (benevolent loan) from the depositors to the bank and granting them pecuniary or non-
pecuniary benefits; and (iv) accepting saving deposits into an investment pool and treating them
as investment deposits which are explained below. Generally speaking, the depositors are given a
right of withdrawal without notice in saving accounts but are not entitled for any share in the
profit for the period in which withdrawal is made.

2.1.4.2. Investment Accounts

Investment deposits are the Islamic banks’ counterpart of term deposits in the conventional
system. They are also called profit-and-loss sharing (PLS) or participatory accounts. These

Interest Free Banking Page 12

accounts could be opened either by individuals or companies for any specified period such as six
months, one year or even longer. The depositors do not receive any interest. Instead, they are
entitled for a share in actual profit accrued from the investment operations of the bank. The
profits are shared by the depositors according to their amounts and the period they are held by
the bank in an agreed proportion. As an accounting practice, the amount held in the account is
multiplied with the period for which it has been employed. The profits are distributed on a pro
rata basis on this product. Usually withdrawals are not allowed from the investment accounts
except under special circumstances for which some notice period is required. The depositor will
have to forego his share of profit for the withdrawn amount.

2.1.4.3. Joint or General Investment Account

Some Islamic banks establish some kind of an investment pool in lieu of fixed term deposits. The
investment pool takes the form of a general investment account in which investment deposits of
different maturities are pooled together. They are not tied to any specific investment project but
are utilized in different financing operations of the bank. The profits are accounted and
distributed at the end of the period on a pro rata basis.

2.1.4.4. Limited-Period Investment Deposits

Some Islamic banks also accept investment deposits for a specified period determined by the
mutual consent of the depositor and the bank. The contract may terminate at the end of the period
but profits are distributed and accounted at the end of the financial year.

2.1.4.5. Unlimited-Period Investment Deposits

These investment deposits are automatically renewable without specifying the period. They
could be terminated by giving a specified notice to the bank. Usually the notice period is three
months. No withdrawals or increases in the amount of deposit are permitted during the period.
Profits are calculated and distributed at the end of the financial year.

2.1.4.6. Specified Investment Deposits

Some Islamic banks have evolved an investment deposits scheme with specific authorization to
invest in a particular scheme or a specific trade. In this case the profits of this specific activity
are distributed between the depositor and the bank. In this case the bank works as an agent of the
investor. It may agree to perform this function against an agreed fee or may opt to have a share in
the profit.

Interest Free Banking Page 13

 2.1.5. Uses of Funds by Interest Free Banking
Islamic financing techniques on the uses of funds side of the balance-sheet marked a more
significant departure from the traditional banking. This is mainly because of the prohibition of
interest rate. Most of the traditional banks use lending on interest as their major financing tool
which is modified with respect to interest rate charged, period of loan, conditions of repayments,
etc. to suit the requirements of various clients and different sectors. Since Islamic banks cannot
use lending on interest as a financing device, they were compelled to find out innovative ways of
financing which would not involve interest.

Consequently, Islamic banks have drawn up the rich treasure of Islamic theory of contract to
come up with the financing techniques which would conform to various requirements of the
Islamic Shari'ah. These contracts were originally devised for commodity trade and deal with the
contracts between two individuals. The application of these contracts at the institutional level and
in the financial sector is a new phenomenon. In course of these applications, some of the
contracts have been slightly modified from the point of view of Islamic jurisprudence. However,
this is not the place to discuss tiic judicial nature of these contracts. Instead, present discussion
shall remain confined to application of these contracts to financial sector as actually put into
practice by contemporary Islamic banks.

Financing techniques used by Islamic banks may be summarized as follows:

2.1.5.1. Murabaha (Mark-Up or Cost-Plus-Based Financing)

This is the most popular technique of financing among the Islamic banks. It has been estimated
that 80 to 90 percent of financial operations of some Islamic banks belong to this category. It
works in the following way:

The client approaches the Islamic bank to get finance for the purchase of a specified commodity.
The bank, either itself or through some agent (who could be the client himself), collects all the
required information about the commodity itself, such as price, nature and specification of the
commodity, names of dealers, etc. The bank informs the client of these details as well as of the
margin it would like to charge on the original price.

In case, these conditions are acceptable to the client, a contract of murabaha transactions will be
signed between the bank and the client. The bank will purchase the specified commodity from
any seller of its choice paying the price of commodity in cash. In case a sale deed is required
Interest Free Banking Page 14
(e.g. in case of car or house) the registration is in the name of the bank. Once the ownership of
the commodity is transferred to the bank, it sells the commodity to the client on the basis of
deferred payment basis against an agreed price.

The new price at which the bank sells the commodity to the client includes the original price
(which is cost to the bank) plus the mark-up the bank is charging (which is the profit margin).
The client pays this price either in installment or in lump sum at an agreed later date.

There is certain requirement for the muraba- ha contract to be valid. It is necessary that profit
margin (or the mark-up) the bank is charging must be determined by mutual agreement between
the parties concerned. Similarly, the good in question should be in the physical possession of the
bank before it is sold to the client. Then transaction between the bank and the seller should be
separate from the transaction between the bank and the purchaser. There should be two distinct
transactions. That is why certain Islamic banks effect a muraba- ha transaction in two stages
using two separate contract forms. The first form is a request to the bank through which the
client informs the bank of his intention to carry out the murabaha. In this contract, the client
promises to buy the good from the bank. It should also be noted that a promise is not legally
enforceable. Hence, the client has a right to change his mind and the bank runs the risk of losing
the money it has invested in this particular murabaha. The second contract deals with the sale of
good by the bank to the client on deferred payment basis, the terms and conditions of which are
clearly spelled out in the contract form.

The murabaha form of financing is being widely used by the Islamic banks to satisfy various
kinds of financing requirements. It is used to provide finance in various and diverse sectors, e.g.
in consumer finance for purchase of consumer durables like cars and household appliances, in
real estate to provide housing finance, in the production sector to finance the purchase of
machinery, equipment, raw material, etc. However, probably the most common use of murabaha
techniques is in financing short-term trade. Murabaha contracts are also used to issue letter of
credit and to finance import trade.

2.1.5.2. Musharakah (Partnership)

Musharakah is another technique of financing used by Islamic banks. In this form, two or more
financiers provide the finance for a project. All partners are entitled to a share in total profits of
the project according to a ratio which is mutually agreed upon. However, the losses are to be

Interest Free Banking Page 15

shared exactly in proportion to capital proportion. All partners have a right to participate in the
management of the project. However, they also have the right to waive this right in favor of any
specific partner.

There are two main types: permanent musharakah and diminishing musharakah. In the first case,
the bank participates in equity and relieves an annual share of profit on a pro rata basis. The
period of termination of the contract is not specified, so it can continue as long as the parties
concerned wish it to continue. The technique of diminishing partnership is getting quite popular
with Islamic banks because of its potentialities. In permanent musharakah, funds may be
committed for a long period, but it is not so in case of diminishing musharakah.

Diminishing musharakah allows equity participation in the first place and share of profit on pro
rata basis. However, the contract also provides a further payment of a sum of money over and
above the bank’s share in profits as a payment of the part of the equity held by the bank. In this
way, the equity held by the bank keeps on getting reduced progressively with time. After a
certain lime, bank will have zero equity and shall cease to be a partner. Islamic banks have found
it quite suitable to finance commercial buildings in this way.

Islamic banks in Sudan, particularly Sudanese Islamic Bank (SIB), have evolved yet another
application of musharakh which has tremendous potential for rural and agricultural development
in the Islamic countries. SIB has been experimenting in providing finance to farmers under
musharakah arrangements.

It works in the following manner: the SIB and the farmer enter into a musharakah contract under
which the bank provides the farmer with the fixed assets such as ploughs, tractors, irrigation
pumps, sprayers, etc. and working capital such as fuel, oil, seeds, pesticides, fertilizers, etc.
Farmer’s equity is confined to provide land, labor and management. Since it is a partnership
contract, there is no need of collaterals or guarantees other than personal guarantees. First, the
farmer is paid 30 percent of the net profit as a compensation for his management. Rest of the net
profit is shared between the bank and the farmer on a pro rata basis for each side’s respective
share in the equity.

Musharakah technique of financing is also used to finance domestic trade, imports and to issue
letters of credit.

Interest Free Banking Page 16

 2.1.5.3. Mudarba (Profit-Sharing)
Several theorists of Islamic banking have postulated mudarba to be a dominant mode of
financing under the scheme of Islamic banking. However, this technique, for various conceptual,
practical and legal hindrances, has not been able to find wide application by the Islamic banks.
The Jordan Islamic Bank (JIB) is one among the few banks which use mudarba as a financing
technique. The law of the JIB mentions two kinds of mudarba: individual and joint.

In case of' individual mudarba, the JIB provides finance to a commercial venture run by a person
or by a company on the basis of profit-sharing. The joint mudarba may be between the investors
and the bank on a continuous basis. The investors keep their money in a special fund operated by
the bank in continuous joint financing. The investors receive a proportionate share of the net
profit realized even without the liquidation of those financing operations which have not reached
the stage of final settlement.

2.1.5.4. I Jar All (Leasing)

Leasing is also one of the approved methods of earning income according to Islamic law. In this
method, a real asset such as a machine, a car, a ship, a house, etc. can be leased by the lessor to
the lessee for a specified period against a specified price. The benefit and cost of each party
should be clearly spelled out in the contract to avoid any element of uncertainty (gharar) with
respect to the responsibility of each party.

Leasing is emerging as a popular technique of financing among the Islamic banks. Some of the
important Islamic banks which use leasing as a technique of financing include Islamic
Development Bank, Bank Islam Malaysia and commercial banks in Pakistan.

Under this scheme of financing, the bank purchases a real asset (the bank may even purchase the
asset as per the specifications provided by the prospective client) and leases it to the client. The
period of lease may be determined by mutual agreement according to the nature of assets. In
general, it may be anywhere between three months to five years or more. During the period of
lease, the asset remains in the ownership of the bank but physical possession of the asset and its
right of use are transferred to the lessee. After the expiry of the lease agreement, these also revert
back to the original owner.

At present, Islamic banks are experimenting with various forms of leasing, one of which is lease
purchase agreement. In this scheme, the lessee can purchase the equipment at the end of the lease
Interest Free Banking Page 17
period at an agreed price. In certain eases, the rental paid during the period of the lease may
constitute part of the price.

2.1.5.5. Loans with Service Charge

Some Islamic banks give loans with service charge. The Council of the Islamic Fiqh Academy,
established by the OIC, in its third session held in Amman on Safar 8-13, 1407 H (October 11-
16, 1986), in a response to a query from the Islamic Development Bank resolved that it is
permitted to charge a fee for loan-related services offered by the bank. However, this fee should
be within actual expenses and any fee in addition to the actual service-related expenses is
forbidden because it is considered to be usurious.

Hence, the amount of the service charge should be carefully calculated. According to this ruling,
it may be calculated in the following manner:

Actual administrative expenditure

Service charge^   x         100

Average assets during the period

A1+A2

Average assets =

where

A1 = Total assets at the beginning of the period.

A2 = Total assets at the end of the period.

Service charge in this manner may be calculated only after the end of the period because it is
only then that actual expenditure on administration will be known. Under the circumstances, it is
possible to levy an approximate service charge on the clients, then reimburse or reclaim the
difference at the end of the period when actual expenses on administration are known.

2.1.5.6. Qard-E-Hasan (Interest-Free Loans)

Most of the Islamic banks also provide interest-free loans to their customers. Practices, however,
differ. Some banks provide the privilege of interest-free loans to the holders of investment

Interest Free Banking Page 18

accounts at the bank. Some other banks have the provision to provide interest free loans to needy
students and other economically weaker sections of the society. Yet some other banks provide
interest-free loans to small producers, farmers, entrepreneurs who are not qualified to get
financing from other sources. The purpose of these loans is to help them start independent life or
to raise their income and standard of living.

2.2. Empirical Review

Abdulmajidet. al (2010) writes about the efficiency in Islamic banking and conventional:
banking an international comparison investigates the efficiency of Islamic and conventional
banks using an output distance approach . They obtain measures of efficiency after allowing the
environmental influences such as country microeconomic conditions accessibility of banking
services and the bank type. The parameter estimates highlight that Islamic banks appear to be
associated with higher input usage. Furthermore by allowing for bank size and international
differences in the underling inefficiency distributions, it demonstrate statically significant
differences in inefficiency related to these factors even after controlling for specific
environmental characteristics and Islamic banking. Due to this Islamic banks are found to have
high returns to scale than conventional banks. While this suggests that Islamic banks may benefit
from increased scale, they emphasis and the results suggest that identifying and overcoming the
factors that cause Islamic banks to have relatively law potential output for a given input usage
levels will be the key challenges for Islamic banking in the coming decades.

Ismaeil, et al. (2010) writes the recent development of insolvency of many conventional banks
made the Central Banks to initiate the acquisition of some banks while others were ordered to
merge. This was a strong signal to seek for alternative banking system. However, the advocacy
for the Islamic banking system as alternative to conventional banking system has been received
with mixed feelings.

Islamic financial system in perspective, operations of Islamic financial system as well as the
challenges and prospects for the country’s economy. It posits that awareness, manpower, legal
framework, societal belief, cash requirements as some of the challenges while economic growth,
attraction of investors, and fostering of egalitarian society are the likely prospects for the
establishment of the Islamic banking. It concludes that Islamic banking system will bring
transformation to all sectors of the economy vis-a viz eradication of poverty, equitable

Interest Free Banking Page 19

distribution of income and employment opportunities in the country through effective
mobilization and allocation of capital.

Roddney Wilson, (2000) writes that Islamic finance has become increasingly significant in
financial centers in the West, notably London, despite the regulatory hurdles presented by
operating in a non Muslim financial environment. The growth of Islamic finance partly reflects
demand from Muslim resident and non-resident clients for Islamic deposit facilities and fund
management services which involve shari’ah compliance. At the same time Islamic financing
methods are viewed as a challenge and opportunity by Western bankers, many of whom have
sought to get involved in this growing industry. In client driven societies there is willingness by
those in financial services to listen and learn from the experiences of Islamic banks, which in the
longer run may bring a major breakthrough for Islamic banking at the retail level in the West.

Hanudin Amin, (2013) in his article of some view-points of Islamic banking retail deposit
products in Malaysia writes that our illuminations are centered on the current accounts, saving
accounts and investment accounts. A brief note on negotiable Islamic certificate of deposits
(NICD) is also provided. These deposit products are examined in terms of their definitions,
features and calculations. On the same note, some discrepancies between deposit facilities
offered by Islamic and conventional banks are exposed. The purpose of such exposition is to
provide novice readers a basic but profound explanation concerning the difference between the
two categories of deposit facilities.

2.3. Conceptual Framework of Interest Free Banking

2.3.1. Principles of Interest Free Banking
Islam has set values and goals that meet all the economic and social requirements of the human
life. Islam is a religion that not only focuses on the success of the afterlife but also organza the
life of a person perfectly. The Islamic laws are known as Sharia that means clear path. In the
present is banking system is against the principles of Islamic banking. Due to the reason, here we
discuss the seven major principles of Islamic Banking and finance:

Interest Free Banking Page 20

 2.3.1.1. Profit And Loss Sharing
It is one of the best principles of Islamic finance where the partners will share their profit and
loss according to the part they played in the business. There will be no guarantee on the rate of
the returns that the Muslims will play the part of a partner and not a creditor.

2.3.1.2. Shared Risk

In the economic transactions, the risk sharing is promoted by the Islamic banking. When two or
more parties will share the risk following the principles of Islamic banking the burden of the risk
will be divided and reduced in the parties. So it will improve the economic activity of the state.

2.3.1.3. Riba
It can be regarded as the prohibition of interest:

 The wealth will get the return without any risk or effort.
 Regardless of the outcome of economic activity the person who gets the loan has to
return the money and Riba to the lender.
 In principles of Islamic banking, taking advantages of the issues that other are facing is
unjust.

2.3.1.4. Gharar
According to the Islamic finance principles, Muslims are not allowed to participate in the
ambiguous and uncertain transactions. According to Islamic rules, both parties should have a
proper control over the business. As well as the complete information should be shared with both
parties so that the profit and loss will be equally shared.

2.3.1.5. Gambling
In Islam, the acquisition of wealth through evil means or participation in gambling is prohibited.
It will protect the Muslims from the conventional insurance products because that is a type of
gambling. On the other hand, Islamic banking works in Takaful that involves mutual
responsibility and shared risks.

2.3.1.6. No Investment In Prohibited Industries

The industries that are harmful to society or have a threat to the social responsibilities are
prohibited in Islam. They include:

Interest Free Banking Page 21

  Pornography.
 Prostitution.
 Alcohol.
 Pork.
 Drug.

According to the Islamic finance principles, you are not allowed to invest in such industries. You
cannot even participate in the mutual funds that will help the industry to flourish.

2.3.1.7. Zakat
There is a property tax included in the rules of Islam that it known as Zakat, which allows the
balanced distribution of wealth. According to the Islamic banking principles the fair amount of
Zakat is deducted from the accounts of Muslim in the holy month of Ramadan. Islamic banks
promote this social responsibility and distribute the amount among the needy.

So we can say that the principles of Islamic finance guide us to invest in an industry that will
help us to achieve the financial and social objectives that have been determined by Islam. The
Islamic finance principles have been designed to make an economy successful. So it is a way of
saving our money from being invested in a wrong path. Principles of Islamic finance are
discussed in more details during Certified Islamic Finance Expert (CIFE) a well-known Islamic
finance certification and diploma in Islamic banking , where you study Islamic banking courses.
These programs are offered by institute of Islamic banking and finance at AIMS.

2.3.2. The Role of Interest Free Banking

A bank under Islamic Shariah can act as an agent (on AlWakalah basis) of the customer and can
carry out the transaction on his behalf. Moreover it can charge agency fee for the services. The
agency fee can be charged in the following cases:

 Payment / receiving of cash on behalf of the customer

 Inward bill of collection
 Outward bill of collection
 LC opening and acceptance

Interest Free Banking Page 22

  Collection of export bills / bills of exchange. In this case the undertaking or guarantee
commission and take-up commission can be Islamized. Bank will charge an agency fee
for accepting the bills, which is bought at face value.
 Underwriting & IPO services

2.3.2.1. Role of the Bank as Guarantor

The bank or financial institute gives a guarantee on behalf of its customer but according to
Shariah, guarantee fee cannot be charged. Normally conventional banks charge fee for following
guarantees:

 Letter of guarantee
 Shipping guarantee

2.3.2.2. Advisory Services

Most of the advisory services provided by the financial institutes can be carried out easily in
compliance with Shariah as long as the nature of business is halal:

 Financial advisory services

 Privatization advisory services
 Equity placement
 Merger & acquisition advise
 Venture capital
 Trading (Capital market operations)
 Cash & portfolio management advice
 Brokerage services (Purchase & buying of share of companies involved in halal business,
a fee could be charged for it).

2.3.2.3. Other allowed Islamic financial services & products

 Remittance
 Zakat deduction.
 Sale & purchase of foreign currency
 Sale & purchase of traveler's checks (local & foreign currency)
 ATM services

Interest Free Banking Page 23

  Electronic online transfer
 Telegraphic transfer (of cash)
 Demand draft
 Pay order
 Lockers & custodial services
 Syndicate funds arrangements services (non-interest or markup based) for some fee.
 Opening of bank account (current & non-interest or nomarkup)
 Clearing facility
 Sales & purchase of shares/stock (of companies involved in halal activities)
 Collection of dividends
 Electronic banking window
 Telephone banking.

Interest Free Banking Page 24

 CHAPTER THREE
3. RESEARCH DESIGN AND METHODOLOGY
3.1. Research Design
In order to achieve the main objective of the study an exploratory and descriptive research design
used to gather as much information as possible to show the challenges and prospects of Islamic
banking service for resource mobilization of Ethiopian commercial banks. According to Ghauri
and Gironhaug, (2005) the basic difference between the three main classes of research designs
are exploratory, descriptive and explanatory. The research can be exploratory when it deals with
unknown problem, Descriptive when there is an awareness of the problem and Explanatory when
the problem is clearly defined. In addition to this According to Yin (1994) exploratory research
is designed to allow the researcher to just look around with respect to some phenomenon, with
aim to develop suggestive ideas.

3.2. Sampling Technique

Dashen Bank has 400+ branches all over the country. The researcher will focus on branches in
the capital, Addis Ababa. C. The researcher will use employees, managers, supervisors and
selected customers of the bank. In selecting the research subject sample the researcher will apply
stratified random sampling in order to find representative sample. Thus, accordingly the
researcher groups the target population of the worker based on educational level, work
experience. The sample size of the respondents will be set randomly by using sample
determination formula developed by Yemane (1967).

N
n= 2
1+ N ( e)

Where: N – Population size

e – Sampling error

n – Sample size

Once after each bank sample size will be determined, the researcher used systematic random
sampling method to select the target employees since their job is directly related to the work. The
researcher won’t go beyond this sample size because of the assumption that increasing the

Interest Free Banking Page 25

number of sample size more than the specified doesn’t increase additional information. Rather it
could be duplication of information.

3.3. Sources of Data

The researcher is planning to use both primary and secondary data. The sources of primary data
will be collected directly from employees, managers and supervisors of Dashen Bank. The
secondary data will also be collected and used to describe and elaborate the conceptual aspects of
the interest free banking and financing services and their applicability. In addition to this
different websites, books written by various authors, bulletins released by foreign banks and
national bank of Ethiopia, etc.

3.4. Data Collection Methods

For accomplishing the research work and research objectives both primary and secondary data
will be gathered. The primary data will be collected from those employees of the banks i.e.
Employees, supervisors and managers of the banks. Thus, in order to obtain the reliable and
sufficient information, structured questionnaires will be used as data collecting instruments.

In an effort to make the research more valid, credible and applicable secondary data will also be
used for the issues raised on the research. For this purpose published sources i.e. different books,
web pages, policy directives, journal articles and various project papers etc will also be explored.

In order to collect sufficient data that can answer the research questions, the researcher designed
questionnaires to bank staffs and management members who have related to their day to day
activities. The questionnaires were distributed to staff members. Data from both sources will be
collected and organized in structural form of tables and graphs.

3.5. Data Analysis Method

After data is collected, the researcher plans to check, sort and screen data for any errors. Besides,
the researcher will also attempt to analyze the various issues that will involve in the introduction
of interest free banking service in the country based on the principles, legal and regulatory
requirements. The researcher will use both qualitative and quantitative data analysis techniques.
Finally the data will be processed and analyzed by statistical package for social science (SPSS)
version 20. To analyze the data descriptive statistics method will be made based on the results of

Interest Free Banking Page 26

the tables and figures using mean value and percentage rank order. The results of the study will
be presented using tables.

Interest Free Banking Page 27