Research Report On

RIBA-FREE BANKING IN PAKISTAN
(A CASE STUDY OF MEEZAN BANK)

TABLE OF CONTENTS
TABLE Of contents .......................................................................................ii ACKNOWLEDGEMENTS.............................................................................i ABSTRACT...................................................................................................ii GLOSSARY..................................................................................................iii CHAPTER 1...............................................................................................1 INTRODUCTION..........................................................................................1 1.1 INTEREST (RIBA):............................................................................1 1.2 SALIENT FEATURES OF INTEREST (RIBA):................................2 1.3 RESEARCH PROBLEM:....................................................................2 1.4 OBJECTIVES OF THE STUDY:........................................................2 1.5 GEOGRAPHICAL SCOPE:................................................................3 1.6 TYPE OF DATA:................................................................................3 1.7 TIME HORIZON:...............................................................................3 1.8 LIMITATIONS:..................................................................................3 1.9 ORGANIZATION OF THE STUDY:.................................................4 CHAPTER 2...............................................................................................6 RIBA AND ITS TYPES.................................................................................6 2.1 Definition of Riba or Interest:..............................................................6

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2.2 Classification Of Riba:.........................................................................7 1. Riba An Nasiyah:................................................................................7 2. Riba Al Fadl:......................................................................................8 2.3 Commercial Interest And Usury:..........................................................8 2.4 Simple And Compound Interest:...........................................................9 CHAPTER 3.............................................................................................10 RIBA PROHIBITION IN ISLAM................................................................10 3.1 Riba in Quran: .........................................................................10

3.2 Riba in Hadees:..................................................................................11 3.3 Imam Fakur-ud-Din Razi’s Views on Interest:..................................12 CHAPTER 4.............................................................................................13 MODERN BANKING SYSTEM.................................................................13 4.1 The Genesis of the Moneylender:......................................................13 4.2 Feeling Against Modern Private Banks:............................................15 4.3 The Effects of Interest on Society:.....................................................15 4.4 The Effects of Fixed Interest Bearing Loans on Business:.................16 4.5 Banks and Islam:................................................................................17 CHAPTER 5.............................................................................................19 PROPOSAL OF RIBA-FREE BANKING...................................................19 5.1 Main Features: .................................................................................19 5.2 Zero Interest and Capital Guarantee:.................................................19 5.3 Lending and Investing:......................................................................20

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5.4 Participatory Financing:.....................................................................21 5.4.1 Financing by Lending:................................................................22 5.5 Interest-free Commercial Banking:....................................................23 5.5.1 Loan Default Insurance:..............................................................24 5.6 Participatory Financing through Commercial Banks:........................24 5.7 Government Bonds:...........................................................................25 5.8 Modular Implementation:..................................................................26 CHAPTER 6.............................................................................................28 ISLAMIC MODES OF DEPOSIT AND FINANCE ...................................28 6.1 Deposit mechanism:...........................................................................28 6.1.1 Al-Wadiah current deposit:.........................................................28 6.1.2 Mudaraba Saving Deposit:..........................................................29 6.1.3 Mudaraba Term Deposit:............................................................29 6.2 Finance Mechanism:..........................................................................30 6.2.1 Bai-Murahaba:............................................................................30 6.2.2 Musharaka (Partnership):............................................................31 Meaning:...............................................................................................31 Types:...................................................................................................31 a. Permanent Musharaka:.....................................................................31 b. Diminishing Musharaka:..................................................................33 6.2.3 Mudaraba:...................................................................................33 6.2.4 Bai-Salam:..................................................................................34

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6.2.5 Istisna Sale:.................................................................................35 6.2.6 Qard Hasana:..............................................................................35 6.2.7 Bai-Muajjal (Deferred Sale):........................................................37 6.2.8 Ijarah:...........................................................................................38 Elements of Ijarah:................................................................................39 6.2.8 Hire-Purchase under Shirkatul Melk or Ijarah Muntahib Bil Tamlek:.................................................................................................39 Stages:..................................................................................................41 6.3 Some Islamic Financial Instruments:.................................................41 Participation Term Certificates (PTCs):................................................41 Mudaraba Certificates:..........................................................................41 CHAPTER 7.............................................................................................43 APPLICATIONS OF ISLAMIC INVESTMENTS......................................43 7.1 Project Financing:...............................................................................43 7.2 Working Capital Financing:...............................................................44 7.3 Import Financing:..............................................................................46 Musharaka /Mudaraba:.........................................................................47 Murabaha:.............................................................................................47 7.4 Export Financing:..............................................................................48 1. Pre shipment financing....................................................................48 Musharaka / Mudaraba:........................................................................48 Murabaha:.............................................................................................49

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2. Post Shipment Financing:................................................................49 CHAPTER 8.............................................................................................51 IDEOLOGY OF PAKISTAN.......................................................................51 8.1 Quaid-e-Azam in Islamic Economic System:....................................51 8.2 Constitution of Pakistan (1973):........................................................53 8.3 Supreme Court Decision (1998-2002) on Interest:............................54 8.4 The Islamization of Economic System of Pakistan:...........................55 8.5 Interest-free Banking in Pakistan:......................................................56 CHAPTER 9.............................................................................................58 CASE STUDY OF MEEZAN BANK .........................................................58 9.1 Our Vision:........................................................................................58 9.2 Mission Statement:............................................................................58 9.3 Shariah Board:...................................................................................58 9.4 Management Team:...........................................................................59 9.5 Corporate Banking & Corporate Finance:.........................................60 9.5.1 Corporate Banking:......................................................................60 a. Working Capital Requirements:.......................................................60 b. Project Financing/Expansion/BMR Requirements:..........................60 c. Export Refinance:............................................................................60 d. Trade Related Services:...................................................................61 9.5.2 Corporate Finance & Advisory:..................................................61 What we offer:......................................................................................62

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9.6 Modes of Investments:.......................................................................64 9.6.1 Equities:......................................................................................64 a. Business of the Investee Company:..................................................64 b. Debt to total assets:..........................................................................64 c. Net illiquid to total assets:................................................................64 d. Investment in Shariah non-complaint activities and income from Shariah non-complaint investments:.....................................................65 e. Net liquid assets vs. share price:......................................................65 9.6.2 Mudaraba:...................................................................................65 9.6.3 Sale on cost plus profit (Murabaha):...........................................66 9.6.4 Musharaka:.................................................................................66 9.6.5 Bai’ Salam:.................................................................................67 9.6.6 Bai’ Muajjal:...............................................................................67 9.6.7 Ready future hedges:...................................................................67 9.6.8 Disposal of haram income:.........................................................68 CHAPTER 10...........................................................................................69 PUBLIC BEHAVOIUR ABOUT INTEREST-FREE BANKING ..............69 10.1 About Subjects:................................................................................69 10.2 Questionnaire Analysis:...................................................................69 10.3 Summary of the analysis ..................................................................75 RECOMMENDATIONS..............................................................................76 CONCLUSION............................................................................................78

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references .....................................................................................................79 QUESTIONNAIRE......................................................................................80 STUDYING THE FEASIBILITY OF INTEREST FREE BANKING IN PAKISTAN..............................................................................................80

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ACKNOWLEDGEMENTS
Writing this research report would have never been possible without the active support of many people, and the collective efforts of many to whom I owe extremely thanks. First of all I would like to thank Al-Mighty Allah who strengthened me to complete this report. Secondly I am very grateful to my teacher………….. for providing me an opportunity to write this report under his highly valuable guidance that was always available to me. Without his cooperation I would not have been able to complete this report. Furthermore I would like to thanks my parents specially my father who has given valuable suggestions and moral support in the preparation of this report. Finally, I like to thank my uncle ………………, who supported me throughout in the collection of information and share their vulnerable ideas regarding Islamic banking.

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ABSTRACT
Islamic banking can change the world economic order, by proving that it can grow as faster as in the conventional banking. Interest is curse from Allah and it is forbidden in Islam. Muslim should avoid interest banking sector. In this fast growing world, Islamic banking has all those facilities which can facilitate from household to industrialist. It is very important to know the definition and forbiddance of Riba and the injunctions relating to its unlawfulness from different angles. On the one hand, there are severe warnings of the Quran and Sunnah and on the other, it has been taken today as an integral part of the world economy. The desired liberation from it seems to be infested with difficulties. The problem is very detail oriented and has to be taken up in all possible aspects. First of all we have to deliberate into the correct interpretation of the Quranic verses on Riba and what has been said in authentic ahadith and then determine what Riba is in the terminology of the Quran and Sunnah, what transaction it covers, what is the underlying wisdom behind its prohibition and what sort of harm it brings to society. We will start from looking at the economic philosophy of Islam vis-à-vis interest. There may be many hurdles in fully establishment of Islamic banking in Pakistan, but this dream of our Qaide would become true (Inshallah). The people of Pakistan would see their generation in full light, with the thinking that we have provide them shelter which will save them from bad effects of the world. The new generation, through Islamic banking would achieve the mission by bringing the Shariah in this country. My best wishes are with this country that is our homeland Pakistan.

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GLOSSARY
Al-Wadiah = Safe Keeping Bai-Muajjal = Deferred-Payment Sale Bai-Salam = Pre-Paid Purchase Baitul Mal = Treasury Tradition = Hadees; Prophet’s Commentary in Quran Ijarah = Leasing Iman = Faith Mithl = Like Mudaraba = Profit-Sharing Modarib = Entrepreneur- Borrower Muqarada = Mudaraba Murabaha = Cost-Plus or Mark-Up Musharaka = Equity Participation Qard Hasana = Benevolent Loan (Interest Free) Rabbul-Mal = Owner of Capital Riba = Interest Shariah = Islamic Law

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CHAPTER 1

INTRODUCTION
An Islamic bank is a financial institution that operates with the objective to implement and materialize the economic and financial principles of Islam in the banking arena. It is defined as: “A financial and social institution whose objectives and operations as well as principles and practices must conform to the principle of Islamic Shariah (jurisprudence), and which must avoid the interest in any of its operations”. Or “A company which carries on Islamic banking business”. Islamic banking business means banking business whose aims and operations do not involve any element which is not approved by the religion Islam. It follows that what makes Islamic banking different from conventional western banking is that there can be no interest (Riba) paid or charged for any transaction or service to ensure justice, welfare and non-exploitation. Off course, the investments of an Islamic bank must be channeled to the Islamic Shariah approved sector by Islamic modes of finance like Mudaraba, Musharaka, Bai-Muajjal, Bai-Salam, Ijarah, Istisna etc which are based on the sharing of risk and profit. Islamic bankers in fact generate ‘profit and loss’ transactions in which the lender or bank shares in gains or losses based on the economic viability of the project and the credit worthiness of the customer. 1.1 INTEREST (RIBA): Interest (Riba) refers to the principle amount plus additional amount charged at some rate for some period of time. The theory of interest has for a 1

long time been a weak point in the science of Economics. The explanation and the determination of the interest rate still give rise to more disagreement amongst economists. Interest has been the point of discussion and is still under discussion in the study of Economics of the world. 1.2 SALIENT FEATURES OF INTEREST (RIBA): The salient features of Riba free banking are: There is no interest on deposits, but capital is guaranteed. Lending and investing are treated differently, loans are interest free but carry a service charge, while investing is on a profit and loss sharing (Mudaraba) basis. 1.3 RESEARCH PROBLEM: By prohibiting interest Islam has endeavored to do away with a hideous form of tyranny and injustice prevalent in the human society. The institution of interest is a great challenge to all those who are trying to divide and reconstruct the Islamic way of life in the modern times. In this paper, it will be discussed how the banking system will be organized without the interest. 1.4       OBJECTIVES OF THE STUDY: Interest and its effects in present banking system Interest free banking system How IFBS works Existing interest free transaction How IFBS can be implemented Public behavior toward IFBS

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GEOGRAPHICAL SCOPE: This research is concerned with the whole of Pakistan but due to

limitations it could not be conducted as per the requirement and as such the research is completed but collecting secondary data from various sources and primary data is collected from within Peshawar. 1.6 TYPE OF DATA: Both secondary and primary data is used to compile this report.  Primary data: Judging the behavior of general public towards the introduction of interest free banking was an essential sub part which is completed by serving a short comprehensive questionnaire, thus data has been collected.  Secondary data: Data pertaining to the topic has been obtained from various books and internet. 1.7 TIME HORIZON: Time being the most important factor without it no one is able to conceive full work. The time allotted for this work was very less and the research is based on the cross-sectional data collection method. 1.8 LIMITATIONS: It will be just to point out various limitations as cautiously faced by us and every time we felt its adverse effects. Few out of many are: The complexity and wide scope of the topic    Lack of financial resources Lack of experience in the research field Lack of knowledge

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ORGANIZATION OF THE STUDY: This research comprised of the following topics:

       

Riba and its types Riba prohibition in Islam Modern banking system Proposal of Riba-free banking system Islamic modes of financing Islamic investments Ideology of Pakistan Public behavior about interest free banking Banking sector is considered to be one of the important and essential

pillars of a nation’s economy. Present banking system whish is based on the principles of interest is highly criticized as it could not offer the appropriate benefits to societies. Thus this system is undesirable on the basis of its lacking to serve human being and serve any society. Particularly for Muslims this system is a threat as it operates against the principles and teachings of Islam. Muslim world is in the process to recapture its historic respectability and honor. Economy is one of the major areas where Muslims are struggling and are looking for improvement. In this regard the elimination of interest from the financial sector is considered to be a major break through. Muslims scholars and many other economists of the world are trying to promote the concepts of interest free banking system. The more the adverse effects of the interest, the greater the probability of interest free banking because people would hate interest based banking system. For example if interest cause selfishness, people will not go for 4

interest. The explanation of the present banking system as based on interest will no more be required. A model or proposed structure with explanation of its probable areas of operation will directly contribute towards the introduction of such a system in Pakistan. Knowing the people behavior about the interest and interest free banking will make the adoption of such system very easy. Explaining the very reason of the existence of the motherland that is its ideology will draw our attention upon the implementation of Islamic rules, regulations, norms and customs and code of life thus providing a better solid ground for promoting and establishing a banking system which matches with the very principles of Islam.

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CHAPTER 2

RIBA AND ITS TYPES
2.1 DEFINITION OF RIBA OR INTEREST: The word “Riba” means excess, increase or addition, which correctly interpreted according to Shariah terminology, implies any excess compensation without due consideration (consideration does not include time value of money). This definition of Riba is derived from the Quran and is unanimously accepted by all Islamic scholars. There are two types of Riba, identified to date by these scholars namely ‘Riba An Nasiyah’ and ‘Riba Al Fadl’. ‘Riba An Nasiyah’ is defined as excess, which results from predetermined interest (sood) which a lender receives over and above principle (Ras ul Maal). ‘Riba Al Fadl’ is defined as excess compensation without any consideration resulting from a sale of goods. ‘Riba Al Fadl’ will be covered in greater detail later. During the dark ages, only the first form ( Riba An Nasiyah) was considered to be Riba. However, the Holy Prophet also classified the second form (Riba Al Fadl) as Riba. The meaning of Riba has been clarified in the following verses of Quran. “O those who believe, fear Allah and give up what still remains of the Riba if you are believers. But if you do not do so, then be warned of war from Allah and His Messenger. If you repent even now, you have the right of the return of your capital; neither will you do wrong nor will you be

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wronged.” Al Baqarah 2:278-9 these verses clearly indicate that the term Riba means any excess compensation over and above the principle which is without due consideration. However, the Quran has not altogether forbidden all types of excess; as it is present in trade as well, which is permissible. The excess that has been rendered haram in Quran is a special type termed as Riba. In the dark ages, the Arabs used to accept Riba as a type of sale which unfortunately is also being understood at the present time. Islam has categorically made a clear distinction between the excess in capital resulting from sale and excess resulting from interest. The first type of excess is permissible but the second type is forbidden and rendered haram. “Seized in this state they say: ‘ Buying and selling is but a kind of interest’. Even though Allah has made buying and selling lawful, and interest unlawful.” Al Baqarah 2:275 2.2 CLASSIFICATION OF RIBA: The first and primary type is called Riba An Nasiyah or Riba Al Jahiliya. The second type is called Riba Al Fadl, Riba An Naqd or Riba Al Bai. 1. Riba An Nasiyah: This is real and primary form of Riba. Since the verses of Quran have directly rendered this type of Riba as haram, it is called Riba Al Quran. Similarly since only this type was considered Riba in the dark ages, it has earned the name of Riba Al Jahiliya. Imam Abu Bakr Hassas Razi has outlined a complete and prohibiting legal definition of Riba An Nasiyah in the following words: “ that kind of loan where specified repayment period and an amount in excess of capital is pre-determined.”

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Riba Al Fadl: The second classification of Riba is Riba Al Fadl. Since the

prohibition of this Riba has been established on Sunnah, it is also called Riba Al Hadees. Riba Al Fadl actually means that excess which is taken in exchange of specific homogeneous commodities and encountered in their hand to hand purchase in sale as explained in the famous hadees: The Prophet said, “Sell gold in exchange of equivalent gold, sell silver in exchange of equivalent silver, sell dates in exchange of equivalent dates, sell wheat in exchange of equivalent wheat, sell salt in exchange of equivalent salt, sell barley in exchange of equivalent barley. But if a person transacts in excess, it will be usury (Riba). However, sell gold for silver anyway you please on the condition it is hand-to-hand (spot) and sell barley for date anyway you please on the condition it is hand-to-hand (spot).” 2.3 COMMERCIAL INTEREST AND USURY: In the 17th century, two new technical terms of interest emerged after the establishment of banking system, namely:  Tijarti Sood (Commercial Interest): Interest paid on loan taken for productive and profitable purposes.  Sarfi Sood (Usury): Interest paid on loan taken for personal need and expenses. When Muslim countries became subjugated to west in their economic field, some westernized Muslims in the 19th century, on one side, saw the increasing progress of the west in trade and industry and on the other side saw the shattering economic condition of fellow Muslims states. They also became conscious of the fact that banking is an inevitable in the field of trade

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and industry not only on national level but also internationally. This prompted them to say that only usury is haram (illegal) but not commercial interest because rendering commercial interest haram would pose irresolvable problems to their way upto industrialization and economic progress. They only included usury in the term ‘Riba’ as categorically prohibited in Quran and Sunnah and freed commercial interest from it calling it totally different from the western concept of interest. Therefore, it was concluded that the prohibition of Riba was restricted to usury while commercial interest was perfectly Islamic. 2.4 SIMPLE AND COMPOUND INTEREST: Riba An Nasiyah can be classified into two types: Simple Interest (Sood-e-Mufrid) Compound Interest (Sood-e-Murakkab)  Definition of Simple Interest: Interest calculated only on the initial investment.  Definition of compound interest: Reinvestment of each interest payment on money invested, to earn more interest. During the pre-Islamic era, when a borrower used to fail to pay back the principal and interest charged to him, then the lender used to extend the loan on the condition that the interest will also become part of the loan (essentially compound interest). The following verses of revealed in order to stop the people from such practices: “O believers, take not doubled and re-doubled interest, and fear God so that you may prosper.” (Surah Al Imran, verses 130-1). Quran were

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CHAPTER 3

RIBA PROHIBITION IN ISLAM
3.1 RIBA IN QURAN: Strict injunctions with regard to interest on money are repeated over and over with the same force and emphasis. Let us see those injunctions: First Revelation (Surah al-Rum, verse 39) "That which you give as interest to increase the peoples' wealth increases not with God; but that which you give in charity, seeking the goodwill of God, multiplies manifold." (30: 39) Second Revelation (Surah al-Nisa', verse 161) "And for their taking interest even though it was forbidden for them, and their wrongful appropriation of other peoples' property. We have prepared for those among them who reject faith a grievous punishment (4: 161)" Third Revelation (Surah Al 'Imran, verses 130-2) "O believers, take not doubled and redoubled interest, and fear God so that you may prosper. Fear the fire which has been prepared for those who reject faith, and obey God and the Prophet so that you may receive mercy." Fourth Revelation (Surah al-Baqarah, verses 275-81) "Those who benefit from interest shall be raised like those who have been driven to madness by the touch of the Devil; this is because they say: "Trade is like interest" while God has permitted trade and forbidden interest. Hence those who have received the admonition from their Lord and desist may keep their previous gains, their case being entrusted to God; but those who revert shall be the inhabitants of the fire and abide therein for ever." (275)

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"God deprives interest of all blessing but blesses charity; He loves not the ungrateful sinner." (276) "Those who believe, perform good deeds, establish prayer and pay the zakat, their reward is with their Lord; neither should they have any fear, nor shall they grieve." (277) "0, believers, fear Allah, and give up what is still due to you from the interest (usury), if you are true believers." (278) "If you do not do so, then take notice of war from Allah and His Messenger. But, if you repent, you can have your principal. Neither should you commit injustice nor should you be subjected to it." (279) "If the debtor is in difficulty, let him have respite until it is easier, but if you forego out of charity, it is better for you if you realize." (280) "And fear the Day when you shall be returned to the Lord and every soul shall be paid in full what it has earned and no one shall be wronged.” (281). 3.2 RIBA IN HADEES: Besides the Quran, a number of reliable traditions (sayings of the Holy Prophet) also exhibit strong prohibitive orders against usury, for instance: From Abu Hurayrah: The Prophet said: "On the night of Ascension I came upon people whose stomachs were like houses with snakes visible from the outside. I asked Gabriel who they were. He replied that they were people who had received interest." (Ibn Majah, Kitab al-Tijarat, Bab al-taghlizi fi alriba; also in Musnad Ahmad) From Jabir: The Prophet may curse the receiver and the payer of interest, the one who records it and the two witnesses to the transaction and

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said: "They are all alike [in guilt]." (Muslim, Kitab al-Musaqat, Bab la'ni akili al-riba wa mu'kilihi; also in Tirmidhi and Musnad Ahmad) According to the well known decree of the second Caliph, Hazrat Umer (may God be pleased with him): “Abstain from usury and anything having as semblance of usury”. 3.3 IMAM FAKUR-UD-DIN RAZI’S VIEWS ON INTEREST: Imam Razi is the first person who shed light on interest from the economic point of view amongst Muslim scholars. He discussed this problem in his great work, the TAFSIR KABIR. According to him, the word ‘riba’ means increase or addition but it does not mean that every kind of increase is unlawful. Another reason for the unlawfulness of riba is that such a transaction necessitates the exacting of another man’s wealth without legal consideration or return. The Prophet (PBUH) has said that a man’s wealth is an unlawful to another as his blood. But if the debtor earns on the amount, from which he was restrained by the creditor to invest if thereafter the debtor pays him ‘something additional’ by way of return, it should be quite lawful for the creditor to receive it. On the other hand, if the debtor is allowed to invest the creditor’s money and the former suffer loss, then the creditor cannot receive the profit, in this case there is element of uncertainty, whereas the ’additional amount’ from the debtor to the creditor is certain. Another reason for the illegality of interest is that people (creditors) would opt only for certain additional amount and would not indulge themselves in some business or occupation, which initials labor and hardship. This would give a set back to public utility, in so far as it is an accepted fact that wordy affairs cannot progress satisfactory without trade, arts and crafts.

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CHAPTER 4

MODERN BANKING SYSTEM
Modern banks perform more or less the same functions, which moneylenders performed before the banking era. It would be beneficial to explain the genesis of the money lenders who is now replaced by modern banks. 4.1 THE GENESIS OF THE MONEYLENDER: Years ago, it was natural for merchants and private individuals to deposit their gold with gold merchants for safe custody, possibly charging a fee for the service provided. The goldsmith in return giving a signed receipt for the gold deposited with him. These receipts began to pass from hand to hand in the settlement of debts, thus forming the original bank notes, since they had to be met upon presentation by the delivery of a specific amount of gold plate. Due to the acceptability of these goldsmith’s notes, the goldsmith found himself in virtual possession of a store of gold which was never claimed, and realized that he could lend this remainder at interest with perfect safety and there upon proceeded to do so, this practice was indeed, in itself unethical and is fraught with serious dangers for the community. Based on his experience, goldsmith would issue notes almost nine tenth of the deposited gold to the borrowers, who would use them to pay their account or debts, thereby also passing into circulation as money. Here again he found that he could not only lend more than nine tenths (lack of demand for redemption) of the gold originally deposited with him but also that he could issue his new personal notes to borrowers up to ten times the amount of his remainder and be quite certain that, in practice not all of this gold will be withdrawn at one and the same time. If therefore, he

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could always supply gold on demand for the proportion of notes continually presented for redemption, he could maintain the illusion that the whole of his note circulation, receipts and personal notes alike, was backed by gold. Let us suppose ten original depositors left with the goldsmith gold equal to one major unit of the currency thus now in circulation total ten units of currency. But by loaning nine unclaimed units of gold to ninety borrowers, ninety of the receipts (notes) are now in circulation and also function as ninety units of the currency thus creating ninety units of currency, which were not in existence, which he claims as his property on which he will charge some interest too. It should be remembered that initially goldsmith owned nothing, at the end of the same number of currency unit whereas the goldsmith now owns ninety units of currency plus interest charges. The whole of this extraordinary creation and appropriation of interest-bearing currency being based on other people’s money deposited with him for safe-custody. The modern banking system is largely based on principles and practices conducted and organized by the goldsmiths as mentioned above. Modern finance, which is carried on under the high-sound titles of High Finance and International Finance, is simply at vast elaboration and mystification based absolutely on the above-mentioned monstrous principles. Since the time of the goldsmiths, these money-lending principles have been extended to the exclusion of all other methods of creating money. Today the money lenders of the world are incorporated under a legalized system, known as the banking system, which is so organized nationally and internationally that 98% of the money is created as a debt in their favor. Under these circumstances, industry’s needs for more money to meet its continuous expansion is necessarily and simultaneously the modern financier’s opportunity to create an equivalent debt against the community. 14

Banking is nothing but money lending and borrowing at interest and Islam has very justly condemned such a system. 4.2 FEELING AGAINST MODERN PRIVATE BANKS: Banks are not without their cities even in western countries, a good deal of ill feeling prevails against modern private banking. As a matter of fact, general public even in western countries has always emphasized that banks should be nationalized. Banking is one of the very few spheres where in certain matters state interference is not only desirable but also essential. The messenger and believer laissez-faire doctrine, Adam Smith also opened that state must impose rules, regulations to restrain individuals, who might endanger security of the whole society as for the banking sector is concerned. Almost all of the economists justify interference by the state and the banking sector. Although today’s banks are involved in more activities and operation and not just lending and depositing that the very basic definition as per company ordinance 1962, highlights that bank’s primary function is to deposit money from the general public lend or advance the same to others and this is the main function of modern banking. That is the logic we have considered this aspect of banking business and have left the others. But note this point over here that all other activities of the banking business revolve around this pivotal function. If today’s modern banks fails to carry out this function they would be flat on the ground. This function is based on the principles of interest, which we have discussed in the early part of this report. 4.3 THE EFFECTS OF INTEREST ON SOCIETY: The ordinary effects of usury or interest and consumption loans on society are too well known to be mentioned here in any details. It is well

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known that such loans not only cripple the borrowers but also demoralize the lenders. Few important points are as under:  The borrowers pay much more than the principal amount, which is unethical and unjust.  Interest based loans degenerate the borrowers and create a very mercenary, greedy, selfish and unsympathetic outlook in the lenders.  It is established fact that the working population has very negligible banking credit facility and must satisfy the pressing needs for credit through various other channels.  In agricultural countries the exploitation of poor farmers by money lenders (usurers) is self-understood phenomenon.  4.4 It causes and develops socio-economics gaps in society. THE EFFECTS OF FIXED INTEREST BEARING LOANS ON BUSINESS: Narrating the phrase “heads I win, tails you lose” can state the effects of fixed interest.  Production loans in modern banking system are issued at fixed rates. The businesses in turn charges higher prices to pay back the loans with the interest charges. Even if they face losses they will have to pay these interest charges.  Capital providers are not essentially required to enter into agreement such that they’ll have to share the losses too. They are only thus to earn something (interest) even if the business encounter losses.  Money is nothing else but purchasing power but under the interest based system this acts as source of earning more money without

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undergoing any intermediate process, e.g., investment in productive activities.  In the events of loss shareholders are paid nothing but the moneylenders (individuals or institutions) are given their fixed, predetermined return, which is against the principles of justice and equity. 4.5 BANKS AND ISLAM: Modern world should know that Islam made a definite provision for a ‘Central National Finance House’ with its branches all over the country. This house was the Bait-ul-Mal, owned by the state and performing all those functions as performed by the modern central banks. Issuance of currency is the right of state, in Islam. All the present banks could continue their businesses with applying two main modifications:  They should not pay any interest to their depositors (Current Accounts as today). The interest that is paid on Fixed Accounts could be converted into dividends.  The bank should not charge any interest from their clients. Actually banks in Islam are not just financial intermediaries rather these are to act as social welfare institutions like Hospitals etc. It should be noted that adapting Islamic economic system the taxable capacity of nation definitely increases and enhance the power of the government to promote more and more welfare activities and operations. At the present banks provide loans at higher rates when there is boom in the economy and restrict extending loans when there are negative impacts on an economy, because banks are more interested in their own interest. The

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situation is eradicated when the banks become partners as Islam does proposed. This would earn more than enough profits for the bank not only to cover its expenses but to extend part of profits to the depositors.

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CHAPTER 5

PROPOSAL OF RIBA-FREE BANKING
5.1 MAIN FEATURES: The salient features of the proposed system are:   There is no interest on deposits, but capital is guaranteed. Lending and investing are treated differently; loans are interest-free but carry a service charge, while investing is on a profit-and-losssharing (Mudaraba) basis. Commercial banks will grant loans but they will not engage in investment-financing. Investment-financing will be done through investment banks and investment companies. Value erosion of capital due to inflation is compensated. With these features the proposed system simply avoids the many problems faced by Islamic banking as practiced today, including its inability to set up and operate interest-free banks in most countries of the world. The problem of inflation is not explicitly treated by any system of banking, but it is a general problem. The system can be considered as consisting of several independent modules. And, one or more could be implemented at a time, according to the requirements of a given situation. 5.2 ZERO INTEREST AND CAPITAL GUARANTEE: Muslims are prohibited by their religion to deal in interest (riba) in any way. Giving and receiving as well as witnessing are all prohibited. Thus an Islamic banking system cannot pay any interest to its depositors; neither can it demand or receive any interest from the borrowers. Nor could the banks witness or keep accounts of these transactions. But the lender is

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entitled to the return of his capital in full. This is a Quranic injunction. The proposed system compiles with these fundamental Islamic requirements. A basic tenet of commercial banking is capital guarantee. The capital entrusted to the bank by a depositor must be returned to him in full. The proposed system fully compiles with this requirement. Islamic banking as practiced today does not provide capital guarantee in all its deposit accounts. In many countries, this is one of the two main objections to permitting the establishment of Islamic banks. There is no objection to paying zero interest on deposits. Thus, by paying zero interest and guaranteeing capital, the proposed system satisfies both the riba-prohibition rule of Islam and the capital guarantee requirement of conventional banking acts. This enables it to obtain permission to set up and operate as a deposit bank in all countries of the world, while obeying the riba-prohibition rule and qualifying to be an Islamic bank. This is of paramount importance to Muslim minorities living in non-Muslim countries. Furthermore, the existence of interest-free banks in all countries will also remove the many difficulties faced today by Islamic banks in transacting international business. 5.3 LENDING AND INVESTING: In conventional banking, depositing is a form of investment for the savers where the capital remains intact while a known income (in form of interest) is promised. To the banks lending is a form of investment where the capital and a known return are assured; the return will also cover all their costs. Since Islam prohibits dealing in interest in any form this type of banking is not acceptable to the Muslims. In Islam, there is a clear difference between lending and investing __ lending can be done only on the basis of zero interest and capital guarantee,

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and investing only on the basis of Mudaraba (profit-and-loss-sharing). Conventional banking does not and need not make this differentiation. But an Islamic bank has to take this into consideration in devising a system to cater to the Muslims. Therefore such a system has to provide for two subsystems __ one to cater to those who would lend and another for those who wish to invest. In the proposed system, the depositors are considered as lenders to the bank and, since a Muslim lender cannot receive any interest, he lends without interest but with the assurance that his capital will be returned in full. This applies to demand (current account) deposits as well as to saving deposits. The bank, in turn, lends (the depositors funds) to the borrower who should return the capital in full plus the costs of the bank’s services and a remuneration (or profit) to the bank for providing these services. This suits some depositors and some borrowers. 5.4 PARTICIPATORY FINANCING: Participating Financing through Investment Banks and Commercial Banks, provides the mechanics of a financing scheme that would cater to the needs of those Muslim capital-holders who wish to earn an income using their capital without involving themselves in riba. The Islamic option for this group is the concept called Mudaraba, which is usually translated as profitand-loss-sharing but is in fact profit-sharing-and-loss-absorbing, and in this book it is named as participatory financing. The basic idea is that two parties, one with capital and the other with know-how, get together to carry out a project. If the project ends in profit they share the profit in a pre-arranged proportion; if it results in loss the entire loss is borne by the financier. There are many variations of this simple model but this is the basic concept.

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5.4.1 Financing by Lending: Traditionally, commercial banks performed two functions: money transfer services, including all current account operations, and money lending. The latter brought in the major part of the bank’s income while the former enabled it to create money and to lend more money than it actually possessed. The primary concerns of the bank were the security of its capital and the ability of the borrower to pay the interest ___ not at the end use of the lent money. Whether it was intended for establishing a new enterprise, to expand an existing one, to bridge a cash flow problem of a running concern, or to be used by a small business, by a sole-owner enterprise, or for consumption purposes, etc. was not the prime concerns of the bank. Neither did it matters whether or how the borrower kept his accounts. The borrower must pay back all the capital and the pre-fixed amount of interest, no matter how he achieved that. In case of Islamic banks, however, the end use mattered because the return on their “investment” (they do not lend) depended on how the profit/loss was achieved and how it was computed. The questions of true and proper bookkeeping by the borrowers (or entrepreneurs) and the auditing of these accounts, and that of determining the actual profit/loss directly attributable to the investment by the bank are still being debated. The inherent inability to resolve these questions is at the bottom of many of the problems faced by the Islamic banks. Devices adopted to overcome these problems have only led to uneasy questions of morality. In the proposed system, only the financing of new enterprises is recognized as amenable to Mudaraba-type financing. The fact that the intermediary becomes an equal partner in the new enterprise avoids the difficulties caused by the above questions. All other types of end uses must

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be financed by loans from commercial banks, which would recover their costs and profits from the borrowers. 5.5 INTEREST-FREE COMMERCIAL BANKING: As we saw earlier, commercial banks performed two functions: money transfer services (including all current account operations) and money lending. In general, the former does not involve any interest. On the other side of the balanced sheet, we have two types of deposits: current account (demand) deposits and saving deposits. Here too, the former generally does not involve any interest. Therefore, current account operations and money transfer operations are free of riba on both sides of the balance sheet. As such all commercial banks are interest-free banks with respect to these operations. The approach adopted is to “first take a closer look at modern banking practices and find out whether it could be eliminated from the existing practices and then to check if the resulting system was still viable”. On the deposit side, what the depositor receives in addition to his capital is the interest. This is riba (pure interest) by definition. If a Muslim refuses this interest because it is prohibited by his religion, then this side of the balance sheet is free of riba. On the other side of the balance sheet, we have the “interest” collected by the bank from the borrower. Ideally, the bank uses the funds it receives from depositors to grant loans to clients. But the “interest” it charges the borrowers is more than the interest it pays the depositors. This is because the former should also cover, besides the interest paid to the depositor, the costs the bank incurs in collecting and disbursing the funds as well as accounting, administration, safekeeping, etc.

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5.5.1 Loan Default Insurance: The risk premium is one of the six components of the cost of borrowing. In conventional banking, the risk premium against default and delays is included in the interest and the bank bears the risk. The interest rate increases as the probability of risk increases; high-risk advances (such as unsecured loans) bearing a higher interest rate than low-risk ones. Every borrower in any bank (in the scheme) is a member of this scheme for the duration of his loan. The premium depends on the amount of loan, and not on the repayment period. The premiums paid by the members go into a collective fund. Any loss suffered by a member-bank due to bad loans is made good from his fund. On complete repayment of a loan the borrower will be paid part of his premium, after allowing for the administrative costs of the scheme and reimbursements to the banks (which depends on the number and size of defaults) during the period of his membership in the scheme, and proportionate to his contribution to the fund. 5.6 PARTICIPATORY FINANCING THROUGH COMMERCIAL BANKS: Commercial banks enjoy a privilege that investment banks and investment companies do not. They are able to create money which privilege they acquire through their current account operations. The process, called credit creation, is explained in the second book in an appendix. Briefly, it means that commercial banks can lend more money than they actually have in their custody. How much more depends on the particular circumstances of the concerned bank, but it can be anywhere from five to nine times. This is also called financing with bank money. A methodology has been developed, where this ability is combined with the concepts of investment accounts (introduced by Islamic banks) and the Mudaraba participation, to produce

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participatory financing through commercial banks. This will enable commercial banks to participate-finance many more projects than investment banks or investment companies could do with the same amount of money. But this is new concept traditional banks are not equipped for. Bankers who wish to engage in this activity will have to have entrepreneurial talents and they have to acquire the necessary skills and cultivate suitable attitudes. Such (unattractive) enterprises are socially and economically the most necessary ones, especially at the micro level; ones that bring direct benefit to people at the periphery __ in the villages, in the small towns, and in the slums of large cities. This is an instrument that can be used to commercially finance social and economic development where it is most needed and will be most appreciated __ at the grass roots level. However, introducing participatory financing into commercial banking is asking it to shoulder extra burdens, including specialized staff training and additional risks. Conventional commercial banks are prohibited from directly investing in commercial enterprises, and hence they will not be able to offer participatory financing. In countries where Islamic banks are prepared to take on extra burdens, which of course, will bring them extra profits. They may consider setting up investment companies as fully owned subsidiaries of local branches. 5.7 GOVERNMENT BONDS: Government issue bonds to obtain long-term loans from the public. The face value of the bond is guaranteed on maturity, and since the bonds are bought on issue at less than the face value, there is a return on them because they can be bought and sold easily; these are good liquid assets, especially for the banks. However, there is a problem when the economy is interest-

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free. The return is interest, and if one wished to avoid interest then he should buy the bond today at its face. But the face value realized on maturity would have lost part of its purchasing power due to inflation! Some have suggested that these bonds be issued on a profit-and-loss-sharing basis. But then such funds are invested by governments in non-profit projects (such as infrastructure, schools and hospitals) or in long-term projects (such as power or irrigation). The dilemma and the debate continue. It is suggested that the bonds be denominated in terms of gold-units. Then there will be no riba, for what is given and what is returned will be the same, in kind and amount; and the lender will not suffer the inroads made by inflation. There is an interesting aside to the suggestion: “… many Muslim individuals and institutions will buy government bonds without any qualms about being involved in riba. The government too stands to gain, because they will now be paying less for the funds than before. But the other side of the coin is that the money now comes in with a moral string attached __ with a patriotic or fi-sabilillah (for-God) motive __ unlike in the conventional case where the motive is private gain __ guaranteed positive return on capital. This puts the government under a moral pressure to use the funds properly and for good causes”. 5.8 MODULAR IMPLEMENTATION: The system proposed above can be considered as consisting of a number of modules. Each module is practically independent of the other. Therefore, one can tailor a system, consisting of one or more modules, depending on the specific circumstances of what is required, where it is required and who wants to implement it. The implementation can also be staggered over time. A few examples are considered in the next paragraphs. The major modules are:

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   

The full commercial bank module The participatory financing module The compensation for inflation module The government bonds module Within the first module there is a savings and loans sub-module, and

within the second there are several options ranging from pure two-person Mudaraba and small investment companies to large investment banks. Except the last module others do not need explicit changes in the laws of the country or of the banking business. Modules 1 and 2 can be implemented under existing banking and business laws. Module 3 will need new laws and Central Bank co-operation for strictly legal enforcement. However, it is possible to implement it by mutual agreement between the bank and its clients. Module 4 needs government action. Countries like Pakistan, Iran and the Sudan (where interest is prohibited by law and where inflation is also high) will have to implement all four modules to fully benefit from the proposed system. But the implementation can be done in stages, module by module. Modules 3 and 4 concern inflation. And inflation is no respecter of religious convictions or prohibitions __ it affects all capital equally. As such these modules are of general acceptability. Therefore they can be implemented, independently of other modules, by any country afflicted with inflation. That includes practically all developing countries. Module 2 is a responsible form of financing. It is not the sole property of Muslims. Therefore it cannot be implemented (in any form of its several options) by any group of people concerned with where their money is invested and how their income is earned.

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CHAPTER 6

ISLAMIC MODES OF DEPOSIT AND FINANCE
The word “Modes” literally means methods, or in other words, it refers to systematic and detailed rules, stipulations and steps to be followed for accomplishing a specific thing. The thing that needs to be accomplished in this context is, however, the subject matter of each of the said modes, i.e. any of the different types of deposits and investment activities by using Shariah expressions i.e. Al-Wadiah current deposit, Mudaraba saving and term deposit, Murabaha, Mudaraba, Musharaka, Ijarah, Istisna etc. 6.1 DEPOSIT MECHANISM: It has been observed that the common practices of Islamic banks, in the sources of funds are as follows: 6.1.1 Al-Wadiah current deposit: All Islamic banks operate Al-Wadiah current accounts commonly known as call deposits or demand deposits. The bank guarantees the full return of the deposits and the depositors are not paid any share of the profit or any other return in any form. Al-Wadiah demand deposits are treated as Amanh (where deposits are handed over by the depositors to the bank as a trust and the bank does not have the authority to use them without obtaining the specific permission of the owner of the funds), or as Qard Hasana (money deposited in these accounts is interest free loan from the a depositor to the bank and the bank is free to utilize these funds at its own risk without any return to the depositors and without needing any authorization).

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6.1.2 Mudaraba Saving Deposit: The bank accepts deposits in a current account on the principle of AlWadiah requesting depositors to give permission to the bank to use these funds at its own risk, but guarantees full return of deposits and shares profit voluntarily. The bank accepts saving deposits with an authorization to invest and share profits in an agreed manner for the period in which a required balance is maintained. The bank accepts saving deposits as part of an investment pool and treats them as investment deposits. 6.1.3 Mudaraba Term Deposit: They are called profit-loss-sharing (PLS) accounts or Participatory Accounts. Individuals or companies can open Mudaraba Term Deposit accounts either in domestic or foreign currency, provided that the bank is allowed to operate in foreign exchange. Deposit holders do not receive any interest. Instead, they participate in the share of the profit or loss of the bank. The return on Mudaraba Term Deposit accounts is determined according to the actual profits earned from the investment operations of the bank and share of the profit in an agreed proportion by depositors according to the amount of their deposits and the period they are held by the bank. Generally speaking, depositors do not have the right to withdraw from these accounts as is customary in time deposits in traditional banks. However, withdrawals can be made under special circumstances if the depositor forfeited his share of the profit for the amount withdrawn. Usually, banks insist on a specified minimum amount to open and maintain this account. Most banks issue an investment certificate to depositors starting the terms and conditions of the deposit.

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6.2

FINANCE MECHANISM: There are seven Islamic financing modes practiced by the most of the

Islamic banks of the world. These are: 6.2.1 Bai-Murahaba: The client approaches the Islamic bank with the request to finance his specific requirement like purchase of capital goods, raw materials, machinery equipment or consumer durable with specification and price information. The bank, after being convinced of the viability of the proposal, informs the client about the margin of profit, which the bank would like to make on the original price. The final price of the commodity, which includes the price of the commodity paid by the bank to the original seller and the bank’s profit with other incidental costs, is deferred to a payment on an installment basis. The sale item is in the possession of the bank before sale to the client. In respect of dealing parties, Bai-Murabaha may be of two types:  Ordinary Bai-Murabaha: It is a direct transaction between a buyer and a seller. Here, the seller is an ordinary trader who purchases goods from the market in the hope of selling these goods to another party for a profit. In this case, the seller undertakes the entire risk of his capital investment in the goods purchased.  Bai-Murabaha Order on and Promise: It involves three parties __ the buyer, the seller and the bank. Under this agreement, the bank acts as an intermediary trader between the buyer and the seller. In other words, upon receipt of an order and arrangement to purchase a certain product from the buyer, the bank will purchase the product from the seller to fulfill the order.

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6.2.2 Musharaka (Partnership): Meaning: The word “Musharaka” is derived from the Arabic word Sharikah meaning partnership. Islamic jurists point out that the legality and permissibility of Musharaka is based on the injunctions of the Quran Sunnah, and ijma (consensus) of the scholars. It may be noted that Islamic banks are inclined to the various forms of shariakt-al-inan because of its built-in flexibility. At an Islamic bank, a typical Musharaka transaction may be conducted in the following manner. One, two or more entrepreneurs approach on Islamic bank to request the financing required for a project. The bank along with other partners provides the necessary capital for the project. All partners, including the bank, have the right to participate in the project. They can also waive this right. The profits are to be distributed according to an agreed ratio, which need not to be the same as the capital proportion. However, losses are shared in exactly the same proportion in which the different partners have provided the finance for the project. Types: Musharaka may take two forms: a. Permanent Musharaka: In this case, the bank participates in the equity of a company and receives an annual share of the profits on a pre-rate basis. The period of termination of the contract is not specified. This financing technique is also referred to a continued Musharaka.

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The contributions of the partners under this mode may be equal or unequal percentages of capital for the purpose of establishing a new incomegenerating project or to participate in an existing one. In this arrangement, each participant owns a permanent share in the capital structure and receives his share of profits accordingly. This type of partnership is intended to continue until the company is dissolved. However, one can exit the partnership by selling his share of the capital to another investor. Permanent Musharaka is used by Islamic banks in many incomegenerating projects. They can provide financing to their customers, in exchange for ownership and profit sharing in the proportion agreed upon by both parties. In addition, the bank may leave the responsibility of management to the customer-partner and retain the right of supervision and follow up. The three steps to establishing Permanent Musharaka are discussed below:  One-partnership in capital: The bank tenders part of the capital required in its capacity as a partner and authorizes the customer/partner to manage the project. The partner tenders part of the capital required for the project and is entrusted with what he holds from the bank funds.  Two-Results of the Projects: The intent of the project is growth. However, the project may be profitable or it may loss money.  Three-The Distribution of wealth accrued from the Project: In the event a loss is incurred, each partner bears part of the loss proportionate to his share in capital. In the event the venture is profitable, earnings are divided between the two parties (the bank and the partner) in accordance with the agreement. 32

b.

Diminishing Musharaka: Diminishing or Digressive Musharaka is a special form of Musharaka,

which ultimately culminates in the ownership of the asset or the project by the client. It operates in the following manner. The bank participates as a financial partner, in full or in part, in a project with a given income forecast. An agreement is signed by the partner and the bank, which stipulates each party’s share of the profits. However, the agreement also provides payment of a portion of the net income of the project as repayment of the principal financed by the bank. The partner is entitled to keep the rest. In this way, the bank’s share of the equity is progressively reduced and the partner eventually becomes the full owner. When the bank enters into a Diminishing Musharaka its intention is not to stay in the partnership until the company is dissolved. In this type of partnership, the bank agrees to accept payment on an installment basis or ion lump sum, an amount necessary to buy the bank’s partnership interest. In this way, as the bank receives payments over and above its share in partnership profits, its partnership interest reduces until it is completely bought out of the partnership. After the discharge, the bank withdraws it claims from the firm and it becomes the property of the partner. The decreasing partnership arrangement is an Islamic bank innovation. It differs from the permanent partnership only in continuity. It appears that there are four steps of the diminishing partnership. 6.2.3 Mudaraba: The term Mudaraba refers to a contract between two parties in which one party supplies capital to the other party for the purpose of engaging in a business activity with the understanding that any profits will be shared in a 33

mutually agreed upon. Losses, on the other hand, are the sole responsibility of the provider of the capital. Mudaraba is also known as Qirad and Muqarada. Mudaraba is a contract of those who have capital with those who have expertise, where the first party provides capital and the other party provides the expertise with the purpose of earning Halal (lawful) profit which will be shared in a mutually agreed upon proportion. This type of business venture serves the interest of the capital owner and the Modarib (agent). The capital owner may not have the ability or the experience to run a profitable business. On the other hand, the agent (the Modarib) may not have adequate capital to invest in a business or project. Therefore, by entering into a contract of Mudaraba each party compliments one another, allowing a business venture to be financed. 6.2.4 Bai-Salam: Bai-Salam is a term used to define a sale in which the buyer makes advance payment, but the delivery is delayed until some time in the future. Usually the seller is an individual or business and the buyer is the bank. The Bai-Salam sales serve the interests of both parties (Ibid). The seller receives advance payment in exchange for the obligation to deliver the commodity at some later date. He benefits from the Salam sale by locking in a price for his commodity, thereby allowing him to cover his financial needs whether they are personal expenses, family expenses or business expenses. The purchaser benefits because he receives delivery of the commodity when it is needed to fulfill some other agreement, without incurring storage costs. Second, a BaiSalam sale is usually less expensive than a cash sale. Finally a Bai-Salam agreement allows the purchase to lock in a price, thus protecting him from price fluctuation.

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6.2.5 Istisna Sale: The Istisna sale is a contract in which the price is paid in advance at the time of the contract and the object of sale is manufactured and delivered later. The majority of the jurists consider Istisna as one of the divisions of Salam. But the Hanafie School of jurisprudence classifies Istisna as an independent and distinct contract. The jurists of the Hanafie School have given various definitions to Istisna some of which are: “That it is a contract on a commodity on liability with the provision of work”. The purchaser is called ‘Mustasnia’ contractor and the seller is called ‘Sania’ maker or manufacturer and the thing is called ‘Masnooa’, manufactured, built made. Islamic banks can utilize Istisna in two ways.  It is permissible for the bank to buy a commodity on Istisna contract then sell it after receipt for cash or deferred payment.  It is also permissible for the bank to enter into Istisna contract in the capacity of seller to those who demand a purchase of a particular commodity and then draw a parallel Istisna contract in the capacity of a buyer with another party to manufacture the commodity agreed upon in the first contract. Each transaction is deemed a separate contract with payment being made in cash either immediately or on a deferred basis. Any disagreements that may arise are settled under each contract separately according to the provisions therein. 6.2.6 Qard Hasana: Qard Hasana is a contract in which one of the parties (the lender) places into the ownership of the other party (the borrower) a definite parcel of his property, in exchange nothing more than the eventual return of something in the same value of the property loaned. 35

Since interest on all kinds of loans is prohibited in Islam, a loan that is to be given in accordance with the Islamic principle has to be, by definition, a benevolent loan (Qard Hasana) i.e. a loan without interest. It has to be granted on the grounds of compassion, i.e. to remove the financial distress caused by the absence of sufficient money in the face of dire need. Since banks are profit driven organizations, it would seem that there is not much opportunity for the useful role. Hence, they make provisions to provide Qard Hasana besides engaging in income generating activities. There may be slight variations among different Islamic banks in the use of this technique. The Faisal Islamic Bank of Egypt provides interest-free benevolent loans to the holders of the investment and current accounts, in accordance with the conditions set forth by its board of directors. The bank also grants benevolent loans to other individuals under conditions decreed by its Board. On the other hand, the Jordan Islamic Bank Law authorizes it to give “benevolent loans (Qard Hasana) for productive purposes in various fields to enable the beneficiaries to start independent lives or to raise their incomes and standard of living. Iranian banks are required to set aside a portion of their resources out of which interest free loans (Qard Hasana) can be given to small producers, entrepreneurs and farmers who are not able to secure financing for investment or working capital from other alternative sources, and needy customers. It should also be noted that Iranian banks are permitted to charge a minimum service fee to cover the cost of administering these funds. Finally in Pakistan, Qard Hasana is part of the bank’s normal financing activities. Qard Hasana loans are granted compassionate basis and no service charges are imposed on the borrower. While these loans are considered loans of compassion, they are expected to be repaid when it is possible for the borrower to do so. Furthermore in Pakistan, Qard Hasana

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operations are concentrated in the head office of each bank. Branch offices are not permitted to extend these loans. 6.2.7 Bai-Muajjal (Deferred Sale): The term “Bai” and “Muajjal” are derived from the Arabic words ‘Bai’ and ‘Ajal’. The word ‘Bai’ means purchase and sale and the word ‘Ajal’ means a fixed time or a fixed period. “Bai-Muajjal” is a sale for which payment is made at a future fixed date or within a fixed period. In short, it is a sale on credit. The Bai-Muajjal may be defined as a contract between a buyer and a seller under which the seller sells certain specific goods, permissible under Shariah and law of the country, to the buyer at an agreed fixed price payable at a certain fixed future date in lump sum or in fixed installments. Important Features of Bai-Muajjal:   There are some important features of Bai-Muajjal as given below: It is permissible and in most cases, the client will approach the bank with an offer to purchase a specific good through a Bai-Muajjal agreement.  ii. It is permissible to make the promise binding upon the client to purchase the goods from the bank. In other words, the client is required to either satisfy the promise or to indemnify to bank for damages caused by breaking the promise without excuse.  iii. It is permissible to take cash/collateral security to guarantee the implementation of the promise or to indemnify the bank for damages caused by non-payment.  It is also permissible to document the debt resulting from Bai-Muajjal by a guarantor, or a mortgage or both, like any other debt. 37

Mortgage/Guarantee/Cash security may be obtained prior to the signing of the Agreement or at the time of signing the Agreement.  Stock and availability of goods is a basic condition for signing a BaiMuajjal Agreement. Therefore, the bank must purchase the goods in accordance with the specifications of the client, prior to signing the Bai-Muajjal Agreement with the client.  All goods purchased on behalf of a Bai-Muajjal agreement are the responsibility of the bank until they are delivered to the client.  The bank must deliver the goods to the client at the time and place specified in the contract.  The bank may sell the goods to the client at a higher price than the purchase price to earn.   The price is fixed at the time of the agreement and cannot be altered. The bank is not required to disclose the profit made on the transactions. 6.2.8 Ijarah: Fuqaha (jurists) have defined Ijarah as ownership of a benefit for consideration. This is also known as lease or Hire contract. Al-Ijarah is an Arabic term which is derived from “Ujr” or “Ujrat” which means ‘consideration’ or ‘return’ or ‘wages’. According to the Islamic Shariah (jurisprudence), Ijarah is a contract between two parties’ __ the lessor and the lessee, where the lessees (Hirer or Mustajir) have the right to enjoy/reap a specific benefit against a specified consideration/rent/wages from the lessor __ the owner (Muajjir).

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Elements of Ijarah: According to the majority of Fuqaha, there are three general and six detailed elements of Ijarah:   The wording: This includes offer and acceptance. Contracting parties: This includes a lessor, the owner of the property, and a lessee, the party that benefits from the use of the property.   Subject matter of the contract: This includes the rent and the benefit. The lessor (Mujjir) _ The individual or organization who leases out/rents out the property or service is called the lessor.  The lessee (Mustajir) _ The individual or organization who hires/takes the lease of the property or service against the consideration rent/wages/remuneration is called the lessee (Mustajir).  The benefit (Maajur) _ The benefit that is leased/rented out is called the benefit (Maajur).  The rent (Ajr or Ujrat) _ The consideration either in monetary terms or in quantity of goods fixed to be paid against the benefit of the goods or service is called the rent or Ujrat or Ajr. 6.2.8 Hire-Purchase under Shirkatul Melk or Ijarah Muntahib Bil Tamlek: Hire-Purchase under Shirkatul Melk has been developed through practice. Actually, it is synthesis of three contracts:  Shirkatul Melk: ‘Shirkat’ means partnership. Shirkatul Melk means share in ownership. When two or more persons supply equity, purchase an asset and own the same jointly and share the benefit as

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per agreement and loss in proportion to their respective equity, the contract is called Shirkatul Melk. In this case of Hire-Purchase under Shirkatul Melk, Islamic banks purchase assets to be leased out, jointly with client under equity participation, own the same and share benefit jointly till the full ownership is transferred to the client.  Ijarah: The term ‘Ijarah’ has been defined as a contract between two parties, the lessor and the lessee, where the lessee enjoys or reaps a specific service or benefit against a specified consideration or rent from the asset owned by the lessor. It is a lease agreement under which a certain asset is leased out by the lessor or to a lessee against specific rent or rental for a fixed period.  Sale contract: This is a contract between a buyer and a seller under which the ownership of certain goods or assets is transferred by the seller to the buyer against agreed upon price paid by the buyer. In this case of Hire-Purchase under Shirkatul Melk, the lessor bank sells or transfers its title to the assets under a sale contract on payment of sale price. Thus in Hire Purchase under Shirkatul Melk mode, both the bank and the client supply equity in equal or unequal proportion for purchase of an asset like land, building, machinery, transports, etc., purchase the asset with that money, own the same jointly, share benefit as per agreement and bear the loss in proportion to their respective equity. The share/part or portion of the asset owned by the bank is leased out to the client partner of a fixed rent per unit of time for a fixed period. Lastly, the bank sells and transfers the ownership of its share/part/portion to the client against payment of price fixed for that part either gradually part by part or as a whole within the lease period or on expiry of the lease agreement. Hire-Purchase under Shirkatul Melk contract is to a great extent similar to the contract of

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Ijarah Montahib Bil Tamlek as termed by Accounting and Auditing Standards Board of the Account and Auditing Organization of Islamic Financial Institutions (AAOIFI). Stages: Hire Purchase under Shirkatul Melk Agreement has got three stages:    6.3 Purchase of asset under joint ownership of the lessor and the lessee. Hire, and Sale and transfer of ownership by the lessor to the partner-lessee. SOME ISLAMIC FINANCIAL INSTRUMENTS: An Islamic financial instrument can be defined as “an instrument representing a share in a joint capital collected for investment with the aim of realizing profit, issued by the investing party in his capacity as Modarib (agent manager) or by a third party on his behalf; such certificate is negotiable and capable of being turned into liquid money”. Participation Term Certificates (PTCs): In Pakistan, Participation Term Certificates (PTCs) have replaced debentures. PTCs are transferable cooperate instruments based on the principle of profit and loss sharing to replace debentures for providing medium and long term funds for industrial and other financing. Instead of receiving interest, as in the case of debentures, the holders of PTCs share in the profit or loss of companies raising finance through this device. Mudaraba Certificates: Mudaraba Certificates are being used by Islamic Investment Companies to mobilize funds for investment in a variety of ways. Mudaraba Certificates are usually of two types: Specific purpose Mudaraba Certificates

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and General Purpose Mudaraba Certificates. Specific purposes Mudaraba Certificates are related to financing of specific projects and mature only on the completion of the project. General purpose Mudaraba Certificates can have a specific or an indefinite duration. Both types of certificates can be issued in negotiable form, either registered or bearer. Mudaraba Certificates can be distributed in an underwriting or sales effort of a fixed term, or to continuously available or be available on a periodic basis.

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CHAPTER 7

APPLICATIONS OF ISLAMIC INVESTMENTS
7.1 PROJECT FINANCING: The concept of Musharaka and Mudaraba is based on some basic principles. As long as these principles are fully complied with, the details of their application may vary from time to time. Keeping in view these basic principles project financing is discussed below. In the case of project financing, the traditional method of Musharaka or Mudaraba can be easily adopted. If the financier wants to finance the whole project, the form of Mudaraba can come into operation. If investment comes from both sides, the form of Musharaka can be adopted. In this case, if the management is the sole responsibility of one party, while the investment comes from both, a combination of Musharaka and Mudaraba can be brought into play. Since Musharaka or Mudaraba would have been affected from the very inception of the project, no problem with regard to the valuation of capital should arise. Similarly, the distribution of profits according to the normal accounting standards should not be difficult. However, if the financier wants to withdraw from the Musharaka, while the other party wants to continue the business; the latter can purchase the share of the former at an agreed price. In this way the financier may get back the amount he has invested along with a profit, if the business has earned a profit. On the other hand, the businessman can continue with his project, either on his own or by selling the first financier's share to some other person who can substitute the financier. If the sale of the share on one time basis is not feasible for the lack of liquidity in the project, the share of the financier

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can be divided into smaller units and each unit can be sold after a suitable interval. Whenever a unit is sold, the share of the financier in the project is reduced to that extent, and when all the units are sold, the financier totally comes out of the project. 7.2 WORKING CAPITAL FINANCING: Where finances are required for the working capital of a running business, the instrument of Musharaka may be used in the following manner: The capital of the running business may be evaluated with mutual consent: The value of the business can be treated as the investment of the person who seeks finance, while the amount given by the financier can be treated as his share of investment. The Musharaka may be affected for a particular period, like one year or six months or less. Both the parties agree on a certain percentage of the profit to be given to the financier, which should not exceed the percentage of his investment, because he shall not work for the business. On the expiry of the term, all liquid and non-liquid assets of the business are again evaluated, and the profit may be distributed on the basis of this evaluation. Although, according to the traditional concept, the profit cannot be determined unless all the assets of the business are liquidated, yet the valuation of the assets can be treated as "constructive liquidation" with mutual consent of the parties, because there is no specific prohibition in Shariah against it. It can also mean that the working partner has purchased the share of the financier in the assets of the business, and the price of his share has been determined on the basis of valuation, keeping in view the ratio of profit allocated for him according to the terms of Musharaka. Sharing in the gross profit only: Financing on the basis of Musharaka according to the above procedure may be difficult in a business having a

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large number of fixed assets, particularly in a running industry, because the valuation of all its assets and their depreciation or appreciation may create accounting problems giving rise to disputes. In such cases, Musharaka may be applied in another way. The major difficulties in these cases arise in the calculation of indirect expenses, like depreciation of the machinery, salaries of the staff etc. In order to solve this problem, the parties may agree on the principle that, instead of net profit, the gross profit will be distributed between the parties, that is, the indirect expenses shall not be deducted from the distributable profit. It will mean that all the indirect expenses shall be borne by the industrialist voluntarily, and only direct expenses (like those of raw material, direct labor, electricity etc.) shall be borne by the Musharaka. But since the industrialist is offering his machinery, building and staff to the Musharaka voluntarily, the percentage of his profit may be increased to compensate him to some extent. This arrangement may be justified on the ground that the clients of financial institutions do not restrict themselves to the operations for which they seek finance from the financial institutions. Their machinery and staff etc. is, therefore, engaged in some other business also which may not be subject to Musharaka, and in such a case the whole cost of these expenses cannot be imposed on the Musharaka. Running Musharaka Account on the Basis of Daily Products: Many financial institutions finance the working capital of an enterprise by opening a running account for them from where the clients draw different amounts at different intervals, but at the same time, they keep returning their surplus amounts. Thus the process of debit and credit goes on up to the date of maturity, and the interest is calculated on the basis of daily products. Keeping in view the basic principles of Musharaka the following procedure may be suggested for this purpose: 45

A certain percentage of the actual profit must be allocated for the management.

The remaining percentage of the profit must be allocated for the investors.

The loss, if any, should be borne by the investors only in exact proportion of their respective investments.

The average balance of the contributions made to the Musharaka account calculated on the basis of daily products shall be treated as the share capital of the financier.

The profit accruing at the end of the term shall be calculated on daily product basis, and shall be distributed accordingly. If such an arrangement is agreed upon between the parties, it does not

seem to violate any basic principle of the Musharaka. However, this suggestion needs further consideration and research by the experts of Islamic jurisprudence. Practically, it means that the parties have agreed to the principle that the profit accrued to the Musharaka portfolio at the end of the term will be divided on the capital utilized per day, which will lead to the average of the profit earned by each rupee per day. The amount of this average profit per rupee per day will be multiplied by the number of the days each investor has put his money into the business, which will determine his profit entitlement on daily product basis. 7.3 IMPORT FINANCING: Musharaka can be used for Import Financing as well. There are two types of bank charges on the letter of credit provided to the importer: 1. 2. Service charges for opening an LC Interest charged on LCs, which are not opened on full margin. 46

Collecting service charges for this purpose is allowed, but as interest cannot be charged in any case, experts have proposed two methods for financing LCs: 1. 2. Based on Musharaka / Mudaraba Based on Murabaha

Musharaka /Mudaraba: This is the best substitute for opening the LC. The bank and the importer can make an agreement of Mudaraba or Musharaka before opening the LC. If the LC is being opened at zero margins then an agreement of Mudaraba can be made, in which the bank will become Rqb-ul-Maal and the importer Modarib. The bank will own the goods that are being imported and the profit will be distributed according to the agreement. If the LC is being opened with a margin then a Musharaka agreement can be made. The bank will pay the remaining amount and the goods that are being imported will be owned by both of them according to their share of investment. The bank and the importer, with their mutual consent can also include a condition in the agreement, whereby; Musharaka or Mudaraba will end after a certain time period even if the goods are not sold. In such a case, the importer will purchase the bank's share at the market price. Murabaha: At present Islamic banks are using Murabaha, to finance LC. These banks themselves import the required goods and then sell these goods to the importer on Murabaha agreement. Murabaha financing requires the bank and the importer to sign at least two agreements separately; one for the purchase of the goods, and the other 47

for appointing the importer as the agent of the bank (agency agreement). Once these two agreements are signed, the importer can negotiate and finalize all terms and conditions with the exporter on behalf of the bank. 7.4 EXPORT FINANCING: A bank plays two very important roles in Exports. It acts as a negotiating bank and charges a fee for this purpose, which is allowed in Shariah. Secondly it provides export-financing facility to the exporters and charge interest on this service. These services are of two types: 1. Pre shipment financing Pre Shipment Financing: Pre shipment financing needs can be fulfilled by two methods 1. 2. Musharaka / Mudaraba Murabaha

Musharaka / Mudaraba: The most appropriate method for financing exports is Musharaka or Mudaraba. Bank and exporter can make an agreement of Mudaraba provided that the exporter is not investing; other wise Musharaka agreement can be made. Agreement in such case will be easy, as cost and expected profit is known. The exporter will manufacture or purchase goods and the profit obtained by exporting it will be distributed between them according to the predefined ratio. A problem that can be encountered by the bank is that if the exporter is not able to deliver the goods according to the terms and conditions of the importer, then the importer can refuse to accept the goods, and in this case

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exporter's bank will ultimately suffer. This problem can be rectified by including a condition in Mudaraba or Musharaka agreement that, if exporter violates the terms and conditions of import agreement then the Bank will not be responsible for any loss which arises due to this negligence. This condition is allowed in Shariah as the Rabb-ul-mal is not responsible for any loss that arises due to the negligence of Modarib. Murabaha: Murabaha is being used in many Islamic Banks for export financing. Banks purchases goods that are to be exported at price that is less than the price agreed between the exporter and the importer. It then exports goods at the original price and thus earns profit. Murabaha financing requires bank and exporter to sign at least two agreements separately, one for the purchase of goods and the other for appointing the exporter as the agent of the bank (that is agency agreement). Once these two agreements are signed, the exporter can negotiate and finalize all the terms and conditions with the importer on behalf of the bank. 2. Post Shipment Financing: Post shipment finance is similar to the discounting of the bill of exchange. Its alternate Shariah compliant procedure is discussed below: The exporter with the bill of exchange can appoint the bank as his agent to collect receivable on his behalf. The bank can charge a fee for this service and can provide interest free loan to the exporter, which is equal to the amount of the bill, and the exporter will give his consent to the bank that it can keep the amount received from the bill as a payment of the loan. Here two processes are separated, and thus two agreements will be made. One will authorize the bank to collect the loan on his behalf as an agent, for which he will charge a particular fee. The second agreement will 49

provide interest free loan to the exporter, and authorize the bank for keeping the amount received through bill as a payment for loan. These agreements are correct and allowed according to Shariah because collecting fee for service and giving interest free loan is permissible

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CHAPTER 8

IDEOLOGY OF PAKISTAN
Before August 14, 1947 there was no Pakistan if it was, it was in minds and hearts of thousands of Muslims of the sub-continent. British power was the only lord of this piece of land, who defeated Muslims and established their own ‘Raj’. When struggle against this suppression started and reached to its peak. Muslims leaders like Allama Muhammad Iqbal, Muhammad Ali Jinnah and their companions realized the importance of a separate homeland for Muslims where Muslims of this region would be free to act upon the teachings of Islam, and evolve their own Islamic system for the element of their lives and prosperity of their homeland. The slogan “Pakistan ka matlab kya ………” attracted all the Muslim and united them under the auspicious leadership of Quaid-e-Azam. This slogan was nothing but a clear-cut message to the followers of Islam that they will have a piece of land where Islamic laws and principles would be practiced. It was a promise of forming up a true modern Islamic state, a model for the rest of Muslim Ummah to follow. It will be worth noticing to know the father of the nation’s stance upon the practicing and introduction of Islamic Economic System in the motherland. 8.1 QUAID-E-AZAM IN ISLAMIC ECONOMIC SYSTEM: The founder of Pakistan had made it clear on more than one occasion that one of the important purposes of the establishment of Pakistan was enforcement of the Islamic Economic system. At the opening ceremony of State Bank of Pakistan on 1st July 1948, he showed his keen interest in this respect and said;

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“I shall watch with the keenness the work of your research organization in evolving banking practices compatible with Islamic ideals of social and economic life. The economic system of the west has created almost insolvable problems for humanity and to many of us it appears that only a miracle can save it from disaster that is now facing the world. It has failed to do justice between men and to eradicate frictions from the international field. The adoption of the western economic theory and practice will not help us in achieving our goal of erecting a happy and contended people we must work out our destiny in our own way and present to the world an economic system based on the Islamic concept of equality of manhood and social justice”. Quaid-e-Azam also believed in the nationalization of some key industries. In an interview to a representative of the associated press of America on 8th November 1945, he said; “I believe that in these modern days, essential key industries enough to be controlled and managed by the state. That also applies to certain public utilities. But what is a key industry and what is a utility service, are matters for the law makers to say, not for me”. On another occasion the founder of Pakistan at Chittagong on March 23, 1948, he said; “You are only voicing my sentiments and the sentiments of millions of Muslims when you say that Pakistan should be based on sure foundations of social justice and Islamic socialization which emphasize equality and brotherhood of man”. The term Islamic socialism used by Quaid was nothing else than an explanation of the Economic system of Islam in the modern terminology.

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This term was actually coined by Syed Jamal-ud-Din Afghani to give an idea of the Islamic Economic System to the western scholars. Concluding this discussion we can see that Quaid-e-Azam considered all the economic system of the west unfit for a modern Islamic state and wanted to evolve a new system based on the teachings of Islam. It was unfortunate that soon after the establishment of Pakistan, Quaid-e-Azam parted us, and nobody after his death cared to enforce the Islamic system of economy cherished by him and desired by whole of the nation. The reason being that its enforcement would have eliminated the absentee landlords and capitalists from the Pakistani society. While after independence this class wielded political power in the country and hindered the enforcements of the economic system of Islam. 8.2 CONSTITUTION OF PAKISTAN (1973): Present constitution i.e. of 1973 is also providing a strong base to introduce an interest free economic system to be fully compatible with the principles of Islam, even though it cannot be termed as fully Islamic. Relevant contents of the constitution are mentioned below: According to Article-2 of the constitution Islam shall be the state religion. This article simply suggests that the laws, rules, norms, practices, customs and culture every aspect of life should be compatible with the teaching of Islam. While Article-38 (a) states, “the state shall secure the well-being of the people, irrespective of sex, caste, creed or race, by raising this standard of living, by preventing the concentration of wealth and means of production and distribution in the hands of few to the detriment of general interest and by ensuring equitable adjustment of rights between employers and employees and land-lords and tenants”.

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Note the phrase, “the preventing of the concentration of wealth and means of production and distribution in the hands of few”. Interest is declared to be the main cause of concentration of wealth. Article-38 (f) directly deals with the elimination of Riba from any sort of business and trade transactions. This sub-article state, “Elimination of Riba as early as possible”. This constitution of 1973 is an agreed document, which was enacted after nearly two years of discussion and debate in the Assembly, a consensus of opinion was arrived at and this constitution was framed and passed. With the addition of fourteen amendments, the constitution is highly accepted by almost every unit of the political houses of the state. The nation of the country accepts the enforcement of this constitution. No it is the duty and responsibility of the government to implement it in its true spirit and shape, and this constitution prevent Riba, propose Islamic vision of economic system i.e. interest-free economic system. 8.3 SUPREME COURT DECISION (1998-2002) ON INTEREST: This was historic decision and verdict given by the Supreme Court of Pakistan, whereby interest was declared unlawful and totally against the teachings of Islam. The court ordered the government for putting all its efforts to abolish the present interest based banking system and to introduce completely interest-free banking system within a given period of time. Although governments have been trying to introduce Islamic economic systems but the effort so far made in this context cannot be marked even satisfactory. It requires willingness and determination to convert present system into interest-free system. The contributions made by various governments are mentioned in the subsequent paras of the chapter.

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8.4

THE

ISLAMIZATION

OF

ECONOMIC

SYSTEM

OF

PAKISTAN: As an Islamic country the government has titled towards the changes in its economic system. So different plans were implemented but practically a new Islamic order was promulgated in 1979 that aimed to transfer the whole economic system in to an Islamic economy. Different steps were taken like application of an Islamic taxation system, in establishment of Zakat and elevation of interest from financial system etc. after realizing the difficulty of eliminating interest from economic system. The government of Pakistan has taken following steps to establish different corporations and interest-free DFIs.  NIT: The first phase came in 1979 when NIT operations were converted into interest-free transactions. NIT was established in November 1962 with the aim to mobilize savings for investments in the corporate sector to burden the base of holding.  ICP: ICP was established in 1966, and perform as an investment bank with the objectives that to develop the capital market and broaden the equity investment. Its conversion into interest-free basis has taken place in two stages. In first stage 12 mutual founds were converted into investors scheme and debenture financing was converted into Participation Term Certificate.  BEL: In 1979 this investment institution was established with an objective to encourage private sector investment in medium and large industry in Pakistan by providing interest-free financing facilities and services.

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8.5

INTEREST-FREE BANKING IN PAKISTAN: Pakistan was created in the name of Islam on august 14, 1947. since

then, the interest is playing the cardinal role in the resource allocation of the economy. The principle of interest as the guiding force is diametrically opposed to the Islamic system. The previous government could not and did not dare to change the well-dug system based on interest due to the following reasons:  Saving accounts and PLS term deposits shall be accepted on profit and loss sharing basis.  The deposits of the banks are also to be utilized in interest-free investments. Bank started with mark-up pricing. Later on, Participation Term Certificates were introduced to substitute for existing interest based instruments for financing. From July 1, 1982 the banks were allowed to meet the working capital requirements of their clients on the basis of Musharaka and Leasing and Hire Purchase.  From July 1, 1984 the commercial banks were allowed to provide finances under Islamic modes. The renewal of accommodation for working capital on interest basis was to be limited to six months. From January 1, 1985 all new banks financing to government, public sectors, corporations and joint stock companies were to and are entirely on the basis of Islamic modes of financing.  From April 1, 1985 even in case of firms and individuals, all new financing by banks and financial institutions were to be in accordance with the requirements of Shariah.

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By the end of fiscal year 1985, the entire assets side of the banks and other financial institutions would be transferred into accepted modes of Islamic financing as was decided them. The non-bank financial institutions have taken lead in Islamizing their

operations. In July, 1970 interest has eliminated from the operations of ICP, NIT. Small Business Finance Corporation (SBFC) took up interest-free operation from July 1, 1980, NDFC, from July 30, 1985, IDBP from January, 1985. Bankers Equity Limited (BEL) corporate in 1979 has done pioneering work in the area as already mentioned. The government led by late President Zia-ul-Haque accepted the challenge and took revolutionary steps to Islamize the country. The government is of the firm view that Riba implied on all types of interest and there is no disagreement over this issue among Ulemas. As regards the fear of reduced savings, it is based on the misconception. Saving, according to the modern economists, is a function of income rather than of interest. Referring to the other misgiving, the banking system will not collapse, if the investment is made in the safe projects. If the funds under the interest-free system yielded more return, there will not be any fear of the transfer of accounts to foreign banks or of reduced deposits.

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CHAPTER 9

CASE STUDY OF MEEZAN BANK
Meezan Bank is Pakistan's first scheduled Islamic commercial bank, and operates strictly under the principles of Islamic Shariah. 9.1 OUR VISION: Establish Islamic banking as banking of first choice to facilitate the implementation of an equitable economic system, providing a strong foundation for establishing a fair and just society for mankind. 9.2 MISSION STATEMENT: To be a premier Islamic bank, offering a one-stop shop for innovative value added products and services to our customers within the bounds of Shariah, while optimizing the stakeholders' value through an organizational culture based on learning, fairness, respect for individual enterprise and performance. 9.3 SHARIAH BOARD: The members of the Shariah Board of Meezan Bank are Internationally-renowned scholars serving on the boards of many Islamic banks operating in different countries. The members of the Shariah Board are: 1. 2. 3. 4. Justice (Retd.) Muhammad Taqi Usmani Dr. Abdul Sattar Abu Ghuddah Sheikh Essam M. Ishaq Dr. Muhammad Imran Ashraf Usmani - Shariah Advisor

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9.4 1. 2. 3. 4.

MANAGEMENT TEAM: Irfan Siddiqui President & Chief Executive Officer Ariful Islam Chief Operating Officer Head of Corporate & Business Development Chief Financial Officer & Company

Najmul Hassan

Shabbir Hamza Khandwala Secretary

5. 6. 7. 8. 9. 10. 11. 12. 13. 14. 15. 16. 17. 18. 19.

Dr. Muhammad Imran Usmani Shariah Advisor Mohammad Haris Head of Structured Finance & Karachi Corporate

Ayaz Wasay Head of Treasury & Financial Institutions Arshad Majeed Head of Operations

Pervez Mobin Head of Human Resources & Administration Mohammad Sohail Khan Head of Car Ijarah

Munawar Rizvi Head of Branch Expansion & Business Promotion Faiz-ur-Rehman Head of Information Technology Zafar Ali Khan Head of Marketing, Liability Products & Housing Finance Saleem Wafai Head of Internal Audit Ms. Mehnaz Ikram Legal Advisor Abdullah Ghaffar Memon Regional Manager - South Rizwan Ata Regional Manager - Central Saleem Khan Regional Manager - North

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9.5

CORPORATE BANKING & CORPORATE FINANCE: The Corporate Banking Department is geared towards providing

comprehensive and innovative financial solutions to the banks’ client base through a diverse product offering. The focus is on nurturing and developing a long-term relationship with clients by understanding their unique financing requirements and providing Shariah compliant financing solutions. The Bank offers following products and services to its customers: 9.5.1 Corporate Banking: The unit tailors solutions for a broad array of financing needs, both short and long term, and has experience of working closely with customers who are seeking innovative Shariah compliant solutions for such needs. a. Working Capital Requirements: The Bank offers a wide range of products to meet the customers’ working capital requirements through various Shariah compliant modes of financing such as Murabaha, Musharaka, Mudaraba, Istisna and Salam. b. Project Financing/Expansion/BMR Requirements: Meezan Bank specializes in offering unique project financing solutions, which have been developed using a wide array of product offerings, which include Diminishing Musharaka, Ijarah, Mudaraba, Istijrar, Murabaha and Istisna forms of financing and derivatives thereof. c. Export Refinance: Meezan Bank enjoys a distinction vis-à-vis its competitors, as it is the only Bank in Pakistan to offer a Shariah compliant “Islamic Export Refinance Scheme (IERS)” approved by the State Bank of Pakistan (SBP).

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The scheme has been developed by the product development team of Meezan Bank in close coordination with SBP keeping in view the unique needs and requirements of exporters. The scheme is available in both Part-I and Part-II as per the original Export Refinance Scheme (ERF) of SBP. d. Trade Related Services: The Bank offers a complete range of trade products to its customers including Sight/Usance Letters of Credit, Letters of Guarantee, Export bill collection, Export bill purchase etc. These products are based on various modes of Islamic Finance and have been designed to suit the needs of the customers. 9.5.2 Corporate Finance & Advisory: The unit also provides a range of Advisory services integrating industry, product and regional specialization to help businesses address their strategic issues and formulate and execute dynamic business strategies. In a short span of time the unit has been able to develop core specialization in Privatization Mandates, Mergers and Acquisition, buy-side/sell-side advisory, financial restructuring and related fields. The unit counsels its clients on the most advantageous a transaction structures and tactics available and creates new structures to get difficult or complicated M&A deals done. Whether advising on a multi-billion rupee M&A transaction or origination and marketing & distribution of primary market transactions, the Corporate Finance Department brings superior innovation, experience and capabilities to each of our clients.

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What we offer: 1. 24/7 Banking: Meezan Bank’s 24/7 Banking brings to you a world of total access and convenience, where you and your money are in touch all the time. The 24/7 Banking services include our 24/7 ATM, 24/7 card and our 24/7 Call Center. 2. Riba Free - Meezan Providence: Is a long-term investment product specially designed to cater to the needs of corporate and business concerns for purposes of investing their Provident, Pension and Gratuity Funds? 3. Riba Free - Certificates of Islamic Investment: An investment product designed to meet short or long term needs. With a minimum investment of only Rs.50, 000 it provides investment options from 3 months to 5 years, with an option for monthly return. Furthermore, these certificates can be encashed at any time without any charge or penalty, only the profit rates will be adjusted according to the tenure completed. 4. Riba Free - Monthly Musharaka Certificate: Is a flexible investment product, which has been designed to give a monthly return? Depositors participate with the Bank in a pool of investments that is comprised of Murabaha and Ijarah transactions and guaranteed to be Halal. The minimum investment required is only Rs.100, 000 and the profit is disbursed upon completion of the month. The facility also provides the option of withdrawing the investment at any time. 5. Riba Free - Dollar Saving Account: With a minimum deposit requirement of only US$100, the dollar saving account is under a Mudaraba arrangement that is strictly in conformity with the principles of Islamic Shariah. Profit on this account is also paid on a 62

monthly basis and comes with a range of benefits including checking facility, free balance certificates, and personal financial consultancy services. 6. Riba Free - Rupee Saving Account: A unique bank account that offers the opportunity to earn Halal profits, while enjoying a range of added benefits. It can be opened with a minimum amount of only Rs.10, 000. The profit on this account is calculated and paid on a monthly basis, and comes with a variety of free benefits including personalized check books, no restrictions on transactions, priority banking and so on. 7. Riba Free - Current Account: A bank account that is ideal for businesses and individuals looking for Shariah compliant banking and ease of access. With a minimum amount of only Rs.10, 000 this product offers you a range of benefits including personalized checking facility, no restrictions on the number of transactions, more. 8. Riba Free - Karobari Munafa Account: Karobari Munafa is a savings account specifically tailored for large Corporate or GoP controlled entities. It allows customers to earn higher returns on surplus cash balances. It has no preset transaction limits and comes with a variety of free packaged benefits. 9. Car Ijarah - Islamic Car Financing: Our totally Halal auto finance facility that is very affordable, with quick processing and minimal documentation. Car financing that is very competitively priced, hassle-free, and totally Halal. Ijarah is simply a rental agreement under which the car is given on rent for an agreed period ranging from free Call Center facilities, free balance certificates, priority banking and much

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3 to 5 years. There is no advance rental, no up-front insurance payment, and as little as 20% security deposit. 10. Easy Home: Islamic Housing Finance: Welcome to Pakistan’s long awaited totally Shariah-compliant Home Finance facility! One that is comprehensive, affordable, and totally hassle-free. At Meezan Bank, we are committed to meeting our customers’ needs in a truly Shariahcompliant manner coupled with dedicated service excellence. Meezan Bank’s Easy Home is the answer you’ve been waiting for. 9.6 MODES OF INVESTMENTS: Some modes of investments to be utilized by MBF are given below: 9.6.1 Equities: Shariah complaint investments in equities would meet the following five criteria which have been researched upon and approved by our Shariah Advisor. a. Business of the Investee Company: The basic business of the investee company should be Halal. Accordingly investment in shares of conventional banks, insurance companies, leasing companies, companies dealing in alcohol, tobacco, pornography etc are not permissible. b. Debt to total assets: The total interest bearing debt of the investee company should not exceed 45% of the total assets. c. Net illiquid to total assets: The total illiquid assets of the investee company as a percentage of the total assets should be at least 10%.

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d.

Investment in Shariah non-complaint activities and income from Shariah non-complaint investments: The following two conditions will be observed for screening

purposes:  The total investment of the investee company in Shariah noncomplaint business should not exceed 33% of the total assets.  The income from Shariah non-complaint investment should not exceed 5% of the gross revenue (net sales plus other income) e. Net liquid assets vs. share price: The net liquid assets (current assets minus current liabilities) per share should be less than the market price of the share. The Shariah complaint criteria represent the minimum acceptable criteria for investment by MBF. After initial screening of the companies on the above criteria, MBF invest in short-listed companies:  Which provide opportunity to earn regular income in the form of dividends   Which have good growth prospects in terms of future expansion, and Which are liquid so as to provide the ease of entry and exit.

9.6.2 Mudaraba: Mudarabas are a well-establishes Shariah compatible activity that the fund could undertake. The term refers to the form of business contract in which one party brings capital and the other personal effort. The proportionate share in profit is determined by mutual agreement. But the loss, if any, is borne only by the owner of the capital, in which case the entrepreneur gets nothing for his labor. The financier is known as "Rabb-ul65

Mal" and the entrepreneur as "Modarib". As a financing technique adopted by Islamic institutions, it is a contract in which all the capital is provided by the Islamic institution while the business is managed by the other party. The profit is shared in pre-agreed ratios, and loss, if any, unless caused by negligence or violation of terms of the contract by the Modarib is borne by the Islamic institution. The institution passes on his loss to the depositors. 9.6.3 Sale on cost plus profit (Murabaha): Murabaha is a Shariah complaint activity also known as sale on profit, cost plus profit, sale at stated cost price and mark-up, or sale at a specified profit margin. The term is however now used to refer to a sale agreement whereby the seller purchases the goods desired by the buyer and sells them at an agreed marked-up price, the payment being settled within an agreed time frame, either in installments or lump sum. The seller/ institution undertake all the management needed for the purchase and also bears the risk for the goods until they have been delivered to the buyer. This has been adopted as a mode of financing by a number of Islamic institutions. As a financing technique, it involves a request by the client to the institution to purchase a certain item for him. The institution does that for a definite profit over the cost, which is settled in advance. 9.6.4 Musharaka: The literal meaning of Musharaka is sharing. The root of the word “Musharaka” in Arabic is Shirkah, which means being a partner. Under Islamic jurisprudence, Musharaka means a joint enterprise formed for conducting some business in which all partners share the profit according to a specific ratio while the loss is shared according to the ratio of the contribution. It is an ideal alternative for the interest based financing with far reaching effects both on production and distribution. Partnership can be in the form of joint ownership of property, called “Shirkat-ul-Melk” or in the 66

form of partners contributing a certain portion of capital or services, which is called: Shirkat-ul-aqd”. 9.6.5 Bai’ Salam: This term refers to the advance payment for goods which are to be delivered later. Normally, no sale can be affected unless the goods are in existence at the time of the bargain. But this type of sale forms an exception to the general rule provided the goods are defined and the date of delivery is fixed. The objects of this type of sale are mainly tangible things but exclude gold or silver as these are regarded as monetary values. Barring these, Bai’ Salam covers almost all things which are capable of being specifically described as to quantity, quality and workmanship. It is also applied to a mode of financing adopted by Islamic financial institutions. It is usually applied in the agricultural sector where the institution advances money for various inputs to receive a share in the crop, which the institution sells in the market. This kind of sale is also used nowadays as a mode of financing that is also called ‘parallel Salam’. 9.6.6 Bai’ Muajjal: The term means the sale on deferred payment basis or a credit sale. It is a contract in which the seller allows the buyer to pay the price of the commodity at a future date in a lump sum or in installments. 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. 9.6.7 Ready future hedges: Ready future hedges make use of a buy transaction in the ready market and a simultaneous sell transaction in the futures market in the same scrip, hence locking in the difference between the two prices at the time of executing the two transactions. Ready future hedges provide a Shariah 67

complaint alternative to the carry out trade (cot) market because the difference between the future and spot price of certain scrip at any time closely approximates the going cot rates. Ready future hedges are Shariah complaint because they make use of buying and selling with different parties, rather than engaging in a sell and buy-back transaction with the same party. Also, ready future hedges are executed during the normal trading session, whereas there is a separate market of cot transactions which takes place after the close of normal trading. 9.6.8 Disposal of haram income: Where some haram income accurse to the fund, it will be denoted to the approved charity that is unconnected with the fund, investment adviser, its directors. Officers, trustee, Shariah advisor, auditors of sponsors (sometimes referred to as “purification” of fund income). This will be done in consultation with the Shariah adviser.

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CHAPTER 10

PUBLIC BEHAVOIUR ABOUT INTEREST-FREE BANKING
As indicated in introductory chapter that a short and comprehensive questionnaire was prepared to evaluate the attitude and behavior of the people about the interest-free banking. This questionnaire was distributed among 300 individuals of different status and different background. Subject was contacted personally. The results of this exercise are shown in the following paras. 10.1 ABOUT SUBJECTS: Analysis of the data collected through questionnaire showed that out of 300 subjects 175 were male and the rest of 125 were female, 130 subjects were graduates and 170 were post-graduates. Subjects belonged to various field of life which includes lecturers (35), bank managers and employees (120), students (85) and others (60). Their age groups varied such that subjects who were under 30 years of age counted 120, those who were under 40 years were 168 and subjects up to the age of 60 years were 12. These figures are clearly shown with the help of graphs. In the following text responses related to each question asked are presented in a sequence that matches the sequence of the instrument served. 10.2 QUESTIONNAIRE ANALYSIS: First question of the instrument provided data to calculate the preference of the respondents about interest-free and interest based banking system. From the pie chart, it is clear that 253 out of 300 subjects favored the later one respectively.

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In the next question asked it was found that 275 of the subjects suggested that the government of Pakistan should introduce interest-free banking system while the rest of the respondents were not in favor of this system.
Preferences Regarding Interest Based & Interest Free Banking System 6%

Yes No

94%

Government should introduced IFBS

8%

Yes No
92%

When the respondents where asked whether government efforts so for made are up to the mark or not maximum of the respondents expressed their views indicating that the Government efforts about introducing an interest 70

free banking system are not satisfactory. The figure describes that total 225 individuals are not satisfied with the effort and only 75 are of the opposite view, 50 out of these 75 are just satisfied with the government effort and 25 subjects were strongly satisfied with the excellence of effort been made by government.

Government efforts for Introduction IFBS and people response
No. of respondants
120 100 80 60 40 20 0 1 25 2 3 25 4 0 5 6 0 7 0 8 0 9 75 50 24 10 100

Series 2 Series 1

1

2

3

4

5

6

7

8

9

10

Degree of satisfaction
As per Question # 4, Interests free banking ensures economic justice in the society as 200 of the respondents opined where as 100 subjects did not agree with assumption. The below chart shows

Interest Free Banking will facilitate economic justice in the economy of the country
33%

Yes No
67%

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As government has been trying for introduction of an interest free banking system so when respondents were asked to express their views, so 180 subjects were not satisfied with the sufficiency of these reforms and 120 out of 300 subjects expressed their satisfaction in the reforms so far introduce by the government.

Present Islamic Reforms in banking system are sufficient

44%

56%

Yes No

The pie chart describes that 250 subjects were in favour of converting the existing system into an interest free banking system. The rest 50 respondents indicated otherwise.
Existing mix banking system needs to be improved and complete interest free banking system should be facilitated
17%

Yes No

83%

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It was expressed by most of the respondents including maximum of bank employees that existing system could be converted into an interest free banking system, 50 of the respondents stated it bring hundred percent possible. As a whole 174 were of the opinion that it can be done so, 48 of the respondent did not agree and 25 of the respondents were not completely against the possibility of conversion but they were hesitant. The existing banking structure can be converted into interest free banking system? Most of the respondents (225) indicated that it could not be possible favourable to run two parallel systems i.e. interest free and interest based banking system while 75 subjects as shown in

80 70 60 50 40 30 20 10 0 Series 1 Responses

75

50 35 35 35

50

50

Series 1 Responses
6
6 6 75

1
1 1 35

2
2 2 35

3

0

4

0

5
5 5 35

7
7 7 50

8
8 8 50

9 0
9 9 0

10
10 10 50

3 3 0

4 4 0

where of the opinion that two parallel systems could run at the same time.

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Two parallel system i.e. interest free and interest based banking should run at the same time
25% Yes No 75%

An encouraging set of information was that 275 of the respondents opted to be clients of an interest free bank and only 25 of them opted for interest based banking system.

If I have the opportunity to choose bank, being a client, I well always prefer
8%

Interest Based Banking Interest Free Banking 92%

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The below plotted chart indicates that 225 of the sample size are willing to become employees of interest free bank if they have opportunity to choose and 75 would opt for the other (interest based bank) in such a situation.

If i have opportunity to opt for a bank, as an employee, i will alwasy prefer

25%

Interest Based Banking Interest Free Banking 75%

10.3 SUMMARY OF THE ANALYSIS These results indicate that people do prefect and desire for interest free banking system, and have no specific complaints about such a system. It is possible to motivate the general public and introduce interest free banking system with high possibility of success in the future. Government efforts would be highly appreciated and would enhance the level of satisfaction of the public. With sufficient efforts and training the existing system can be converted into interest free banking system. If impossible to do so at once, government may take gradual steps to interest free banking system.

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RECOMMENDATIONS
Interest free banking is not impracticable concept. There are financial institutions in the world which are operating without charging any interest. Even in Pakistan such institutions are in action. However there are hurdles and hindrances which need to be removed to introduce an interest-free banking in Pakistan. Here are few recommendations which will facilitate the establishment of this proposed system: 1. Education people of Pakistan about the concept so that to develop their trust and confidence in the proposed system. 2. Full booking by the government, it will not only enhance the public trust and confidence but also facilitate its implementation. 3. Following up of a national level body (Against Interest Movement) that world indulge itself in matters related to subject this body should have four basic units each for one province and of federal area unit that should operate in regions like Kashmir, and northern areas. This area of operations should include research and development too. AIM should have economists, bankers, lawyers, religious scholars and other as required. 4. Close relations with other Islamic states of the world should be established to promote this concept on international level. An Islamic international body should be proposed, that should promote this concept not only in Islamic world but should educate other countries and nations. It should be noted that, in this regard poor or third world countries could be very easily altercated toward such a system, thus resulting in greater influential power in the world.

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5.

The maintenance of proper society is a must; hence efforts should be made to grown people according to the teaching of Islam. Honesty, trust-worthiness, simplicity, truthfulness, spirit of scarifies are few important and required traits that should prevail in society that want to eliminate the evil of interest.

6.

Various sects that exist should be brought together to chalk out a single system; this responsibility should be delegated to AIM to facilitate consensus.

7.

A nationalized modern interest free bank should be incorporated after a intensive marketing operations. The main object (equity and welfare) should be the hallmark of its promoting strategy. The operation, progress and achievements should be closely monitored and information should be disseminated to the general public. AIM could be given this responsibility.

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CONCLUSION
The interest free banking is a concept which is quite compatible with the teachings of Islam. Pakistan is an Islamic state and its ideology is based on the Islamic principles and practices. Its constitutions demand the enforcement of Islamic laws and rules. The general public of Pakistan is true followers of Islam and they believe in the validity of the teachings of Islam, as a basic principle of their belief (eman). There is a wide scope for interest-free banking system as modern banking system has failed to fill gap and bring socio-economic equality among people, society and even countries and nations. Muslims world is about 25% of the world’s population occupying nearly 20% of total area. They own 40% of oil and gas resources, hence there exist a big market for interest free banking. If proper attention and honest efforts are made there is no doubt that an interest free banking system would increase savings which will result in more investments, more economic growth and above all equal distribution of wealth (money) in Pakistan.

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REFERENCES
1. Ahmad, Sheikh Mahmud, (1952). “Economics of Islam", Lahore: Alnoor printing press. 2. Dr. Muhammad Imran Ashraf Usmani, “Islamic Banking and Finance”, PhD Islamic Finance, Shariah Advisor Meezan Bank. 3. El-Ashker, A.A.F. (1987). “The Islamic Business Enterprise”, London: Croom Helm. 4. Qureshi, A.I. (1974). “Islam and the Theory of Interest” (ed. 2nd). Lahore: Ashraf Press. 5. Siddiqui, I.H. (1997). “Practice and Law of Banking in Pakistan” (ed. 6th ) Lahore: Crescent Printing Press. 6. Siddiqui, N. (1981) “Banking without Interest” (ed. 4th). Lahore: Islamic publication Limited. 7. 8. www.pak.gov.com.pk www.meezanbank.com

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QUESTIONNAIRE
STUDYING THE FEASIBILITY OF INTEREST FREE BANKING IN PAKISTAN 1. 2. 3. 4. 5. 6. 7. Name: ___________________________ Sex: _____________________________ Age: _____________________________ Education: ________________________ Designation: _______________________ Department: _______________________ Do you prefer interest free banking over interest based banking system? • • 8. Yes No

Government of Pakistan should introduce interest free banking? • • • Yes No If NO – Why ________________________

9.

Government efforts about introducing interest free banking are

excellent. • • • Agree Strongly agree Disagree 80

• 10.

Strongly disagree

Interest free banking will facilitate economic justice in the economy? • • Yes No

11.

If I have the opportunity to opt for a bank as an employee I will always prefer: • • Interest free banking Interest based banking

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