Islamic Banking.

Hammad Raza Sahoo.

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 Principles of Islamic Finance

• In Islamic jurisprudence there are two types of Ahkam (rulings)

i. Ibaadaat (worship)
ii. Mu’amlaat (mutual dealings)

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 Principles of Islamic Finance
Ibaadaat (worship) governs the relationship between man and Allah. The
general principle is that nothing is permitted unless explicit or analogical
permission by the Law Giver.
Mu’amlaat (mutual dealings) governs the relationship among mankind. The
General principle is that everything is permitted unless clearly prohibited by
Allah SWT.

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 Principles of Islamic Finance
• Islam permits the contracting parties to agree on any conditions as long as
they do not violate any Shariah ruling.
• Hadith
“All the conditions agreed upon by the Muslims are upheld, except a
condition which allows what is prohibited or prohibits what is lawful”
(Sunan Abu Dawood, 1981)

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 Principles of Islamic Finance

Few prohibitions relevant to constructing financial contracts:

• Prohibition of Riba
• Prohibition of Gharar
• Prohibition of Maysir

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ISLAMIC BANKING

IN

PAKISTAN

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 Brief History of Islamic banking in
Pakistan

• Islamic Provisions in the Constitution of Pakistan:

• Islam was declared state religion (1973 constitution)
• All the three constitutions say:
• “Steps should be taken to enable the Muslims {of Pakistan}, to order their
lives, in individual and collective spheres, in accordance with the teachings
and requirements of Islam as set out by Quran and Sunnah”

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 Brief History of Islamic banking in
Pakistan
• Islamic Provisions in the Constitution of Pakistan:
• Features of Islamic Provisions

• It was further affirmed that:

• State shall eliminate Riba as early as possible {Article 38(F)} and

that

• All existing laws shall be brought in conformity with the injunctions

of Islam and no law shall be enacted which is repugnant to these
injunctions {Article 227}
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 BRIEF HISTORY OF ISLAMIC BANKING IN
PAKISTAN

• Quaid-e-Azam, the father of the nation, in his speech

at the occasion of the inauguration of State Bank of
Pakistan, had expressed the desire for evolving an
Islamic system of banking.

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 History of Islamic banking in Pakistan

• The process of economy wide Islamisation of the banking system in

Pakistan was initiated after a declaration by then president in February
1979.

Govt. plans to remove the interest from economy within three years.
.

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 History of Islamic banking in Pakistan

• From July 1, 1982 banks were allowed to provide finance for meeting
the working capital needs of trade and industry on a selective basis
under the technique of Musharaka.

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 History of Islamic banking in Pakistan

• The State Bank of Pakistan had specified 12 modes of non-interest

financing classified in three broad categories namely:
Loan Financing
Trade Related Financing
Investment Mode of Financing

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 Ruling of Federal Shariah Court (November
14, 1991)

• Procedure adopted for the Islamization of the financial system was

declared un-Islamic.
• Various operations were declared repugnant to the injunctions of Islam.
• Govt. and some banks appealed to the Shariah Appellate Bench of
Supreme Court against aforesaid verdict of FSC.

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 Supreme Court Judgment (19th December
1999)

• The SAB delivered its judgment on December 23, 1999 rejecting the
appeals and directing that laws involving interest would cease to have
effect finally by June 30, 2001.
• In the judgment, the Court concluded that the present financial
system had to be subjected to radical changes to bring it into
conformity with the Shariah. It also directed the Government to set
up, within specified time frame, a Commission for transformation of
the financial system and two Task Forces to plan and implement the
process of the transformation. The Court indicated some measures,
which needed to be taken, and the infrastructure and legal
framework to be provided in order to have an economy conforming
to the injunctions of Islam.

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 Post Judgment Measures

• CTFS was constituted in January 2002 in State

Bank of Pakistan.

• A Task Force was set up in the Ministry of Finance

to suggest the ways to eliminate interest from
Government financial transactions.

• Another Task Force was set up in the Ministry of

Law to suggest amendments in legal framework to
implement the Court’s Judgment.

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 CURRENT STRATEGY

Policy Decision:-
• It was decided that the shift to interest free economy would be
made in a gradual and phased manner and without causing any
disruptions.

• This decision was made in a meeting held on September 4, 2001

under the Chairmanship of the President of Pakistan, attended
by officials of the Ministries of Finance and Law, Governor State
Bank of Pakistan, Chairman and some members of the Council of
Islamic Ideology and the Chairmen of the CTFS and the two Task
Forces.

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CURRENT STRATEGY

• Gradual approach for Transformation of economy

• Full fledged Islamic banks be established in Private sector
• Islamic banking Subsidiaries in existing banks be allowed

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 POLICY OBJECTIVES

• Introduce, promote and implement Islamic Banking in Pakistan

• as a parallel banking system
• comparable and compatible to conventional banking system and
• Shariah compliant

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 SBP Shariah Board

• Central Shariah Board established at SBP which advises SBP

on the procedures, laws and regulations pertaining to
Islamic Banking in the light of Shariah principles.
• Current membership consists of five persons
• Two Shariah scholars
• One Chartered accountant
• One lawyer
• One banker

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 SBP Shariah Board

Role and Responsibilities

• Review and approve for Shariah compliance the
products/instruments developed by SBP for
conducting its central banking and monetary
management functions under the Islamic modes.
• Advise SBP on PRs developed for Islamic banking
sector.
Conflict Resolution in Shariah Rulings.

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Islamic Modes of Financing

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 MURABAHA

• A margin of profit based sale where the seller

expressly mentions the cost of commodity and adds
agreed margin of profit.

• Price must be fixed in an unambiguous manner. If

deferred, due date should be known and specific.

•
Understanding Murabaha.

• In a murabaha contract of sale, a client petitions a bank to purchase

an item on their behalf. Complying with the client's request, the bank
establishes a contract setting the cost and profit for the item, with
repayment typically in installments. Because a set fee is charged
rather than riba (interest), this type of loan is legal in Islamic
countries. Islamic banks are prohibited from charging interest on
loans according to the religious tenet that money is only a medium of
exchange and has no inherent value; so banks must charge a flat fee
for continuing daily operations.

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 MURABAHA

• Subject of sale must exist and it should be in

ownership of the seller at the time of sale.
• Bank makes purchases through agent;
• Payment to supplier and issuance of invoice by him;
• Price once agreed cannot change;
• Penalty in case of delay. To go to charity;
• Buyer may be asked to furnish security;
• No rollover is possible;
• Buyback arrangement is prohibited
• All conditions of sale must be met
Example.

• Example of Murabaha
• Bilal would like to buy a boat that sells for $100,000 from Billy's Boat
Shop. To do so, Bilal would contact a murabaha bank, that would buy
the boat from Billy's Boat Shop for $100,000 and sell it to Bilal for
$109,000, to be paid in installments over a three year period. The
amount Bilal pays is a fixed amount to a bank that owns the asset
and there is no interest charge involved. Also, if Bilal defaults on any
payments, there are no additional charges that he would incur. The
additional amount Bilal pays over the cost price from the boat shop is
in effect a 3% loan, but because it is offered as a fixed payment
without any additional costs, it is allowed by Islamic law.

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 IJARAH (LEASING)
• Ijarah is an alternative to financing in which a financer buys and rent a
productive asset to a person short of funds and is in need of such asset.

• The aim of such arrangement is to obtain the rentals and proceeds by

receiving the benefits of the assets through time.
IJARAH (LEASING)

•- Lessors’s ownership;
• - Delivery of assets to lessee essential to
claim rentals;
• - Lessor’s ownership during the entire term of
lease;
• - Rental in absolute terms. -- -
Predetermined lease period
• - Penalty for delay;
• - Lessee bear the operating expenses;
Example.

• Suppose, for example, a person takes a five-year interest-bearing

loan to buy a car. After two years, if he finds that keeping the car and
the loan is uneconomical, he can sell the car in the market and repay
the loan. This is not so in the case of ijara. Ijara finance cannot be
terminated prematurely.
• In Islamic finance, al Ijarah does lead to purchase usually refers to a
leasing contract of property (such as land, plant, office automation, a
motor vehicle), which is leased to a client for stream of rental and
purchase payments, ending with a transfer of ownership to the
lessee, and otherwise follows Islamic regulations.

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 ISTISNA

• Istisna’ means asking someone to construct, build or

manufacture an asset. In Islamic finance, istisna' is
generally a long-term contract whereby a party
undertakes to manufacture, build or construct assets,
with an obligation from the manufacturer or producer
to deliver them to the customer upon completion. In
practice, the key advantage of an istisna’ contract is
that it can provide flexibility to the customer, where
payments can be made in installments linked to
project completion, at delivery or after project
completion. In contrast to istisna', for salam contract
the payment has to be made in full, in advance.
Example.

• Infrastructure projects are the main examples of istisna' application.

This includes: construction of power plants, factories, roads, schools,
hospitals, building and residential developments.
• The parties to an istisna' contract are: the Producer or Manufacturer;
the Bank (i.e. the financier); and the Customer (i.e. purchaser of
goods).

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 SALAM

Arabic means “To advance”

A contract where the purchaser pays the
price in advance and delivery of subject
matter is postponed to specified time in
future.
It is suitable for the finance of agricultural
operation.
Farmers used to get loans on interest for
farming now they use salam
SALAM

•- Full payment of price at the time of contract

• - Firm agreement on quality, quantity,
specifications
• - Date and place of delivery must be specified
• - Commodities which can be offered in Salam
• - Availability of commodity;
• - No buy back with the Seller
• - Security can be asked for
MUDARABA

• Mudarabah or "Sharing the profit and loss with venture capital",[10]

is a partnership or trust financing contract (similar to western
equivalent of General and Limited Partnership) where one partner
(rabb-ul-mal or "silent partner"/financier),[11] gives money to
another (mudarib or "working partner") for investing in a commercial
enterprise.
• The rabb-ul-mal party provides 100 percent of the capital and the
mudarib party provides its specialized knowledge to invest the
capital and manage the investment project. Profits generated are
shared between the parties according to a pre-agreed ratio. If there
is a loss, rabb-ul-mal will lose his capital, and the mudarib party will
lose the time and effort invested in the project.
• The profit is usually shared 50%-50% or 60%-40% for rabb ul mal-
mudarib
 MUSHARAKA

• Musharakah is a joint enterprise or partnership structure in Islamic

finance in which partners share in the profits and losses of an
enterprise. Since Islamic law (Sharia) does not permit profiting from
interest in lending, musharakah allows for the financier of a project or
company to achieve a return in the form of a portion of the actual
profits according to a predetermined ratio. However, unlike a
traditional creditor, the financier also will share in any losses should
they occur, also on a pro rata basis. Musharakah is a type of shirkah al-
amwal (or partnership), which in Arabic means "sharing."
Example.

• For example, suppose that individual A wants to start a business but

has limited funds. Individual B has excess funds and wishes to be the
financier in musharakah with A. The two people would come to an
agreement to the terms and begin a business in which both share a
portion of the profits and losses. This negates the need for A to
receive a loan from B.

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