Fundamentals of Interest

Free Banking
11/12/2022 1
 contents

1. INTRODUCTION ,

2. CONCEPTS OF IFB’S,

3. PRODUCTS/SERVICE MODELS OF
IFB,

4. ACCOUNTING STANDARDS,

5. RISKS IN IFB, and

6. ELIGIBILITY FOR IFB SERVICES.

11/12/2022 2
 Introduction
1.1 What is Interest Free Banking ?
Interest Free Banking (IFB):

Is ‘a banking business in which mobilizing

or advancing of funds taken in a manner

consistent with Islamic Finance Principles

and mode of operation that avoids

receiving or paying interests’, (NBE’s

Directive No.SBB 51/2011);

11/12/2022 3
F
d
r
eu
e
c
t
 Interest Free Banking Windows:
B
a ‘Units within a conventional bank that exclusively
in offer IFB services’ (NBE’s Directive No.SBB
o
k 51/2011);
in
n A system of financial activities consistent with

g Shariah, based on Islamic principles which at the core

… refuses collecting interest/Riba, transactions involving

uncertainty and speculation.

11/12/2022 4
 Introduction
What is Interest Free Banking ?
 Riba is Arabic for “growth” or “increase” and denotes the
payment or receipt of interest for the use of money.

 In prohibiting riba, Islam seeks to foster an environment

based on fairness and justice. A loan with a fixed return
to the lender regardless of the outcome of the
borrower’s course of action is viewed as unfair.
Riba is also believed to be exploitative and unproductive
because it is considered to represent sure gain to the
lender without any possibility of loss as well as a reward
in return for no work.

11/12/2022 5
de
eu
cB Interest/Riba- two Common Types:
at A. Rate-for-duration (Riba Al Nasiah)-

n Specified, predetermined repayment in excess of

ik loan/capital. (Fixed, Guaranteed, Increases with the increase

oi of time) E.g. Simple & Compound interest

nn B. Excess Exchanges (Riba Al Fadl)-

g When specified items are exchanged for the same kind at
. unequal measures or on deferred basis, this is Riba. Eg One
. Kg of salt is exchanged for two kg. One kg of dates is
, exchanged for two kg of dates, irrespective of quality
11/12/2022 6
CONVENTIONAL BANKING
&
INTEREST FREE BANKING

11/12/2022 7
 Interest Free Banking…

money
Bank Client

money + money
(interest)

Conventional
Banking System

8
 Interest Free Banking…

Bank Goods & Client

Services

money

Interest Free
Banking System

9
Characteristic Interest Free Banking System Conventional Banking
System
(interest based)
Business Functions and operating Functions and
framework modes are based on Shari’a, operating modes are
and Islamic banks must based on secular
ensure that all business principles, not
activities are in compliance religious laws or
with Shari’a requirements. guidelines.
Interest Financing is not interest Financing is interest
charging (riba) oriented and should be oriented, and a fixed
based on risk-and-reward or variable interest
sharing. rate is charged for
the use of money.
Interest on Account holders do not Depositors receive
deposits receive interest interest and a
(riba) but may share risk and guarantee of principal
rewards of repayment.
investments made by the
11/12/2022 10
Characteristic Interest Free Banking System Conventional Banking
System
(interest based)

Risk sharing in Islamic banks offer equity Risk sharing is not

equity financing financing with risk sharing for generally offered but
a project or venture. Losses is available through
are shared on the basis of the venture capital firms
equity participation, whereas and investment banks,
profit is shared on the basis which may also
of a pre-agreed ratio. participate in
management.

Restrictions Islamic banks are allowed to Conventional banks

participate only in economic may finance any lawful
activities that are Shari’a product or service.
compliant. For example, banks
cannot finance a business that
involves selling pork or alcohol.

11/12/2022 11
Characteristic Interest Free Banking System Conventional Banking
System
(interest based)
Penalty on Islamic banks are not allowed Conventional banks
default to charge normally charge
penalties for their enrichment. additional Interest in
They may, case of late payments
however, allow imposition of or defaults.
default or late
payment .Penalties may be
donated to a charity
Avoidance of Transactions with elements of Speculative
gharar gambling or speculation are investments are
discouraged or forbidden. allowed.
Customer The status of an Islamic bank The status of a
relationships in relation to its clients is conventional bank in
that of partner and investor. relation to its clients
is one of creditor and
debtor.
11/12/2022 12
Characteristic Interest Free Banking System Conventional Banking
System
(interest based)

Shari’a Each Islamic bank must have a Conventional banks

supervisory supervisory board to ensure have
board that all its business activities requirement.
are in line with Shari’a
requirements.
Statutory An Islamic bank must be in
requirements compliance with the statutory
requirements of the National
bank of the country in which
it operates and also with
Shari’a guidelines.
11/12/2022
no such
A conventional bank
must be in compliance
with the statutory
requirements of the
central bank of the
country in which it
operates and in some
places, the banking
laws of state or other
localities.
13
 Introduction
1.2 Motivations
1.Access to formal financial service is low in Ethiopia;
2.Existence of large Potential demand, can be inferred
from:
 Request for IFB service for long
 Target population represent large group ~attest 30% of the
population; Encarta, 2008
 Non interest bearing saving customers & deposit has been
growing;+ Birr 350,000,000.
 NBE’s authorization directive.
3.IFB is increasingly common Globally: 80-Countries,
500 institutions, USD 2 trillion assets, 17% growth
per annum;
4.Suitable Regulatory and legal environment.

11/12/2022 14
 INTRODUCTION
1.3 OBJECTIVES & BENEFITS OF
IFB
1. Demand cannot cater with
conventional banking;
2. Tailor-made banking services
facilitate financial inclusion;
3. Financial inclusion helps for
high deposit resource
4. For customer satisfaction-
retain existing, expand base.

11/12/2022 15
oD
r
U
y
C
o  The pioneering effort, led by Ahmad Elnaggar, took
T
f the form of a savings bank based on profit-
I sharing in the Egyptian town of Mit Ghamr in 1963.
I
O
F This experiment lasted until 1967 by the time there
N
B were nine such banks in the country.
’  In 1973, the Islamic Development Bank was set-up.
s
 The first Islamic bank in Malaysia was established
in 1983. In 1993, commercial & merchant banks
were allowed to offer Islamic banking products and
services under the Islamic Banking Scheme (IBS).

11/12/2022 16
o
D
f
U
I
C
F
•These institutions however, are required to
T
B
’separate the funds and activities of Islamic
Is
banking transactions from that of the conventional
O
(banking business.
N
c•1977 (Sudan) Faisal Islamic Bank of Sudan was
o
established.
n
t•1979 (Bahrain) Bahrain Islamic Bank was
.established.
.
)•Today (Western) Citibank, HSBC, Islamic Bank of
Britain, Barkley’s offer Islamic Financial services.
11/12/2022 17
 INTRODUCTION
1.4 EXPERIENCE /PERFORMANCE
(cont..)
 1991 (Bahrain) Recognizing the need for
standards. Accounting and Auditing
organization for IFI was established
 Board (IFSB) was established . Sets to and
disseminates the prudential and supervisory
standards and core principles that are in
compliance of Shariah.

11/12/2022 18
O
f
D
U
I
C
F
B
T
’
Is
O
(N
c
o
n
t
.
.
)
11/12/2022 19
T
R
I
O
D
F
U
B
C
T
A. WINDOW MODEL:
Refers to conventional banks that offer Islamic banking products and
I
B
O services using their existing infrastructure, including staff and

N branches. E.g. ABSA Islamic Bank south Africa, Internationally, most

a of the large banking houses have followed the same route, E.g

n Citibank, HSBC, Lioyds of London

k B. DEDICATED BRANCH MODEL:

i
This model is similar to the windows model, however, in the

case dedicated branch are established for the delivery of

n Sheriah compliant products.

g 11/12/2022 20
IO
R

F
D
U
B
C C. FULLY FLEDGED MODEL:
T
Operations and management are clearly separated between
I
B
O the subsidiary Islamic bank and the parent conventional bank.
a E.g Albaraka Bank Limited in South Africa
N

n D. SUBSIDIARY MODEL:

In this Scenario, a conventional Bank develops a

k subsidiary under its entity to deliver Sheriah
i compliant products, advantage can establish its own
n process and an independent operating structure .
g
11/12/2022 21
 INTRODUCTION

ARGUMENTS FOR INTEREST FREE BANKING WINDOW MODEL

1. Gradual implementation
It takes time to
• Build a customer base
• Educate people
• Change regulatory environment
• Develop human resource capabilities
• Acquire adequate infrastructure
2. Efficiency
• Lowest cost within the shortest period of time
• Leverage on existing infrastructure (people and
physical resources)
• Avoid duplication of resources

11/12/2022 22
 INTRODUTION
ARGUMENTS FOR INTEREST FREE BANKING WINDOW MODEL
CONTD…

3. Effective development

• Variety of products

• Market familiarization of products

• Wider marketing base

4. Take advantage of technological advancement of

conventional banks

• Standard operating procedures, information systems,

control and monitoring systems

5. Capture non-Muslim market

11/12/2022 23
VI. Sources of Shariah (LAW)

A. The Glorious Qur’an

The Quran stated that

"0h believers, fear Allah, and give up what is still due to you from
the interest (usury), if you are true believers." [Surah 2 Verse 278]

B. Sunnah (Tradition)
Prophet Muhammad (PBUH) said:

“Exchange of gold with gold, silver with silver, wheat with wheat,
barley with barley, dates with dates and salt with salt should be of
equal quantities and spot. Anyone who varies the quantities or
allows one side of the exchange to be different, indulges in riba for
which buyer and seller are both equally responsible.”

11/12/2022 24
.

Ijma
C. (Consensus)

It is a consensus on various issues amongst the
ably-recognized scholars that provide guidance
to the Muslim Ummah
(nation) on various issues.

Qiyas
D. (Analogy)
Qiyas
 refers to analogy that is extrapolated from a

juristic rule derived from the Qur’an, Sunnah, or through

Ijma on the basis of an underlying principle or ‘illah’(underlying

rationale for a legal rule)

11/12/2022 25
 2. Fundamental Principles of IFB

 Any predetermined, conditional payment over and

above the actual Principal amount is prohibited
 Islam allows only one kind of loan and that is
Qard-al-hasan (goodly loan) whereby the lender
does not charge any interest or additional amount
over the money lent.
 Profit and loss principle is proportional to the risk
 Islam encourages Muslims to invest their money
and to become partners in order to share profits
and risks in the business instead of becoming
creditors.
 Islamic finance is based on the belief that the
provider of capital and the user of capital should
equally share the risk of business ventures.

11/12/2022 26
 2. Fundamental Principles of IFB…
 Making money from money is not Islamically
acceptable
◦ Money is only a medium of exchange, a way of defining
the value of a thing; but it does not view money as a
commodity that should be bought and sold at a
profit, simply by being placed at a bank or lent to
someone else.
◦ The human effort, initiative, and risk involved in a
productive venture are more important than the money
used to finance it.
 Gharar (Uncertainty, Speculation, Ignorance,
Deception) is also prohibited
◦ The prohibition of a Gharar transaction is due to
deception.
◦ This can arise either through ignorance of the goods,
the price, or through an inaccurate description of the
goods
11/12/2022 27
 2. Fundamental Principles of IFB…
 There are several types of gharar, all of which are
haram. The following are some examples:

 Selling goods that the seller is unable to deliver.

 Selling known or unknown goods against an unknown
price, such as selling the contents of a sealed box
 Selling goods without proper description, such as
shop owner selling clothes with unspecified sizes
 Selling goods without specifying the price, such as
selling at the 'going price'
 Making a contract conditional on an unknown event,
wherein the time is not specified
 Selling goods on the basis of false description
 Selling goods without allowing the buyer the properly
examine the goods
11/12/2022 28
2. Fundamental Principles of IFB…
Maysir (Gambling)
◦ Gambling is a form of Gharar because the gambler is
ignorant of the result of his gamble.
◦ It can also be regarded as a transaction in which there is a
possibility that one party can suffer a total loss.
◦ It must be noted that while gambling has an element of
uncertainty, not every type of uncertainty is gambling.
◦ It should be noted that maysir is one of the key elements in
the prohibition of conventional insurance.
 Products & Services invested in, must be
permissible
◦ Trading in Pork, dead animals, alcohol, for example
would not be financed by an IFB;
◦ property financing could not be made for the
construction of a casino; and an IFB could not lend
money to other banks at interest.
11/12/2022 29
T
O

S
F

R
E
T
 Profitin a business venture is determined ex
U
O
R
post—that is, depending on the outcome of
N
F
/ the venture but based on the predetermined
P
R profit/loss ratios. (for partnership
I
O
F
contracts)
F
I
T
 On the other hand, interest, which is
B determined ex ante—that is, predetermined
…
F
R regardless of the outcome of the venture.
O  Profit in a trade or a sale may be
M
determined ex ante, but it is based on
C trading real assets between contracting
A
P
parties, not lending of money on interest.
11/12/2022 30
THE THREE LEGAL MAXIMS:

A.General Permissibility : Everything is allowed

unless specifically prohibited

B.PLS (Profit and loss sharing) : The one who

takes the risk has the right to share in the profit

C.Asset Backed Financing : If you want the asset

financing then you have to show the asset

11/12/2022 31
Think Point !
President Obasanjo of Nigeria speaking in
the year 2000, commented on his country’s
debt to international creditors, saying : “All
that we had borrowed up to 1985 or 1986 was
around $5 billion and we have paid about
$16 billion yet we are still being told that
we owe about $28 billion. That $28 billion
came about because of the injustice in the
foreign creditors' interest rates. If you ask
me what is the worst thing in the world, I will
say it is compound interest.” So $5 billion was
borrowed and, fifteen years later, $44 billion
was due (either paid or due to be paid) ! !

11/12/2022 32
IV. IFB Contracts
First we shall discuss, explicitly Forbidden Acts Over Contracts:

 Selling forbidden items; (by law);

 Two Sales in one Contract; e.g
◦ Combining a loan contract with the receipt
of a gift
◦ Combining the sale of an item on the
condition of the use of another item
 Back-to-back sale; it is sales of the same
object between the same contracting parties,
changing roles in a contract, the second sale
being dependent on the first. For example, a
precondition of a sale in another sale.
11/12/2022 33
The
 sale of credit: It is not lawful to sell something on credit and

then buy it back from the person you sold it to at a lower price.

This difference in price is a typical example of Riba An Nasiyah

Selling
 a debt with a debt; it is not permissible to sell something

that does not exist (in terms of an asset or commodity) common

example is the factoring of debt. While it is permissible for a debt

to be transferred, it cannot be sold at a discount, premium or at

par.

Generally,
 Integrity, Honesty, Piety, Disclosure of faults,

Avoiding deception are Integral parts of IFB Contracts

11/12/2022 34
Contract/aqd/
A contract is a transaction that is executed between two or
more parties for mutual benefit
For a contract to be valid

 At least two independent parties

 Material effect following the exchange of item under
consideration
 Offer and acceptance relating to the item and the price
of the item
IFB contracts begin with making promises

11/12/2022 35
…

V. Types of IFB Contract Modalities

There are four Basic categories of IF Banking Legal

Contracts ,and are commonly called SPAS
1. Sales/Exchange Contracts:
A. Markup (Murabaha ) Contract- for purchase & sell
of goods
B. Forward Sale (Salam) Contract- For produce and
Sale;
C. Leasing (Ijarah) Contract- For Make/buy and lease
of durable, fixed assets;
D. Work-in-Progress Financing (Istisna) Contract -
for Construction/Assembly/manufacturing of assets

11/12/2022 36
2. Partnership Contracts:
A. Profit and Loss Sharing (Mudaraba) Silent
partnership
B. Profit/Loss Sharing (Musharaka) Joint Venture
3. Agency Contracts (Wakalah):
 Assignment of rights and obligations to other party,
4. Security Contracts:
A. Surety (Kafala) Contracts- for performance
guarantees;
B. Transfer of debt (Hawalah) contracts - for
Local/Foreign Money Transfer;
C. Pledge and mortgage (Rahn) contracts - for debt
collateral

11/12/2022 37
Penalty Payments for Late/ Defaults.
Three Views:

1. The principle doesn’t allow to penalize defaulters;

2. The defaulters have to be fined for fairness reason;

3. Can be fined using initial agreement but exclude from income (-Charity and also for goodly
loan)

Default Recovery:
 Collateral- depending on the degree of risk involved;
 Penalized based on prior agreements;
 Rescheduling –Without additional payments;
 Recoverable amounts -actual costs opportunity costs.

Compensation to PLS-Deposits
 Profit Equalization (Stabilization) Reserve (PER)
 Investment Risk Reserve (IRR) for protection of mudaraba pool;

11/12/2022 38
 3.1 DEPOSIT PRODUCTS:
1. (Wadiah Amanah ) Safekeeping Deposit
◦ Guarantee is given for the principal amount,
◦ No agreed benefit to depositors ;
◦ Purpose: Safety and convenience ;
◦ The fund can be deployed by the bank in any ‘permissible’
activities
◦ The account can be operated with passbook and vouchers .
2. (Qard) Current/Checking/Demand Deposit Account-i
◦ Can be operated similar to the conventional Checking
account
◦ Principal is guaranteed;
◦ The fund can be deployed in any ‘permissible’ area chosen by
the bank;
◦ Benefit payment is not obligatory .

11/12/2022 39
3. Mudarabah Saving:
◦ No prior guarantee for principal & benefit;
◦ The fund can be deployed in any
‘permissible’ activities selected by the bank.

4. Mudarabah Fixed time Deposit Account

◦ Is time bound. i.e., the deposit period is
determined in the contract to be made
between the depositor and the bank;
◦ No prior guarantee for principal and
benefit ;
◦ Limitations on withdrawal during specified
period based on prior agreement;
11/12/2022 40
3.2 Financing products
1) Trade Finance,
2) Equity or Investment Participation Finance ;
3) Lending Money.
1. Trade Finance:
Generally involve participation in buy-and
sale, buy/make-and-lease, sale-and-buy as well
as manufacture/produce-and –sale contracts.

11/12/2022 41
 Trade Financing Contracts have the
following varities:
A. Murabahah/Markup/Cost-Plus-profit/
based on client’s promise to buy goods,
bank buys an item identified by and for a
client. The client agree to repay the bank
the price and an agreed profit later
either on installment or lump sum bases
B. Ijarah/Leasing/
is where the bank buys/prepares an
item for a client and leases it to
him/her for a special rent and term.
The term may be the assets’
expected/economic life.
11/12/2022 42
◦The owner of the asset (the bank) bears all the risks
associated with ownership.
◦Initial ‘promise to give’ or ‘promise to sale’ is required
when the agreement is either to finally give or sale
the leased item to the lessee.

C. Istisna/Work-in- Progress/
◦Involves advance payments for future delivery of

goods. It can also involve future payment and future

delivery of goods. In this case, Banks pre-sell the
goods to a client for cash on delivery basis, and
negotiate the purchase of the commodities with the
supplier
11/12/2022 43
 D. Salam/Advance Payment against-deferred-
delivery-of-goods/
◦ Agreement to purchase at a predetermined price, a
specified kind of commodity, not available with the
seller, which is to be delivered on a specified future
date, in a specified quantity.
2. Investment Participation /Equity Financing
Models
There are mainly two Partnership financing models:
A. Joint-Venture(Musharakah);
B. Silent Partnership (Mudarabah).

3. Lending Money. (only Qard Al Hassen)

11/12/2022 44
 3.Products OF IFB…
3.3 Trade Service products
 Murabahah L/C
 Wakalah L/C
 Musharakah L/C
3.4 Money Transfer Services/Hawalah
 Local Money Transfer Services
 International Money Transfer Services
3.5 FOREX Services
3.6 Guarantee Services /Kafalah, etc

11/12/2022 45
Two organizations are known globally in design of
Accounting and Auditing Standards:
1. AAOIFI (Accounting and Auditing Organization for
Islamic Financial Institutions) Based in Bahrain
 Develop Accounting and Auditing and Sheriah
standards relevant to Islamic financial institutions
(IFI)
2. IFSB (Islamic Financial Services Board) Based in
Malaysia
 By December 2005 IFSB (Islamic financial service
Board) has issued two standards
 Principles of risk management, and
 Capital adequacy standards for Islamic financial
services

11/12/2022 46
 5. Risks in IFB
 Unlike conventional banks, IFB share business risks with

investors and borrowers.

 All risks faced by conventional banks, Liquidity risk, credit

risk, market risk including exchange rate volatility, legal

risk and operational risks, the measurements and

mitigations are common.

The following risks are termed as peculiar to IFB’s.

Displaced commercial Risk- when clients does not receive

what a market offering them;

11/12/2022 47
 5. Risks in IFB…
 Withdrawal Risk- shifting for better profit share;

 DCR lead to withdrawal then liquidity risk then

bankruptcy risk
 Governance Risk-failure to govern the institution,

 Fiduciary Risk - deviations from entrusted

responsibilities;
 Sheria -non -compliance risk

 Reputational Risk–defamations due to

irresponsible actions of management

11/12/2022 48
 6. Eligibility for IFB Services

 Any natural/legal persons who honor the

principles, deal with lawful business and
pertinent requirements;

11/12/2022 49
 THE END
THANK YOU!!!

11/12/2022 50