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Islamic Banking in Theory and Practice

Islamic banking
Islamic banking is banking or banking activity that is consistent with the principles of Islamic law (Sharia) and its practical application through the development of Islamic economic.

Objective of Islamic Banking

Objective of Islamic Banking is to make positive contribution to the fulfillment of socio-economic objectives of the society

Islamic Bank
Islamic Bank is a financial and social

institution which identifies itself with the principles of Shariah, as laid down by Holy Quran and Sunnah, as regards its objective, principles, practices and operations.

Principles of Islamic Banking

Transactions must be free of interest (riba) Risk sharing Goods and services that are illegal (haram) from the Islamic point of view cannot be produced or consumed. Activities or transactions involving speculation (gharar) must be avoided. Zakat (the compulsory Islamic tax) must be paid.

Islamization Of Banking In Pakistan

in 1948, Mr. Muhammad Ali Jinnah emphasized the virtues of Islamic principles and in his address at the inauguration of the State Bank of Pakistan (SBP), said:

I shall watch with keenness the work of your Organization in evolving banking practices compatible with Islamic ideas of social and economic life. We must work our destiny in our own way and present to the world an economic system based on true Islamic concept of equality of manhood and social justice.

Islamization Of Banking In Pakistan

In 1977-1978, the process of Islamization of banking system was started. In October, 1977 the council of Islamic Ideology was charged with responsibility of bringing about Islamic economic and banking system.
The Islamic Ideological Council presented its report in 1980, later there was a criticism on the report too.

Implementation Of Islamic Banking In Pakistan

Stage-1 Interest was first eliminated from July, 1979 from the transactions of NIT. Stage-2 From first January, 1981, profit and loss sharing saving and term deposits was introduced by commercial banks in place of simple saving and fixed deposit scheme.

Stage-3: In August, 1981, HBFC was allowed to provide finance on rent sharing basis for house building. Students were allowed Qarze-Hasana without interest. Stage-4: In 1983, hire purchase system of financing was introduced. Stage-5: From July 1, 1984 to December 31,1984 all banks in the country were to make finance available also on the basis of Islamic modes of financing in addition to existing interest based system.

Stage-6: From January 1985, all types of finances provided by the bank to the government and their agencies were permissible on Islamic basis only. Stage-7: From April 1985, all types of finances provided by the bank to all clients were to be on Islamic basis only. Stage-8: From July 1985, all deposits were to be on the basis of participation in profit and loss of banks except current account.

The Commission for Transformation of Financial System (CTFS) was constituted in January 2000, in SBP to transform the financial system. Later in FY02 finance minister declared some regulations for the elimination of Riba/Interest from the financial system of Pakistan.

SBPs contribution towards Islamic Banking

A bank can be established with capital investment by the state or by the individual. The minimum number of shareholders shall be two. The maximum number of shareholders shall be determined by the requirement of business. The net basic capital shall be divided in equal shares and individuals can then purchase an equal number of different number of shares.

The profit or loss shall be distributed in proportion to the value of shares of each partner in banking business. The bank should confine itself to providing capital to entrepreneurs on Shirakah or Modarba basis. To enhance its income the bank can provide various services to the general public or government.

In order to create more capital the bank enter into business with individual or corporations on Shirakah and Modarba basis. The bank shall be authorized to use the joint capital for expenses on buildings, equipment and salaries of staff.
The banks partners shall be free to carry on their individual and private businesses.

All decisions regarding the bank shall be taken in consultation with all its shareholders or representative committee. The financial liability of the banks shareholders shall be unlimited. Every shareholder shall be free to terminate his Shirakah. At the death of a partner, his Shirakah will come to an end.

Difference between conventional & Islamic banking

medium of exchange and store of value. Therefore, it can be sold at a price higher than its face value and it can also be rented out.

though it is used as a medium of exchange and store of value. Therefore, it cannot be sold at a price higher than its face value or rented out.

1. Money is a commodity besides 1. Money is not a commodity

2. Time value is the basis for charging interest on capital.

2. Profit on trade of goods or charging on providing service is the basis for earning profit.

3. Interest is charged even in case the organization suffers losses by using banks funds. Therefore, it is not based on profit and loss sharing.

3. Islamic bank operates on the basis of profit and loss sharing. In case, the businessman has suffered losses, the bank will share these losses based on the mode of finance used (Mudarabah, Musharakah). 4. The execution of agreements for the exchange of goods & services is a must, while disbursing funds under Murabaha, Salam & Istisna contracts.

4. While disbursing cash finance, running finance or working capital finance, no agreement for exchange of goods & services is made.

5. Conventional banks use money as a commodity which leads to inflation.

5. Islamic banking tends to create link with the real sectors of the economic system by using trade related activities.

money Bank money + money (interest) Client



Goods & Services money



Business of Islamic Bank

1. Customers Deposits

2. Financing

a) Current Accounts (b) Savings Accounts (c) General Investment (d) Special Investment Accounts

(a) Al-Mudharabah; (b) Al-Musharakah; (c) Al-Bai bi Thaman Ajil; (d) Al-Ijara; (e) Al-Bai al Takjiri; (f) Al-Qardul Hasan

Customers Deposits
Current Accounts
The Bank accepts deposits from its customers looking for the safe custody of their funds and absolute convenience in their use in the form of current accounts on the Islamic principle of Al-Wadiah.

Savings Accounts
The Bank accepts deposits from the customers looking for safe custody of their funds and a degree of convenience in their use together with the possibility of some profits in the form of savings account on the Islamic principle of Al- Wadiah. The Bank provides its customers with Savings Pass Books and other usual services connected with Savings Accounts.

General investment Accounts

The Bank accepts deposits from its customers looking for investment opportunities for their funds in the form of general investment accounts on the Islamic principle of Al-Mudarabah. The deposits will have to be for a specified period. The Bank acts in this case as the entrepreneur and the customers as the provider of capital.

Special Investment Accounts

Bank may also selectively accept deposits from its Government or Corporate customers in the form of Special Investment Accounts. These accounts are also operated on the principle of Al-Mudarabah.

financing under the principle of al-Mudharabah
The Bank may undertake to finance acceptable projects under the principle of al-Mudharabah. In this case, the Bank is the provider of the capital and will provide 100% financing for the relevant project. The initiator of the project is the entrepreneur who will manage the project. The Bank cannot interfere in the management of the project but has the right to undertake the follow-up and supervision tasks.

financing under the principle of al-musharakah

The Bank may undertake to finance acceptable projects under the principle of al-musharakah. In this case the Bank together with the initiator or initiators of the relevant project will provide the whole financing for the project in agreed proportions. All parties including the Bank have the right to participate in the management of the project but all parties have the option to surrender such right.

Financing under the principles of al-bai Bithamin ajil (deferred sale)

The Bank may finance its customers who wish to acquire a given asset but to defer the payment for the asset for a given period or to pay by installments under the principle of al-bai Bithamin ajil.

Financing under the principle of al-Ijara (leasing)

The Bank may finance its customers to acquire the right to use the services of a given asset under the principle of al-Ijara. The Bank first purchases the asset required by the customers. Subsequently the Bank leases the asset to the customer for a fixed period subject to lease rentals and other terms and conditions as agreed by both parties.

Financing under the principle of al Bai ul Takjiri

The Bank may finance its customers who initially wish to use the services of a given asset but subsequently to own the asset under the principle of al-bai ul Takjiri. The procedure is the same as in ijara or leasing, except that both parties agree that at a point of time, the customers will purchase from the Bank the asset-concerned at an agreed price with all the lease rentals previously paid constituting part of such price.

Qard al-hassan (Benevolence loan)

A unique product of the Islamic bank, is a zero-return loan (a negative investment). All Islamic banks are urged or required to make these benevolence loans to needy and poor people.

if u loan to ALLAH, a beautiful loan, He will double it to your(Credit)


Other Services
Trade financing including letters of credit and letters of guarantee.
Islamic Export Credit Refinancing Scheme. Remittance and transfer of funds.

Sale and purchase of foreign currency.

Financial assistance from the bank

the central bank,serving both as a lender of last resort as well as provider of refinance, can advance to the applicant Islamic bank the liquidity required ascertaining the magnitude of its urgent needs. such a liquidity support operation can be conducted on the basis of MUDARABAH and MUSHARAKAH.

Participation in the clearing house

Islamic bank should be allowed to participate in the claearing house operations. Since participation in the clearing house requires that the bank should have current account with the central bank, short term overdraft facilities, free of interest, should be allowed by the central bank to Islamic bank to cover shortfalls for any short time period.

Central banks control

permission to establish banks, to practice banking activities and to open new branches. Specifying the terms governing the designation of board of directors. Commitment to submit required statements to monetary authorities.

Correspondence services Each of them can open an operating account with no interest. Each of the two banks will collect bills, drafts. Cheques of other banks.

Exchange of funds
Islamic banks can accept funds on the basis of MUDARABAH from conventional bank in the form of an investment account with a return. Such return will be same as paid by Islamic bank to their clients.

joint financing.
A large number of the conventional banks have opened interest free windows that can be helpful in promotion of financial cooperation between the interest free and interest based institutions.

Exchange of information:
clients dealing with Islamic banks may also be dealing with commercial bank. There must be exchange of information about such clients by banks.

Joint training program:

Islamic banks can participate with other banks in the training programs.

Current Status of Islamic Banking in Pakistan

While the number and operations of Islamic banks are fast expanding, this segment of the market is still small relative to the appetite for Islamic finance. Pakistan is launching a gradual and steady approach to Islamic banking.

Despite rapid expansion in industry, the share of Islamic banking in the total banking system is a modest 3.2%. It only caters for around 23,000 borrowers through around 170 branches relative to the country-wide 5 million borrowers (or 4.8 million excluding microfinance borrowers) tapped through 7,700 branches by conventional banks.

Current Status of Islamic Banking in Pakistan

Financing and investment levels of Islamic banks barely range around Rs77 billion, which is below 3% of the total banking systems advances.
On the product side, Islamic banks so far offer about 75% of products currently available in conventional banking while clean lending for consumer financing products, like personal loans and credit cards. Islamic banks operate exclusively in large cities with some now venturing into secondary cities but they are absent from rural areas where there is great potential for business growth.

Islamic Banking In Global Scenario

Islamic Development Bank (IDB):
First Islamic Bank established in 1975 in Jeddah, by the persuasion finance ministers of Islamic Countries with an authorized capital of 6 billion Islamic Dinars. 56 member countries worldwide.

IDB and Pakistan:

Pakistan has 127.26 million Islamic Dinars which is 3.06% of the whole subscription. IDB has helped Pakistan in its Nuclear Program.

Islamic Banks and Financial Institutions

According to the General Council for Islamic Banks and Financial Institutions there are currently 275 institutions worldwide that follow Islamic banking and financing principles, collectively managing in excess of $200 billion. These institutions are spread throughout 75 countries, including Europe and the United States. Twenty institutions now offer a variety of Islamic financial services in the United States. An increasing number of western financial institutions now offer Islamic investment products to Muslim investors. Growing at the rate of 15percent per annum.

Role of Islamic Banks in Economy

Islamic banks work as a trading concern and financial intermediary to perform interest-free activities. Islamic banks perform activities in the right direction towards economic development.

Islamic banks perform a variety of fund-based and non-fund based functions to facilitate their customers.
Islamic banks play a vital role in the economy to promote productive activities that enhance economic growth and prosperity. Islamic banks ensure stable economy;fair distribution of income; reduce injustice; risk sharing,

What we need to do
Aggressive deposit mobilization to augment domestic financial savings of the country Diversification and innovation of financial structures.

Promote financial industry diversification

Enhance understanding and capacities of Islamic Banking Risk Management Promote international standards and best practices in Islamic Industry Promote good corporate governance in Islamic banking

What do we need now

Revival of Bayt-ul-Mal (House of Wealth), a system which expresses the glorious days of Muslim rule. Bayt-ul-Mal:
Financial institution for administration of taxes. Royal treasury of Sultans and Caliphs. Administered distribution of Zakah.