ISLAMIC BANKING (By Prof PNN Iyer, professoriyer@mail.

com ) Jan-
09

1. Overview of Islamic Banking.............................................................................................................4

1.1 Islamic Economics.....................................................................................................4
1.2 Islamic Banking.........................................................................................................5
1.3 Modes of Islamic Finance..........................................................................................6
1.3.1 Murabaha............................................................................................................6
1.3.2 Ijarah...................................................................................................................6
1.3.3 Ijarah-Wal-Iqtina................................................................................................6
1.3.4 Musharakah.........................................................................................................6
1.3.5 Musawamah........................................................................................................7
1.3.6 Istisna'a...............................................................................................................7
1.3.7 Bai Muajjal.........................................................................................................7
1.3.8 Mudarabah..........................................................................................................7
1.3.9 Bai Salam............................................................................................................7
2. Islamic Banking Issues.........................................................................................................................8
2.1 Human resource for Sharia'h compliance..................................................................8
2.2 Unresolved Fiqh Issues..............................................................................................8
2.3 Legal framework........................................................................................................8
2.4 Excess Liquidity........................................................................................................8
2.5 Technology................................................................................................................9

3. Islamic Investment Funds....................................................................................................................9

3.1 A comprehensive equities trading solution designed around the Murabaha
Investment Management platform.................................................................................11
3.1.1 Online Trade Opportunity.................................................................................11
3.1.2 Equity Financing Solution................................................................................12
3.1.3 Flows, stocks and positions..............................................................................13
3.1.4 Portfolio Management......................................................................................15
3.1.5 Back Office and Settlement..............................................................................16
3.1.6 Financial Accounts Management.....................................................................16
3.1.7 Equity Research Analysis.................................................................................17
4. Glossary Of Terms...............................................................................................................................18
5. Abbreviations/Acronyms..................................................................................................................24
6. References..............................................................................................................................................26
1. Overview of Islamic Banking

1.1 Islamic Economics

Islamic banking is based on the principles of Islamic economics — an

economic framework in accordance with Islamic law (Sharia'h).
There are two types of Islamic economics:
 Caliphate , the Islamic form of government representing the political
unity and leadership of the Muslim world (Islamic political framework)
 Assuming the political framework is non-Islamic, therefore, seeking to
integrate some prominent Islamic tenets into a secular economic
framework
Caliphate is the absolute Islamic rule, thus the economy focuses on
distribution of resources in order to meet the basic and luxurious needs of
individuals in society, and the state has a clear role in policing, taxation,
managing public assets, and ensuring the circulation of wealth.
Assuming non-Islamic political framework simply proposes two main tenets:
no interest can be earned on loans and socially responsible investing. This is
the way conventional banking is Islamized—the first step towards an Islamic
economic framework.
Modern day Islamic scholars and academics have developed various modes of
Sharia'h compliant financing that are designed to work within the prevailing
capitalist economic framework. In order to achieve this balance numerous
concessions have been afforded to financial institutions that would not apply
if a viable interest free economic system existed. The intention behind
making these concessions is to encourage the evolution of this type of
alternative system.

1.2 Islamic Banking

Islamic banking refers to a system of banking or banking activity that is

consistent with Islamic law (Sharia’h) principles and guided by Islamic
economics. In particular, Islamic law prohibits usury, the collection and
payment of interest, also commonly called RIBA. Generally, Islamic law also
prohibits trading in financial risk (which is seen as a form of gambling). In
addition, Islamic law prohibits investing in businesses that are considered
unlawful, or haraam.

Islamic finance has been gaining momentum on a global scale for the
last 30 years.

Many Islamic Banks have sprung up over the last few years. These
changes are occurring both in Muslim and in western countries, and
are driven by a global trend amongst Muslims to become more
observant of their faith. It might have been the reason why Islamic
Banking emerged, however, today Islamic Banking is sought by
Muslims and non-Muslims due to the benefits it offers.
Industry size is currently estimated at more than $400 billion, with projected
growth of 15% per annum.

Financial institutions around the globe are trying to keep pace with the
growing demand for Sharia’h compliant products and services.
 
 

1.3 Modes of Islamic Finance

1.3.1 Murabaha

Literally it means a sale on mutually agreed profit. Technically, it is a

contract of sale in which the seller declares his cost and profit. Islamic banks
have adopted this as a mode of financing. As a financing technique, it
involves a request by the client to the bank to purchase certain goods for him.
The bank does that for a definite profit over the cost, which is stipulated in
advance.

1.3.2 Ijarah

Ijarah is a contract of a known and proposed usufruct against a specified and

lawful return or consideration for the service or return for the benefit
proposed to be taken, or for the effort or work proposed to be expended. In
other words, Ijarah or leasing is the transfer of usufruct for a consideration
which is rent in case of hiring of assets or things and wage in case of hiring
of persons.

1.3.3 Ijarah-Wal-Iqtina

A contract under which an Islamic bank provides equipment, building or

other assets to the client against an agreed rental together with a unilateral
undertaking by the bank or the client that at the end of the lease period, the
ownership in the asset would be transferred to the lessee. The undertaking or
the promise does not become an integral part of the lease contract to make it
conditional. The rentals as well as the purchase price are fixed in such
manner that the bank gets back its principal sum along with profit over the
period of lease.
1.3.4 Musharakah

Musharakah means a relationship established under a contract by the mutual

consent of the parties for sharing of profits and losses in the joint business. It
is an agreement under which the Islamic bank provides funds, which are
mixed with the funds of the business enterprise and others. All providers of
capital are entitled to participate in management, but not necessarily required
to do so. The profit is distributed among the partners in pre-agreed ratios,
while the loss is borne by each partner strictly in proportion to respective
capital contributions.

1.3.5 Musawamah

Musawamah is a general and regular kind of sale in which price of the

commodity to be traded is bargained between seller and the buyer without
any reference to the price paid or cost incurred by the former. Thus, it is
different from Murabaha in respect of pricing formula. Unlike Murabaha,
seller in Musawamah is not obliged to reveal his cost. Both the parties
negotiate on the price. All other conditions relevant to Murabaha are valid for
Musawamah as well. Musawamah can be used where the seller is not in a
position to ascertain precisely the costs of commodities that he is offering to
sell.

1.3.6 Istisna'a

It is a contractual agreement for manufacturing goods and commodities,

allowing cash payment in advance and future delivery or a future payment
and future delivery. Istisna'a can be used for providing the facility of
financing the manufacture or construction of houses, plants, projects and
building of bridges, roads and highways.

1.3.7 Bai Muajjal

Literally it means a credit sale. Technically, it is a financing technique

adopted by Islamic banks that takes the form of Murabaha Muajjal. It is a
contract in which the bank earns a profit margin on his purchase price and
allows the buyer to pay the price of the commodity at a future date in a lump
sum or in installments. It has to expressly mention cost of the commodity and
the margin of profit is mutually agreed. 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.

1.3.8 Mudarabah

A form of partnership where one party provides the funds while the other
provides expertise and management. The latter is referred to as the Mudarib.
Any profits accrued are shared between the two parties on a pre-agreed basis,
while loss is borne only by the provider of the capital.

1.3.9 Bai Salam

Salam means a contract in which advance payment is made for goods to be
delivered later on. The seller undertakes to supply some specific goods to the
buyer at a future date in exchange of an advance price fully paid at the time
of contract. It is necessary that the quality of the commodity intended to be
purchased is fully specified leaving no ambiguity leading to dispute. The
objects of this sale are goods and cannot be gold, silver or currencies.
Barring this, Bai Salam covers almost everything, which is capable of being
definitely described as to quantity, quality and workmanship.

2. Islamic Banking Issues

2.1 Human resource for Sharia'h compliance

Users of Islamic financial services assign primary importance to Sharia'h

compliance of the services they use. It is understandable that Sharia'h
noncompliance entails a serious operational risk and can result in withdrawal
of funds from and instability of an Islamic bank, irrespective of its initial
financial soundness. Sharia'h compliance is hence a serious matter for an
Islamic bank, in addition to its compliance with other regulatory
requirements.

2.2 Unresolved Fiqh Issues

Lack of standard financial contracts and products can be a cause of ambiguity

and a source of dispute and cost. In addition, without a common
understanding of certain basic foundations, further development of banking
products is hindered.
2.3 Legal framework

An appropriate legal, institutional and tax framework is a basic requirement

for establishing sound financial institutions and markets. Islamic
jurisprudence offers its own framework for the implementation of commercial
and financial contracts and transactions.
Nevertheless, commercial, banking and company laws appropriate for the
enforcement of Islamic banking and financial contracts do not exist in many
countries.

2.4 Excess Liquidity

Islamic banks have over 60 % excess liquid funds which cannot be properly
utilized due to non-availability of Sharia'h Compliant products and
instruments.
The competitiveness and soundness of financial institutions depend on the
availability of efficient financial products. Islamic banks urgently need
Sharia'h compliant products to meet a number of pressing needs.

2.5 Technology

Designing technological solutions around a concept requires extensive

knowledge of the domain. Conventional banking today is technologically
advanced; however, for crafting Islamic financial solutions, considerable time
and expertise are required.
Islamic Banking — Possible Solutions
 Establishment of Shari'ah Governance Systems

 Settling unresolved Fiqh Issues

 A sufficient number of well-trained, competent, high-caliber Islamic

finance professionals and management teams with the required
expertise

 Well-informed individual and corporate consumers, knowledgeable

about Islamic banking and takaful

 The availability of Sharia'h compliant products (Sharia'h Compliant

Stocks, Sukuks, etc.)
  Development of a Legal, Regulatory, and Institutional Framework
complying with Sharia'h

 Advanced technology solutions designed to support Islamic Finance

3. Islamic Investment Funds

Islamic investment funds are relatively big and varied in number but in terms of funds
under management they are very modest compared to the conventional fund industry.

The single largest Islamic equity fund is the Al-Ahli Global Trading Equity Fund of
National Commercial Bank of Saudi Arabia with funds under management of about
US$600m. With the exception of one or two others, most of the Islamic mutual funds
have funds under management of between US$10m to US$75m, which makes the Islamic
fund industry marginal in the wider picture of the Islamic banking market.

Investment funds include equities, real estate funds, currency funds, Sukuk fund of funds,
commodity funds, leasing funds, and private equity funds. Perhaps the most developed
are the real estate and commodity funds.

Equities as an investment asset class vies with real estate and gilts (government bonds).
But investors from the Middle East are traditionally more at home with real estate
investment because of the "bricks and mortar" mentality. The government bond market in
the region is virtually non-existent and in any case there is a dearth of Shariah-complaint
treasuries worldwide, save Malaysia.

However, the stock market boom in the last few years in the GCC especially driven by
"an irrational exuberance" has seen greater involvement in equities. But the 30 per cent
market crash in 2005 has tempered caution. In contrast, the massive growth in real estate
development in the region underlines the fact that investors remain more comfortable
with the asset class.

Shariah governance and the lack of regulatory and legal frameworks in the GCC have
also contributed to the stagnation of the mutual fund industry per se and the Islamic fund
industry in particular. In Kuwait and other markets, there is still an underlying resistance
to equity funds because of a misconceived Shariah interpretation.
Nevertheless, with a young demography, and huge liquidity, the mutual fund industry
will persist and perhaps flourish with the right product offerings and expertise in
structuring, marketing, stock selection, and portfolio and investment management.

Malaysia and Saudi Arabia are by far the two largest markets for Islamic mutual funds.
Malaysia has over 90 such funds and two institutions in Saudi Arabia - Alrajhi Bank and
National Commercial Bank by far dominate the industry in the GCC with the two largest
families of Shariah-compliant funds.

The emergence of Islamic equity indexes such as the Dow Jones and FTSE has opened
up new areas for innovation in this respect especially index-linked funds and other more
exotic products such EFTs (Exchange Traded Funds).

There is also huge potential for private equity funds and for Takaful (Islamic insurance)
funds. Although the sector has seen a proliferation of single private equity transactions,
there are only a handful of Islamic private equity funds in the market. Takaful premiums
have to be invested in Islamic instruments. Most are currently invested in commodity
Murabaha transactions on the London Metals Exchange or the Commodity Murabaha
Programme led by bank Negara Malaysia.

Structuring Islamic equity products is well established even amongst western fund
managers. Structuring value-added Islamic equity funds is the real challenge!

3.1 A comprehensive equities trading solution designed around the

Murabaha Investment Management platform

It should comprise of a suite of specialized modules that facilitate Islamic financial

institutions and their clients to invest in the equities markets profitably. Furthermore, it
should allow Islamic financial institutions to provide collateralized lending to their clients
by allowing them Margin Financing against shares and enabling them to watch live stock
market movements, buy and sell equities on-line, view their positions, and analyze their
portfolios in an absolutely secure environment.

This equities trading solution should be aimed at facilitating Islamic Institutions to

develop an investment pool from various sources and facilitate onward financing to end-
clients using a fully collateralized, low risk model.

The trick lies in intelligently managing investors’ risk by using criteria predefined by the
financial institutions on a case to case basis—providing real-time information, alerts, and
automated sales.

The following key features of the solution have been captured below:
· Direct trade execution
· Back office settlement
· Margin/Murabaha financing
· Portfolio management
· Margin monitoring
· Financial accounting

Swift settlement procedures need to be integrated within the equities trading solution
suite to facilitate direct settlement of executed trades, commission adjustments, tax
calculations, brokerage billing, and trade contracts.

Bank clients may invest in equities, mutual fund units, and other investment opportunities
directly with the stock exchange through this equities trading solution.
The equities trading solution should be designed to exhibit a flexible architecture that will
allow it to seamlessly interface with other financial systems, while also adding on new
features designed for upcoming business opportunities such as Mutual Funds Units
Trading, Commodity Exchange Trading, etc.

The Equities trading solution Suite should consist of the following modules:

3.1.1 Online Trade Opportunity

Online Trade should facilitate bank clients to trade online using their allocated margin.
Thus, margin trading will allow customers to leverage existing securities for purchase of
additional securities. Customer accounts will be protected against overdraft by providing
a pre-sanctioned convenient line of credit. Online Trade should track margin balance and
collateral valuation in real time and activity information for customer accounts—
including real-time market rates, customer account balances, trade logs, margin checks,
and portfolio valuation.

The following should be the major features of Online Trade:

• Equity market research
• Online trade execution
• Multiple-broker setup
• Periodic trade history
• Rule-based trading
• Security measures
• After-hours trading
• Order matching
• Margin trading
• News updates
• Customer’s portfolio management and valuation
• Assortment of order placement options available (Limit Order,
Market Order and Stop Loss Order)
• Equity trade financing facility
• Trading gateway integration
• Trading against collaterals
• Real-time market updates

3.1.2 Equity Financing Solution

Margin Financing should be designed to offer a comprehensive solution to provide

financing against collaterals to bank customers managing all aspects of lending and
payback. This solution should be available in two versions—one that will follow the
Conventional Margin Financing System while the other which will be designed around
the Islamic Murabaha Financing Model.

The Margin Financing system should facilitate financial institutions and their customers
to invest in the equities markets and provide collateralized lending to end-clients.

Margin Financing should be designed to provide the following key features:

• Maintenance of collaterals at safe levels

• Dynamic margin call monitoring in real-time
• Collateral tracking
• Alerts (if collateral value falls below the margin financing limit granted)
• Electronic gateway integration
• Integration with the Online Trade Facility
• Automatic calculation of available financing limits
• Margin call alerts on customer accounts
• Alert for Non-Performing loan accounts
• Alert before forced-selling against customer accounts
• Seamless integration with major core banking and other enterprise applications
• Integration with other external systems
• Scalable to multiple database platforms
• Multiple levels of security and access controls
• Hassle free maintenance and support
• Loan servicing and customer account maintenance features
• Bank capital and reserve monitoring
• Regulator reporting

3.1.3 Flows, stocks and positions

It is necessary to identify what kinds of financial transactions done by IIFS may be
associated with claims on and liabilities to residents and non-residents. All underlying
data of PSIFIs are in the form of either stocks or flows.

I. Flows
Flows are monetary expressions of economic actions undertaken by institutional units
and any other events that take place during an accounting period which could affect the
economic status of institutional units. Flows reflect the creation, transformation,
exchange, transfer or extinction of economic value, causing changes in the volume,
composition or value of an institutional unit’s assets, liabilities and net worth.

Flows can be classified either as transactions or other economic flows:

(a) Transactions represent interactions between institutional units by mutual agreement

or actions analytically useful to be treated like transactions within an institutional unit,
often because the unit is operating in two different capacities, involving goods, services,
income, transfers, and non-financial and financial assets.

(b) Other economic flows represent changes in the volume or value of an asset of
liability that do not result from transactions. Volume changes are other changes in the
volume of assets, such as losses due to extraordinary events, while value changes are
holding gains and losses arising from price or exchange rate movements.

In practice, total recorded flows during a period can be divided into three separate
components:

(a) Transactions – that is, financial flows that arise by mutual agreement between
institutional units, from the creation, liquidation or change of ownership of financial
assets or liabilities. Changes of ownership may occur through the sale, transfer or other
discharge of all rights, obligations and risks associated with a financial asset or liability.

(b) Revaluations – that is, financial flows arising from changes in prices of financial
assets and liabilities and/or the exchange rate that may affect the domestic currency
values of assets and liabilities denominated in foreign currencies.

(c) Other changes in the volume of assets (OCVA) – that is, financial flows that arise
from asset and liability changes other than those arising from transactions and
revaluations, including write-off claims, reclassification of assets, monetisation or
demonetisation of gold, allocation or cancellation of SDRs, and other events.

II. Stocks

Stocks are positions in or holdings of assets and liabilities of an institutional unit at a

specific time and the unit’s resulting net worth. In this Compilation Guide, flows and
stocks are parts of an integrated system whereby all changes in stocks can be explained
by a relationship with the flows according to the following equation:
S¹ = S0 + F
Where,

S¹ represents the value of a specific financial stock at the beginning of an accounting

period
S0 represents the value of a specific financial stock at the end of an accounting period

F represents the net value of all flows during the period

In general, stocks are closely linked to flows, since the value of any stock held at any
given time is the cumulative value of all flows that may have occurred during the period
to an asset or a liability held since its initial acquisition. As such, changes in stocks take
fully into account all prior flows (entries and withdrawals plus other changes, either in
volume or in value) recorded between periods.

In this example, opening stock refers to the value of the outstanding stock of a category
of financial assets or liabilities at the beginning of an accounting period. Closing stock
refers to the value of the outstanding stock of a category of financial assets or liabilities at
the end of an accounting period, which is equivalent to the value of the opening stock
plus flows arising from transactions, revaluations and OCVA.

III. Positions

Positions refers to the value of outstanding stocks of financial and non-financial assets
and liabilities held at one point in time, usually at the reference date of the balance sheet
by each institutional unit or institutional sector or the economy as a whole.

Assets and liabilities are the components of the balance sheets of the total economy and
institutional sectors. A balance sheet is a statement, drawn up at a particular point in time,
presented with liabilities and net worth on the right side and assets on the left. Net worth
is the difference in value between all financial and non-financial assets owned by an
institutional unit or an institutional sector and outstanding liabilities – that is, the
balancing item of a balance sheet. As such, net worth cannot be measured independently
of other entries and it does not relate to any specific set of transactions.

Financial assets are entities over which ownership rights are enforced by institutional
units and from which economic benefits may be derived in the form of holding gains or
property income. The fact that there is a counterpart liability of another institutional unit
distinguishes financial assets from other types of assets in the SNA 1993.

Non-financial assets are entities over which ownership rights are enforced by institutional
units, individually or collectively, and from which economic benefits may be derived by
their owners by holding or using them over a period of time. Non-financial assets consist
of tangible assets, both produced and non-produced, as well as intangible assets for which
no corresponding liabilities are recorded.

Produced assets comprise non-financial assets that have come into existence as outputs
from production processes, including fixed assets, inventories and valuables (assets
acquired and held primarily as stores of value). Non-produced non-financial assets are
both tangible (e.g. land, subsoil assets, water resources and non-cultivated biological
resources) and intangible (e.g. patents, leases and purchased goodwill) assets that come
into existence other than through processes of production.

Although they may fulfil other functions, financial assets are directly stores of value,
while most non-financial assets generally serve two purposes, as objects usable in
economic activities and as stores of value.

3.1.4 Portfolio Management

A Portfolio Management system especially designed for individual, corporate, and

financial institutions’ portfolios of different sizes and various levels of complexities—
managing equities and fixed income securities holdings.
Securities should be segregated and compliance reports should be accordingly generated.

Portfolio Management integrated with Online Trading to generate purchase and sales
confirmations, thus updating information on holdings.
Through an embedded report-writer customized reports should be printed easily.
Information from the history files should be easily exported to databases, spreadsheets,
and word processors.

The following are the major features of Portfolio Management:

• Opening stocks
• Present stock holdings
• Electronic trading gateway integration
• Accrual on investments/holdings
• Real-time stock market valuation
• Corporate actions/announcements
• Profit and loss statements
• Risk/exposure monitoring and reporting

3.1.5 Back Office and Settlement

Back Office and Settlement will help shorten the transaction settlement cycle by
effectively tackling the top ranked post-execution challenges faced by organizations
trading in capital markets.
To achieve cost control and efficiency, the primary focus should be on delivering
comprehensive and modular solutions for post-execution processing ranging from deal
capture through enrichment, settlement, and subsequent post-settlement activities.
Back Office and Settlement should cover a wide range of asset classes, currencies, and
OTC products with fast exception management for timely discrepancy resolution. The
system should automate trading of securities and provides reports for management,
accounting, and compliance for banks, brokerage houses, and trading departments.

The salient features of Back Office and Settlement are listed below:
• Integration with the trading platform
• Physical/CDC shares inventory
• Settlement date schedules
• Brokerage slabs and categories
• Cost factors input
• Clearing house/brokers exposure reports
• Client exposure summary
• Periodic and summary reports
• Tax calculations and reports
• Market valuation of stocks
• Equity trade financing provision
• Margin financing provision
• Handling of all types of equity settlements
• Customer bills and contracts
• Commission history and summary reports
• Brokerage bills for multi-broker operations

3.1.6 Financial Accounts Management

The following are the key features of Financial Accounts Management:

• Petty cash subsidiaries

• Maintenance of chart of accounts
(Customer and GL)
• Multiple voucher types
• Transaction vouchers
• Voucher printing
• Reversal voucher option
• Subsidiary ledger
• Cash book/ bank book

3.1.7 Equity Research Analysis

Research system should provide in-depth research and analysis to investors, letting them
have up-to-date technical research and data in the following manner:
• Access to real-time and historic charts, institutional investment research, and technical
analysis
• Online stock investment analysis and decision-making tools
• Customized research reports and analysis
• Availability of Pre-IPO and annual growth trends and statistics
• General journal
• General ledger
• Audit trail
• Notes of accounts
• Trial balance
• Income statement
• Balance sheet
• Transaction ledger
• Accounts payable/receivable

4. Glossary of Terms
5.

Abbreviations/Acronyms

6. References
-Isthakdam, Min. of Interior, Saudi Arabia

-Al Rajhi Bank, Saudi Arabia

-Arab Banking Corporation

-Saudi-American Bank

-British Bank of Middle-East

- State Bank of Pakistan

- International Islamic Financial Market (IIFM)

- The Balance Sheet Approach and its Application at the Fund (30 June
2003), Policy Development and Review Department, IMF

- Wikipedia.org