CHAPTER ONE: OVERVIEW OF ISLAMIC BANKS

1.1.

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. The Organization of Islamic conference (OIC) defined an Islamic Bank as a financial institution whose statutes, rules and procedures expressly state its commitment to the principles of Islamic Shariah and to the banning of the receipt and payment of interest on any of its operations. According to Islamic Banking Act 1983 of Malaysia, an Islamic Bank is 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. The banking Industry all over the world is witnessing new challenges in the NeoGlobalized world, one of the most recent one being the Economic Recession which has hit U.S (Early 2009) & later on the whole world. In wake of these emerging trends ,the world is waking up to new forms of banking which are considered to be based on more strong foundations of ethical principles and have shown significantly lesser signs of stress during crisis as compared to conventional banking. Islamic finance & banking is one of those types of banking which are considered to be shock-proof and are becoming a cause of debate in emerging Asian economies like India, not predominantly because these countries have substantial Muslim population to cater to Islamic Banking but because of the other reasons cited above.

1.2.

Objectives:

The objective of Islamic Banking is not only to earn profit, but to do good and bring welfare to the people, Islam upholds the concept that money, income and property belong to Allah and this wealth is to be used for the good of the society. Islamic Banks operate on Islamic principles of profit and loss sharing and other approved modes of Investment. It strictly avoids interest which is the root of all exploitation and is responsible for large scale inflation and unemployment. An Islamic Bank is committed to do away with disparity and establish justice in the economy, trade, commerce and industry; build socio-economic infrastructure and create employment opportunities.

1.3.

History and Present Status of Islamic Banking around the World

The History of Islamic Banking can be divided in to two parts. First When it still remained an Idea, Second-When it became a reality-by private initiative in some counties and by law in others. Islamic Banking as an Idea: The scholar of the recent past in early fifties started writing for Islamic Banking in place of Interest Free Banking. In the next two decades Islamic Banking attracted more attention. Early seventies saw the institutional involvement. Conference of the Finance Ministers of the Islamic Countries was held. The involvement of institutions and Government led to the application of theory to practice and resulted in the establishment of the Islamic Banks. In this process the Islamic Development Bank (IDB) was established in 1975.

The coming into being of Islamic Banks: The first private Islamic Bank, the Dubai Islamic Bank was also set up in 1975 by a group of Muslim businessmen from several countries. Two more private banks were founded in 1977 under the name of Faisal Islamic Bank in Egypt and Sudan. In the same year the Kuwaiti Government set up the Kuwait Finance House.

A number of innovative concepts and techniques were introduced in early Islamic banking, including bills of exchange, the first forms of partnership (mufawada) such as limited partnerships (mudaraba), and the earliest forms of capital (al-mal), capital accumulation (nama al-mal),cheques, promissory notes, trusts(see Waqf), startup companies, transactional accounts, loaning, ledgers and assignments. Organizational enterprises similar to corporations independent from the state also existed in the medieval Islamic world, while the agency institution was also introduced during that time. Many of these early capitalist concepts were adopted and further advanced in medieval Europe from the 13th century onwards. In the ten years since the establishment of the first private commercial bank in Dubai, more than 50 Islamic Banks have come into being. Though nearly all of them are in Muslim countries, there are some in Western Europe as well: in Denmak, Luxembourg, Switzerland and the UK. In most countries the establishment of Islamic banking had been by private initiative and was confined to that bank. In Iran and Pakistan, however, it was by government initiative and covered all banks in the country. The Governments in both these counties took steps in 1981 to introduce Islamic Banking.

10

CHAPTER 2: RESEARCH METHODOLOGY

2.1.

Scope of the Study

As per a financial analysis by Moodys Investors Service expressed in ifinanceexpert.wordpress.com, Islamic financial institutions had total assets in 2009, despite a gloomy international economic environment, of $US950 billion ($1.03 trillion).But it estimated that the sectors potential was worth at least at least $US5.0 trillion ($5.43 trillion) and the industry is continuing to expand globally.Islamic banking has been left relatively unscathed by the global financial crisis, largely because of rules forbidding engagement in the kind of risky business that sank mainstream institutions like Lehman Brothers. India has a Muslim population of some 150 million, making it the state with the secondlargest Muslim population in the world after Indonesia. This Muslim population is readymade untapped customer base for the growing Islamic banking industry. We also believe and strive to verify by this project that Islamic finance instead of being promoted and marketed as a Religion-based system, if marketed purely on its features as a new banking system to Non-Muslims, would be acceptable and to what extent if it is? The general public in this respect is taken to be from the Muslim & Non-Muslim Population in the middle class bracket of India which is believed to form one of the largest growing strata of population and which can readily understand the Concepts of contacts in Islamic Finance. The study is limited to the Mumbai region of India as far as collection of primary data is concerned in face to face interview with the experts. We have tried to reduce this limitation by taking the opinion of various sects as we assume that local regional culture have little or no effect on the financial rules governing a particular Islamic sect.

11

2.2.

Objective of the study

The main objective of this project is to look at the various perspectives which are carried by various people or organizations or sects about Islamic banking in India and to arrive at a common conclusion as to how the modern Islamic banks form policies at strategic and tactical level so as to accommodate all these perspectives and build a sustainable business model in Asian countries like India. Thus, the feasibility analysis of Islamic banking and its products /contracts in India is the main aim. The scope of secondary findings from such an exploratory model always exist and any such critical & contingent finding which falls near or around the purview of our primary objective will always be a part of research findings.

2.3.

Research Methodology

To make this project majority of the information is compiled using secondary data. The data is collected from the internet using various sites, newspapers and news magazines. Also the reports of a few banks have been referred to compile this data. Since, most of the topnotch Islamic Banks are outside India it was difficult to visit them and get primary data from them. But nevertheless, technology combats this problem and most of the data required was available on their website. A detailed list of the sources has been provided in the bibliography. Since the study is about feasibility of Islamic finance in India, to collect views of the general population, a questionnaire based online survey was conducted. Results of survey and the questionnaire are given towards the end of the report.

12

2.4.

Areas Of Research

In this study, i have only focused on feasibility of India as the next destination for Islamic Finance & Banking in the coming recent years. In this study we seek to understand the perception of Indian 1) 3) 4) Politico-legal system Muslim Middleclass (Group 1) Non-Muslim Middleclass (Group 2)

On the basis of their point of views ,understanding , likability & acceptability (as a concept) and other minor differences in the concepts regarding Islamic finance , So as to project the future picture of Islamic finance in India and to Suggest ways & models to regularize it as an option along with conventional banking.

The major areas of research regarding Islamic finance will include topics like 1) Arbun: Earnest money/Down payment, 2) Gharar: Uncertainty such as short selling, speculation and derivatives, 3) Ijara: An Islamic lease agreement, 4) Istisna: Salam contracts applied to manufacturers, with the possibility of payment in installments, 5) Maysir: Gambling, speculation, conventional insurance and derivatives, 6) Mudaraba: Investment partnership, 7) Murabaha: Purchase and resale, 8) Musharkah: Profit and loss sharing,

13

9) Riba: Interest, 10) Salam: commodity forward, 11) Sukuk: Islamic bond, 12) Takaful: Islamic insurance, 13) Tawarruq: Reverse murabahah, 14) Urboon: Depositing small fraction of price in a deal to be concluded in the future and others with varying degree of importance.

14

CHAPTER 3: REVIEW OF LITERATURE

3.1.

Introduction:

Islamic banking refers to a system of banking or banking activity that is consistent with the principles of Islamic law (Sharia) and its practical application through the development of Islamic economics. Sharia prohibits the payment or acceptance of interest fees for the lending and accepting of money respectively, (Riba, usury) for specific terms, as well as investing in businesses that provide goods or services considered contrary to its principles (Haraam, forbidden). While these principles were used as the basis for a flourishing economy in earlier times, it is only in the late 20th century that a number of Islamic banks were formed to apply these principles to private or semi-private commercial institutions within the Muslim community.

During the Islamic Golden Age, early forms of proto-capitalism and free markets were present in the Caliphate, where an early market economy and an early form of mercantilism were developed between the 8th-12th centuries, which some refer to as "Islamic capitalism". A vigorous monetary economy was created on the basis of the expanding levels of circulation of a stable high-value currency (the dinar) and the integration of monetary areas that were previously independent.

3.2.

Riba (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). The definition of riba in classical Islamic jurisprudence was "surplus value without counterpart." or "to

15

ensure equivalency in real value" and that "numerical value was immaterial." During this period, gold and silver currencies were the benchmark metals that defined the value of all other materials being traded. Applying interest to the benchmark itself (ex natura sua) made no logical sense as its value remained constant relative to all other materials: these metals could be added to but not created (from nothing). Applying interest was acceptable under some circumstances. Currencies that were based on guarantees by a government to honor the stated value (i.e. fiat currency) or based on other materials such as paper or base metals were allowed to have interest applied to them. When base metal currencies were first introduced in the Islamic world, no jurist ever thought that "paying a debt in a higher number of units of this fiat money was riba" as they were concerned with the real value of money (determined by weight only) rather than the numerical value. For example, it was acceptable for a loan of 1000 gold dinars to be paid back as 1050 dinars of equal aggregate weight (i.e., the value in terms of weight had to be same because all makes of coins did not carry exactly similar weight).

3.3.

Modern Islamic Banking

The first modern experiment with Islamic banking was undertaken in Egypt under cover without projecting an Islamic imagefor fear of being seen as a manifestation of Islamic fundamentalism that was anathema to the political regime. The pioneering effort, led by Ahmad Elnaggar, took the form of a savings bank based on profit-sharing in the Egyptian town of Mit Ghamr in 1963. This experiment lasted until 1967 (Ready 1981), by which time there were nine such banks in the country. In 1972, the Mit Ghamr Savings project became part of Nasr Social Bank which, till date, is still in business in Egypt. In 1975, the Islamic Development Bank was set-up with the mission to provide funding to projects in the member countries. The first modern commercial Islamic bank, Dubai Islamic Bank, opened its doors in 1975. In the early years, the products offered were basic and strongly founded on conventional banking

16

products, but in the last few years the industry is starting to see strong development in new products and services. Islamic Banking is growing at a rate of 10-15% per year and with signs of consistent future growth. Islamic banks have more than 300 institutions spread over 51 countries, including the United States through companies such as the Michigan-based University Bank, as well as an additional 250 mutual funds that comply with Islamic principles. It is estimated that over US$822 billion worldwide shariah-compliant assets are managed according to The Economist. This represents approximately 0.5% of total world estimated assets as of 2005. The World Islamic Banking Conference, held annually in Bahrain since 1994, is internationally recognized as the largest and most significant gathering of Islamic banking and finance leaders in the world. The Vatican has put forward the idea that "the principles of Islamic finance may represent a possible cure for ailing markets."

3.4.

Principles of Islamic Banking

Islamic banking has the same purpose as conventional banking except that it operates in accordance with the rules of Shariah, known as Fiqh al-Muamalat (Islamic rules on transactions). The basic principle of Islamic banking is the sharing of profit and loss and the prohibition of riba(usury). Common terms used in Islamic banking include profit sharing (Mudharabah), safekeeping (Wadiah), joint venture (Musharakah), cost plus (Murabahah), and leasing (Ijarah). In an Islamic mortgage transaction, instead of loaning the buyer money to purchase the item, a bank might buy the item itself from the seller, and re-sell it to the buyer at a profit, while allowing the buyer to pay the bank in installments. However, the bank's profit cannot be made explicit and therefore there are no additional penalties for

17

late payment. In order to protect itself against default, the bank asks for strict collateral. The goods or land is registered to the name of the buyer from the start of the transaction. This arrangement is called Murabaha. Another approach is EIjara wa EIqtina, which is similar to real estate leasing. Islamic banks handle loans for vehicles in a similar way (selling the vehicle at a higher-than-market price to the debtor and then retaining ownership of the vehicle until the loan is paid).

An innovative approach applied by some banks for home loans, called Musharaka al-Mutanaqisa, allows for a floating rate in the form of rental. The bank and borrower form a partnership entity, both providing capital at an agreed percentage to purchase the property. The partnership entity then rents out the property to the borrower and charges rent. The bank and the borrower will then share the proceeds from this rent based on the current equity share of the partnership. At the same time, the borrower in the partnership entity also buys the bank's share of the property at agreed installments until the full equity is transferred to the borrower and the partnership is ended. If default occurs, both the bank and the borrower receive a proportion of the proceeds from the sale of the property based on each party's current equity. This method allows for floating rates according to the current market rate such as the BLR (base lending rate), especially in a dual-banking system like in Malaysia. There are several other approaches used in business transactions. Islamic banks lend their money to companies by issuing floating rate interest loans. The floating rate of interest is pegged to the company's individual rate of return. Thus the bank's profit on the loan is equal to a certain percentage of the company's profits. Once the principal amount of the loan is repaid, the profit-sharing arrangement is concluded. This practice is called Musharaka. Further, Mudaraba is venture capital funding of an entrepreneur who provides labor while financing is provided by the bank so that both profit and risk are shared. Such participatory arrangements between capital and labor reflect the Islamic view that the borrower must not bear all the risk/cost of a failure, resulting in a balanced distribution of income and not allowing lender to monopolize the economy.

18

Islamic banking is restricted to Islamically acceptable transactions, which exclude those involving alcohol, pork, gambling, etc. The aim of this is to engage in only ethical investing, and moral purchasing. In theory, Islamic banking is an example of full-reserve banking, with banks achieving a 100% reserve ratio. However, in practice, this is not the case, and no examples of 100 per cent reserve banking are observed. Islamic banks have grown recently in the Muslim world but are a very small share of the global banking system. Micro-lending institutions founded by Muslims, notably Grameen Bank, use conventional lending practices and are popular in some Muslim nations, especially Bangladesh, but some do not consider them true Islamic banking. However, Muhammad Yunus, the founder of Grameen Bank and microfinance banking, and other supporters of microfinance, argue that the lack of collateral and lack of excessive interest in micro-lending is consistent with the Islamic prohibition of usury (riba).

3.5.

SHARIAH ADVISORY COUNCIL/CONSULTANT

Islamic banks and banking institutions that offer Islamic banking products and services (IBS banks) are required to establish a Shariah Supervisory Board (SSB) to advise them and to ensure that the operations and activities of the bank comply with Shariah principles. On the other hand, there are also those who believe that no form of banking can ever comply with the Shariah.[24] In Malaysia, the National Shariah Advisory Council, which additionally set up at Bank Negara Malaysia (BNM), advises BNM on the Shariah aspects of the operations of these institutions and on their products and services. (See: Islamic banking in Malaysia). In Indonesia the Ulama Council serves a similar purpose.

19

A number of Shariah advisory firms (either standalone or subsidiaries of larger financial groups) have now emerged to offer Shariah advisory services to the institutions offering Islamic financial services. Issue of independence, impartiality and conflicts of interest have also been recently voiced .WDIBF World Database for Islamic Banking and Finance has been Developed to provide complete knowledge about all the websites related to this type of banking.

3.6.

Islamic Financial Transaction Terminology

BAI' AL-INAH (SALE AND BUY-BACK AGREEMENT) The financier sells an asset to the customer on a deferred-payment basis, and then the asset is immediately repurchased by the financier for cash at a discount. The buying back agreement allows the bank to assume ownership over the asset in order to protect against default without explicitly charging interest in the event of late payments or insolvency. Some scholars believe that this is not compliant with Shariah principles. There is an another definition of this bai as per the Imam ibn-e-Hijam if three persons are involved in this Sale (buy back finance) than, this bai Inah change into bai Tawarruq. He defines this bai as ; suppose Zhaid is in need of 2000 Rs, and he(Zhaid)goes to Jamshed for 2000Rs,In answer to this Jamshed says I will not give u qard (Loan)instead u can buy this item for Rs 2500 from me,so Zhaid buys this item from Jamshed for Rs.2500, immediately Aslam (3rd)person buys the same item from Zhaid for Rs 2000 and take the possession of the item and handover the item to Seller i.e (Jamshed) the amount which is due to be paid to Zhaid by Aslam is now referred to seller no 1 i.e Jamshed , Jamshed after receiving back the same item from Aslam(which was sold to Zhaid for 2500)pays Zhaid Rs 2000 and writes Rs 2500 in his book against Zhaid.In this way Jamshed earns a interest of Rs 500 This is termed as bai Tawarruq .

20

BAI' BITHAMAN AJIL (DEFERRED PAYMENT SALE) This concept refers to the sale of goods on a deferred payment basis at a price, which includes a profit margin agreed to by both parties. This is similar to Murabahah, except that the debtor makes only a single installment on the maturity date of the loan. By the application of a discount rate, an Islamic bank can collect the market rate of interest

BAI MUAJJAL (CREDIT SALE) Literally bai muajjal 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 the 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. (Deferred-payment sale)

MUSHARAKAH Musharakah ( joint venture with capital )is an arrangement or agreement between two or more partners ,whereby each partner provides funds to be used in a venture. Profits made are shared between the partners according to the invested capital. In case of loss, each partner looses the capital in the same ratio .If the Bank is providing capital , same conditions apply. It is this financial risk, according to the Shariah, that justifies the bank's claim to part of the profit. All the parnters may or may not participate in carrying out the business. The parnter/s who is also working, gets greater profit ratio as compared to the sleeping partner. The Difference b/w Musharkah and Madharaba is that, in Musharaka, each partner participates with some capital, whereas in Madharaba, there is a capital provider, ie. a financial institution and an enterpreneur, who has zero financial participation. Note that Musharaka and Madharaba are commonly overlapping. [27]

21

MUDARABAH "Mudarabah" is a special kind of partnership where one partner gives money to another for investing it in a commercial enterprise. The investment comes from the first partner who is called "rabb-ul-mal", while the management and work is an exclusive responsibility of the other, who is called "mudarib". The Mudarabah (Profit Sharing) is a contract, with one party providing 100 percent of the capital and the other party providing its specialist knowledge to invest the capital and manage the investment project. Profits generated are shared between the parties according to a pre-agreed ratio. Compared to Musharaka, in a Mudaraba only the lender of the money has to take losses.

MURABAHA This concept refers to the sale of goods at a price, which includes a profit margin agreed to by both parties. The purchase and selling price, other costs, and the profit margin must be clearly stated at the time of the sale agreement. The bank is compensated for the time value of its money in the form of the profit margin. This is a fixed-income loan for the purchase of a real asset (such as real estate or a vehicle), with a fixed rate of profit determined by the profit margin. The bank is not compensated for the time value of money outside of the contracted term (i.e., the bank cannot charge additional profit on late payments); however, the asset remains as a mortgage with the bank until the default is settled. This type of transaction is similar to rent-to-own arrangements for furniture or appliances that are very common in North American stores.

22

MUSAWAMAH Musawamah is the negotiation of a selling price between two parties without reference by the seller to either costs or asking price. While the seller may or may not have full knowledge of the cost of the item being negotiated, they are under no obligation to reveal these costs as part of the negotiation process. This difference in obligation by the seller is the key distinction between Murabaha and Musawamah with all other rules as described in Murabaha remaining the same. Musawamah is the most common type of trading negotiation seen in Islamic commerce.

BAI SALAM Bai 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 based on these metals. Barring this, Bai Salam covers almost everything that is capable of being definitely described as to quantity, quality, and workmanship.

HIBAH (GIFT) This is a token given voluntarily by a debtor to a creditor in return for a loan. Hibah usually arises in practice when Islamic banks voluntarily pay their customers a 'gift' on savings account balances, representing a portion of the profit made by using those savings account balances in other activities. It is important to note that while it appears similar to interest, and may, in effect, have the same outcome, Hibah is a voluntary payment made (or not made) at the bank's

23

discretion, and cannot be 'guaranteed.' However, the opportunity of receiving high Hibah will draw in customers' savings, providing the bank with capital necessary to create its profits; if the ventures are profitable, then some of those profits may be gifted back to its customers as Hibah.

IJARAH Ijarah means lease, rent or wage. Generally, Ijarah concept means selling the benefit of use or service for a fixed price or wage. Under this concept, the Bank makes available to the customer the use of service of assets / equipments such as plant, office automation, motor vehicle for a fixed period and price.

ADVANTAGES OF IJARAH 1. 2. 3. Ijarah provides the following advantages to the Lessee: Ijarah conserves the Lessee' capital since it allows up to 100% financing. Ijarah gives the Lessee the right to access the equipment on payment of the first

installment. This is important as it is the access and use (and not ownership) of equipment that generates income. 4. Ijarah arrangements aid corporate planning and budgeting by allowing the

negotiation of flexible terms 5. Ijarah is not considered Debt Financing so it does not appear on the Lessee'

Balance Sheet as a Liability. This method of "off-balance-sheet" financing means that it is not included in the Debt Ratios used by bankers to determine financing limits. This allows the Lessee to enter into other lease financing arrangements without impacting his overall debt rating.

24

6.

All payments towards Ijarah contracts are treated as operating expenses and are

therefore fully tax-deductible. Leasing thus offers tax-advantages to for-profit operations. 7. Many types of equipment (i.e computers) become obsolete before the end of their

actual economic life. Ijarah contracts allow the transfer of risk from the Lesse to the Lessor in exchange for a higher lease rate. This higher rate can be viewed as insurance against obsolescence. 8. If the equipment is used for a relatively short period of time, it may be more

profitable to lease than to buy. 9. If the equipment is used for a short period but has a very poor resale value, leasing

avoids having to account for and depreciate the equipment under normal accounting principles.

IJARAH THUMMA AL BAI' (HIRE PURCHASE) Parties enter into contracts that come into effect serially, to form a complete lease/ buyback transaction. The first contract is an Ijarah that outlines the terms for leasing or renting over a fixed period, and the second contract is a Bai that triggers a sale or purchase once the term of the Ijarah is complete. For example, in a car financing facility, a customer enters into the first contract and leases the car from the owner (bank) at an agreed amount over a specific period. When the lease period expires, the second contract comes into effect, which enables the customer to purchase the car at an agreed to price. The bank generates a profit by determining in advance the cost of the item, its residual value at the end of the term and the time value or profit margin for the money being invested in purchasing the product to be leased for the intended term. The combining of these three figures becomes the basis for the contract between the Bank and the client for the initial lease contract. This type of transaction is similar to the contractum trinius, a legal maneuver used by European bankers and merchants during the Middle Ages to sidestep the Church's

25

prohibition on interest bearing loans. In a contractum, two parties would enter into three concurrent and interrelated legal contracts, the net effect being the paying of a fee for the use of money for the term of the loan. The use of concurrent interrelated contracts is also prohibited under Shariah Law.

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.

MUSHARAKAH (JOINT VENTURE) Musharakah is a relationship between two parties or more, of whom contribute capital to a business, and divide the net profit and loss pro rata. This is often used in investment projects, letters of credit, and the purchase or real estate or property. In the case of real estate or property, the bank assesses an imputed rent and will share it as agreed in advance. 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 preagreed ratios, while the loss is borne by each partner strictly in proportion to respective capital contributions. This concept is distinct from fixed-income investing (i.e. issuance of loans)

26

QARD HASSAN/ QARDUL HASSAN (GOOD LOAN/ BENEVOLENT LOAN) This is a loan extended on a goodwill basis, and the debtor is only required to repay the amount borrowed. However, the debtor may, at his or her discretion, pay an extra amount beyond the principal amount of the loan (without promising it) as a token of appreciation to the creditor. In the case that the debtor does not pay an extra amount to the creditor, this transaction is a true interest-free loan. Some Muslims consider this to be the only type of loan that does not violate the prohibition on riba, since it is the one type of loan that truly does not compensate the creditor for the time value of money.[29]

SUKUK (ISLAMIC BONDS) Sukuk is the Arabic name for a financial certificate but can be seen as an Islamic equivalent of bond. However, fixed-income, interest-bearing bonds are not permissible in Islam. Hence, Sukuk are securities that comply with the Islamic law (Shariah) and its investment principles, which prohibit the charging or paying of interest. Financial assets that comply with the Islamic law can be classified in accordance with their tradability and non-tradability in the secondary markets.

TAKAFUL (ISLAMIC INSURANCE) Takaful is an alternative form of cover that a Muslim can avail himself against the risk of loss due to misfortunes. Takaful is based on the idea that what is uncertain with respect to an individual may cease to be uncertain with respect to a very large number of similar individuals. Insurance by combining the risks of many people enables each individual to enjoy the advantage provided by the law of large numbers.

27

WADIAH (SAFEKEEPING) In Wadiah, a bank is deemed as a keeper and trustee of funds. A person deposits funds in the bank and the bank guarantees refund of the entire amount of the deposit, or any part of the outstanding amount, when the depositor demands it. The depositor, at the bank's discretion, may be rewarded with Hibah (see above) as a form of appreciation for the use of funds by the bank.

WAKALAH (POWER OF ATTORNEY) This occurs when a person appoints a representative to undertake transactions on his/her behalf, similar to a power of attorney.

3.7.

Basic Features And Conditions Of Salam

1.

The transaction is considered Salam if the buyer has paid the purchase price to the

seller in full at the time of sale. This is necessary so that the buyer can show that they are not entering into debt with a second party in order to eliminate the debt with the first party, an act prohibited under Sharia. The idea of Salam is to provide a mechanism that ensures that the seller has the liquidity they expected from entering into the transaction in the first place. If the price were not paid in full, the basic purpose of the transaction would have been defeated. Muslim jurists are unanimous in their opinion that full payment of the purchase price is key for Salam to exist. Imam Malik is also of the opinion that the seller may defer accepting the funds from the buyer for two or three days, but this delay should not form part of the agreement.

28

2.

Salam can be effected in those commodities only the quality and quantity of which

can be specified exactly. The things whose quality or quantity is not determined by specification cannot be sold through the contract of salam. For example, precious stones cannot be sold on the basis of salam, because every piece of precious stones is normally different from the other either in its quality or in its size or weight and their exact specification is not generally possible.

3.

Salam cannot be effected on a particular commodity or on a product of a particular

field or farm. For example, if the seller undertakes to supply the wheat of a particular field, or the fruit of a particular tree, the salam will not be valid, because there is a possibility that the crop of that particular field or the fruit of that tree is destroyed before delivery, and, given such possibility, the delivery remains uncertain. The same rule is applicable to every commodity the supply of which is not certain.

4.

It is necessary that the quality of the commodity (intended to be purchased through

salam) is fully specified leaving no ambiguity which may lead to a dispute. All the possible details in this respect must be expressly mentioned.

5.

It is also necessary that the quantity of the commodity is agreed upon in

unequivocal terms. If the commodity is quantified in weights according to the usage of its traders, its weight must be determined, and if it is quantified through measures, its exact measure should be known. What is normally weighed cannot be quantified in measures and vice versa.

6.

The exact date and place of delivery must be specified in the contract.

29

7.

Salam cannot be effected in respect of things which must be delivered at spot. For

example, if gold is purchased in exchange of silver, it is necessary, according to Shari'ah, that the delivery of both be simultaneous. Here, salam cannot work. Similarly, if wheat is bartered for barley, the simultaneous delivery of both is necessary for the validity of sale. Therefore the contract of salam in this case is not allowed.

3.8.

Islamic Equity Funds

Islamic investment equity funds market is one of the fastest-growing sectors

within the Islamic financial system. Currently, there are approximately 100 Islamic equity funds worldwide. The total assets managed through these funds currently exceed US$5 billion and is growing by 1215% per annum. With the continuous interest in the Islamic financial system, there are positive signs that more funds will be launched. Some Western majors have just joined the fray or are thinking of launching similar Islamic equity products. Despite these successes, this market has seen a record of poor marketing as emphasis is on products and not on addressing the needs of investors. Over the last few years, quite a number of funds have closed down. Most of the funds tend to target high net worth individuals and corporate institutions, with minimum investments ranging from US$50,000 to as high as US$1 million. Target markets for Islamic funds vary, some cater for their local markets, e.g., Malaysia and Gulf-based investment funds. Others clearly target the Middle East and Gulf regions, neglecting local markets and have been accused of failing to serve Muslim communities. Since the launch of Islamic equity funds in the early 1990s, there has been the establishment of credible equity benchmarks by Dow Jones Islamic market index (Dow Jones Indexes pioneered Islamic investment indexing in 1999) and the FTSE Global Islamic Index Series. The Web site failaka.com monitors the performance of Islamic equity funds and provide a comprehensive list of the Islamic funds worldwide.

30

3.9.

Islamic Laws On Trading

The Qur'an prohibits gambling (games of chance involving money) and insuring

ones' health or property (also considered a game of chance). Thehadith, in addition to prohibiting gambling (games of chance), also prohibits bayu al-gharar (trading in risk, where the Arabic word gharar is taken to mean "risk" or excessive uncertainty). The Hanafi madhab (legal school) in Islam defines gharar as "that whose consequences are hidden." The Shafi legal school defined gharar as "that whose nature and consequences are hidden" or "that which admits two possibilities, with the less desirable one being more likely." TheHanbali school defined it as "that whose consequences are unknown" or "that which is undeliverable, whether it exists or not." Ibn Hazm of theZahiri school wrote "Gharar is where the buyer does not know what he bought, or the seller does not know what he sold." The modern scholar of Islam, Professor Mustafa Al-Zarqa, wrote that "Gharar is the sale of probable items whose existence or characteristics are not certain, due to the risky nature that makes the trade similar to gambling." There are a number of hadith that forbid trading in gharar, often giving specific examples of gharhar transactions (e.g., selling the birds in the sky or the fish in the water, the catch of the diver, an unborn calf in its mother's womb etc.). Jurists have sought many complete definitions of the term. They also came up with the concept of yasir (minor risk); a financial transaction with a minor risk is deemed to be halal (permissible) while trading in non-minor risk (bayu al-ghasar) is deemed to be haram. What gharar is, exactly, was never fully decided upon by the Muslim jurists. This was mainly due to the complication of having to decide what is and is not a minor risk. Derivatives instruments (such as stock options) have only become common relatively recently. Some Islamic banks do provide brokerage services for stock trading.

31

Chapter 4: SUKUK (ISLAMIC BONDS)

4.1.

Introduction
Sukuk (plural of Sakk, "legal instrument, deed, check") is the Arabic name

for a financial certificate, but commonly refers to the Islamic equivalent of bond. Since fixed income, interest bearing bonds are not permissible in Islam, Sukuk securities are structured to comply with the Islamic law and its investment principles, which prohibits the charging, or paying of interest. Financial assets that comply with the Islamic law can be classified in accordance with their tradability and non-tradability in the secondary markets. Conservative estimates by the Ten-Year Framework and Strategies suggest that over $1.2 trillion of assets are being managed according to Islamic investment principles. Such principles form part of Shari'ah, which is often understood to be Islamic Law, but it is actually broader than this in that it also encompasses the general body of spiritual and moral obligations and duties in Islam. In the Persian Gulf and Asia, Standard & Poor's estimates that 20 per cent of banking customers would now spontaneously choose an Islamic financial product over a conventional one with a similar risk-return profile. Sukuk financing resembles the similarly religious concept of gemach or Jewish interest-free loans, which subscribe to both the positive Torah commandment of lending money and the Torah prohibition against charging interest on a loan. Such religiouslyinspired non-interest loan systems can be quite mystifying for outsiders. A good analogy is one of ethical or green investing. Here the universe of investable securities is limited by certain criteria based on moral and ethical considerations. Islamic finance is also a subset of the global market and there is nothing that prevents the conventional investor from participating in the Islamic market.

32

Although often written in English media as "sukuk" (singular) and "sukuks" (plural), sukuk is actually a plural word. The correct Arabic forms are "sakk" (singular) and "sukuk" (plural).

4.2.

History
In classical period Islam Sakk (sukuk) which is cognate with the European root

"cheque" from Persian '( )pronounced check' - meant any document representing a contract or conveyance of rights, obligations or monies done in conformity with the Shariah. Empirical evidence shows that sukuk were a product extensively used during medieval Islam for the transferring of financial obligations originating from trade and other commercial activities. The essence of sukuk, in the modern Islamic perspective, lies in the concept of asset monetization - the so called securitisation - that is achieved through the process of issuance of sukuk (taskeek). Its great potential is in transforming an assets future cash flow into present cash flow. Sukuk may be issued on existing as well as specific assets that may become available at a future date.

4.3.

Principle
Sukuk can be structured alongside different techniques. While a conventional

bond is a promise to repay a loan, Sukuk constitutes partial ownership in a debt (Sukuk Murabaha), asset (Sukuk Al Ijara), project (Sukuk Al Istisna), business (Sukuk Al Musharaka), or investment (Sukuk Al Istithmar). Most commonly used Sukuk structures replicate the cash flows of conventional bonds. Such structures are listed on exchanges, commonly Luxembourg Stock Exchange

33

and London Stock Exchange in Europe, and made tradable through conventional organisations like Euroclear or Clearstream. A key technique to achieve capital protection without amounting to a loan is a binding promise to repurchase certain assets, e.g. in the case of Sukuk Al Ijara, by the issuer. In the meantime a rent is being paid, which is often benchmarked to an interest rate like LIBOR (which is disliked by Sharia Scholars). From a Sharia perspective, certificates of debt are not tradable (although a different view is held by many in Malaysia), and certain structuring elements for Sukuk Al Musharaka, Sukuk Al Mudaraba and Sukuk Al Istithmar faced severe criticism in late 2007 by Sheik Muhammad Taqi Usmani, followed by a meeting of the Accounting and Auditing Organisation for Islamic Financial Institutions (AAOIFI). The most accepted structure, which is tradable, is thereafter the Sukuk Al Ijara. Debt certificates can be only bought before the finance occurs and then held to maturity from an Islamic perspective, which is critical on debt trading at market value regarding any difference to be like the prohibited Riba (interest on money). As Shariah considers money to be a measuring tool for value and not an asset in itself, it requires that one should not receive income from money (or anything that has the genus of money) alone. This generation of money from money (simplistically, interest) is "Riba", and is forbidden. The implication for Islamic financial institutions is that the trading and selling of debts, receivables (for anything other than par), conventional loan lending and credit cards are not permissible. This principle is widely understood to mean uncertainty in the contractual terms and/or the uncertainty in the existence of an underlying asset in a contract, which causes issues for Islamic scholars when considering the application of derivatives. Sharia also incorporates the concept of maslahah or "public benefit", denoting that if something is overwhelmingly in the public good, it may yet be transacted and so hedging or mitigation of avoidable business risks, may fall into this category, but there is still much discussion yet to come on this issue.

34

4.4.

Sukuk Secondary Market

Sukuk securities tend to be bought and held and, as a result, little of the securities enter the secondary market (allowing them to be traded). Furthermore, only public Sukuk are able to enter this market, as they are listed on stock exchanges. The secondary market whilst developing remains a niche segment with virtually all of the trading done at the institution level. The size of the secondary market remains unknown, though LMC Bahrain state they traded $55.5 million of Sukuk in 2007. The European Islamic Investment Bank (EIIB) in an interview published on Sukuk.net stated "Secondary market trading volume has contracted significantly in the first half of 2008 when compared to 2007 where Sukuk with a nominal value of approximately $0.5bn was traded." "Sukuk bonds" are designed to get around religious laws banning the payment of interest for money lending. But one of the most volatile debts in the Dubai World standstill is a $3.5bn Islamic bond due to be repaid in December. HSBC estimates there is $822bn Islamic finance debt outstanding in the world.

35

CHAPTER 5: CONTROVERSIES IN ISLAMIC BANKING

Sukuk are widely regarded as controversial due to their perceived purpose of evading the restrictions on Riba. Conservative scholars do not believe that this is effective, citing the fact that a Sakk (Islamic bond) effectively requires payment for the time-value of money. This can be regarded as the fundamental test of interest. Sukuk offer investors fixed return on their investments which is also similar in appearance to interest in that the investor's return is not necessarily dependent on the risks of that particular venture. However, banks that issue Sukuk are investing in assets--not currency. The return on such assets takes the form of rent, and is evenly spread over the rental period. The productivity of the asset forms the basis of the fixed income stream and the return on investment. Given that there is an asset underlying the value of the certificate, there may be, depending on the value of the asset, more security for the investors involved, accounting for the additional appeal of Sukuk as a method of financing for investors.

In Islamabad, Pakistan, on June 16, 2004: Members of leading Islamist political party in Pakistan, the Muttahida Majlis-e-Amal (MMA) party, staged a protest walkout from the National Assembly of Pakistan against what they termed derogatory remarks by a minority member on interest banking: Taking part in the budget debate, M.P. Bhindara, a minority MNA [Member of the National Assembly]...referred to a decree by an Al-Azhar University's scholar that bank interest was not un-Islamic. He said without interest the country could not get foreign loans and could not achieve the desired progress. A pandemonium broke out in the house over his remarks as a number of MMA members...rose from their seats in protest and tried to respond to Mr Bhindara's observations. However, they were not allowed to speak on a point of order that led to their walkout.... Later, the opposition members were

36

persuaded by a team of ministers...to return to the house...the government team accepted the right of the MMA to respond to the minority member's remarks.... Sahibzada Fazal Karim said the Council of Islamic ideology had decreed that interest in all its forms was haram in an Islamic society. Hence, he said, no member had the right to negate this settled issue. Some Islamic banks charge for the time value of money, the common economic definition of Interest (Riba). These institutions are criticized in some quarters of the Muslim community for their lack of strict adherence to Sharia. The concept of Ijarah is used by some Islamic Banks (the Islami Bank in Bangladesh, for example) to apply to the use of money instead of the more accepted application of supplying goods or services using money as a vehicle. A fixed fee is added to the amount of the loan that must be paid to the bank regardless if the loan generates a return on investment or not. The reasoning is that if the amount owed does not change over time, it is profit and not interest and therefore acceptable under Sharia. Islamic banks are also criticized by some for not applying the principle of Mudarabah in an acceptable manner. Where Mudarabah stresses the sharing of risk, critics point out that these banks are eager to take part in profit-sharing but they have little tolerance for risk. To some in the Muslim community, these banks may be conforming to the strict legal interpretations of Shari a but avoid recognizing the intent that made the law necessary in the first place. The majority of Islamic banking clients are found in the Gulf States and in developed countries. With 60% of Muslims living in poverty, Islamic banking is of little benefit to the general population. The majority of financial institutions that offer Islamic banking services are majority owned by Non-Muslims. With Muslims working within these organizations being employed in the marketing of these services and having little input into the actual day to day management, the veracity of these institutions and their services are viewed with suspicion. One Malaysian Bank offering Islamic based investment funds was found to have the majority of these funds invested in the gaming industry; the managers administering these funds were non Muslim. [33] These types of

37

stories contribute to the general impression within the Muslim populace that Islamic banking is simply another means for banks to increase profits through growth of deposits and that only the rich derive benefits from implementation of Islamic Banking principles.

38

CHAPTER 6: PROBLEMS FACED BY ISLAMIC BANKING IN THE WORLD

6.1.

Overview
Twenty-five years ago Islamic banking was considered a wishful thinking.

However, serious research work of the past two and half decades has shown that Islamic banking is a feasible and viable way of financial intermediation. A number of Islamic banks have also been established during this period under heterogeneous social and economic milieu. The successful operation of these institutions and the countrywide experiences in Pakistan, Iran, Sudan and partly in Malaysia are sufficient to show that Islamic banking offers an alternative method of commercial banking. The commendable achievements during the last twenty years should not lead us to ignore the problems that Islamic banking is facing, and there is no dearth of those. While many problems are a result of the inappropriate environment in which Islamic banks are working, there are others which have arisen from the practices of Islamic banks themselves. Most of the Islamic Banks operate on Bai- Murabaha, Bai Muazzal, Bai- Salam, Istisna, Hire Purchase/ Leasing mode of Investment i.e. Islamic Banks always prefer to run on markup/ guaranteed profit basis having Shariah coverage. For this reason some times the conventional Economists and General people fail to understand the real difference between Islamic Banking and conventional Banking.

The Islamic banks face a number of problems like: First, they have not yet been successful in devising an interest-free mechanism to

place their funds on a short-term basis. They face the same problem in financing consumer loans and government deficits.

39

Second, the risk involved in profit-sharing seems to be so high that most of the

banks have resorted to those techniques of financing which bring them a fixed assured return. As a result, there is a lot of genuine criticism that these banks have not abolished interest but have in fact only changed the nomenclature of their transactions. (Example while financing use of conventional KIBOR, and fixed profits + variable in monthly mudarbah certificates issued by Meezan bank LTD.

Third, the Islamic banks do not have the legal support of central banks of their

respective countries (except in Pakistan and Iran), which exposes them to great risks.

Fourth, the Islamic banks do not have the necessary expertise and trained

manpower to appraise, monitor, evaluate and audit the projects they are required to finance.(comparatively to conventional banks like MCB) As a result, they cannot expand despite having excess liquidity. The future of Islamic banks hinges, by and large, on their ability to find a viable alternative to interest for financing all types of loans. They should recognize that their success in abolishing interest has been at least partial and they have yet to go a long way in their search for a satisfactory alternative to interest. Simultaneously, Islamic banks need to improve their managerial capabilities by training their personnel in project appraisal, monitoring, evaluation and performance auditing. Moreover, the future of Islamic banks also depends on developing and putting into practice such accounting standards which provide timely and reliable information of the type that the Islamic banks would require for profit-sharing, rent-sharing or for cost-plus financing. These standards are yet to be developed. The Islamic banks would have to work hard to pursue their clients to accept these standards so that a reliable information base is established. They should introduce their own bench mark for deciding profit sharing other then the conventional KIBOR.

40

6.2.

Forward contact/booking of foreign currency

The value of US Dollars ($), Pound Sterling, Euro and others are not fixed in

Pakistan; they are fluctuating from time to time. Most of our imports and exports are made in USD and USD being a strong currency always moves upward and the exporters are in better position than the importer in our country. In Pakistan Forward Booking is required to check the exchange fluctuation for import of heavy/project Machineries where it take long time say one year or six months to produce the same. But due to the restrictions of Shariah we can not cover the risk of Exchange fluctuation by forward contract as Forward Booking is not permitted by Shariah. As per Shariah, currency, transaction is to be made under certain terms and conditions laid down for sarf by Shariah, such as spot possession of both the currencies by both the parties which is not available in forward Booking. It is also prohibited to deal in the forward money market even if the purpose is hedging to avoid loss of profit on a particular transaction effected in a currency whose value is expected to be declined. This problem requires a solution by Shariah experts

6.3.

Unfamiliarity with the Islamic Banking System

The first problem is that despite the growth of Islamic banks over the last 30 years,

many people in the Muslim and non-Muslim world do not understand what Islamic banking actually is. The basic principle is clear, that it is contrary to Islamic law to make money out of money and that wealth should accumulate from trade and ownership of real assets. However, there does not appear to be a single definition of what is or not an Islamic-banking product; or there is not a single definition of Islamic banking. A major issue here is that it is the Shariah Councils or Boards at individual Islamic banks that actually define what is and what is not Islamic banking, and what is and what is not the acceptable way to do business, which in turn can complicate assessment of risk for both the bank and its customer. More generally, the uncertainty over what is, or is not, an

41

Islamic product has so far prevented standardization. This is difficult for regulators as they like to know exactly what it is, they are authorizing. It is also an added burden on the banks that have to educate customers in new markets.

6.4.

Portfolio Management
The behavior of economic agents in any country is determined partly by past

experience and present constraints. The Islamic banks are still growing in experience in many countries. Regarding constraints, Islamic banks in different countries do not freely choose arrangements, which best suit, their need. As a result, their activities are not demand-oriented and do not react flexibly to structural shifts in the economic setting as well as to changes in preferences It is known to the bank management that a certain portion of the short-term fund is normally not withdrawn at maturity; these funds are used for medium or long-term financing. However, a precondition for this maturity transformation is that the bank be able to obtain liquidity from external sources in case or unexpected withdrawals. Islamic banks, without having an interest-free Islamic money and capital market, have no adequate instruments to meet this pre-condition for effective maturity transformation. On the other hand, Islamic banks can enhance term transformation if there is an interest-free bond market or a secondary market for Islamic financial papers. Adequate financial mechanism still has to be developed, without which financial intermediation, especially the risk and maturity transformation, is not performed properly.

6.5.

The Regulatory environment

The relationship between Islamic banks and monetary authorities is a delicate one. The central bank exercises authority over Islamic banks under laws and regulations engineered to control and supervise both traditional banks. Whatever the goals and

42

functions are, Islamic banks came into existence in an environment where the laws, institutions training and attitude are set to serve an economy based on the principles of interest. The operations of Islamic banks are on a profit and loss share basis (PLS), which actually does not come fully under the jurisdiction of the existing civil laws. If there are disputes to be handled, civil courts are not sufficiently acquainted with the rationale of the operations of Islamic Banking. Regarding the protection of depositors, Islamic Banks are required to let the authorities know the difference between money paid into current accounts and money paid into investment accounts. Islamic banks operate in two broad types of deposits: a) Deposits which cover transaction balance. These have a 100 percent reserve

requirement and completely safe, thus satisfying the needs of risk averters. b) The PLS or equity account, in which depositors are treated exactly as if they were shareholders in the bank. There is no guaranteed rate of return or nominal value of the share. In non-Muslim counties (i.e., the countries with less than 50% Muslim population) the central banks are very stringent in granting licenses for Islamic banks to operate. In order to be established in those countries Islamic banks must also meet the additional requirements of other government and non-government authorities.

6.6.

Absence of Liquidity Instruments

Many Islamic banks lack liquidity instruments such as treasury bills and other

marketable securities, which could be utilized either to cover liquidity shortages or to manage excess liquidity. This problem is aggravated since many Islamic banks work under operational procedures different from those of the central banks; the resulting noncompatibility prevents the central banks from controlling or giving support to Islamic banks if a liquidity gap should occur. So the issue of liquidity management must come under active discussion and scrutiny by the authorities involved is Islamic banking

43

6.7.

Use of Advanced Technology and Media

Many Islamic banks do not have the diversity of products essential to satisfy the growing need of their clients. The importance of using proper advanced technology in upgrading the acceptability of a product and diversifying its application cannot be over emphasized. Given the potentiality of advanced technology, Islamic banks must have to come to terms with rapid changes in technology, and redesign the management and decision-making structures and, above, all introduce modern technology in its operations. Many Islamic banks also lack the necessary expertise and institutional capacity for Research and Development (R & D) that is not only necessary for the realization of their full potential, but also for its very survival in this age of fierce competition, sophisticated markets and an informed public. Islamic banking cannot but stagnate and wither without dynamic and ongoing programmes. In addition, Islamic banks have so far not used the media appropriately. Even the Muslims are not very much aware that the Islamic banking is being practiced in the world. Islamic banks have not ever used an effective media to publicize their activities. The authorities concerned in Islamic banks should address these issues on a priority basis.

6.8.

Need for Professional Bankers

The need for professional bankers or managers for Islamic banks cannot be over

emphasized. Some banks are currently run by direct involvement of the owner himself, or by managers who have not had much exposure to Islamic banking activities, nor are conversant with conventional banking methods. Consequently, many Islamic banks are not able to face challenges and stiff competition. There is a need to institute professionalism in banking practice to enhance management capacity by competent

44

bankers committed to their profession. Because, the professionals working in Islamic banking system have to face bigger challenge, as they must have a better understanding of industry, technology and the management of the business venture they entrust to their clients. They also have to understand the moral and religious implications of their investments with the business ventures. There is also a need for banking professionals to be properly trained in Islamic banking and finance. Most banks professionals have been trained in conventional economics. They lack the requisite vision and conviction about the efficiency of the Islamic banking.

6.9.

Blending of Approach of Islamic Scholars with the Approach of the Conventional Bankers

Bankers, due to the nature of their jobs have to be pragmatic or application-oriented. There is and will be tendency in the bankers practicing in Islamic banks to mould or modify the Islamic principles to suit the requirement for transactions at hand. Additionally, being immersed in the travails of day to day banking, they find little time or inclination to do any research, which can make any substantial contribution to the Islamic banking. Islamic Scholars active in researching Islamic Banking and finance, on the other hand, typically have a normative approach, i.e. they are more concerned with what ought to be. A very few of them are knowledgeable about banking or the needs of the customers.

45

Chapter 7: Problems of Islamic Bank Operating under Conventional Banking System

7.1.

Failure of Islamic banks to finance high-return projects

Islamic bank fails to appropriate high profit from high-return projects since the owners of these projects prefer borrowing from conventional banks where cost of borrowing turns out to be lower. That means, only the projects with rates of return equal to or below the market rate of interest are left with the Islamic banks. At this situation, Islamic banks are not able to invest on the projects having rates of return below the prevailing rate of interest thereby limiting their capacity to utilize investment opportunity to the level of their conventional counterpart. This leads to limiting the application of profit-loss-sharing modes such as Mudaraba and Musharaka. In other words, Islamic banks, at that situation, switch over to other modes of financing such as Murabahah, hire purchase, leasing, etc.

7.2.

Sacrifice of allocative efficiency

Allocative efficiency of Islamic bank, if it is truly a profit-loss-sharing bank, is built-in to its financing mechanism. It is not possible to achieve the desired level of allocative efficiency when entrepreneurs switch over from Islamic banks to conventional banks to avoid high cost borrowing. Profitability of projects being the ideal device of efficient resource allocation, at this situation, does not apply to Islamic banking system as it, considering the rational behavior of the borrower, takes recourse to modes other than

46

profit-loss-sharing. This situation continues as long as Islamic banks operate side by side with the conventional banks. Experts are very much worried about this situation of Islamic banking. Up till now no effective policy prescription is available to the Islamic banks to ameliorate the situation.

7.3.

Loss of distributive efficiency

It has also been found that distributive efficiency of Islamic banking is lost when an Islamic bank starts operation under conventional banking framework. Any shift from profit-loss-sharing modes leads the system break the direct relationship between the incomes of the entrepreneurs, the bank and the depositors. The inefficiency of conventional banking about distribution is neither influenced nor modified by the introduction of Islamic banking in the economy.

47

CHAPTER 8: PROBLEM SPECIFIC TO ISLAMIC BANKING IN INDIA

Absence of Islamic Money Market

In the absence of Islamic money market in India, the Islamic banks cannot invest their surplus fund i.e., temporary excess liquidity to earn any income rather than keeping it idle.(how ever in Pakistan SBP issue SUKOOK bonds) Because all the Government Treasury Bills, approved securities and Pakistan Bank Bills in Pakistan are interest bearing. Naturally, the Islamic banks cannot invest the permissible part of their Security Liquidity Reserve and liquid surplus in those securities. As a result, they deposit their whole reserve in cash with state Bank.where SBP invest these funds islamicaly under supervision of Shariah board and gives the profits to these banks. Similarly, the liquid surplus also remains uninvested. On the contrary, the conventional banks of the country do not suffer from this sort of limitations. As such, the profitability of the Islamic banks in Pakistan is adversely affected.

Absence of Suitable Long-term Assets

The absence of suitable long term assets available to Islamic banks is mirrored by lack of short term tradable financial instruments. At present there is no equivalent of an interbank market in Pakistan where banks could place, say, over night funds, or where they could borrow to satisfy temporary liquidity needs. Trading of financial instruments is also difficult to arrange when rates of return are not known until maturity.Obviously, these factors place Islamic banking in Pakistan at a distinct disadvantage compared to its conventional banking counterpart.

48

Shortage of Supportive and Link Institutions

Any system, however well integrated it may be, cannot thrive exclusively on its built-in elements. It has to depend on a number of link institutions and so is the case with Islamic banking. For identifying suitable projects, Islamic banking can profitably draw the services of economists, lawyers, insurance companies, management consultants, auditors and so on. They also need research and training forums in order to prompting entrepreneurship amongst their clients. Such support services properly oriented towards Islamic banking are yet to be developed in Pakistan.

Organizing Relationship with Foreign Banks

Another important issue facing Islamic banks in Pakistan is how to organise their relationships with foreign banks, and more generally, how to conduct international operations. This is, of course, an issue closely related to the creation of financial instruments, which would be simultaneously consistent with Islamic principles and acceptable to interest-based banks, including foreign banks

Long-term Financing
Islamic Banks stick very closely to the pricing policies of the government. They can not benefit from hidden costs and inputs, which elevate the level of prices by certain entrepreneurs without any justification. On the other hand, Islamic banks as financial institutions are even more directly affected by the failure of the projects they finance. This is because the built in security for getting back their funds, together with their profits, is in the success of the project. Islamically, it is not lawful to obtain security from the partner against dishonesty or negligence, both of which are very difficult if not impossible to prove.

49

Political Reasons
While France, Japan, UK and other countries have opened the door for Multi Billion dollar business of Islamic Banking, for some reasons India is still distancing itself from it. The first reason is religion-based politics. Since every Government needs to ensure that the majority community should not get anguished by any action, there is always a threat for the ruling party that if a bill is introduced in the parliament to amend the Banking Regulation Act 1949 just to allow Islamic Banking in India, the communal political parties and organs may propagate saying that the ruling party is trying to appease the Muslims by Islamising the financial system to ensure their votes.

The second reason is exclusion of Indian Muslims from the financial regulation. Muslims being just 0.78% in RBI and negligible in the Ministry of Finance are insufficient to attract others about the true potential of Islamic Banking in India. There is hardly any economist within the RBI and the Ministry of Finance to illustrate the significance of Islamic Banking and Finance for socio-economic growth of India. Though, RBI constituted a working group in 2005 delegating the task to study the feasibility of Islamic Banking in India, there was not any qualified person in that group to do so. Thus the working group of RBI led by Mr. Anand Sinha failed to visualise significance of Islamic Banking for Indian economy and concluded that it is not possible to allow Islamic Banking in India under present regulatory framework.

The third reason is dominance of US-based economists in India. Since majority of high officials in Indian financial and monetary system are graduates from US School of Economics, they tend to listen the US Economists. The US will never like India to go for Islamic Banking, because if India does so, US will swiftly lose the huge capital flow from Gulf countries which in turn will divert from US to Indian market. While communal political parties defy Islamic Banking, the secular parties accompanied with economists qualified from US have further distanced Islamic banking for India.

50

CHAPTER 9: ANALYSIS OF THE SURVEY CONDUCTED

9.1.

Questionnaire on Islamic Banking Circulated

NAME AGE GENDER RELIGION LOCATION

Q1.Do you know Islamic banking all in all? a) Yes b) To some extent c) Have heard of it d) No-what is it?

Q2. If an Islamic bank comes in India, what will matter to you the most? a) Principles & ethics b) Higher returns / lower payment of loan c) Less risk d) None

51

Q3. How likely would you put your money in an Islamic bank, if it opens? a) Maximum b) Somewhat more c) To an extent d) Somewhat less e) Least

Q4. If an Islamic bank pays you less as compared to conventional bank, would you still go for it? a) Yes b) No

Q5. If an Islamic bank comes to your doorstep, what would be your position? a) I will put all my money in an islamic bank b) I will put only a part of my money c) I will not park my money at all d) I will wait & watch before deciding to invest

Q6. What is your level of faith on Islamic banking? a) Maximum b) Somewhat more c) To an extent d) Somewhat less e) Least

52

Q7. Islamic banking is recession-proof and hence least risky. How likely this statement does leads to an increase in the feeling of association with an Islamic bank? a) Maximum b) Somewhat more c) To an extent d) Somewhat less e) Least

Q8. How much importance does Islamic banking have in your mind? a) Maximum b) Somewhat more c) To an extent d) Somewhat less e) Least

Q9. What is most important to you regarding a bank? a) Returns/interest b) Services c) Policy/ethics d) Convinience/nearness e) Others(please specify)

53

9.2.

Findings of the Survey

Question 1

COMBINED AWARENESS RESULT

12% 13% 36%
YES TO SOME EXTENT HAVE HEARD OF IT

39%

NO-WHAT IS IT?

The combined result showed that most of the people had a fair idea about Islamic Banking.

(GROUP 1) AWARENESS RESULT

7%

(GROUP 2) AWARENESS RESULT

8%
48%

YES TO SOME EXTENT HAVE HEARD OF

24%

12%

YES TO SOME EXTENT HAVE HEARD OF IT NO-WHAT IS IT?

37%

IT NO-WHAT IS IT?

27%

37%

The awareness level of group 1 (48%) was clearly higher than that of group 2 (12%) as far as clear perception of understanding is concerned but If we consider to some extent and have heard of it as the middle categories then they are more in group 2(64%) as compared to group1(44%).

54

Question 2

REASON FOR CHOICE (COMBINED)

2% 18% 28%
PRINCIPLES HIGH RETURN LESS RISK NONE

52%

The combined results show that high return / low payment of loan is the expectation of people in general (52%). Then comes Principles and lesser risk in decreasing order.

REASON FOR CHOICE (GROUP 1)

5% 16% 43%
PRINCIPLES HIGH RETURN LESS RISK NONE

REASON FOR CHOICE (GROUP 2)

3% 26%

28%

PRINCIPLES HIGH RETURN LESS RISK NONE

36%

43%

The group 1 shows a high percentage of people voting in favour of principles (43%) followed by high returns which shows that principles matter a lot for group 1. The group 2 results are showing a high tendency towards returns (43%).followed by principles and risk in decreasing order.

55

Question 3

PERCIEVED LIKELIHOOD FOR ISLAMIC BANK

12% 13% 15% 25% 35%
MAXIMUM SOMEWHAT MORE TO AN EXTENT SOMEWHAT LESS

LEAST

PERCIEVED LIKELIHOOD FOR ISLAMIC BANK (GROUP 1)

5% 4%
MAXIMUM

PERCIEVED LIKELIHOOD FOR ISLAMIC BANK (GROUP 2)

MAXIMUM

29% 34%

SOMEWHAT MORE TO AN EXTENT SOMEWHAT LESS LEAST

24%

26%

SOMEWHAT MORE TO AN EXTENT SOMEWHAT LESS

28%

22% 0%

28%

LEAST

Through this we realise the Group 1 has a higher confidence and faith than Group 2.

56

Question 4

PRINCIPLE PERCEPTION (COMBINED)

29% YES NO 71%

PRINCIPLE PERCEPTION(GROUP 1)

PRINCIPLE PERCEPTION (GROUP 2)

18%
YES NO YES

50%

50%

NO

82%

As observed, Group 1 shows lesser scepticism (18%) than Group 2(50%) due to higher belief and faith in the system amongst Group 1 people.

57

Question 5

INVESTMENT PLAN (COMBINED)

16% 28%
ALL PART NOT WAIT

15%

41%

INVESTMENT PLAN (GROUP 1)

INVESTMENT PLAN (GROUP 2)

4%

32%

24%

ALL PART NOT WAIT

32% 39%

ALL PART NOT WAIT

6%

38%

25%

Group 1 shows higher readiness to park funds (24%) than Group 2 that shows a stark difference (4%). Also, the percentage in the wait and not at all category is higher in Group 2 (57%) than in Group 1 (38%) which shows lack of faith or lack of awareness.

58

Question 6

FAITH (COMBINED)
6% 18% 15% MAXIMUM SOMEWHAT MORE 13% TO AN EXTENT SOMEWHAT LESS LEAST 48%

FAITH (GROUP 1)
3% 11% 12%
MAXIMUM SOMEWHAT MORE TO AN EXTENT SOMEWHAT LESS

FAITH (GROUP 2)
12% 12%
MAXIMUM SOMEWHAT MORE TO AN EXTENT

24% 50%

28% 42% 6%

SOMEWHAT LESS LEAST

LEAST

Amongst Group 1, only 14% show lack of faith in the principles and Islamic Banking as a concept whereas in Group 2, 40% show lack of faith.

59

Question 7

ASSOCIATION (COMBINED)
6% 15%

18%

MAXIMUM SOMEWHAT MORE TO AN EXTENT

13% 48%

SOMEWHAT LESS LEAST

ASSOCIATION(GROUP 1)
1% 10% 4%
MAXIMUM

ASSOCIATION (GROUP 2)
7% 30% 30%
MAXIMUM SOMEWHAT MORE TO AN EXTENT SOMEWHAT LESS

26%
18%

SOMEWHAT MORE TO AN EXTENT SOMEWHAT LESS LEAST

45%

29%

LEAST

The fact that Islamic Banking is recession proof creates a higher association with Group 2 which is good sign and confirms the fact that it can be used to attract more customers amongst that group. The level of scepticism amongst both groups is 11% only, which is again a good sign.

60

Question 8

IMPORTANCE LEVEL (COMBINED)

4% 7%

30%
30%

MAXIMUM SOMEWHAT MORE TO AN EXTENT SOMEWHAT LESS LEAST

29%

IMPORTANCE LEVEL(GROUP 1)
5% 10% 7% 43%
SOMEWHAT MORE TO AN EXTENT SOMEWHAT LESS MAXIMUM

IMPORTANCE LEVEL (GROUP 2)

MAXIMUM

5% 29% 36%
SOMEWHAT MORE TO AN EXTENT SOMEWHAT LESS

35%

21% 9%

LEAST

Group 2 again shows less importance towards Islamic Banking highlighting the fact that the group needs more emphasis and effort. It needs to be well trained towards Islamic banking, its concepts and Principals.

61

Question 9

1%

DECIDING FACTOR (COMBINED)

13% 8%
RETURNS/INTEREST SERVICES

33% 45%

POLICY/ETHICS CONVINIENCE/NEARNESS OTHERS

DECIDING FACTOR (GROUP 1)

5% 0% 5% 28% RETURNS/INTERES T SERVICES POLICY/ETHICS

DECIDING FACTOR (GROUP 2)

0% 21% RETURNS/INTE REST SERVICES POLICY/ETHICS 29% 33% CONVINIENCE/ NEARNESS OTHERS

17%

62%

CONVINIENCE/NEA RNESS

Services being a key deciding factor in the selection of a bank, highlights the need for Islamic banking institutes to focus on services. Ethics being the second choice for selection of a bank, works as an advantage for Islamic banks.

62

CHAPTER 10: PORTERS FIVE FORCE ANALYSIS FOR ISLAMIC BANKING

Based on the analysis of the survey conducted and other secondary data, following is an analysis of the Islamic banking on the basis of Porters Five Force Model.

63

CHAPTER 11: CONCLUSION

Islamic banks can satisfy most of the efficiency conditions if they can operate as a sole system in an economy. Conventional banking, on the other hand, does not satisfy any of the efficiency conditions analyzed above. However, when Islamic banks start operation within the conventional banking framework, their efficiency goes on decreasing in a number of dimensions. The deterioration is not because of Islamic bank's own mechanical deficiencies; rather it is the efficiency-blunt operation of the conventional banking system that puts a negative impact on the efficient operation of Islamic banks. This does not mean that the survival of Islamic banks operating within the conventional banking framework is altogether threatened.

Evidence from Bangladesh indicates that Islamic banks can survive within the conventional banking framework by switching over from PLS to trade-related modes of financing. Even under the conventional banking framework Islamic banks can operate with certain level of efficiency by applying in a reasonable percentage the PLS modes the distinguishing features of Islamic banking. This has been possible in some countries of the Muslim world where the management of Islamic banks was cautious about possible impacts of every policy measure. Particularly, the management of these banks was judicious in selecting major sectors or areas of their operations.

Islamic Banking has a huge market potential in India as India is the 3rd largest Muslim populated country in the world. It can address the long drawn issue of Financial inclusion and will create a feel good factor among Muslims. Muslims would come out of isolation and it can be used as a facilitating tool to combat terrorism in few states of India. Indian government can gain diplomatic advantages to make financial dealings with

64

Muslim dominated nations and can attract equity finance from gulf countries for infrastructure development, thereby financing the fiscal deficit. There exist significant challenges to materialize the objective of expansion of Islamic Banking in India. Lack of experts in this field leads to differences in interpretation and compliance with Shariah laws. Moreover in case of India, Banking regulation Act of 1949 needs to be suitably modified to introduce Islamic Banking. New Standard Accounting practices have to be developed. Islamic Banking per say goes against the secular framework of our nation and can create financial segregation. It can also be exploited politically, so it has to be seen in the right light.

There is a need to customize and advertise Islamic banking to make it equally attractive to Non-Muslims. The product trends are positive in India and given the double digit growth of Islamic Banking in other Asian countries like Asia and Singapore, it is definitely a viable option for India.

McKinsey & Company Inc. and Bearys Group have started doing big businesses through Shariah Investments funds. East wind launched Islamic Index; and Reliance Money and Religare have launched Shariah Complaint Portfolio Management Services. As a result Indian Stock market is also observing some better trends in Shariah complaint stocks. According to Sabry Ghouse, head of retail banking at Al Rajhi in Malaysia, non-Muslim customers now make up a sizeable proportion of the entire customer base.

65

CHAPTER 12: RECOMMENDATIONS

In order to operate in global markets effectively, it is desirable that the size of operations of Islamic banks be substantially increased. In this regard, serious consideration should be given to mergers. Islamic banks have to increase their size as well as form strategic alliances with other banks. It will also be useful to build bridges between existing Islamic banks and those conventional banks that are interested to do banking on Islamic principles.

To promote teaching, training and research in Islamic banking and finance and to produce and disseminate authentic information on their activities with a view to develop new Islamic financial products, it is proposed that Islamic banks strengthen their cooperation with the assistance of the Islamic Research and Training Institute.

With a view to broaden the equity base of the economies of Muslim countries, it is desirable to establish institutions dealing more in equities. These include mutual funds, unit trusts, pension plans etc. It would also be desirable to encourage businesses through macro-economic policies to increase the use of equity finance and decrease their reliance on debt. Until Islamic countries do not opt for a complete Islamic banking system, it is necessary to enact some laws to facilitate the operation of a mixed system. In this context, one of the most serious problems being faced by Islamic banks is the lack of proper legal framework to deal with cases of delayed payments and bad loans expeditiously. Since Islamic banks cannot charge interest on the delayed debts, they face a bigger risk of default as well as loss in income. These considerations, among others, necessitate that special laws for the introduction and practice of Islamic banking be put in place.

66

Another important policy issue relates to tax treatment. Under the conventional system, interest paid by corporations is treated as a tax-deductible expense. Similar treatment must be given to the dividends paid out by financial institutions. It is proposed that an autonomous Board for shariah supervision of Islamic banks, may be constituted. In addition, there is also a need for Central banks in Muslim countries to consider the special nature of Islamic banking and devise suitable international standards for major control variables similar to the Basle Committee for Banking Supervision.

There is an urgent need to increase the supply of scholars with dual specialisation in shari'ah and finance. In order to meet this need, it is recommended that courses may be introduced for shari'ah scholars in economics and finance. Similarly, courses in shari'ah especially designed for economists and financial experts may be initiated.

Banks will have to come out of Religious set up and offer products of wider spectrum to a wider audience. Its a challenge to provide a solution that adheres to the basics of the Islamic finance concept and at the same time remains flexible enough to meet the demands of the changing environment. There is a need to advertise Islamic Banking so that it could be used by Non- Muslims as well.

IT application has to be strengthened for supporting such a complex business model. All major IT providers like TCS, Infosys etc do provide such solutions to overseas clients, but keeping in mind the strong Regulatory framework of India, IT process will have to be customized.

Islamic banking experts will have to be brought in and a standard accounting and auditing practice across geographies will have to be introduced and therefore, there exists a need for improvement of corporate governance and risk management.

67

Due to scholastic differences within Islam, there exist different interpretations on the definition of a product being Shariah compliant. The five teachings, Shafii, Shia, Hanafi, Hanbali and Maliki, all have subtle differences. There have been many standardization initiatives, one of which is initiated by the Accounting and Auditing Organization for Islamic Financial Institution (AAOIFI). The Islamic Financial Services Board is also working to create common financial reporting standards for Islamic banks.

There are several other areas that Islamic banks need to strengthen, ranging from IAS39 based classification and provisioning to SOX compliance and KYC norms. In the face of the global banking crisis emanating out of subprime mortgage financing, there will be greater pressure on banking formats like Islamic finance to propagate them by creating a positive perception among customers while ensuring adequate and effective risk management Mechanisms. Though much work is being done, its still not known clearly how Basel II will affect Islamic banks and how exactly risk capital will be derived for better risk management.

68

BIBLIOGRAPHY
Websites
www.nbp.com.pk/EcomomicBulletin/Economic%20Bulletin%20JanFeb%202005.pdf
www.islam-finance.com/FAQ.html www.lariba.com/knowledge-center/faqs.htm#question1

www.ajif.org (American Journal of Islamic Finance) www.hifip.harvard.edu (Harvard Islamic Finance Information Program)
www.aaoifi.com (The Accounting and Auditing Organization for Islamic Financial Institutions) www.ihilal.com (online distributor of Islamic financial products and services) www.islamic-banking.com (The Institute of Islamic Banking and Insurance ) www.islamic-finance.net (Islamic Business and Finance Network)

www.failaka.com
www.fcsdubai.com/principles.htm www.cbuae.gov.ae (Central Bank of UAE) www.alrajhibank.com.sa/historyandgrowth.htm

www.khaleejtimes.com www.gulfnews.com www.islamic-banking.com/ibanking/ifi.php

www.djindexes.com/jsp/islamicMarketOverView.jsp www.aaoifi.com www.failaka.com www.fcsdubai.com/principles.htm www.islamicbanking.blogsome.com/ www.situationsasia.com/story/islamic-banking-and-finance-role-and-relevance-recessionisteconomy www.indianmuslims.in/problems-and-prospects-of-islamic-banking-in-india-%E2%80%93-roadmap-ahead/ www.radianceweekly.com/188/4804/sc-kindles-hope-of-justice-for-the-encountered/2010-0124/islamic-finance/story-detail/challenges-for-islamic-banking-in-india.html

69

Magazines:
Aggarwal, R. and T. Yousef (2000), Islamic banks and Investment Financing, Journal of Money, Credit, and Banking, 32(1), 93-120. Al-Jarrah, I.M. (2002), Efficiency in Arabian Banking. Dissertation, University of Wales Bangor. CRISIL Young Thought Leader (2008), ISLAMIC BANKING IN INDIA Pawandeep MEhra

70