ASSIGNMENT TOPIC:

FUNCTIONING OF VARIOUS ISLAMIC MODES OF BANKING WITH RESPECT TO PAKISTAN

What is Islamic Banking?

Islamic banking has been defined as banking in consonance with the ethos and value system of Islam and governed, in addition to the conventional good governance and risk management rules, by the principles laid down by Islamic Shariah. Interest free banking is a narrow concept denoting a number of banking instruments or operations, which avoid interest. Islamic banking, the more general term is expected not only to avoid interest-based transactions, prohibited in the Islamic Shariah, but also to avoid unethical practices and participate actively in achieving the goals and objectives of an Islamic economy. Philosophy of Islamic banking and finance Islamic Shariah prohibits interest but it does not prohibit all gains on capital. It is only the increase stipulated or sought over the principal of a loan or debt that is prohibited. Islamic principles simply require that performance of capital should also be considered while rewarding the capital. The prohibition of a risk free return and permission of trading, makes the financial activities in an Islamic set-up real asset-backed with ability to cause value addition. Islamic banking system is based on risk-sharing, owning and handling of physical goods, involvement in the process of trading, leasing and construction contracts using various Islamic modes of finance. As such, Islamic banks deal with asset management for the purpose of income generation. They will have to prudently handle the unique risks involved in management of assets by adherence to best practices of corporate governance. Once the banks have stable stream of Halal income, depositors will also receive stable and Halal income. Profit has been recognized as reward for (use of) capital and Islam permits gainful deployment of surplus resources for enhancement of their value. However, alongwith the entitlement of profit, the liability of risk of loss on capital rests with the capital itself; no other factor can be made to bear the burden of the risk of loss. Financial transactions, in order to be permissible, should be associated with goods, services or benefits. At macro level, this feature of Islamic finance can be helpful in creating better discipline in conduct of fiscal and monetary policies. Besides trading, Islam allows leasing of assets and getting rentals against the usufruct taken by the lessee. All such things/assets corpus of which is not consumed with their use can be leased

out against fixed rentals. The ownership in leased assets remains with the lessor who assumes risks and gets rewards of his ownership.

History of Islamic Banking in Pakistan:

Pakistan, created in the name of Islam, appeared on the map of the world on 14th august 1947. Since then, interest is playing the cardinal role in the resource allocation of the economy. The principle of interest as the guiding force is diametrically opposed to the Islamic system. Steps for Islamization of banking and financial system of Pakistan were started in 1977-78 by late President Zia-ul-Haque as he accepted the challenge and took revolutionary steps to Islamize the economy. Pakistan was among the three countries in the world that had been trying to implement interest free banking at comprehensive/national level. But as it was a mammoth task, the switchover plan was implemented in phases. The main steps taken under these phases are: The Islamization measures included the elimination of interest from the operations of specialized financial institutions including HBFC, ICP and NIT in July 1979 and that of the commercial banks during January 1981 to June 1985. The legal framework of Pakistan's financial and corporate system was amended on June 26, 1980 to permit issuance of a new interest-free instrument of corporate financing named Participation Term Certificate (PTC). An Ordinance was promulgated to allow the establishment of Mudaraba companies and floatation of Mudaraba certificates for raising risk based capital. Amendments were also made in the Banking Companies Ordinance, 1962 (The BCO, 1962) and related laws to include provision of bank finance through PLS, mark-up in prices, leasing and hire purchase. From July 1, 1982 banks were allowed to provide finance for meeting the working capital needs of trade and industry on a selective basis under the technique of Musharaka. From July 1, 1984 the commercial banks were allowed to provide finances under Islamic modes. From July 1, 1985 all new bank financing to Government, public sectors, corporations and joint stock companies were to and are entirely on the basis of Islamic modes of financing. As from April 1, 1985 all finances to all entities including individuals began to be made in one of the specified interest-free modes. From July 1, 1985, all commercial banking in Pak Rupees was made interest-free. From that date, no bank in Pakistan was allowed to accept any interest-bearing deposits and all existing deposits in a bank were treated to be on the basis of profit and loss sharing. By the end of fiscal year 1985, the entire assets side of the banks and other financial institutions would be transferred into accepted modes of Islamic financing.

The non-banking financial institutions have taken the lead in Islamizing their operations. In July, 1970 interest was eliminated from the operations of ICP, NIT. Small Business Financing Corporation (SBFC) took up interest-free operation from July 1, 1980, NDFC from June 30, 1985, IDBP from January, 1985. Bankers Equity Limited (B.E.T) corporate in 1979 has done

pioneering work in the area. These were the main steps taken for Islamization of banking and financing in Pakistan. Later on, other major steps were taken to strengthening banking system in the light of Islam. The year 2002-2003 witnessed strengthening measures taken in the areas of banking, non-bank financial companies and the capital markets.

ISLAMIC MODES OF BANKING AND FINANCING:

The State Bank of Pakistan had specified 12 modes of non-interest financing classified in three broad categories. However, in any particular case, the mode of financing to be adopted was left to the mutual option of the banks and their clients .Islamic modes of financing refer to interestfree economy. In bringing the economy to the conjunctions of Islam the following modes of financing in live with Islam. 1-Financing by Lending/loans financing by lending Loans with Services charges Qarze Hasna

2-Trade Financing Mark up Mark down Leasing Hire purchase Development charges

3-Investments Musharaka Modaraba Participation term certificates(PTC) Equity Participation and Purchase of Shares Rent sharing

Given below is a brief summary of these 12 modes.

1- Financing by Lending/ loans financing by lending:

There are two instruments of lending under the caption Loans Financing by Lending as approved by the State Bank of Pakistan.

Loans with Services charges:

It is a new concept of lending ad is based on IJTEHAD. The banks are permitted to lend funds free of interest. They are to recover only the actual service charges from the users of the funds. The maximum service charges permissible to each bank are determined by the State Bank of Pakistan. These service charges are termed as 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 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. This mode of financing is being used by the banks for financing of exports. It can also be applied on other needy sectors such as financing of agricultural inputs to small farmers, provision of funds to salaried persons getting actual service charges etc. Qarze Hasna:

This is also an interest-free loan scheme. Under the scheme, interest free loans are granted by the nationalized banks to the students who do not have sufficient means to pursue on their education. the students with outstanding caliber, facing financial problems, are given loans free of interest so that they can continue their educational career. Qarze-Hasna is given to students who are less than 35 years and is available for post of intermediate studies in engineering, medicine, agriculture, electronics, commerce, economics etc. Loans are registered on the name of the student and will be secured by the guarantee of the parents. For repayment of loan, a grace of 2 years is granted after the completion of studies. In case of drop outs or commission of an act of moral turpitude or crime, the loan will become payable immediately.

2- Trade Financing
The State Bank of Pakistan has approved five trade related modes of financing .They are as follows. Mark up

This concept is derived from Bai Mujjal. Literally bai' muajjal means a credit sale. Technically, it is

a financing technique adopted by Islamic banks that takes the form of murabahah 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. Bai' muajjal is also called a deferred-payment sale. However, one of the essential descriptions of riba is an unjustified delay in payment or either increasing or decreasing the price if the payment is immediate or delayed. 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. The mechanism of financing on the basis of mark up in price of deferred basis is as follows: 1. The customer contacts the bank for financing the purchase of goods. 2. The bank purchases the required goods and sells these to him on the mutually agreed upon price. The purchase and selling price, other costs, and the profit margin (mark up) must be clearly stated at the time of the sale agreement. The agreed upon price is paid in future on a specified date by the customer of the financier. 3. The payment of sale price may be either in lump sum or in installments. 4. The technique of mark-up can find general application in financing input requirements of industry and agriculture as well as in the financing of domestic and import trade.

Mark down: A decrease in a security price made by a dealer because of changing market conditions. In banking terminology, it is the purchase of property or assets, which may be moveable or immoveable, by bank with Buy Back Agreement. The customer sells the property to the bank with the promise to buy it back at a specified date. The payment may be paid back through installments or lump sums. The difference between the purchase of the property by the bank and that of its sale price to the customer is profit of the bank.

Leasing: Leasing is a financial instrument in which the property of the leased asset remains with the leasing company while the lessee obtains the right to use the asset by paying lease rentals

for the life time of the leasing contract. At the maturity of the leasing contract the ownership of the leased asset is transferred to the lessee at a symbolic cost. Leasing, also called 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. 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. It is a type of medium long term financing instrument. Hire purchase Hire purchase (HP) financing is one of the most common ways for people to buy private vehicles. If you take on HP financing, you become the hirer while the financier financing the vehicle is the owner. As the hirer, you will have to pay installments to the financier based on an agreed duration while you will have possession of the vehicle. When all installments are paid up, ownership is then transferred to you, the hirer. In this system, banks and other financial institutions can provide finance for the purchase of various fixed assets under a joint ownership arrangement. In addition to repayment of the principal, they would receive a share in the nature of net rental out of the profits earned on the assets. The state bank of Pakistan has allowed the commercial banks to provide finance for the purchase to their clients in trade and industry on the basis of hire purchase. The bank purchases the desired product on the request of the client. The client pays the amount in periodical installments. The installments are worked out in such a manner that the bank earns a substantial profit plus the actual cost of the product. Development charges: Another very important mode of financing is development charges. Banks make advances to its customer so that they can improve or upgrade their assets, land or property. This act adds value to the property. The share in the value of the property is termed as development charges. It is the profit that the bank earns as a result of financing on others assets.

3- Investments
Musharaka (Profit and Loss sharing) : Musharaka 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. Musharaka may be summarized as: The investment in Musharaka comes from all the partners. In Musharaka, all the partners can participate in the management of the business and can work for it. In Musharaka all the partners share the loss to the extent of the ratio of their investment. . The liability of the partners in Musharaka is normally unlimited. Therefore, if the liabilities of the business exceed its assets and the business goes in liquidation, all the exceeding liabilities shall be borne pro rata by all the partners. However, if all the partners have agreed that no partner shall incur any debt during the course of business, then the exceeding liabilities shall be borne by the partner alone who has incurred a debt on the business in violation of the aforesaid condition. In Musharaka, as soon as the partners mix up their capital in a joint pool, all the assets of the Musharaka become jointly owned by all of them according to the proportion of their respective investment. Therefore, each of them can benefit from the appreciation in the value of the assets, even if the profit has not accrued through sales. Profits are to be shared as agreed and the agreed ratio of distribution of profits may not necessarily be proportional to the respective capital contribution of the two parties.

The modern business concerns being run on the basis of Musharaka are as under: 1. Partnership: It is regulated by(a) Partnership rules framed by the government, (b) Business practices prevailing in the business community. 2. Limited company: This type of Musharaka is strictly controlled by the statutory rules framed by the government. Its commercial activities are, however, influenced by the business practices (urf). 3. Co-operative societies: This Musharaka is also governed by statutory rules. Its commercial activities are influenced by the practices prevailing in the business community.

Modaraba Certifications:

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. 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. Mudarabah can be summarized as: Mudarabah, investment is the sole responsibility of the rabb-ul-mal. The rabb-ul-mal (investor party) has no right to participate in the management which is carried out by the mudarib only. In mudarabah the loss, if any, is suffered by the rabb-ul-mal only, because the mudarib does not invest anything. His loss is restricted to the fact that his labor has gone in vain and his work has not brought any fruit to him. However, this principle is subject to a condition that the mudarib has worked with due diligence which is normally required for the business of that type. If he has worked with negligence or has committed dishonesty, he shall be liable for the loss caused by his negligence or misconduct. The liability of rabb-ul-mal is limited to his investment, unless he has permitted the mudarib to incur debts on his behalf. Here all the goods purchased by the mudarib are solely owned by the rabb-ulmal, and the mudarib can earn his share in the profit only in case he sells the goods profitably. Therefore, he is not entitled to claim his share in the assets themselves, even if their value has increased. Profit is shared in agreed ratio. Mudaraba certificates are transferable.

Participation term certificates(PTC)

It is an instrument for medium and long term financing. These are issued by joint stock companies to scheduled banks and financial institutions for raising funds. The investor by purchasing the P.T.C becomes entitled to have share in profit and loss of issuing company. The company has to maintain a register in which the P.T.C's issued shall be registered. P.T.C is replacement of debenture finance. Main features as under: P.T.C's are transferable. Profits are shared in agreed ratio. The losses are shared in the ratio of bank and company investment.

These certificates are issued for a period of ten years or more. Only JOINT STOCK Companies can raise funds by issuing PTCs. P.T.C holders have the option to participate in all meetings of the company.

The Certificate of Participation is a financial document that is often employed when a municipal government or other government entity creates a bond issue. Rather than paying interest on the bonds or guaranteeing a face value at the end of the project, the investor receives a return based on the lease revenues associated with the offering. Making use of this process can work very well for the municipality, since it will free the issuer from restrictions on the amount of debt that can be incurred during the course of the project. For many cities and towns, the Certificate of Participation approach to a bond issue will follow a simple formula. A bond issue is created in order to fund the construction of some sort of capital facility that is within the city limits. Rather than owning the facility outright during the period of construction, the city essentially leases the facility during the construction period and makes installment payments toward the lease. When the payment schedule is completed, the municipality assumes ownership of the completed facility. For the investor, the Certificate of Participation represents proof of involvement in the bond issue. Purchasing a share of the lease revenues can be an attractive alternative to the more traditional bond for a couple of reasons. Payments are made to the investor for the duration of the project, based on the percentage of share that the investor has in the lease agreement. This means that the investor does not necessarily have to wait for a bond to mature before he or she begins to receive a return on the investment. Of course, payments specified by the terms of the Certificate of Participation can be deferred until later in the project, if the investor prefers to receive larger payments at less frequent intervals. P.T.Cs are of two types: 1. Short term PTC: it is issued by a company for meeting its working capital requirements 2. Long term PTC: such a PTC is issued by a company to finance its long term capital requirements, such as fixed assets, modernization of machinery etc.

Equity Participation and Purchase of Shares:

Equity sharing means sharing risks and rewards of ownership. Under this mode of financing, the bank or the financer purchases the share of the company at market price. The bank can become the share holder instead of lender. Main features are as under: The investor purchases the shares to participate in equity. These shares are purchased by the Bank or financier at market rate or agree price. Profits are shared in the form of annual dividends. The losses are shared in the form of reduction in market price of shares. If the company needs more funds the promoters can ask to increase equity base. The shares can only be purchased from stock exchange listed companies.

Rent share:

Investment on Rent Sharif Basis ha has the following features: Rent sharing is generally applicable to financing for purchase or construction of houses. The bank and the client will contribute funds, as agreed, to purchase or construct the house. Rent of the building will be estimated area wise, and will be shared in the ratio of their investments or as agreed upon. Rent may be revised after every three years.

These were the 12 modes of banking and financing in Islam as practiced by Pakistani Banks and other Muslim banks of the world. But a question often asked about the Islamic code of banking is Can Islamic banks play any role in economic development of the Country? The answer is YES. Islamic banks, while functioning within the framework of Shariah, can perform a crucial task of resource mobilization, their efficient allocation on the basis of both PLS (Musharaka and Mudaraba) and non-PLS (trading & leasing) based categories of modes and strengthening the payments systems to contribute significantly to economic growth and development. Sharing modes can be used for short, medium and long-term project financing, import financing, pre-shipment export financing, working capital financing and financing of all single transactions. In order to ensure maximum role of Islamic finance in development of the economy it would be necessary to create an environment that could induce financiers to earmark more funds for Musharakah/Mudarabah based financing of productive units, particularly of small enterprises. The non-PLS techniques, as acceptable in the Islamic Shariah, not only complement the PLS

modes, but also provide flexibility of choice to meet the needs of different sectors and economic agents in the society. Trade-based techniques like Murabaha with lesser risk and better liquidity options have several advantages vis--vis other techniques but may not be as fruitful in reducing income inequalities and generation of capital goods as participatory techniques. Ijarah related financing that would require Islamic banks to purchase and maintain the assets and afterwards dispose of them according to Shariah rules, require the banks to engage in activities beyond financial intermediation and can be very much conducive to the formation of fixed assets and medium and long-term investments. On the basis of the above it can be said that supply and demand of capital would continue in an interest-free scenario with additional benefit of greater supply of risk-based capital alongwith more efficient allocation of resources and active role of banks and financial institutions as required in asset based Islamic theory of finance. Islamic banks can not only survive without interest but also could be helpful in achieving the objective of development with distributive justice by increasing the supply of risk capital in the economy, facilitating capital formation, and growth of fixed assets and real sector business activities. Salam has a vast potential in financing the productive activities in crucial sectors, particularly agriculture, agro-based industries and the rural economy as a whole. It also provides incentive to enhance production as the seller would spare no effort in producing, at least the quantity needed for settlement of the loan taken by him as advance price of the goods. Salam can also lead to creating a stable commodities market especially the seasonal commodities and therefore to stability of their prices. It would enable savers to direct their savings to investment outlets without waiting, for instance, until the harvesting time of agricultural products or the time when they actually need industrial goods and without being forced to spend their savings on consumption. Banks might engage in fund and portfolio management through a number of asset management and leasing & trading companies. Such companies/entities can exist in the economy on their own or can be an integral part of some big companies or subsidiaries, as in the case of Universal Banking in Europe. They would manage Investors Schemes to mobilize resources on Mudarabah basis and to some extent on agency basis, and use the funds so collected on Murabaha, leasing or equity participation basis. Subsidiaries can be created for specific sectors/operations, which would enter into genuine trade and leasing transactions. Low-risk Funds based on short-term Murabaha and leasing operations of the banks in both local as well as foreign currencies would be best suited for risk-averse savers who cannot afford possible losses, in PLS based investments. Under equity based Funds, banks can offer a type of equity exposure through specified investment accounts where they may identify possible investment opportunities from existing or new business clients and invite account-holder to subscribe. Instead of sharing in the banks profit, the investors would share the profits of the enterprise in which funds are placed with the bank taking a management fee for its work. Banks can also offer open-ended Multiple Equity Funds to be invested in stocks. Small and medium enterprises (SME) sector has a great potential for expanding production

capacity and self-employment opportunities in the country. Enhancing the role of financial sector in development of SME sub-sector could mitigate the serious problems of unemployment and low level of exports. The banks may introduce SME Financing Funds with various geographical locations. The corporate sector and the commercial banks may set up a network of such Funds under the aegis of SECP by establishing institutions under syndicate arrangements or otherwise.