INTRODUCTION TO

ISLAMIC BANKING &

FINANCE
By

Muhammad Ayub

(Former) Head, Islamic Banking, NIBAF

State Bank of Pakistan
Presented at
AlHuda CIBE Workshop at Lahore

Topics to be Discussed

Why Islamic Banking?

The Prohibition and Concept of Riba
Key Misconceptions General Myths
Features of an Islamic Bank Overview
Overview of Islamic finance Modes
Shirkah Musharakah and Mudarabah
Murabaha
Ijarah
Diminishing Musharakah

Islamic Banking?
Banking encompassing Islamic injunctions
To avoid:
Riba Earning returns from loans and debts or
Selling debt contracts at discount
Gharar Absolute Risk or Excessive uncertainty in
contracts, Gambling and chance-based games
(Qimar)
General Prohibitions
unethical practices
Shariah Compliance & Prudent Banking

Riba Prohibition
All revealed religions
Severe Prohibition in Quran $ Sunnah

Unanimity on Riba Prohibition;

Problem then?
Interpretation
Consensus
4

Quran Guides on Def of

Riba
Financial Liability:
Qard (Loan) : to give anything in ownership of other
by way of virtue - same or similar amount of that
thing would be paid back on demand or at the
settled time.
Dayn (Debt) : Incurred by way of trade or rent or any
other credit transaction - ought to be returned at
the settled time without any profit.
Verse 2: 279 guides that whatever is over and above
the principal of loans or debts is Riba.
5

Riba?
All increases in wealth or benefits accruing
to a person without any labour, risk, or
expertise.
One who wishes to earn profit on his
monetary investment must bear the loss or
damage accruing to the business where his
money capital is to be used.
Nature of transaction important.
Trading- Bai- Risk taking, value addition
Leasing Ijarah - Risk taking, value addition
Exchange transaction Monetary transactions
Lending a virtuous act; not a business
Hand to hand exchange of currencies
6

Misconceptions - Myths
Any Return on deposits is Riba;
Any prefixed return Riba
Islamic banking: cost-less money
available Approach of Businesses
Repayment of loans not a serious issue
be waived of
Trade profit similar to interest on loans /
debts

Reality

Differentiating:
Trading, loaning and
leasing
Return by way of pricing of goods and their
usufruct needs to be fixed: permissible.
Islamic banking is also a business, It does
not mean availability of cost free money.
Repayment of debts is must.
Time value of money is accepted to the
extent of pricing of goods but not in the form
of conventional opportunity cost concept.
8

Riba - Unanimity
Banu Thaqif of Taif, not to forego
interest on their receivables; Banu Amr
ibnal Moghirah refused to pay interest;
Referred to the H Prophet, the
Revalation came:

O you who believe. Fear Allah, and give up the Riba

that remains outstanding if you are (in truth)
believer. (11:278).
9

Riba - Unanimity (Contd)

If you do not do so, then be sure of

being at war with Allah and his
Messenger. But, if you repent, then
you have your principal. (11:279)

10

 And if you repent, then you have your

principal. Wrong not, and you shall not be
wronged . {without inflicting or receiving
injustice}

11

And fear the day when you shall be brought back

to Allah.

Then shall every soul be paid what it earned

and none shall be dealt with unjustly.

12

Riba versus Bai

Those who protested and argued that lending on

interest was like an act of trade, were
admonished through revelation that while trade
was permitted, riba was forbidden and in loan
transactions they were entitled to their principal
sums only.

13

Some other Myths

Credit and cash market prices of a
commodity must be same
Profit margin on credit sale by banks
resembles Riba.
Sharing vs. Non Sharing instruments:
Permissibility & Priority two different
aspects
Money can be rented like other assets
14

Reality
Profit margin that Islamic banks charge in their
trade operations is permissible if trading principles
given by Islam are properly taken care of.
PLS modes have preference but Debt creating
modes also permissible; Banks can use any modes
keeping in view the Risk Profile of the investors
and nature of business and cash flow of
entrepreneurs.
Money cannot be rented
15

 They used to say that it is all equal whether we

increase the price in the beginning of the sale,
or we increase it at the time of maturity. It is
this objection which has been referred to in the
verse by saying They say that the sale is very
similar to Riba. (Ibn-Abi-Hatim)
16

Types of Riba
Riba Al-Fadl - sale transactions,
Quality premium in exchange of low
quality with better quality goods of same
kind; prohibited e.g. dates for dates,
wheat for wheat etc.
Riba Al-Nasia - loan transactions.
Riba Al-Nasia (Riba Al-Ouran) involved in
credit/delay; modern banking transactions
falls under Riba Al-Nasia,
17

Overall Consensus
Council of Islamic Ideology (CII): Preliminary Work
CII Report on Elimination of Interest from the
Economy (June, 1980) Unanimously Endorsed
Representation of all Muslim sects in Pakistan
Justice Dr. Tanzil-ur-Rahman (J Afzal Cheema)
Mawlana Zafar Ahmad Ansari
Mufti Sayyahuddin Kakakhel
Khawaja Qamruddin Siyalvi
Mawlana Muhammad Taqi Usmani
Mawlana Muhammad Hanif Nadvi
Allama Syed Muhammad Razi
Mr. Khalid M Ishaq
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Other Prohibitions
Compensation-based restructuring of debts
Selling debt contracts at discount Excessive
uncertainty in contracts (Gharar)
Gambling and chance-based games
Forward foreign exchange transactions
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Gharar
Excessive uncertainty regarding subject matter and
the price;
Inadequacy and Inaccuracy of Information Uncertainty - lack of adequate value-relevant
information Transparency and disclosure .
Any bargain in which the subject matter / result of it
is hidden; settlement risk / counterparty risk
involved
Only exception: "Salam (forward sale with
prepayment)." and Istisnaa (order to manufacture)
Rationale of this exemption.

20

Gambling
Maysir (game of chance) :getting something
too easily or getting a profit without
working for it.
Qimar includes every form of gain or
money, acquisition of which depends purely
on luck and chance.
All Lottery based prize Schemes covered
under the definition of gambling and Maysir.
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Encouragements
Benevolence
Transparency and disclosures
Purification of income
Comprehensive and universal ethical
approach
Documentation
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Welfare Economy Framework

Socio-economic Justice
Distributive Justice
Ethics and value system
Functioning of the Market & Role of the State:
Right of ownership, freedom of enterprise, over
seeing role of the State.
Transparency and disclosures
Competitive price mechanism
Creating additional value and sharing gains
Closer linkage between real economy & finance
Society happy both materially and spiritually.

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Businesses / Modes of
Arabs
Trading, Muzaraah, Musaqat (Gardening with
Shirkah), Services (Ujrah and Ijarah) The
Main businesses;
Barter and the Money based transactions;
Individual Businesses, with self capital or
arranged on Riba;
Loans, Debts (Credit /Future contracts
Salam/Salf
Partnership
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Impact of contracts
Bai: Definite transfer of ownership of goods against
payment of price-spot, delayed and forward; Profit
permissible
Ijarah (leasing): Transfer of usufruct of goods. Any
thing which cannot be used without consuming its
corpus, or whose corpus changes its form in the
process of its use, cannot be leased out like money,
edibles, fuel, etc. Rental permissible
Riba: Exchange transactions involving temporary
transfer of ownership of assets against payment. Any
return prohibited.
Qadr Hassan / Tabarrue: Temporary transfer of
ownership of goods/assets free of any payment;
25

What Islamic Banking?

Banking encompassing Islamic injunctions
To avoid:
Riba Earning returns from a loan contract or
Selling debt contracts at discount
Gharar Absolute Risk or Excessive uncertainty in
contracts, Gambling and chance-based games
(Qimar)
General Prohibitions
unethical practices
Shariah Compliance & Prudent Banking
Achieving the goals and objectives of an Islamic
economy.

26

A Paradigm Shift!
Conventional
Borrowing on
interest
Lending on
interest
Money the
Subject matter
Services against
wages or commission

Islamic

Trading- Shariah
Rules
Leasing
Doing other real
sector businesses
through sole
proprietorship or
Shirkah
Services against
wages or
commission
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Principles of Islamic Finance

Lending a virtuous act Not a business.
Prohibition of Riba and Gharar; permission of
trading.
All gains to principal not prohibited.
Deciding Factor: nature of transaction.
Profit to be earned by sharing risk and reward
of ownership through pricing of goods,
services or benefits.
Time has value that can be discounted only
through price; not in the form of interest,
sometimes negative value as well.
28

Profit linked with Liability

Ownership cannot be separated from the risk
of its loss
Al Kharaj Bil daman
The above implies that entitlement to return
from an asset is intrinsically linked to the
liability of loss of that asset
What that implies for the attitude towards
risk?
What that implies for time value of money?

in loans
in deferred sales

29

Cardinal Principles

(Contd)

Ability to cause value addition.

Differentiating: Trading, loaning and leasing
Ownership Transfer in: Sale of assets, Loans and
Leasing;
Any thing which cannot be used without consuming its
corpus, cannot be leased out like money, edibles, fuel,
etc.
Taking rent on leasing of asset permissible while rent on
loan is prohibited.
Repayment of loan- Must.
Husan al qada: Repaying a loan in excess of the
principal.
Debt contracts cannot be sold at discount.
30

Cardinal principles
Risk and return / rights and liabilities must go
side-by-side;
The subject of exchange has to be valid and
should not involve Gharar;
Notional assets stand no where in Islamic
finance;
Non-existing assets can become the subject
matter of exchange with the conditions
applicable to Salam;
The main objective of exchange transactions
has to be completion of the exchange process
from the both sides.
31

Alternative Financing
Principles
Participation and sharing principle
Deferred trading principle
Interest free loans
Combination of contracts
32

Wealth and trading rules

Forms of
Wealth (Mal)
Goods, durable
assets, shares
of companies

Classification

Trading rule

Non-debts

Market prices

Money

Sarf

Services

Pooled assets
are traded in
accordance
with the rule of
the dominant
assets

Usufructs
Money, gold
and silver
Debts

Pure debts

Hawala al
dayn

33

Exchange Rules
Different for different contracts and types of wealth:
Goods, Durable assets, Shares representing pool
of assets - Market based pricing
Gold silver or any monetary units (Athman)
Rules of Bai al Sarf
Usufruct and services (Leasing/ Services)
Loans/Debts Repayment or Assignment of the
same amount.
Well-Known Injunction on exchange of six
commodities: Gold, Silver, Wheat, Barley, Dates and
Salt.
34

Exchange Rules (Nawawi)

Illah (Effective Cause of prohibition): Unit of value and
Edibility
When underlying illah is different, short fall/excess and
delay both are permissible, e.g. sale of gold for wheat.
When commodities of exchange are similar, excess
and delay both are prohibited, e.g. gold for gold or
wheat for wheat, Rupee for Rupee, etc.
When commodities of exchange are heterogeneous
but the illah is same, as in the case of gold for silver
(medium of exchange) or wheat for rice (edibility), then
excess/deficiency is allowed, but delay in exchange is
not allowed.
35

Exchange of Currencies

Contd)

Special rules for exchange of monetary

values.
Currency Futures: Some scholars forbid them
while others distinguish between the two
cases:
First, where one currency is delivered on spot and
the other is delayed - forbidden.
Second, permitted, involves the future exchange of
both currencies at the previously agreed rate.
36

Banking - A Business

Banking or Benevolence ?

Principle of Islamic banking business: Sharing of

profit and loss on post facto basis arising from:
i. (Deferred) Trading profit margin for the
seller
ii. Rentals on leased assets
iii. PLS
iv. Combination of contracts
Return free (loans)

37

Main Financial Contracts

A. Debt creating Modes (Low Risk Category)
1. Qard Al-Hasan (interest-free loan)
2. Bai Muajjal (Price deferred sale)
3. Murabaha and Musawama
4. Salam (Commodity sale)
5. Istisnaa ((Order to Manufacture)
B. Semi-debt Modes
1. Ijara
C. Sharing or Non-debt Modes (Full Risk
Category)
1. Musharaka (Close to Venture Capital)
2. Specific Purpose Mudaraba
3. General Purpose Mudaraba

38

conditions for Valid sale

General Rule:

Commodity should have come

into existence.
It should be in ownership of the
seller.
The commodity should also be
under physical or constructive
possession of the seller.
Two exceptions to this rule- Salam & Istisnaa
39

Contract of Valid Bai

V a lid B a i
P r ic e
T h a m a n

S u b je c t M a t t e r
( M a b e 'e )

D e liv e ry / C o n v e y a n c e
(Q a b z a )

K n o w n
( M a lo o m )

E x is t e n t/
e x i s t a b le

P h y s ic a l
( H a q iq i)

C e r t a in
M u t a 'a y y a n

V a lid f o r
O w n e r s h ip /
P o s s e s s io n

C o n s tr u c t iv e
( H u k m i)

O w n e r s h ip /
r is k o f
s e lle r
V a l u a b le
U s e a b le
( n o t p r o h ib it e d
in S h a r ia h )

40

Principles of Credit Sale

Installments Sale permissible,
price exceeds the spot price.

even if the deferred

Deferred prices can vary so long as price not finalised.

Sale cannot take place until the parties agree to a
particular price & mode of payment.
Not permissible to fix the spot price on cash basis,
then to charge interest expressly tied with different
periods.
Commercial papers are lawful types of authentication
of a debt by putting it down in writing; - Treated by
Shariah near to mandatory.

41

Two main prohibited Sales

Bai al inah Buy-back arrangement
Creditor purchasing assets from debtor on
cash and selling back to him on credit
Bai al Dayn - sale of debt
Trading of debt securities
On face value- Hawalah - Permissible
On premium or discount Not permissible
42

Rules in Murabaha
Basic concept: Sale on mutually agreed profit margin on
the known cost of goods; payment of sale price is
deferred.
Real, tangible goods to be traded and not papers of debt
or credit documents.
Murabaha cannot be used as mode in case no commodity
is purchased by the client.
Buy-back arrangement: not allowed.
MUAJJAL; Credit price may include margin of mark-up,
taking into consideration the deferred payment. As a
debt, no return can be charged on the amount of Note/Bill.

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MURABAHA

Contd

Seller having a good title

physical / constructive possession.
Defaulter: different punishments, penalty for
charity.
Solatium through court (out of penalty).
Client as Agent to the Bank;
Better to have a third party as agent;
Roll-over.
Asset price Risk or commodity risk ( client
might not take delivery);
Market risk,
Credit risk,
Reputational Risk
44

Rules in Musawamah
A general kind of sale: Price bargained without any
reference to the price paid or cost incurred.
Seller not obliged to reveal his cost.
Different from Murabaha in pricing formula only.
Musawamah can be used for big single deals.

45

Salam and Parallel Contracts

(Future Sale)
Prepayment of price in full for goods to be delivered in
future.
Allowed by Holy Prophet (SAW) himself to meet
farmers money need.
Banks will receive contracted commodities, not money.
Parallel Salam: a bank can sell a commodity purchased
through Salam for even the same date of delivery or the
quantity;
As long as the two contracts are not made
conditional on each other.
46

Purpose of Salam
To meet the need of farmers who need money
to grow their crops and to look after their family
up to the time of harvest.
To finance someone who is in need to grow something
or acquire something for further sale.

To meet the need of traders for import and

export business.
The buyer also enjoys a lower purchase price, since he
pays in advance.
Acceptance of Time. Value of Money through pricing of
goods
47

Salam Conditions
Fungible homogeneous goods
not where delivery has to be simultaneous,
e.g. Gold, silver or currencies.
Date and place of delivery must be specified
in the contract.
In case of a number of commodities, the
amount and delivery period should be
separately fixed.
48

Salam Conditions Contd

The bank can sell the Salam Commodity
through a parallel contract of Salam for the
same date of delivery.
For a parallel Salam, the two contracts should
be independent and separately enforceable.
Bank can also obtain a unilateral promise to
purchase from a third party.
Agency
To sell anywhere in the market
49

Istisnaa (Order to Manufacture)

Istisnaa, an agreement for order to manufacture,
culminating into a sale at an agreed price;
The things to be manufactured must be known and
specified to the extent of removing any ignorance
or lack of knowledge of its kind, type, quality, and
quantity.
Price be known in advance that can be readjusted
only by mutual consent of the parties.
50

Istisnaa

(Contd)

Prepayment not necessary in Istisnaa

Not
necessary
for
seller
to
manufacture the commodity himself
Parallel Istisnaa contract; without any
condition attached to the original
Istisnaa contract.
51

Salam, Istisna Differentiated

ISTISNA
The subject on which
transaction of Istisna
is based, is always a
thing which needs to
be manufactured.
Price must be fixed,
but need not to be
paid in advance

SALAM
Subject can be
anything; Agri
produce,
Manufactured goods
all units of which are
normally of the same
.
Price has to be paid
in full in advance
52

Salam, Istisna Differentiated

ISTISNA
Time of Delivery
does not have to be
fixed ; can be
delivered before the
settled time.
The contract can be
cancelled before the
manufacturer starts
working.

SALAM
Time of delivery is an
essential part of the
sale
The contract cannot
be cancelled
unilaterally.

53

Distinction of Istisna

Penalty on default

Shart-e-Jazai

54

Ijarah Rules
Subject Matter:
The corpus of the leased asset should exist till the
expiry of lease period;
The corpus of the leased asset should remain in
the ownership of the lessor during the whole
period of lease; in case of Shirkah pro-rata
ownership.
The lessor must accept responsibility of any
defect in leased asset (without negligence of the
lessee) which hinders the intended use of asset.
Sale Separate and independent contract
55

Flexibility in Ijarah
Fixed Vs. variable / floating return
Time of execution of the contract
Potential in Sukuk Issue

56

Shirkah - Partnership
Commingling by two or more persons
either their money or work or obligations
to earn a profit or a yield or appreciation in
value and to share the loss if any
according
to
their
proportionate
ownership.
Musharakah, Mudarabah, Diminishing
Musharakah
57

Types of Partnership
Musharakah: All partners provide funds not
necessary equally, and all have right to wok;
Shirkatulmilk: Partnership in Ownership
Automatic compulsory
Arranged - Optional

Shirkatulaqd: General / Commercial

partnership for joint business
Musharakah general contractual
partnership
One party provides capital and the other
management

58

Profit / Loss Sharing

Profit distribution: as per agreed ratio;

Loss: in proportion to the investment of
each party.
Profit allocation: in percentages of earning
(profit) and not a sum of money or a percentage
of the capital or investment.
No guarantee of the capital
Loss?
59

Structures of Musharakah
Permanent Musharakah: partners can sell - as in
case of Shares of Joint Stock Companies.
Temporary (Redeemable) Musharaka: for limited
time period, e.g. PTCs or Musharakah based
TFCs; After agreed time period(s),
Diminishing Musharakah: one partner promises to
buy the share of the other partner gradually until
the title to the property is completely transferred to
him.
60

Reference Rates
Reference rates needed for executing and pricing the
contracts.
Different scales for different kinds of financial contracts.
For Conventional finance: Only one reference rate
(interest rate),
Islamic finance: debt/semi-debt contracts and non-debt
(equity) contracts,
Therefore, two reference scales are needed:
Price mark up/rent reference scale
Share ratio reference scale, through the Central Bank
Mudaraba ratio or Interbank Mudaraba ratio.
61

Challenges
Parallel Functioning of the two systems the
greatest challenge
Creating Awareness
Catering to the education and training needs.
Development of Shariah compliant financial
instruments - for SLR, Govt. Financing.
Changes in legal and taxation structure.
Responsibility of advising, coordination and
leadership by any institution/authority for the
transformation process.
Commitment at all levels.
Ultimate Objective: To establish banks that are
Shariah compliant, enjoy depositors confidence,
and are efficient and stable!
62

Key Areas in Future

Direction

Justifiable profit distribution mechanism

Focusing asset management
Potential scope of Shariah complaint
financial engineering
Financial stability
Shariah complaint risk management tools
Corporate governance, transparency and
disclosures requirements

63

Thanks
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