Quaid-e-Azam Mohammad Ali Jinnah Founder of Islamic Republic of Pakistan On the Occasion of the Opening Ceremony of the State

Bank of Pakistan on July 1, 1948

INTRODUCTION
Islam by its real meaning denotes the phenomenon of completely following the command of somebody in general understanding it is the state in which somebody follows the instruction of ALLAH Almighty. Islam by its very nature is not a religion like any other religion. It is a Deen which denotes a complete way of living and provides us with the complete set of instructions to be followed in the whole life of a Muslim. These include the Ibadaat and Muamlaat i.e the modes of worship in different styles and the matters of dealings with others. We know that being a Muslim demands the state of adherence to the complete set of instructions made available to us through the Holy Quran and Sunnah, irrespective of such instructions being included in the Ibadaat or Muamlaat. The set of instructions received, which we generally call our Deen, in addition to our matters, provide us full guidance in the matters relating to business. In this study, we will try to understand and apply such principles in the affairs of managing the finances of a business in Pakistan, within the framework provided by ALLAH Almighty through its Messenger (SAAWS). Since, the most crucial issue for doing business is this era is the matter of avoiding interestbearing and similar transactions, a major area of this study is devoted on interest-free financing alternates and interest-free financial management. In this study, we have considered most of the options available for the interest-free system. In this respect, it is worthwhile to note that certain schools of thought have objections of certain tools of Islamic finance on various grounds. Similarly, it has also been established by almost all schools of thought that a few of these tools are doubtful in a few aspects, hence, although being permissible or Mubah, it is advisable to avoid them. Without going into details for rationale of such comments, we would just identify the situation in case of each of the tools and

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would leave the matter on judgment of the reader or recommend him to consult his respective Shariah to avoid any ambiguity.

Capitalism and Islamic Financial System: what's the difference?

Is there any real difference between the Capitalist and the Islamic economic system? Both systems allow you to make money, but they are completely different in how money is accumulated and spent. The reasons for such great differences is the source and hence, the ultimate goal of each system. Capitalism is based on the concept that economics is that which examines man's needs, which are unlimited and how to satisfy these unlimited needs. The system depends upon the separation of church and state or in other words, the separation of the Creator from life's affairs. The concept of freedom plays a major role in the Capitalist ideology. Freedom is guaranteed by the state, therefore, man is totally free to satisfy his needs in any manner possible as long as he does not legally infringe on the freedom of others. One needs only to look onto the streets around us to see the devastating results of this form of system. It is because of the freedom of satisfying needs that the pornography and alcohol/drug industry are two of the biggest profit making businesses in the Capitalist system. Is this the type of society in which we want to live and raise our children? The Islamic economic system is derived from the only source that is capable of satisfying the needs and desires of everyone, without resulting in chaos. The source of these rules is our Creator. Islam, coming from the Creator, does not deny the needs of humans, but instead, it sets guidelines on how these needs and desires are to be fulfilled. As human beings, we have the freedom to use our minds to prove that a Creator does exist, and that Islam is the Creator's mercy to us to guide our lives and live it with purpose. Once we accept Islam freely, we then follow the rules of Islam. This shows how Islam defines the freedom in our lives. Freedom is living by the best system possible, not creating a system that destroys the lives of human beings. Capitalism is also based on the theory of relative scarcity. This means that there always has

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to be a real or as in the majority of cases, a forces insufficiency of commodities to meet the needs of the people. This is not in keeping with the reality life. Today, there are more than enough goods and commodities to satisfy the needs of everyone, but because this in fact, contradicts the principle of relative scarcity, some people are left without the fulfillment of their basic needs of food, shelter, and clothing while others seem to have too much of one or more. This theory divides the society such that a small percentage of people hoard almost all the wealth while the rest of society struggles to have a home and food. Islam does not share this idea of relative scarcity. Islam does not allow this to happen. The basic needs are guaranteed to every Muslim and non-Muslim living under the rule of Islam. These needs include the tangible, such as adequate food, clothing, and shelter, as well as the intangible, such as medicine, education and security. The primary goal is to have everyone producing and everyone consuming. The Islamic economic system is not based on price as the method of distribution of goods, but rather, how to distribute funds and benefits to all citizens. With the basic needs satisfied, everyone can live a happier life because people are allowed to search for the livelihood that suits them best and makes them the happiest. The whole society prospers from this system because when people are doing what makes them happy instead of only what makes them money, they are more successful and productive. There may be great economic differences among the people and the means to have the basics for life will be provided for all. This takes into account the fact that people have different skills, motivational levels and entrepreneurial desires and there is no sin in high earnings. The Islamic economic system is just a part of Islam. It cannot be separated from it and discussed as an individual component. Islam ordered the Muslims:

"Seek the abode of the Hereafter in that, which Allah has given you, and neglect not your portion of the world, and be kind as Allah has been kind to you and seek not corruption in the Earth.

Islamic Financial System

ISLAMIC FINANCIAL SYSTEM differs from CAPITALISM in many ways mainly it is the concept of collective interest rather than individual gain. The basic Islamic economic principles are as follows: 1) DETERMINATION OF PRIORITIES: AAKHERAT is the top priority. 2) ALLOCATION OF RESOURCES: No remuneration to capital. 3) DEVELOPMENT: Only HALAL ways of earning and for halal purpose. 4) DISTRIBUTION OF INCOME: Different ways such as sadqaat, zakat etc. 5) RIGHT TO WEALTH: The right to wealth is with the govt. which then distributes it among the factors of production.

Purpose of Islamic banking

Vision Statement
To make Islamic banking the banking of first choice for the providers and users of financial services.

Mission Statement
To promote and develop Islamic Banking industry in line with best international practices, ensuring Shariah Compliance and transparency. 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 (Ijara). Islamic banking activities must be practiced consistent with the Shariah and its practical application through the development of Islamic economics. Many of these principles upon which Islamic banking is based are commonly accepted all over the world, for centuries rather than decades. These principles are not new but arguably, their original state has been
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altered over the centuries. The basic purpose of Islamic banking is to develop a financial system the very basics of which resolve around justice and morality.

Products Of Islamic Financial System:

The term Islamic banking refers to a system of banking or banking activity that is consistent with Islamic law (Shariah) principles and guided by Islamic economics. In particular, Islamic law prohibits usury, the collection and payment of interest, also commonly called riba in Islamic discourse. In addition, Islamic law prohibits investing in businesses that are considered unlawful, or haraam (such as businesses that sell alcohol or pork, or businesses that produce media such as gossip columns or pornography, which are contrary to Islamic values). In the late 20th century, a number of Islamic banks were created to cater to this particular banking market. There are many important products which are offered by Islamic financial institutions but some important products with definition are listed as under :

1. Musharakah
Musharakah (joint venture) is an 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 loses capital in the same ratio. If the Bank provides capital, the same conditions apply. It is this financial risk, according to the Shariah, that justifies the bank's claim to part of the profit. Each partner may or may not participate in carrying out the business. A working partner gets a greater profit share compared to a sleeping (non-working) partner. The difference between Musharaka and Mudharaba is that, in Musharaka, each partner contributes some capital, whereas in Mudharaba, one partner, e.g. A financial institution provides all the capital and the other partner, the entrepreneur, provides no capital. Note that Musharaka and Mudharaba commonly overlap.

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2. 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.

3. Murabahah
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 common in North American stores.

4. 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

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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.

5. 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.

6. 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.

7. 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 pre-agreed 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).

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8. Sukuk (Islamic bonds)
Sukuk, plural of Sakk, is the Arabic name for financial certificates that are the Islamic equivalent of bonds. 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.

9. 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.

10. 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.

Islamic Banking Vs. Conventional Banking.

Conventional Banks 1. The functions and operating modes of conventional banks are based on fully manmade principles. 2. The investor is assured of a predetermined rate of interest. 3. It aims at maximizing profit without any restriction. Islamic Banks 1. The functions and operating modes of Islamic banks are based on the principles of Islamic Shariah. 2. In contrast, it promotes risk sharing between provider of capital (investor) and the user of funds (entrepreneur). 3. It also aims at maximizing profit but subject to Shariah restrictions.
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4. It does not deal with Zakat. 4. In the modern Islamic banking system, it has become one of the service-oriented functions of the Islamic banks to be a Zakat Collection Centre and they also pay out their Zakat. 5. Participation in partnership business is the fundamental function of the Islamic banks. So we have to understand our customers business very well. 6. The Islamic banks have no provision to charge any extra money from the defaulters. Only small amount of compensation and these proceeds is given to charity. Rebates are give for early settlement at the Banks discretion. 7. It gives due importance to the public interest. Its ultimate aim is to ensure growth with equity.

5. Lending money and getting it back with compounding interest is the fundamental function of the conventional banks. 6. It can charge additional money (penalty and compounded interest) in case of defaulters.

7. Very often it results in the banks own interest becoming prominent. It makes no effort to ensure growth with equity.

8. For interest-based commercial banks, borrowing from the money market is relatively easier. 9. Since income from the advances is fixed, it gives little importance to developing expertise in project appraisal and evaluations. 10. The conventional banks give greater emphasis on credit-worthiness of the clients. 11. The status of a conventional bank, in relation to its clients, is that of creditor and debtors. 12. A conventional bank has to guarantee all its deposits.

8. For the Islamic banks, it must be based on a Shariah approved underlying transaction. 9. Since it shares profit and loss, the Islamic banks pay greater attention to developing project appraisal and evaluations. 10. The Islamic banks, on the other hand, give greater emphasis on the viability of the projects. 11. The status of Islamic bank in relation to its clients is that of partners, investors and trader, buyer and seller. 12. Islamic bank can only guarantee deposits for deposit account, which is based on the principle of al-wadiah, thus the depositors are guaranteed repayment of their funds, however if the account is based on the mudarabah concept, client have to share in a loss position..

Islamic Financial System Guidelines given by State Bank of Pakistan for establishment Islamic Banking:
Recently, State Bank of Pakistan has allowed the formation of full-fledged Islamic banks in the private sector. The existing scheduled commercial banks were also authorized to open subsidiaries for Islamic banking operations. Such subsidiaries shall be considered as the Islamic Banking Subsidiaries and shall have a separate body of governance. It is a statutory requirement for the bank to appoint a Shariah Adviser / Shariah Supervisory Committee consisting of Shariah scholars of repute to advise the Islamic bank on matters pertaining to Shariah. Shariah Adviser / Committee will be responsible to vet all agreements, and products offered by the Islamic bank. The detailed criteria for setting up Islamic Banking Subsidiaries have been issued by the State Bank, which are highlighted as below: 1. The proposed subsidiary shall be a Public Limited Company and shall be listed on the Stock Exchange; 2. The banking subsidiary (Islamic) are required to conduct the banking activities strictly in accordance with the Shariah principles; 3. To commence the business, the subsidiary shall have a minimum paid up capital of Rs. 1 billion; and 4. At least 51% of the total paid up capital shall be subscribed by the (parent) banking company, and a maximum of 49% of shares shall be offered to public.

Islamic Banking Division:

The bank shall be required to set up an Islamic Banking Division (IBD) at the head office / country office in Pakistan. The bank is also required to prepare a full detail of the organizational structure of the IBD and submit to State Bank. The responsibilities of IBD are as follows:

(a) To manage and be responsible for the operations of Islamic Banking Branch
(IBB) including policy and procedural matters;
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(b) To liaise with other departments in the bank and the Shariah Adviser / Committee to ensure smooth operations of IBB; (c) To ensure that all funds pooled into the Islamic Banking Fund (IBF) are channeled into Shariah complaint financing and investment activities; (d) To arrange training of staff on Islamic banking; (e) To arrange for compilation and submission of such returns, as may be required to be submitted to State Bank from time to time; (f) To ensure that all directives and guidelines, particularly those applicable to Islamic banking, issued by State Bank are strictly complied with; (g) To maintain the Statutory Cash Reserve and Liquidity Requirement with State Bank as prescribed by State Bank from time to time; and (h) Other roles and responsibilities as determined by the bank or State Bank from time to time.

Islamic Banking Fund (IBF):

The bank shall be required to maintain a minimum fund of Rs. 50 million or 8% of risk weighted assets of IBB, whichever is higher. The funds of Islamic Banking shall be funded by the head office or its country office and controlled by the IBD for the operations of IBB.

Shariah Compliance:
Obviously, the sole purpose of the Islamic bank is to conduct banking strictly in accordance with the Shariah principles, as outlined in Holy Quran and Sunnah. The bank is required to ensure the Shariah compliance on all the agreements, and products and services offered and handled by the IBD and / or IBB. The responsible authority for the Shariah compliance is the Shariah Adviser / Committee consisting of Shariah scholars having sufficient related knowledge, qualifications and experience. The Shariah adviser or Shariah Supervisory Committee, appointed by the bank, shall advise the IBD on all of the business matters pertaining to Shariah.
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Islamic Financial Accounting Standard:
Recently the Institute of Chartered Accountants of Pakistan (ICAP) has issued the first Islamic Financial Accounting Standard (IFAS) 1 -Murabaha. The purpose of this Standard is to provide guidance for the transactions regarding Murabaha. Murabaha is a particular kind of sale where seller expressly mentions the cost he has incurred on the commodities to be sold and sells it to another person by adding some profit or mark up thereon which is known to the buyer. Thus, Murabaha is a cost plus transaction where the seller expressly mentions the cost of a commodity sold and sells it to another person by adding mutually agreed profit thereon which can be either in lump-sum or through an agreed ratio of profit to be charged over the cost, thus resulting in an absolute price. According to IFAS 1, Murabaha should fulfill the following conditions: (a) The thing or commodity is in existence; (b) It is owned by the seller; (c) The bank must have a good title to the commodity before it sells it to its clients; and (d) The commodity must come into the possession of the bank, whether physically or constructive, in the sense that the commodity must be its risk, though for a short period. For a Murabaha transaction, the bank itself may purchase the commodity and keep it in its possession. But, as soon as the client purchases the commodity from the bank, the ownership, as well as the risk, passes to the client. According to this Standard, for a valid Murabaha transaction, the financing must be in accordance with Shariah principles.

Departmental Objectives:

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1. Drive and Implement the Strategic Plan for Islamic banking industry 2. Strengthen the existing regulatory framework for Islamic Banking Industry 3. Strengthen and broaden the scope and functioning of SBP Shariah Board through inclusion of more members and engaging of consultants of international repute 4. Arrangement of IFSB events, particularly Council and Technical Committee meetings, along with the side events in Pakistan in November, 08 5. Leverage from/support the efforts of IFSB, IDB/IRTI, AAOIFI, IIFM and other international institutions for promotion of Islamic banking in Pakistan 6. Coordination with BPRD regarding licensing of full fledged Islamic Banks (IBs) and their branches and Islamic Banking Branches of conventional banks (IBBs) and formation of Islamic banking subsidiaries 7. Coordination with BID for Shariah compliance inspection of IBIs and proper compliance of the observations/recommendations of inspection report (regarding Shariah Compliance) 8. Utilizing SBP-SECP Joint Forum for the promotion of Islamic financial industry 9. Support industry players in development of Shariah-compliant liquidity management instruments 10. Utilizing the Shariah Advisor Forum for conflict resolution and for discussion on AAOIFI Shariah Standards for their adoption in Pakistan 11. Conduct awareness programme within and outside SBP to eliminate the misconceptions and to develop the confidence of the public about Islamic banking 12. Publication of Islamic Banking Bulletin (IBB) and Islamic Banking System review (IBSR) and facilitate different departments in preparing various SBP publications 13. Human resource capacity building in the Islamic banking industry through coordination with educational institutes

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