Professional Documents
Culture Documents
For that I started study and took me quite some time to study
the relevant literature of Islamic banking. I am indebted to Sir Attaullah
Shah for providing me the data of Islamic banking and providing some
guidance in the study of relevant and pertinent literature. After that I felt
that now I am able to clarify the misgivings and myths faced by the
Islamic banking.
I fell short of words to express my gratitude to the learned
pioneers of interest free banking, particularly Dr. Muhammad Uzair,
Muhammad Taqi Usmani, Dr. Muhammad Imran Ashraf Usmani and Dr.
Ziauddin Ahmad the then Deputy Governor, State Bank of Pakistan. I
studied their books and derived immense benefit from their intellectual
writings, without them firming up my views thereon would not have been
possible. Nevertheless, what ever shortcomings, visible or latent, are to be
found, they reflect none but me. My special thanks are also to my friends
for providing me support and encouragement during the writing of this
research.
By Muhammad Abbas Khan
March 17, 2007
Chapter 1
Evolution
Shariah Principles
Throughout Asia, the Middle East and Europe, more and more
banks and their customers are turning to Islamic finance. A growing
number of the decisions to do so are increasingly made on commercial
rather than religious grounds. The rising global interest in Islamic finance
has led to major expansions in the number of institutions offering Islamic
financial services. Global financial institutions, led by HSBC, Citigroup,
ABN AMRO, Deutsche Bank and BNP Paribas, have now set up either
Islamic divisions or Islamic subsidiaries.
1. Policy Division
2. Shariah Compliance Division
3. Business Support Division
Rationale
Clarification:
For the clarification of this misgiving it is proposed to discuss
the true nature and meaning of Riba, usury and interest, so that we can
understand and ascertain whether interest comes within the purview of
Riba as stipulated in Shariah.
Historical Background
Even prior to the dawn of Islam, over 1400 years ago, the
majority of ancient philosophers and almost all the religions of the world
had prohibited money lending as a business; Riba, interest or usury. If one
goes back into history, as far as one can, it would be found that lending
and borrowing as a transaction between members of a society was started
as a commercial operation after the switching over from the barter system
to the money system. Money lending with the earning motive became a
common phenomenon in most of the societies of the world, but people
engaged in this business were generally not regarded respectable during
any period of history.
Clarification:
But here the basic question arises that why interest is regarded
as the kingpin of the modern banking system. According to my
perspective there are two basic reasons behind this phenomenon.
Clarification:
To clarify this myth about Islamic baking, first of all my
question to this kind of myth is:
Does the fixed interest system really give fair return to the
depositors?
Most often in inflationary situation under the present system
depositors get a negative real rate of interest. If the rate of interest on
deposits is, say 8%, and if the rate of inflation is 12%, the depositors get a
negative rate of interest of 4%.
Mathematically
Rate of interest = 8%
Inflation rate = 12%
12% - 8% = 4%
As compared to this a system which is based on profit and loss
sharing will be able to capture a part of inflationary profits and hence, if
properly worked, is capable of giving better return to the depositors.
Suppose depositor deposit 100,000 rupees in bank under profit
loss sharing system and the depositor and bank agreed on 30%:70%, so
after declaring of profits suppose six months later the depositor will get
30% profit while the ban k will get 70% profit which can cover all their
administrative and daily expenses.
Clarification:
Of course it is all right in theory, they say. But will it actually
happen in practice? When you start interest free banking will it really be
possible for banks to get more by way of return, so that they can give
better returns to depositors as compared to the present day interest based
system? And this connection they point out that, as we know there is
widespread concealment of profits and the accounts are not the true
accounts of the various concerns. Well I think these kind of malpractices
and stealing are there in the conventional system and these evils do exists
and it is a real problem and this the problem which has to be faced when
Islamic banking is introduced. But I do not regard it as an insurmountable
problem. The problem should not exist at all if, along with the introduction
of institutional reforms by way of abolition of interest and introduction of
zakah, efforts are also made for bringing about those values in our society
which Islam really advocates. If our society is really permeated by Islamic
values and ethos, there should be no problem of this kind that people will
try to conceal their profits from the banks but even in the interim, because
nobody perhaps can wait till the whole society is purified and everybody
begins to work according to the ideals and standards of Islam. Ways can
be found through which this problem can be surmounted. And here I
would refer only to three steps that can be taken when interest free
banking is introduced which will minimize the problem which arise from
the concealment of profit. One is a basic reform in income tax system. The
effort should be to so reform the present income tax system that factors
responsible for the concealment of profits are eliminated or at least
minimized.
The second thing that can be done is to bring about some
important changes in accounting and auditing systems. For example, when
the profit-sharing system introduced, it can be stipulated that auditors of a
firm’s accountants will be appointed with the mutual agreement of the
bank and the firm. Some reforms in the auditing system itself may be
needed. And finally, the banks will also be overseeing the operations of
the concerns to which they made financial assistance available. They can,
in the case of big companies, establish their presence in the management. I
might also add that even in the present social environment, institutions like
the NIT and ICP are making profits and declaring dividends. And when
the scope of the interest-free operations is expanded to cover also the
distributive trade, construction industry etc., there is no reason why banks
should not be able to make more profits than NIT and give a positive
return on the savings that are deposited with the banking system.
Clarification:
This is the most important myth regarding Islamic banking to
be clarified. Here the thing I have to say is that interest-free banking does
not necessarily mean that no other device can be employed except profit
sharing. Obviously the ideal is profit and loss sharing. When our society
gets fully literate and Islam places very great importance on the abolition
of illiteracy this problem will not exist. But in the meantime when you
have this problem of illiteracy and the problem of so many people who
cannot maintain accounts or proper accounts, it is possible that under the
Islamic system of banking, banks deal with these parties on the basis of
certain other modes which have been permitted by Islam and in this
respect Shariah allows different modes of financing which are below.
Islamic banks around the world have introduced various
financial products based on the profit and risk sharing principle of Islamic
banking. The areas in which Islamic banks are more active are trade and
commodity, finance property and leasing and providing short-term capital
to the business. Some of the basic financial modes of Islamic banking are
as follows.
Before going to explain the Islamic modes of financing, I want
to clarify some basic rules of sales which are necessary for a valid sale in
Islamic Shariah.
I. Murabaha:
ISSUES IN MURABAHA:
Following are some of the issues in Murabaha financing:
3) penalty of default
Another issue with Murabaha is that if the client defaults in
payments of the price of the due date, the price can’t be changed nor can
penalty fees be charged.
4) Rollover in Murabaha
Murabaha transaction cannot be rollover for a further period as
the old contract ends. It should be understood that Murabaha is not a loan
rather the sale of commodity, which is differed to a specific date. Once
this commodity is sold, its ownership transfers from the bank to the client
and it is therefore no more a property of the seller. Now what the seller
can claim is the only the agreed price and therefore there is no question of
effecting another sale on the same commodity between the same parties.
1) The most common mistake is to assume that Murabaha can be used for all
types of transaction and financing. This mode can only be used when a commodity is to
be purchased by the customer. If funds are required for some other purpose Murabaha
can’t be used.
2) The document is signed for obtaining funds for a specific commodity and
therefore it is important to study the subject matter of the Murabaha.
Uses of Murabaha
Murabaha can be used in following conditions:
Short / Medium / Long term finance for:
• Raw material
• Inventory
• Equipment
• Asset financing
• Import financing
• Export financing
• Consumers good financing
• House financing
• Vehicle financing
• Land financing
• Shop financing
• PC financing
• Tour package financing
• Education package financing
• All other services that can be soled in the form of
package(i.e. services like education, medical etc as a package )
• Securitization of Murabaha agreement (certificate) is allowed
at par value only otherwise certain rules of Islamic financing must be met.
2. Bai’ Muajjal
Bai Muajjal is the Arabic acronym for “sale on deferred
payment basis”. The deferred payment becomes a loan payable by the
buyer in a lump sum or installment (as agreed between the two parties). In
Bai Muajjal all those items can be sold on deferred payment basis which
come under the definition of capital where quality does not make a
difference but the intrinsic value does. Those assets do not come under
definition of capital where quality can be compensated for by the price and
Shariah scholars have an ijmah (consensus) that demanding a high price in
differed payment in such a case is permissible.
3. SALAM
CONDITIONS OF SALAM:
1. It is necessary for the validity of Salam that the buyer
pays the price in full to the seller at the time of affecting the sale. In the
absence of full payment, it will be tantamount to sale of a debt against a
debt which is expressly prohibited by the Holy Prophet (PBUH).
Moreover, the basic wisdom for allowing Salam is to fulfill the “instant
need” of the seller. If it’s not paid on full, the basic purpose will not be
achieved.
2. Only those goods can be sold through a Salam contract in which the
quantity and quality can be exactly specified for example precious stones can’t be sold on
the basis of Salam because each stone differed in quality, size, weight and their exact
specification is not possible.
3. Salam can’t be effected on a particular commodity or on a product of a
particular field or farm e.g. Supply of wheat of a particular field or the fruit of a particular
tree since their is a possibility that the crop is destroyed before delivering and given such
possibility, the delivery remains uncertain.
4. All details in respect to quality of good soled must be expressly specified
leaving no ambiguity, which may lead to a dispute.
5. It is necessary that the quantity of the commodity is agreed upon in
absolute terms. It should be measured or weighed in its usual measure only, meaning
what is normally weighed cant be quantified and vice versa.
6. The exact date ion place of delivering must be specified in the contract.
7. Salam can’t be affected in respect of things, which must be delivered at
spot.
8. The commodity for Salam contract should remain in the market right from
the day of contract up to the date of delivery or at least till the date of delivery.
9. The time of delivery should be at least 15 days or one month from the date
agreement. Price in Salam is generally lower than the price in spot sale. The period
should be long enough to affect prices. But Hanafi Fiqh didnt specify any minimum
period for the validity of Salam. It is all right to have an earlier date of delivery if the
seller consents to it.
10. Since price in Salam is generally lower than the price in spot sale; The
difference in the two prices may be a valid profit for the bank.
11. A security in the form of guarantee, mortgage or hypothecation may be
required for a Salam in order to ensure that the seller delivers.
12. The seller at the time of delivery delivers commodities and not money to
the buyer who would have to establish a special cell for dealing in commodities.
BENIFITS:
There are two ways of benefiting from the contract of Salam:
1) After purchasing a commodity by way of Salam, the
financial institutions can sell it through a parallel contract of Salam for the
same date of delivery. The period of Salam in the second parallel contract
is shorter and the price is higher than the first contract. The difference
between the two prices shall be the profit earned by the institution. The
shorter the period of Salam, the higher the price and the greater the profit.
In this way institutions can manage their short term financing portfolios.
2) The institutions can obtain a promise to purchase from a
third party. This promise should be unilateral from the expected buyer.
The buyer does not have to pay the price in advance. When the institutions
receive the commodity, it can sell at a pre-determined price to a third party
according to the terms of the promise.
PARALLEL SALAM:
1) In an arrangement of parallel Salam there must be two
difference and independent contract; one where the bank is a buyer and the
other in which it is a seller. The two contracts can’t be tied up and
performance of one should not be contingent on the other. For example, if
‘A’ has purchased from ‘B’ 1000 bags of wheat by way of Salam to be
delivered on 31st December, ‘A’ can contract a parallel Salam with ‘C’
to deliver to him 1000 bags of wheat on 31 December. But while
contracting parallel Salam with ‘C’, the delivery of wheat to ‘C’ cant is
conditioned with taking delivery form ‘B’. Therefore even if ‘B’ didn’t
delivered wheat on 31 December, A is duty bound to deliver 1000 bags of
wheat to C. He can seek whatever recourse he has against B, but he can’t
rid himself from his liability to deliver wheat to C. similarly, if B has
delivered defective goods, which don’t conformed to the agreed
specifications, A is still obligated to deliver the goods to C according to
the specifications agreed with him.
2) A Salam arrangement can’t be used as a buy back facility
where the seller in the first contract is also the purchaser in the second.
Even if the purchaser in the second contract is a separate legal entity, but
owned by the seller in the first contract; it would not tantamount to a valid
parallel Salam agreement. For example A has purchased 1000 bags of
wheat by way of Salam from B- a joined stock company. B has a
subsidiary C, which is a separate legal entity but is fully owned by B. A
cant contract the parallel Salam with C. However, if C is not wholly
owned by B, A cannot parallel Salam with it, even if some share holders
are common between B and C.
4. ISTISNA’
Istisna is a sale transaction where a commodity is transacted
before it comes into existence. It is an order to a manufacturer to
manufacture a specific commodity for the purchaser. The manufacturer
uses its own material to manufacture the required goods.
CANCELLATION OF CONTRACT:
After giving prior notice, either party can cancel the contract
before manufacturing party has begun its work. Once the work starts, the
contract can’t be cancelled unilaterally.
TIME OF DELIVERY:
As pointed out earlier, it is not necessary in Istisna that the time
of delivery is fixed. However, the purchaser may fix a maximum time for
delivery which means that if the manufacturer delays the delivery after the
appointed time, he will not be bound to accept the goods and to pay the
price.
In order to ensure that the goods will be delivered within the
specified period, some modern agreements of this nature contain a penal
clause to the effect that in case the manufacturer delays the delivery after
the appointed time, he shall be liable to a penalty which shall be calculated
on daily basis. Can such a penal clause be inserted in a contract of Istisna
according to Shariah? Although the classical jurists seem to be silent about
this question while they discuss the contract of Istisna, yet they have
allowed a similar condition in the case of Ijarah. They say that if a person
hires the services of a person to tailor his clothes, the fee may be variable
according to the time of delivery. The hirer may say that he will pay
Rs.100 in case the tailor prepares the clothes one day and Rs.80 in case he
prepares them after two days.
On the same analogy, the price in Istisna may tied up with the
time of delivery, and it will be permissible if it is agreed between the
parties that in the case of delay in delivery the price shall be reduced by a
specified amount per day.
USES OF ISTSNA:
• House financing
• Financing of plant/ factory/
• Factory building
• BOT arrangements
• Construction of buildings and plants
5. IJARAH (LEASING)
BASIC RULES
Transferring of usufruct not ownership
In leasing an owner transfers its usufruct to another person for
an agreed period, at an agreed consideration.
Subject of lessee
Should be valuable, identified and quantified
Period of lease
• The period of leas must be determined in clear terms
• It is necessary for a valid lease that the leased asset is fully
identified by the parties.
Lessee as Ameen
• The lessee is liable t compensate the lessor for every harm
to the leased asset caused by any misuse or negligence.
• The leased asset shall remain in the risk of the lessor
throughout the least period in the sense that any harm or loss caused by the
factors beyond the control of the lessee shall be born by the lesser.
Lease of jointly owned property
• A property jointly owned by two or more persons can be
leased out, and the rental shall be distributed between all joint owners
according to the proportion of their respective shares in the property.
• A joint owner of a property can lease his proportionate
share only to his co sharer, and not to any other person.
Determination of Rental
• The rental must be determined at the time of contract for the whole period
of lease.
• It is permissible that different amounts of rent are fixed for different
phases during the least period, provided that the amount of rent for each phase is
specifically agreed upon at the time of affecting lease. If the rent for a subsequent phase
of the lease period has not been determined or has been left at the option of the lesser, the
lease is not valid.
• The determination of rental on the basis of the aggregate cost incurred in
the purchase of the asset bye lessor, as normally done in financial leases, is not against
the rule of Shariah, if both parties agreed to it, provided that all other conditions of a
valid lease prescribed by the Shariah are fully adhere to.
• The lesser can’t increase the rent unilaterally, in any agreement to this
effect is void.
• The rent or any part thereof may be payable in advance before the
delivering of he asset to lessee, but the amount show collected by the lesser shall remain
with him as on account payment and shall be adjusted towards the rent after its been due.
• The lease period shall commence from the date on which the lease asset
has been delivered to the lessee.
• If he leased asset has totally loss the function for which it we leased, the
contract will stain terminated.
• The rentals can be used on or benchmarked with some index as well. In
this case the ceiling in floor rentals can be identified for validity of lease.
6. IJARAH WA IQTINA
(LEASING AND PROMISE TO GIFT)
SUB-LEASE
If the leased asset is used differently by different users, the
lessee can’t sub-lease the leased asset except with the expressed
permission of the lessor. If the lessor permits the lessee for sub-leasing, he
may sub-lease it. If the rent claimed from the lessee is equal to or less than
the rent payable to the owner/ original lessor, all the recognized schools of
Islamic jurisprudence are unanimous on the permissibility of the sub-lease.
However, the options are different in case the rent charge from the sub-
lessee is higher than the rent payable to the owner. Imam Shafi and some
other scholars allow it and hold that the sub-lessor may enjoy the surplus
received from the sub-lessee. This is preferred view in the Hanbali School
as well. On the other hand, Imam Abu Hanifah is of the view that the
surplus received from the sub-lessee in this case is not permissible for the
sub-lessor to keep and he will have to give that surplus in charity.
However, if the sub lessor has developed the least property by adding
something to it or has rented it in a currency different forms the currency
in which he himself pays rent to the owner/ the original lessor, he can
claim a higher rent from his sub-lessee and can enjoy the surplus.
7. Muqarada:
Clarification:
Clarification:
But my query to such kind of myth is why should it be so?
There are three kinds of factors which are relevant to the possibilities of
defaults.
1st, to whom finance is provided
2nd, for what purpose the finance is provided
3rd, what type of supervision is exercised by the financial
institutions on the end use of the resources.
Now these elements are essentially the same whether it is an
interest based banking system or it is a system which is based on profit
sharing under Shariah principles. If sufficient care is not exercised in
respect of these three elements defaults are sure to arise and as we know
they do arise in the modern systems even though it is based on interest. In
fact, i feel that a system which is not based on interest will be superior and
the chances of default should be minimized if properly worked. This is
because as compared to the fixed interest system, the banks will be more
closely associated with the end-use of funds. In the fixed interest system
tendency is that the banks are satisfied if they get enough security for the
advances and if they feel that the company has profits enough to cover re
payment of its capital and the amount of interest, they are not concerned
even if the profitability is nil after paying interest to banks. But when they
begin to share in the profit they will be more concerned about the efficient
working of the enterprises and, therefore, from that point of view under
the new system, the defaults should be less rather than more.
Clarification:
Well, this is an argument similar to one which says that since
the banks have short terms liabilities they should not lend on long term
basis because this can create a problem of liquidity. This use to be a
fashionable argument a few decades back but very little really is heard
about that now. For one reason we know that in a number of countries the
liabilities of the banking systems are not pre dominantly sight liabilities. In
fact, in our country Pakistan, we find that about fifty percent of the
liabilities are other than demands liabilities. A part from that, with the
growth of central banking and the concept of what we call shift ability of
assets, the liquidity can be ensured by the central bank which is under no
constraint as it can create any amount of credit in times of need. So it can
come to the assistance of the banking systems in time stress.
So i think one should not exaggerate the difficulties about
liquidity. Moreover, not all the finance that will b provided by the banks
under the Islamic banking systems will be for long terms because when
the whole banking systems switches over to a system which is not based
on interest, banks will be expected to provide both short term finance and
long term finance and therefore, by proper management they should be
able to arrange a cash flow which will be quite adequate to take care of the
demands that may be made on the banking systems for withdrawal of the
deposits. I might also add that if you study the history of grow of banking
in the western countries you will find that before central banks came on
the same and before the system of deposits insurance came into fashion,
there were cases of bank failures in a number of countries.
9. The ninth misgiving, which has been expressed by
Clarification:
According to my perspective regarding this query, i am not in
the favor of undue interference by banks under the profit sharing system in
the affairs and daily conduct of the business concerns. It should be
possible to have enough safeguards against too much interference, but
some say of the financial institutions and the running of the business
concerns should not be unhealthy. In fact i think it will have a healthy
effect. Even in the present interest based system a trend has been in
evidence that banks and other financial institutions set a number of
conditions while providing finance. And it is not only about Pakistan but a
number of countries in the rest. The trend is that while making finance
available, the banks do make it a condition that the borrowing concern will
not incur additional long term debt obligations without the permission of
the bank from which they have borrowed in the first instance. In some
countries banks do establish their presence on the management of the
concerns to whom they provide financial resources. In some countries the
declaration of dividend by a concern is also made conditional on the banks
first formatting the concerns to make that amount of dividend declaration.
Clarification:
My perspective regarding this query, it is quite true that under
the profit sharing system there is no stipulation for payment of a fixed
return on the funds provided. In other words, there is no binding
commitment beforehand that the business concerns will make available to
the banks a certain amount of return irrespective of what profit it earns and
irrespective of the fact that it may incur a loss. But once a concern makes a
profit the system that we envisage will entitle the banks to receive and
agreed share of the profit of that concern. It can thus be seen that capital is
not been provided free to the business concerns. In fact, in the case of
highly profitable undertakings banks may well earn much more under the
profit sharing system than under the fixed interest systems. So it is not
correct to say that capital is been provided free.
However, when the whole system gets going, one can visualize
that while mainly work on the system of profit and loss sharing there can
be some institutional mechanisms whereby some sectors can be provided
finance without any return whatsoever that is without claiming any part of
the profit even if profits are made. But this will have to be a conscious
decision and it will have to be taken in context of socio economic
objectives of a particular country. For example, if the objective of
economic policy is to bring about a certain transfer of resources from one
section of society to another it is perfectly legitimate to have a system
whereby resources of the bank will be provided completely free without
share in the profit of a particular sector or a particular sub sector, while
banks appropriate large parts of profits that might be made in other
sectors, thereby setting up a mechanism of transfer of resources from
certain sectors of high income generation to sectors of low income
generations.