Analysis Of the Salient Features Of Islamic Finance

Introduction Of Islamic Finance

What is Islamic Finance?
Roughly 20% of the world's population is Islamic. While some in the Western world
think this population is only in the Middle East, the religion is truly global: from the
Middle East, to Afghanistan, to the US, to Indonesia, and every where in between. While
the extremists are the ones in the news each day, the vast majority of Moslems are
peaceful, respect other religions, and do not hate business nor finance. Attention to
Islamic finance obviously accelerated since 9-11, but it is worthy to note that an Islamic
finance was meeting was actually scheduled for 9-12 in the WTC and that the Islamic
Finance movement was already growing very rapidly. According to estimates in the
Wall Street Journal Islamic finance is roughly a $150 billion dollar market.

So what is Islamic Finance? and how is it different from the traditional Finance we are
familiar with in the Western World?

There are two key differences:

1. The first and most famous (and on which we will focus the bulk of our attention)
is the no-interest rule. That is, you can not earn interest on a loan nor be required
to pay interest on loans.
2. The second difference is that money is to be invested only in worthy causes. This
is largely equivalent to the western concept of socially responsible investing.

The Quran is the holy book of Islam (you can think of it as their bible if it makes it easier
for you). In it, believers find the verses that forbid Riba (or interest). Alarijhi Bank has
created a site (in both English and Arabic) that has the 4 key verses upon which the no-
interest principle is based.

Many of the differences in Islamic Finance (especially Islamic banking) revolve around
this no interest principle. For example, Islamic banks must take equity positions in
homes rather than taking a traditional mortgage. Others examples include essentially
profit sharing plans, leasing, and repurchase plans. These allow the Financial Institution
to make money while satisfying the no-interest principle.

The second difference between Islamic finance and traditional finance is the emphasis on
socially responsible investing. While in the western finical tradition there are many
investors who invest in "socially responsible" means, Socially Responsible investing is
not as wide spread as it is within the Islamic tradition.

Islam takes a holistic view of the person. Thus someone who is good does good things.
This includes investing responsibly to assure that the money does not go
for "bad" purposes. These "bad" purposes include the usual subjects such as drugs,
weapons, alcohol , porno and of course terrorism. Again this is really no different than
traditional socially responsible investing.
Principles Of Islamic Finance
Islamic banking has the same purpose as conventional banking except that it operates in
accordance with the rules of Shariah, known as Fiqh al-Muamalat (Islamic rules on
transactions). The basic principle of Islamic banking is the sharing of profit and loss and
the prohibition of riba (usury). Common terms used in Islamic banking include profit
sharing (Mudharabah), safekeeping (Wadiah), joint venture (Musharakah), cost plus
(Murabahah), and leasing (Ijarah).

In an Islamic mortgage transaction, instead of loaning the buyer money to purchase the
item, a bank might buy the item itself from the seller, and re-sell it to the buyer at a profit,
while allowing the buyer to pay the bank in installments. However, the bank's profit
cannot be made explicit and therefore there are no additional penalties for late payment.
In order to protect itself against default, the bank asks for strict collateral. The goods or
land is registered to the name of the buyer from the start of the transaction. This
arrangement is called Murabaha. Another approach is EIjara wa EIqtina, which is
similar to real estate leasing. Islamic banks handle loans for vehicles in a similar way
(selling the vehicle at a higher-than-market price to the debtor and then retaining
ownership of the vehicle until the loan is paid).

An innovative approach applied by some banks for home loans, called Musharaka al-
Mutanaqisa, allows for a floating rate in the form of rental. The bank and borrower form
a partnership entity, both providing capital at an agreed percentage to purchase the
property. The partnership entity then rents out the property to the borrower and charges
rent. The bank and the borrower will then share the proceeds from this rent based on the
current equity share of the partnership. At the same time, the borrower in the partnership
entity also buys the bank's share of the property at agreed installments until the full equity
is transferred to the borrower and the partnership is ended. If default occurs, both the
bank and the borrower receive a proportion of the proceeds from the sale of the property
based on each party's current equity. This method allows for floating rates according to
the current market rate such as the BLR (base lending rate), especially in a dual-banking
system like in Malaysia.

There are several other approaches used in business transactions. Islamic banks lend their
money to companies by issuing floating rate interest loans. The floating rate of interest is
pegged to the company's individual rate of return. Thus the bank's profit on the loan is
equal to a certain percentage of the company's profits. Once the principal amount of the
loan is repaid, the profit-sharing arrangement is concluded. This practice is called
Musharaka. Further, Mudaraba is venture capital funding of an entrepreneur who
provides labor while financing is provided by the bank so that both profit and risk are
shared. Such participatory arrangements between capital and labor reflect the Islamic
view that the borrower must not bear all the risk/cost of a failure, resulting in a balanced
distribution of income and not allowing lender to monopolize the economy.
Islamic banking is restricted to islamically acceptable transactions, which exclude those
involving alcohol, pork, gambling, etc. The aim of this is to engage in only ethical
investing, and moral purchasing.

In theory, Islamic banking is an example of full-reserve banking, with banks achieving a

100% reserve ratio.[15] However, in practice, this is not the case, and no examples of 100
per cent reserve banking are observed.[16]

Islamic banks have grown recently in the Muslim world but are a very small share of the
global banking system. Micro-lending institutions founded by Muslims, notably Grameen
Bank, use conventional lending practices and are popular in some Muslim nations,
especially Bangladesh, but some do not consider them true Islamic banking. However,
Muhammad Yunus, the founder of Grameen Bank and microfinance banking, and other
supporters of microfinance, argue that the lack of collateral and lack of excessive interest
in micro-lending is consistent with the Islamic prohibition of usury (riba

Rationale

The essential feature of Islamic banking is that it is interest-free. Although it is often

claimed that there is more to Islamic banking, such as contributions towards a more
equitable distribution of income and wealth, and increased equity participation in the
economy (Chapra 1982), it nevertheless derives its specific rationale from the fact that
there is no place for the institution of interest in the Islamic order.

Islam prohibits Muslims from taking or giving interest (riba) regardless of the purpose
for which such loans are made and regardless of the rates at which interest is charged. To
be sure, there have been attempts to distinguish between usury and interest and between
loans for consumption and for production. It has also been argued that riba refers to usury
practised by petty moneylenders and not to interest charged by modern banks and that no
riba is involved when interest is imposed on productive loans, but these arguments have
not won acceptance. Apart from a few dissenting opinions, he general consensus among
Muslim scholars clearly is that there is no difference between riba and interest. In what
follows, these two terms are used interchangeably.

The prohibition of riba is mentioned in four different revelations in the Qur'an (1) . The
first revelation emphasizes that interest deprives wealth of God's blessings. The second
revelation condemns it, placing interest in juxtaposition with wrongful appropriation of
property belonging to others. The third revelation enjoins Muslims to stay clear of
interest for the sake of their own welfare. The fourth revelation establishes a clear
distinction between interest and trade, urging Muslims to take only the principal sum and
to forgo even this sum if the borrower is unable to repay. It is further declared in the
Qur'an that those who disregard the prohibition of interest are at war with God and His
Prophet. The prohibition of interest is also cited in no uncertain terms in the Hadith
(sayings of the Prophet). The Prophet condemned not only those who take interest but
also those who give interest and those who record or witness the transaction, saying that
they are all alike in guilt (2) .

It may be mentioned in passing that similar prohibitions are to be found in the

preQur'anic scriptures, although the 'People of the Book', as the Qur'an refers to them,
had chosen to rationalize them. It is amazing that Islam has successfully warded off
various subsequent rationalization attempts aimed at legitimizing the institution of
interest.

Some scholars have put forward economic reasons to explain why interest is banned in
Islam. It has been argued, for instance, that interest, being a pre determined cost of
production, tends to prevent full employment (Khan 1968; Ahmad n.d.; Mannan 1970).
In the same vein, it has been contended that international monetary crises are largely due
to the institution of interest (Khan, n.d), and that trade cycles are in no small measure
attributable to the phenomenon of interest (Ahmad 1952; Su'ud n.d.). None of these
studies, however, has really succeeded in establishing a causal link between interest, on
the one hand, and employment and trade cycles, on the other. Others, anxious to vindicate
the Islamic position on interest, have argued that interest is not very effective as a
monetary policy instrument even in capitalist economies and have questioned the efficacy
of the rate of interest as a determinant of saving and investment (Ariff 1982).

A common thread running through all these discussions is the exploitative character of
the institution of interest, although some have pointed out that profit (which is lawful in
Islam) can also be exploitative. One response to this is that one must distinguish between
profit and profiteering, and Islam has prohibited the latter as well.

Some writings have alluded to the 'unearned income' aspect of interest payments as a
possible explanation for the Islamic doctrine. The objection that rent on property is
considered halal (lawful) is then answered by rejecting the analogy between rent on
property and interest on loans, since the benefit to the tenant is certain, while the
productivity of the borrowed capital is uncertain. Besides, property rented out is subject
to physical wear and tear, while money lent out is not. The question of erosion in the
value of money and hence the need for indexation is an interesting one. But the Islamic
jurists have ruled out compensation for erosion in the value of money, or, according to
Hadith, a fungible good must be returned by its like (mithl): 'gold for gold, silver for
silver, wheat for wheat, barley for barley, dates for dates, salt for salt, like for like, equal
for equal, and hand to hand ...' (3) .

The bottom line is that Muslims need no 'proofs' before they reject the institution of
interest: no human explanation for a divine injunction is necessary for them to accept a
dictum, as they recognize the limits to human reasoning. No human mind can fathom a
divine order; therefore it is a matter of faith (iman).

The Islamic ban on interest does not mean that capital is costless in an Islamic system.
Islam recognizes capital as a factor of production but it does not allow the factor to make
a prior or predetermined claim on the productive surplus in the form of interest. This
obviously poses the question as to what will then replace the interest rate mechanism in
an Islamic framework. There have been suggestions that profit-sharing can be a viable
alternative (Kahf 1982a and 1982b). In Islam, the owner of capital can legitimately share
the profits made by the entrepreneur. What makes profit sharing permissible in Islam,
while interest is not, is that in the case of the former it is only the profit-sharing ratio, not
the rate of return itself that is predetermined.

It has been argued that profit-sharing can help allocate resources efficiently, as the profit-
sharing ratio can be influenced by market forces so that capital will flow into those
sectors which offer the highest profit sharing ratio to the investor, other things being
equal. One dissenting view is that the substitution of profit-sharing for interest as a
resource allocating mechanism is crude and imperfect and that the institution of interest
should therefore be retained as a necessary evil (Naqvi 1982). However, mainstream
Islamic thinking on this subject clearly points to the need to replace interest with
something else, although there is no clear consensus on what form the alternative to the
interest rate mechanism should take. The issue is not resolved and the search for an
alternative continues, but it has not detracted from efforts to experiment with Islamic
banking without interest.

The Modes Of Islamic Banking

Bai' al-inah (sale and buy-back agreement)

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

Bai' bithaman ajil (deferred payment sale)

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

Bai muajjal (credit sale)

Literally bai muajjal means a credit sale. Technically, it is a financing technique adopted
by Islamic banks that takes the form of murabaha muajjal. It is a contract in which the
bank earns a profit margin on the purchase price and allows the buyer to pay the price of
the commodity at a future date in a lump sum or in installments. It has to expressly
mention cost of the commodity and the margin of profit is mutually agreed. The price
fixed for the commodity in such a transaction can be the same as the spot price or higher
or lower than the spot price. (Deferred-payment sale)

Musharakah

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

Mudarabah

"Mudarabah" is a special kind of partnership where one partner gives money to another
for investing it in a commercial enterprise. The investment comes from the first partner
who is called "rabb-ul-mal", while the management and work is an exclusive
responsibility of the other, who is called "mudarib".

The Mudarabah (Profit Sharing) is a contract, with one party providing 100 percent of the
capital and the other party providing its specialist knowledge to invest the capital and
manage the investment project. Profits generated are shared between the parties
according to a pre-agreed ratio. Compared to Musharaka, in a Mudaraba only the lender
of the money has to take losses.

Murabaha

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

This type of transaction is similar to rent-to-own arrangements for furniture or appliances

that are very common in North American stores.

Musawamah

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

Bai salam

Bai salam means a contract in which advance payment is made for goods to be delivered
later on. The seller undertakes to supply some specific goods to the buyer at a future date
in exchange of an advance price fully paid at the time of contract. It is necessary that the
quality of the commodity intended to be purchased is fully specified leaving no
ambiguity leading to dispute. The objects of this sale are goods and cannot be gold,
silver, or currencies based on these metals. Barring this, Bai Salam covers almost
everything that is capable of being definitely described as to quantity, quality, and
workmanship.

Basic features and conditions of Salam

1. The transaction is considered Salam if the buyer has paid the purchase price to the
seller in full at the time of sale. This is necessary so that the buyer can show that
they are not entering into debt with a second party in order to eliminate the debt
with the first party, an act prohibited under Sharia. The idea of Salam is to
provide a mechanism that ensures that the seller has the liquidity they expected
from entering into the transaction in the first place. If the price were not paid in
full, the basic purpose of the transaction would have been defeated. Muslim jurists
are unanimous in their opinion that full payment of the purchase price is key for
Salam to exist. Imam Malik is also of the opinion that the seller may defer
accepting the funds from the buyer for two or three days, but this delay should not
form part of the agreement.
2. Salam can be effected in those commodities only the quality and quantity of
which can be specified exactly. The things whose quality or quantity is not
determined by specification cannot be sold through the contract of salam. For
 example, precious stones cannot be sold on the basis of salam, because every
piece of precious stones is normally different from the other either in its quality or
in its size or weight and their exact specification is not generally possible.
3. Salam cannot be effected on a particular commodity or on a product of a
particular field or farm. For example, if the seller undertakes to supply the wheat
of a particular field, or the fruit of a particular tree, the salam will not be valid,
because there is a possibility that the crop of that particular field or the fruit of
that tree is destroyed before delivery, and, given such possibility, the delivery
remains uncertain. The same rule is applicable to every commodity the supply of
which is not certain.
4. It is necessary that the quality of the commodity (intended to be purchased
through salam) is fully specified leaving no ambiguity which may lead to a
dispute. All the possible details in this respect must be expressly mentioned.
5. It is also necessary that the quantity of the commodity is agreed upon in
unequivocal terms. If the commodity is quantified in weights according to the
usage of its traders, its weight must be determined, and if it is quantified through
measures, its exact measure should be known. What is normally weighed cannot
be quantified in measures and vice versa.
6. The exact date and place of delivery must be specified in the contract.
7. Salam cannot be effected in respect of things which must be delivered at spot. For
example, if gold is purchased in exchange of silver, it is necessary, according to
Shari'ah, that the delivery of both be simultaneous. Here, salam cannot work.
Similarly, if wheat is bartered for barley, the simultaneous delivery of both is
necessary for the validity of sale. Therefore the contract of salam in this case is
not allowed.

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.

Ijarah

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

Ijarah provides the following advantages to the Lessee:

Ijarah conserves the Lessee' capital since it allows up to 100% financing.

Ijarah gives the Lessee the right to access the equipment on payment of the first installment. This
is important as it is the access and use (and not ownership) of equipment that generates income.

Ijarah arrangements aid corporate planning and budgeting by allowing the negotiation of flexible
terms

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

All payments towards Ijarah contracts are treated as operating expenses and are therefore fully
tax-deductible. Leasing thus offers tax-advantages to for-profit operations.

Many types of equipment (i.e computers) become obsolete before the end of their actual
economic life. Ijarah contracts allow the transfer of risk from the Lesse to the Lessor in exchange
for a higher lease rate. This higher rate can be viewed as insurance against obsolescence.

If the equipment is used for a relatively short period of time, it may be more profitable to lease
than to buy.

If the equipment is used for a short period but has a very poor resale value, leasing avoids having
to account for and depreciate the equipment under normal accounting principles.

Ijarah thumma al bai' (hire purchase)

Parties enter into contracts that come into effect serially, to form a complete lease/
buyback transaction. The first contract is an Ijarah that outlines the terms for leasing or
renting over a fixed period, and the second contract is a Bai that triggers a sale or
purchase once the term of the Ijarah is complete. For example, in a car financing facility,
a customer enters into the first contract and leases the car from the owner (bank) at an
agreed amount over a specific period. When the lease period expires, the second contract
comes into effect, which enables the customer to purchase the car at an agreed to price.

The bank generates a profit by determining in advance the cost of the item, its residual
value at the end of the term and the time value or profit margin for the money being
invested in purchasing the product to be leased for the intended term. The combining of
these three figures becomes the basis for the contract between the Bank and the client for
the initial lease contract.
This type of transaction is similar to the contractum trinius, a legal maneuver used by
European bankers and merchants during the Middle Ages to sidestep the Church's
prohibition on interest bearing loans. In a contractum, two parties would enter into three
concurrent and interrelated legal contracts, the net effect being the paying of a fee for the
use of money for the term of the loan. The use of concurrent interrelated contracts is also
prohibited under Shariah Law.

Ijarah-wal-iqtina

A contract under which an Islamic bank provides equipment, building, or other assets to
the client against an agreed rental together with a unilateral undertaking by the bank or
the client that at the end of the lease period, the ownership in the asset would be
transferred to the lessee. The undertaking or the promise does not become an integral part
of the lease contract to make it conditional. The rentals as well as the purchase price are
fixed in such manner that the bank gets back its principal sum along with profit over the
period of lease.

Musharakah (joint venture)

Musharakah is a relationship between two parties or more, of whom contribute capital to

a business, and divide the net profit and loss pro rata. This is often used in investment
projects, letters of credit, and the purchase or real estate or property. In the case of real
estate or property, the bank assess 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).

Qard hassan/ Qardul hassan (good loan/benevolent loan)

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

Sukuk (Islamic bonds)

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

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. See Takaful for details.

Wadiah (safekeeping)

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

Wakalah (power of attorney)

This occurs when a person appoints a representative to undertake transactions on his/her

behalf, similar to a power of attorney.

Differences Between
Islamic Bank and Conventional
One must refrain from making a direct comparison between Islamic banking
and conventional banking (apple to apple comparison). This is because they are
extremely different in many ways. The key difference is that Islamic Banking is
based on Shariah foundation. Thus, all dealing, transaction, business approach,
product feature, investment focus, responsibility are derived from the Shariah
law, which lead to the significant difference in many part of the operations
with as of the conventional

The foundation of Islamic bank is based on the Islamic faith and must stay
within the limits of Islamic Law or the Shariah in all of its actions and deeds.
The original meaning of the Arabic word Shariah is 'the way to the source of
life' and is now used to refer to legal system in keeping with the code of
behaviour called for by the Holly Qur'an (Koran). Amongst the governing
principles of an Islamic bank are :

* The absence of interest-based (riba) transactions;

* The avoidance of economic activities involving oppression (zulm)

* The avoidance of economic activities involving speculation (gharar);

* The introduction of an Islamic tax, zakat;

* The discouragement of the production of goods and services which contradict

the Islamic value (haram)

On the other hand, conventional banking is essentially based on the debtor-

creditor relationship between the depositors and the bank on one hand, and
between the borrowers and the bank on the other. Interest is considered to be
the price of credit, reflecting the opportunity cost of money.

Islamic law considers a loan to be given or taken, free of charge, to meet any
contingency. Thus in Islamic Banking, the creditor should not take advantage
of the borrower. When money is lent out on the basis of interest, more often
that it leads to some kind of injustice. The first Islamic principle underlying for
such kind of transactions is "deal not unjustly, and ye shall not be dealt with
unjustly" [2:279] which explain why commercial banking in an Islamic
framework is not based on the debtor-creditor relationship.

The other principle pertaining to financial transactions in Islam is that there

should not be any reward without taking a risk. This principle is applicable to
both labor and capital. As no payment is allowed for labor, unless it is applied
to work, there is no reward for capital unless it is exposed to business risk.

Thus, financial intermediation in an Islamic framework has been developed on

the basis of the above-mentioned principles. Consequently financial
relationships in Islam have been participatory in nature.
Lastly, for the interest of the readers, the unique features of the conventional
banking and Islamic banking are shown in terms of a box diagram as shown
below:-

Conventional Banks Islamic Banks

1. The functions and operating modes 1. The functions and operating modes
of conventional banks are based on of Islamic banks are based on the
fully manmade principles. principles of Islamic Shariah.

2. The investor is assured of a 2. In contrast, it promotes risk sharing

predetermined rate of interest. between provider of capital (investor)
and the user of funds (entrepreneur).

3. It aims at maximizing profit without 3. It also aims at maximizing profit but

any restriction. subject to Shariah restrictions.

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. Lending money and getting it back 5. Participation in partnership business

with compounding interest is the is the fundamental function of the
fundamental function of the Islamic banks. So we have to
conventional banks. understand our customer's business
very well.

6. It can charge additional money 6. The Islamic banks have no provision

(penalty and compounded interest) in to charge any extra money from the
case of defaulters. defaulters. Only small amount of
compensation and these proceeds is
given to charity. Rebates are give for
early settlement at the Bank's
discretion.

7. Very often it results in the bank's 7. It gives due importance to the public
own interest becoming prominent. It interest. Its ultimate aim is to ensure
makes no effort to ensure growth with growth with equity.
equity.

8. For interest-based commercial 8. For the Islamic banks, it must be

banks, borrowing from the money based on a Shariah approved underlying
market is relatively easier. transaction.

9. Since income from the advances is 9. Since it shares profit and loss, the
fixed, it gives little importance to Islamic banks pay greater attention to
developing expertise in project developing project appraisal and
appraisal and evaluations. evaluations.

10. The conventional banks give greater 10. The Islamic banks, on the other
emphasis on credit-worthiness of the hand, give greater emphasis on the
clients. viability of the projects.

11. The status of a conventional bank, 11. The status of Islamic bank in
in relation to its clients, is that of relation to its clients is that of
creditor and debtors. partners, investors and trader, buyer
and seller.

12. A conventional bank
guarantee all its deposits.
has to 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..