ASSIGNMENT

GROUP 4
MEMBER WIKAN ISTHIKA DAYANGKU AZRIANI AWANG ISMAIL KIM DONG HYUN NUR SAFARIYAH BINTI ABDUL HAMID ZUNAIRAH BINTI BUKHARI MATRIX NUMBER EGA 110032 EGA 110024 EGA 110003 EGA 110009 EGA 110007

LECTURER:

ASSOCIATE PROFESSOR DR. RADIAH ABDUL KADER

SUBMISSION DATE: 9TH APRIL 2012 (MONDAY)

QUESTION 1 Al-Quran surah 2: 275 Allah has permitted trade and forbidden riba. Questions: 1. Analyze that Profit is considered as the justified return for capital in Islam. 2. List the differences between profit and riba Answer 1 We will analyze that profit is considered as the justified return for capital in Islam. As we know that return of capital is consist of 2 types, there are: Profit and Interest. Interest is Riba in Islamic point of view, because Riba is unjustice in the society. Based on the Quran surah 2:275 Allah has permitted trade and forbidden riba. First of all we will analyze that profit is justified from the definition, then we will look at the example. Definition of Profit Profit is the return on trade or in the other words we can say that profit is the difference between total revenue and total cost. Based on the meaning by Saiful Azhar Rosly (2005), Profits shows an equivalent countervalue (iwad). Iwad is explained by the amount of effort and risk imputed in the sale. When an entrepreneurs sells at a price higher than the cost of inputs, the profit margin must contains iwad. Existence of risks both before-sale and aftersale. Profit can be positive, negative or zero. Figure 1. Islamic Theory of Profit Trade (Al-Bay)

RISK

PROFIT
=

IWAD

EFFORT

Spesifically in trading (al-bay) an equivalent countervalue or iwad shall consist of two main components, that is Market Risks (ghorm) and Work and Effort, i.e., value addition (kasb). Ibn al-Arabi (d.543/1148) states Every increase, which is without iwad or an equal counter value is Riba. According to Muhammad Ayub (2007) described that Profit shows an ex-post residual, which is only can be known after the business venture (at the end of a business). Definition of Riba Riba in the Arabic word can be defined as addition, expansion, growth or increase. Riba is the increase in things from specified wealth (Abu Bakr Jabir Al-Jazairy, 2001). Allah S.W.T was prohibited riba in the statement; O you who believe! Eat not Riba dubled and multiplied (3:130) The Messenger Muhammad S.A.W also said; Allah curses the one who accepts Riba (usury and interest), the giver of it, the two witnesses of it, and the one who writes it. (The Sunan compilers and At-Tirmithi graded it Sahih) From the definition above, we can justify that Profit is considered as the justified return for capital in Islam due to include iwad, effort and risk undertaken by the entrepreneur. Different with Riba which is only increase the things without any iwad. After this we will give the brief analyzes from the example, so we can see clearly the justified of Profit compare to another return of capital. Component of Profit 1. Effort Profit is reward for entrepreneur effort to improve the quality og goods. A value added goods or service bring a higher price in the market. For the example of such efforts or innovation are: R&D, packaging, branding, advertisement and promotion. The entrepreneur combines existing resources to produce a new combination of value added good or service (transforms inputs in outputs). This is consistent with the principles in the Quran because Allah has created between man diversity of capabilities and He (Allah) has raised you in ranks, some above others: so that He may try you in the gifts that He

has given you (6:165). Further, man will earn what he has strived for: To men is allowed what they earn (work for): And to women what they earn (4:32). This is also consistent with the Tabii Law: A highly organized and innovative entrepreneur is more likely to earn higher profits than one who lacks such capabilities and effort. Therefore, profit as the reward for enterprise (entrepreneurial effort) is justified (halal). The entrepreneur can only claim a return for his effort if profit is made. In the case of losses, the entrepreneur bears losses in terms of his effort not being rewarded. 2. Risks a) Market Risks (before sale risks) Risk of losses before goods are sold because the market uncertanties, such as rise of input cost, natural clamicity, change in consumer taste. b) Liability (after sale risks) Liability that the seller must bear when goods sold are found defective. The supplier provides guarantee/warranty on his product. Profit is the result of risk-taking, or no reward without risks. In other words No pain, No Profit. This is based on the legal maxim (Qawaid Fiqiah). In Islamic finance, money can not earn a profit by itself. Money has to combined with entrepreneurial effort to earn profit. Profit as the justified return of capital in Islam Lending activities based on Riba is not included as a legitimate contract in the theory of property transfer in Islamic law. Lending money in Islam is a transfer of property right from the lender to the borrower. The creditor can only claim the amount that he has lent out (the principal) and not more return. When this happens, the transfer from the debtor to the lender is justified. On the other hand, assume money is lent to the debtor as a business loan and invested in the venture. In this case the lender used the money as capital productively. If profit is generated at the end of venture, the payment of fixed amount is unjustice transfer of property right from the borrower to lender because the lender only received a small fixed amount as interest. A justified reward for the lender would be a proportion of the additional wealth (profits) created. If the venture fails and suffers a loss, the fixed interest is unjustified because there was no additional wealth created from the venture. A justified is Profit Loss Sharing based on ratio or percentage of profit not a fixed percentage of the loan. Based on the

principle of justice the lender has no right to claim any return if the business makes a loss. Profit in the business can be positive, negative or zero. On a larger scale at the societys level, since the lenders are majority rich and borrowers are largely then have nots who mostly require loans for consumption purposes, practice of Riba will result injustice where wealth will be concentrated in the hands of the rich people in the society. So thats why, the Islamic point of view consider that Profit is Justice for all (the society). For the example, let see the case below: Based on Profit Mr. Ali want to open a restaurant but he does not have money. He good in managerial and he has a good plann to open that business. Mr. Burhan is a rich person who work as a Director in the private bank. He interested in the business but does not have enough time to do it. Mr. Ali and Mr. Burhan know each other n have a good relationship. Then Mr. Ali try to discuss with Mr. Burhan about the business. In the end of the discussion they deal to open the restaurant with Mr. Ali as a full entrepreneurship and Mr. Burhan as a capital owner. The agreed based on the Profit Loss Sharing Ratio Mr. Ali : Mr. Burhan = 70% : 30%. The profit that they get can be positive, negative and zero. Based on Riba The case is same however in the end of the discussion they deal to open reataurant with Mr. Burhan as a lender and Mr. Ali as a borrower. Besides that they decided fix interest rate of the amount of capitas as much as 12% per year. Profit is Positive Based on the PLS:In case the business get the profit. Mr. Ali will give the profit to Mr. Burhan as much as 30% of profit and the 70% is for Mr. Ali. This is justice because based on the percentage of profit that they have been deal. Based on the Riba In the beginning of the business Mr. Burhan will give the fixed interest rate to Mr. Ali as much as 12% per year whether the business will get profit or loss. This is unjustice due

towhen the profit is high and the fixed interest below that (small amount of the profit) will unjustice for Mr. Burhan as capital owner. Profit is Negative Based on the PLS: when the profit is negative, Mr. Burhan as the capital owner will loss all what he gave to Mr. Ali as the entrepreneurship. And the risk of Mr. Ali is he can not get the income of the business or result for his efforts. Based on the Riba: If the business loss would not unjustice for Mr. Ali as the entrepreneurship due to he does not have money but must be pay back the principal of capital with the fixed interest rate which is 12%. He is suffering and will be more suffering. Profit is Zero Based on the PLS: both of the parties, either Mr. Ali or Mr. Burhan do not get anything and do not loss anything. Because the profit is zero which means the business is break even point. Based on Riba: Mr. Ali must pay back the amount of capital with the fixed interest rate. So it is unjustice for Mr. Ali, he does not have income from the business but must pay the fixed interest. The example above could shows why the profit is unjustified in Islam. We could see that Profit justice for both, the capital owner (lender) and the entrepreneurship (borrower). Profit in the Banking System Interest-based instruments are prone to favor the rich and work against the interest of the common people. Interest based system create inequity and imbalance in the distribution of wealth in the economy. Banks prefer to loan money to those who have money. When entrepreneurship borrow huge amounts of money from a bank, they utilize the depositors funds for their project. When they earn profit , they will pay nothing to the depositors. If loss may lead to the bankruptcy for the bank itself. In profit loss sharing, both depositors and entrepeneurship would be willing to share the result of the project whether profit or loss, the share the profit based on the ratio. In case loss, all the financial loss will be bear by the capital provider, and the loss od labor would be bear by the entrepreneur. This would build a link between capital providers and parties that have business skills but lack in the capital.

(i)

List the differences between profit and riba.

DIFFERENCES Definition

PROFIT

RIBA

Profit is return on trade, which is the result of To increase, to grow, to multiply and to climb. Riba exists as long difference between revenue and cost, encompassing as the exchange or transaction gives rise to inequality of the effort and risk undertaken by the entrepreneur. countervalues and determent in time of exchange. Permitted in Islam. Prohibitted in Islam. Unequal countervalue.

Prohibition Equal countervalue. Countervalue Wealth creation Deals with real assets thus creates real stock of Deals only with money thus do not create real stock of wealth. wealth from: i. Additional values of the goods sold. ii. Increase in utility through exchange. Equity and financing in Islamic banks does not cause problems through new techniques like murabahah (cost + mark up), al-bai bithaman ajil (sales contract), ijarah (lease contract), takaful (mutual guarantee), mudarabah (partnership) and musyarakah (sharing). Undesirable features of riba-based banking system: i. Inflexibility of riba-based banking system tends to cause loss of productivity in the future. ii. The interest-based system is security-oriented rather than growthoriented. iii. The interest-based system discourages innovation. iv. Other affects: increased inequality and vulnerability.

Impact of the banking system

QUESTION 2

Refer to a two tier mudarabah Islamic bank model. Show using numerical example how total profits generated from mudarabah financing are distributed to the various parties involved.

Assume: a. All deposits mobilized are disbursed by the bank into mudarabah financing to entrepreneurs. b. The number of depositors and entrepreneurs are more than one. c. All depositors agree with a single profit sharing ratio. d. All entrepreneurs agree with a single profit sharing ratio. e. All entrepreneurs have the same level of productivity and use the same level of technology.

1. Two-tier Mudarabah Model a. b. Deposit mobilization and fund utilization: using mudarabah contract (trust profitsharing) Involves 3 parties: i. Depositor (surplus unit) ii. Islamic bank (financial intermediary) iii. Entrepreneur (deficit unit) 2. First tier mudarabah contract: Deposit mobilization a. Parties: the depositor and the Islamic bank b. The depositor acts as the investor: rabb-al-mal c. The bank acts as the entrepreneur: mudarib 3. Second tier mudarabah contract: Fund Utilisation a. Parties: the Islamic bank and the entrepreneur b. The bank acts as the investor: rabb-al-mal c. The entrepreneur is the entrepreneur: mudarib

4. Division of profits between 3 parties = total profits realized by the entrepreneur (mudarib) = banks profit-sharing ratio in the second tier (rabb-al-mal) = depositors profit-sharing ratio in the first tier (rabb-al-mal) D= total mudarabah investment deposits in the bank M= total mudarabah financing supplied by the bank

Beginning at the 2nd tier, the amount of profits received by the mudarib will be shared with the bank. i. ii. /M:share of net profits received by the bank (rabb-al-mal) from the entrepreneur (mudarib) (1-)/M:share of net profits that accrues to the entrepreneur (mudarib)

At the first tier, the amount of profits received by the bank will then be shared with the depositors. i. ii. ()/D: share of net profits received by the depositors (rabb-al-mal) from the bank (mudarib) (1-)/D: share of net profits gained by the bank as an intermediary between the depositors and the entrepreneur

5. Numerical Example Assume: a. All deposits mobilized are disbursed by the bank into mudarabah financing to entrepren eurs. b. The number of depositors and entrepeneurs are more than one. c. All depositors agree with a single profit sharing ratio. d. All entrepreneurs agree with a single profit sharing ratio. e. All entrepreneurs have the same level of productivity and use the same level of technol ogy. M(D)= RM100,000, = 60%, = 30%, = RM30,000

i.

The share of profits for the bank (rabb al mal) at the second tier: /M= (0.3 x 30,000)/100,000= 0.09 The bank earns 9 sen for every RM1 of mudarabah investment.

 Total profits received by the bank= RM9,000

ii.

The share of profits received by all entrepreneurs:

(1)/M= (0.7 x 30,000)/100,000= 0.21 All entrepreneurs earn 21 sen for every RM1 of mudarabah investment. Total profits received by all entrepreneurs= RM21,000 or the share of profits for the bank at the second tier = 30,000 9,000= RM21,000

iii.

The share of profits received by all depositors (rabb al mal) at the first tier: ()/D= 0.6(0.3 x 30,000)/100,000= 0.054

All depositors earn 5.4 sen for every RM1 of mudarabah investment. Total profits received by all depositors= RM5,400

iv.

The banks net profit (The share of profits received by the bank as an intermediary at the first tier):

(1)/D= (0.4 x 0.3 x 30,000)/100,000= 0.036 The bank earns 3.6 sen for every RM1 of mudarabah investment. Total profits received by the bank as an intermediary= RM3,600 Or The share of profits for the bank at the 2nd tier The share of profits received by all depositors (rabb al mal) at the first tier= 9,0005,400= RM3,600

QUESTION 3 Theoretically it is argued that an Islamic banking system based on profit sharing is able to achieve a certain degree of financial stability compared to the conventional banking system. Elaborate. Introduction Islamic banking basically based on Shariah foundation or Islamic law guided by Islamic economics. The principle of Islamic banking includes the prohibition of riba, maisir and gharar in economic activities. Thus, Islamic banking system avoids from involving in any activities that contradict with Islamic ethics value involving in an unethical conduct such as gambling, prostitution, alcohol, pork, pornography monopoly and weaponry. The main differences between Islamic banking and conventional banking system are the absence of interest based transaction or we called it as riba. For instance, surah 2: 275 saying that Allah forbids riba and permit trade and the return from trade is profit (iwad). It made Islamic banking system able to achieve the socioeconomic objectives of efficiency, justice and stability compared to conventional banking system. Discussion a) The Instruments of Islamic banking system based on profit sharing to achieve financial stability. There are two categories of Islamic banking system include: a. profit and loss sharing (PLS): ex: musharakah and mudarabah. b. Purchase and hire of goods or assets and services on a fixed return basis like murabaha, istisnaa, salam and leasing. We are going to focus on the profit sharing system as to answer the question.Basically, Islamic banking system in term contract of profit sharing use mudarabah and musyarakah modes. Mudarabah is a trustee partnership between capital and labour. It is a contract between two parties based on trust whereby one party is investor who on the capital (rabbal- mal) entrust money to entrepreneur as a second party (mudarib) who has the project. Both parties must trust each other to combine their capital and project. Musyarakah is a capital

partnership between two or more individuals or entities where profit or losses are shared between the partners. b) The analysis on Islamic Banking System based on profit sharing compared to the Conventional Banking System.

In conventional economics, the return for capital is interest or riba which is prohibited in Islam. It means that all the profit they gain is basically base on interest which all the benefits will be given to bank customers or we called it as depositors. Interest is prohibited in Islam because it seen as an unjustified means of profit and wealth creation, as according toSaiful Azhar Rosly (2005). Furthermore, the status of a conventional bank, in relation to its clients, is between of creditor and debtors. However, the creditor doesnt put any effort or value added services to the debtor. As a result, there were unbalance in economic and social welfare to society and indirectly threaten the stability of economy. In contrast, Islamic banking system has shift the mind-set of the bankers from conventional system. Bank liabilities are not fixed which is the higher the returns on investment project, the higher the banks share the profits to its shareholders and mudarabah depositors. In cases of losses, the bank will share the losses with mudarib. In addition, a bank doesnt need to pay its shareholders and mudarabah depositors. According to Saiful Azhar Rosli (2005), profits represent an equivalent counter value (iwad) for effort and risks undertaken by the supplier of enterprise. When the requirement of iwad is fulfilled in trading (al-bay) it brings along the sense of equity and justice into business transaction. The principle of Al Quran saying that: He (Allah) has raised you in ranks, some above others: so that, He may try you in gifts that He has given you Surah * (6:165) To men is allotted what they earn (work for) : and to women what they earn

Surah * (4:32)

From both sentences, it is proved that Islam only accepts profits that built from iwad which is containing with the amount of effort (kash) and risk (ghorm). First sentence stressed that Allah has created man with diversity and capabilities to work hard and the second sentence tell us that every individual whether man or women make effort in something, we will earn and reserved for that earn. The Islamic banking system is holding with the principle of Al-Quran base on sentences above. It shows that Islamic banking system is more stable than conventional. This is because, repayment to the depositors is not fixed and depending on the profits earns by the bank. The higher the return on the investment project, the higher the banks share of profits which enables bank to distribute bigger profits to its shareholders and depositors. So that, we can see that the depositors faces some risk (ghorm) before get the profit and fulfil the principle of iwad. In order to make sure investment or project is profitable, Islamic banking system has employed higher cost to the bank to hire expertise workers to screening all the project and investment that involve lots of money. Sharing of losses with the bank enables the depositors to manage the risks better especially during economic downturn. It shows the good relationship between the principle and agent in Islamic banking system compared to the creditor and debtor relationship in conventional system. Depositors rate of return is the agreed ratio of profits obtained by the bank from investment by mudarabah fund. So that, the higher increase in banks shares of profit, the higher raise in the amount of depositors profit. On the other hand, any reduction in earnings of investment will be followed by the fall in the profits of the depositors. It proves that the Islamic banking system can manage the asset and liabilities effectively compared to conventional system. In conventional banking system, deposits have a fixed return which the bank must pay at maturity time. As we said before that the relationship in the conventional banking is creditordebtor relationship, from this point of view we can see that the depositors will always be in the profitable position and the bank is depending on the profits that they will get from the investment activity which has uncertain future. Thus, regardless of the position that the bank will face (profitable or losses), they still need to pay the same amount based on the interest fess as what they have promised to the depositors. Thus, from this we could see, there is instability in the conventional banking system.

When bank face instability between assets and liability, this will lead to systemic risk. Systemic risk caused panic among depositors if the bank cannot afford to pay back the interest fee on the deposit. It became worst when the depositors became panic and decided to take out their deposits. This can cripple the banking system. Another scenario that we can look at is when there is fall in the bank asset which does not followed by the fall in the liability as the bank had promised to the depositors based on the agreed interest fee. For instance, during recession, when earning on assets will fall; deposits lender fail to pay back the borrowed money, conventional bank still has to pay the interest fee using the bank reserves. However if the bank total lending is more than the bank reserves, bank will not be able to pay the interest fee to all its depositors. and the banks will still have to pay to all the depositors although they have insufficient profits to pay. Therefore this will lead to the mismatch between asset and liabilities and leads to instability in banking system. Therefore, compared to conventional banking system, through the profit sharing loss, financial instability does not occur in the Islamic banking system. This system is more stable as the bank did not promise to the depositors on certain amount of returns but depends on profits from the investment that they made. The profits from investment will be shared between the depositors (mudarib) and bank based on the agreed ratio.

If there is shock in the Islamic banking system, i.e. fall in asset due to the losses in the investment, this losses will be bared by both parties; depositors and bank. The depositors also will not demand the return if the investment is having losses. This is why the Islamic banking is more stable compared to the conventional bank. In fact according to WaqarMasood Khan, financial instability will not happened in the Islamic banking. If the country facing economic depression, the depositors tends to save their savings in bank instead of bare the losses if the deposits will be taken out.

c)

Financing Calculation between Islamic and Conventional Banking System

CONVENTIONAL BANKING SYSTEM

ISLAMIC BANKING SYSTEM

Rate of Return : Fixed e.g. : 3% per annum

Rate of Return : Not predetermined e.g. : 70% (mudarib) 30% (bank)

Deposit : RM 10,000

Deposit : RM 10,000 Profitable Profit from Investment RM 20,000 D< ROR : Mudarib : RM 14,000 Bank : RM 3,000

Profitable Profit from Investment RM 20,000 D< ROR : RM300

Breakeven Profit from Investment RM 10,000 D= ROR : RM300

Breakeven Profit from Investment RM 10,000 D= ROR : Mudarib : RM 7,000 Bank : RM 3,000

Loss Profit from Investment RM 8,000 D> ROR : RM300

Loss Profit from Investment RM 8,000 D> ROR : Mudarib : will get the capital after deduct the loss Bank : bare the losses

d) Conclusion From the discussion above, Islamic banking system is more stable compared to Conventional Banking system. This is because conventional bank is more vulnerable to the risk if financial instability occurs. However, this situation does not occur to the Islamic banking system as itprovides flexibility and efficiency to the agents and principles to manage their financial dealings (M. Fahim Khan). Islamic banking system promotes efficiency to the mudarib and rabb- al- mal. As summary, the table below shows the difference and the factors that contribute to the financial stability in Islamic banking compared to conventional banking type. ISLAMIC BANKING The functions and operating modes of Islamic banks are based on the principles of Islamic Shariah. The status of Islamic bank in relation to its clients is that of partners, investors and trader, principle and agent. The rate of return is not predetermined, based on agreed ratio from both parties; depositors and bank. Depositors share on the amount of profits and losses based on agreed ratio CONVENTIONAL BANKING The functions and operating modes of conventional banks are based on fully manmade principles The status of a conventional bank, in relation to its clients, is that of creditor and debtors or lender and borrower. The rate of return is fixed, bank has to fulfill the agreed interest fee and pay the rate regardless of bank position (profit or loss). Depositors demand on interest fee and do not share the losses

Does not face uncertainty leads to financial Uncertainty- the probability where banks stability earning does not enough to cover the interest rate leads to instability Depositors (mudarib) is not risk neutral Depositors risk neutral

Since it shares profit and loss, the Islamic banks pay greater attention to developing project appraisal and evaluations, thus bank will make sure the project will succeed.

Since income from the advances is fixed, it gives little importance to developing expertise in project appraisal and evaluations thus if the project fail, lead to losses in investment. The Islamic banks, on the other hand, give The conventional banks give greater greater emphasis on the viability of the emphasis on credit-worthiness of the clients projects. Islamic bank can only guarantee deposits for A conventional bank has to guarantee all its deposit account, which is based on the deposits 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

REFERENCE 1) Abu Bakr Jabir Al-Jazairy, (May 2001), Minhaj Al-MuslimVol. 2, Darussalam Global leader in Islamic Books. 2) Karim A. A (2005), Identifying Unlawful transactions (Chapter 3), the theory of exchange and the theory of venture (Chapter 4), Islamic Banking: Fiqh and Financial Analysis, pp. 28-47, 49-62. 3) SaifulAzharRosly (2005), Iwad and lawful profit in Islam (chapter 5), Riba, Al-bay and Risk (Ghorm) (chapter 7), Critical Issues on Islamic Banking and Financial Markets, pp 29-32, 37-40. 4) Difference between profit and riba, 2011, http://www.dissertationsgratuites.com/dissertations/Differences-Between-Profit-AndRiba/184725.html 5) Definition of interest, http://www.investorwords.com/2531/interest.html#ixzz1rB8jV6wy 6) Zaharuddin Abdul Rahman, Tuduhan: Riba dan Jual Beli adalah sama, 2009. http://www.zaharuddin.net/index2.php?option=com_content&do_pdf=1&id=858 7) Comparative Economics of Some Islamic Financing Techniques, M Fahim Khan. http://www.irti.org/irj/go/km/docs/documents/IDBDevelopments/Internet/English/IR TI/CM/downloads/IES_Articles/Vol%2021..Fahim%20Khan..COMPARATIVE%20ECONOMICS.pdf 8) Critical issues on Islamic Banking and Financial Markets,Chapter 5 & 7, Saiful Azhar Rosly 9) Waqaar Masood Khan Towards an Interest-Free Islamic Economic System Islamic Econ., Vol. 1, pp. 3-38 http://msalzahrani3.kau.edu.sa/Files/320/Researches/51006_21143.pdf