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Islam prohibits interest, in every form. Prohibition came both in the Quran and the Hadith. Islam does not allow investments in projects which are not legitimate themselves in the eye of Islam.
Islam prohibits interest, in every form. Prohibition came both in the Quran and the Hadith. Islam does not allow investments in projects which are not legitimate themselves in the eye of Islam.
Islam prohibits interest, in every form. Prohibition came both in the Quran and the Hadith. Islam does not allow investments in projects which are not legitimate themselves in the eye of Islam.
affected civilians during the uneven war imposed on Palestine by Israel. Fundamental Questions • Why do we need a different type of banks, while we already have an efficient banking system around us? • How Islamic banks are different from conventional banks? • How the major products of Islamic Banks are designed? Geographical Distribution of Islamic banks An Estimate of the industry size Currently, there are estimated to be over 265 Islamic banks with a market capitalization in excess of US$ 13 billion. Total assets are estimated at over US$ 262. Deposits in Islamic banks are estimated to be over US$ 202 billion worldwide. The average annual growth rate of the Islamic banking industry ranged between 10-20% over the past decade. International Dedicated Orgs Accounting and Auditing Organization for Islamic Financial Institutions (Bahrain). Islamic Financial Services Board (Malaysia). International Islamic Rating Agency (Bahrain). Liquidity Management Centre (Bahrain). International Islamic Financial Market (Malaysia). Conventional Banking • It has very rich history of more than a thousand years across the world. • Facilitates financial intermediation with a view to ensuring efficiency. • The business of a bank is lending and borrowing. Accepts loans from depositors in return for interest. Extends loans to finance-seekers in return for interest. Benefits of Islamic Banking Completeness of financial market New products in the market will complement existing conventional products enhancing customer choice. Competitiveness of financial market New products will strengthen competition in the financial market enhancing consumer surplus. Catering for Muslim investors’ tastes New products promise to conform to religious norms ensuring Muslim investors’ purity in financial life. What are the basic objections? • Islam prohibits interest, in every form. Prohibition came both in the Quran and the Hadith. • Islam does not allow investments in projects which are not legitimate themselves in the eye of Islam. • While efficiency is important, the need for equity has also been emphasized. What to do then? There is nothing wrong in the business of banking. A modern society can not do without it. All we have to do is to change the business as to make it acceptable in Islamic framework. Islam not only stresses on acceptability of what we do (The Ends), it also emphasizes on how we do ( The Means) certain things. How to change it? First, we simply remove those aspects of banking that contradict Islamic standards. But, we can keep those elements of banking that don't violate Islamic norms. While making these changes, we refer to a set of Islamic norms, collectively known as Shariah, which is based on the Quran and The Sunnah (the Prophet’s tradition). The Major Objection: The Riba Riba, the Arabic equivalent of interest, is the amount of money (or anything else) that the borrower is obligated to pay to lender in excess to the principle amount. Conventional banks pay interest on deposits and receive interest on loans. This is the prime reason why conventional banks do not conform to the norms of Shariah. Prohibition of Riba People who indulge in riba shall be raised like those who have been driven to madness by the touch of Devil. That is because they say that a riba-based transaction is like trading, while God has permitted trade and prohibited riba (al-Baqarah 2:275) .
O believers! Fear God and give up outstanding riba if
you are true believers. Watch out! If you do not obey this commandment, then God declares war against you from Himself and from His Prophet. . But, if you give up your outstanding riba, then you can claim your principals. (al-Baqarah 2:278-279) . What is Riba or interest? Before moving to an easier definition of riba, for a definition of interest we can refer to the work of J M Keynes:
Interest in economics denotes the price paid
on money in exchange for the use of a sum of money, the premium, obtained on current cash over deferred cash. (Keynes, 1937) A comprehensive Definition of Riba The International Institute of Islamic Economics (IIIE), defines interest in ‘the Blueprint of Islamic Financial System’ in 1999 as follows: ‘Riba is a discrepancy, which results from the contractual obligation of a party in the context of a direct exchange of money between two parties.’ Interest Vs. Rent, Profit and Fees
Not every known income is interest.
Rent is a known payment to use a leased item. Fees are a known payment to buy services. Interest is a known payment to use money. Profit is the difference between revenue and costs. It is, however, not known in advance. It is therefore not fixed, but variable. Interest forms part of production costs. Profits are the difference between revenues and costs. So “Loan” can’t be a business tool! Islam does not allow anyone to give and take anything extra on a loan. But, today banks make money from the loan business. Depositors receive interest on their loan to banks. Banks receive interest on their loans to Entrepreneurs (Finance-seekers). Islamic banks cant make use of such loans. Where to strike, then? Basic Business Contracts Available Partnership Mudharaba (Profit-Sharing agreement) Musharaka (Profit and Loss Sharing agreement) Trade / Sale Murabaha ( Cost-plus Sale) Bai Muajjal (Cost-plus sale with deferred payment) Leasing Ijara (Operating lease) Initial or Classical Model Two-Tier Mudharaba or Partnership On the Liability side, banks (i.e. shareholders) form a partnership with depositors to invest funds. They agree on the profit sharing ratio. On the Asset side, banks form partnership with entrepreneurs or finance-seekers. They agree on a profit sharing ratio as well. The difference between two ratios contributes towards bank profits after deducting costs. Deposit Products
1. Current Account
It is organized as wadiah or safe-keeping. The
deposits are held in trust and utilized by the bank at its own risk. There is no big difference here between conventional and Islamic banks, as normally no interest is paid on such account. 2. Savings Account
This account is based on Mudharaba principle.
Depositors are owners of funds and the bank is owner of labor. Profits are shared by both parties as per pre- agreed ratio fixed through negotiation. If loss occurs, it is borne by depositor only as owners of fund. The bank loses its effort. 3. Investment Account
Core deposits of an Islamic bank. Based on the
concept of Mudharaba. Islamic counterpart of the conventional fixed deposit products.
1. General Investment Deposits: Open to any
project as selected by the bank.
2. Special Investment Deposit: Tied to any specific
project agreed upon by both parties. Financing Products (Variable Income)
(Trustee Partnership ( .1Mudharaba
The bank provides capital finance for a specific venture indicated by the customer. The bank is the owner of the capital and the customer- entrepreneur provides labor. Profit is shared according to a pre-agreed ratio. Losses, if any, are entirely absorbed by the bank. 2. Joint Venture (Musharaka)
Both the bank and its customer-client contribute to
entrepreneurship and capital. The customer and the bank agree to combine financial resources to undertake any type of business venture, and agree to manage it together. Profits are shared between the bank and the customer in the pre-agreed ratio. Losses are shared in proportion to their respective capital share. 2A. Declining Musharaka: An Innovation
A declining Musharaka is a recent phenomenon.
In it, the bank's share in the equity is diminished each year through partial return of capital. The bank receives periodic profits based on its reduced equity share that remains invested during the period. The share of the client in the capital increases over time, resulting in complete ownership of the venture. Areas of Application Mudharaba is useful for financing projects, such as, real estate, construction of buildings, corporate plants etc. Musharaka is suitable for financing any kind of business venture, where the bank is willing to act as partner. Diminishing Musharaka is used primarily in the area of housing finance. Financing Products (Predictable Income)
Early models of Islamic banks are based on a
two-tier Mudharaba or partnership structure. Subsequent models of Islamic banks use an expanded framework of debt-based mechanisms, e.g. , Murabaha, Bai Muajjal and Ijara, where income can be predicted. 3. Deferred Payment (Bai Muajjal) or Cost-Plus Sale (Murabaha)
Bai Muajjal is a sale where payment of price is
deferred to a future date. Often it includes features of a Murabaha, which implies a sale on a cost-plus basis.
As a financing product, Bai Muajjal and Murabaha
is a very popular, and perhaps the most popular Islamic financing product. Bai Muajjal is a Shariah approved mechanism. So is Murabaha. A Simple model of Murabaha
• Client identifies supplier of the commodity that
he/ she needs, collects all relevant information; • Client approaches Bank for Murabaha finance and promises to buy the commodity from the Bank at a marked-up price; • Bank makes payment of base price to supplier; • Supplier transfers ownership of commodity to Bank; • Bank sells it to the Client at marked-up price; • Client pays marked-up price in full or in parts over future (known) time period(s). 4. Leasing (Ijara)
Ijara in simple terms, implies leasing or hiring
of a physical asset. It is a popular product in which the bank assumes the role of a lessor and allows its client to use a particular asset that it owns. The client or lessee, is in need of the asset. Through ijara, it has chance to generate income using the asset against payment of predetermined rentals. A Simple model of Ijara
1. Client identifies supplier of the asset that
he/she needs, collects all relevant information; 2. Client approaches Bank for ijara of the asset and promises to take the asset on lease; 3. Bank makes payment of price to supplier; 4. Supplier transfers ownership of asset to Bank; 5. Bank leases the asset, transfers possession and right of use to Client; 6. Client pays ijara rentals over future (known) time period(s).