Islamic Banking – A theoritical Approach

Islamic Banking

by Mohamed Ariff, University of Malaya,
taken from Asian-Pacific Economic Literature, Vol. 2, No. 2 (September 1988), pp. 46-62
Islamic banking is a new phenomenon that has taken many observers by surprise. The whole banking system has been islamized in both Iran and Pakistan. In addition, there are some thirty Islamic banks in operation in other parts of the globe, including the Jeddah-based Islamic Development Bank (IDB) but excluding numerous non-bank Islamic financial institutions (see Appendix). What is more, the speed with which Islamic banks have sprung up and the rate at which they have progressed make it worth-while to study them systematically. An attempt is made in this paper (a) to survey the growing literature on Islamic banking, in particular (b) to trace the growth and development of Islamic banking, and (c) to highlight its salient characteristics.

 


Contents

 


Evolution

The first modern experiment with Islamic banking was undertaken in Egypt under cover, without projecting an Islamic image, for fear of being seen as a manifestation of Islamic fundamentalism which was anathema to the political regime. The pioneering effort, led by Ahmad El Najjar, took the form of a savings bank based on profit-sharing in the Egyptian town of Mit Ghamr in l963. This experiment lasted until l967 (Ready l98l), by which time there were nine such banks in the country. These banks, which neither charged nor paid interest, invested mostly by engaging in trade and industry, directly or in partnership with others, and shared the profits with their depositors (Siddiqi l988). Thus, they functioned essentially as saving- investment institutions rather than as commercial banks. The Nasir Social Bank, established in Egypt in l97l, was declared an interest-free commercial bank, although its charter made no reference to Islam or Shariah (Islamic law).

The IDB was established in l974 by the Organization of Islamic Countries (OIC), but it was primarily an inter-governmental bank aimed at providing funds for development projects in member countries. The IDB provides fee- based financial services and profit-sharing financial assistance to member countries. The IDB operations are free of interest and are explicitly based on

 

Shariah Principles

In the seventies, changes took place in the political climate of many Muslim countries so that there was no longer any strong need to establish Islamic financial institutions under cover. A number of Islamic banks, both in letter and spirit, came into existence in the Middle East, e.g., the Dubai Islamic Bank (l975), the Faisal Islamic Bank of Sudan (l977), the Faisal Islamic Bank of Egypt (l977), and the Bahrain Islamic Bank (l979), to mention a few. The Asia-Pacific region was not oblivious to the winds of change. The Philippine Amanah Bank (PAB) was established in l973 by Presidential Decree as a specialized banking institution without reference to its Islamic character in the bank’s charter. The establishment of the PAB was a response by the Philippines Government to the Muslim rebellion in the south, designed to serve the special banking needs of the Muslim community. However, the primary task of the PAB was to assist rehabilitation and reconstruction in Mindanao, Sulu and Palawan in the south (Mastura l988). The PAB has eight branches located in the major cities of the southern Muslim provinces, including one in Makati (Metro Manila), in addition to the head office located at Zamboanga City in Mindanao. The PAB, however, is not strictly an Islamic bank, since interest-based operations continue to coexist with the Islamic modes of financing. It is indeed fascinating to observe that the PAB operates two ‘windows’ for deposit transactions, i.e., conventional and Islamic. Nevertheless, efforts are underway to convert the PAB into a full-fledged Islamic bank (Mastura l988).

Islamic banking made its debut in Malaysia in l983, but not without antecedents. The first Islamic financial institution in Malaysia was the Muslim Pilgrims Savings Corporation set up in l963 to help people save for performing hajj (pilgrimage to Mecca and Medina). In l969, this body evolved into the Pilgrims Management and Fund Board or the Tabung Haji as it is now popularly known. The Tabung Haji has been acting as a finance company that invests the savings of would-be pilgrims in accordance with Shariah, but its role is rather limited, as it is a non-bank financial institution. The success of the Tabung Haji, however, provided the main impetus for establishing Bank Islam Malaysia Berhad (BIMB) which represents a full- fledged Islamic commercial bank in Malaysia. The Tabung Haji also contributed l2.5 per cent of BIMB’s initial capital of M$80 million. BIMB has a complement of fourteen branches in several parts of the country. Plans are afoot to open six new branches a year so that by l990 the branch network of BIMB will total thirty-three (Man l988).

Reference should also be made to some Islamic financial institutions established in countries where Muslims are a minority. There was a proliferation of interest-free savings and loan societies in India during the seventies (Siddiqi l988). The Islamic Banking System (now called Islamic Finance House), established in Luxembourg in l978, represents the first attempt at Islamic banking in the Western world. There is also an Islamic Bank International of Denmark, in Copenhagen, and the Islamic Investment Company has been set up in Melbourne, Australia.

 

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 l982), 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 practiced by petty money-lenders 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 pre-Qur’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 l968; Ahmad n.d.; Mannan l970). 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 l952; 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 l982). 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 pre-determined 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 l982a and l982b). 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 l982). 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.

 

Anatomy

As mentioned earlier, Islam does not deny that capital, as a factor of production, deserves to be rewarded. Islam allows the owners of capital a share in a surplus which is uncertain. To put it differently, investors in the Islamic order have no right to demand a fixed rate of return. No one is entitled to any addition to the principal sum if he does not share in the risks involved. The owner of capital (rabbul-mal) may ‘invest’ by allowing an entrepreneur with ideas and expertise to use the capital for productive purposes and he may share the profits, if any, with the entrepreneur- borrower (mudarib); losses, if any, however, will be borne wholly by the rabbul-mal. This mode of financing, termed mudaraba in the Islamic literature, was in practice even in the pre-Qur’anic days and, according to jurists, it was approved by the Prophet.

Another legitimate mode of financing recognized in Islam is one based on equity participation (musharaka) in which the partners use their capital jointly to generate a surplus. Profits or losses will be shared between the partners according to some agreed formula depending on the equity ratio. Mudaraba and musharaka constitute, at least in principle if not in practice, the twin pillars of Islamic banking. The musharaka principle is invoked in the equity structure of Islamic banks and is similar to the modern concepts of partnership and joint stock ownership. In so far as the depositors are concerned, an Islamic bank acts as a mudarib which manages the funds of the depositors to generate profits subject to the rules of mudaraba as outlined above. The bank may in turn use the depositors’ funds on a mudaraba basis in addition to other lawful modes of financing. In other words, the bank operates a two-tier mudaraba system in which it acts both as the mudarib on the saving side of the equation and as the rabbul-mal on the investment portfolio side. The bank may also enter into musharaka contracts with the users of the funds, sharing profits and losses, as mentioned above. At the deposit end of the scale, Islamic banks normally operate three broad categories of account, mainly current, savings, and investment accounts. The current account, as in the case of conventional banks, gives no return to the depositors. It is essentially a safe-keeping (al-wadiah) arrangement between the depositors and the bank, which allows the depositors to withdraw their money at any time and permits the bank to use the depositors’ money. As in the case of conventional banks, cheque books are issued to the current account deposit holders and the Islamic banks provide the broad range of payment facilities – clearing mechanisms, bank drafts, bills of exchange, travellers cheques, etc. (but not yet, it seems, credit cards or bank cards). More often than not, no service charges are made by the banks in this regard.

The savings account is also operated on an al-wadiah basis, but the bank may at its absolute discretion pay the depositors a positive return periodically, depending on its own profitability. Such payment is considered lawful in Islam since it is not a condition for lending by the depositors to the bank, nor is it pre-determined. The savings account holders are issued with savings books and are allowed to withdraw their money as and when they please. The investment account is based on the mudaraba principle, and the deposits are term deposits which cannot be withdrawn before maturity. The profit- sharing ratio varies from bank to bank and from time to time depending on supply and demand conditions.4 In theory, the rate of return could be positive or negative, but in practice the returns have always been positive and quite comparable to rates conventional banks offer on their term deposits.5

At the investment portfolio end of the scale, Islamic banks employ a variety of instruments. The mudaraba and musharaka modes, referred to earlier, are supposedly the main conduits for the outflow of funds from the banks. In practice, however, Islamic banks have shown a strong preference for other modes which are less risky. The most commonly used mode of financing seems to be the ‘mark-up’ device which is termed murabaha. In a murabaha transaction, the bank finances the purchase of a good or asset by buying it on behalf of its client and adding a mark-up before re-selling it to the client on a ‘cost-plus’ basis. It may appear at first glance that the mark-up is just another term for interest as charged by conventional banks, interest thus being admitted through the back door. What makes the murabaha transaction Islamically legitimate is that the bank first acquires the asset and in the process it assumes certain risks between purchase and resale. The bank takes responsibility for the good before it is safely delivered to the client. The services rendered by the Islamic bank are therefore regarded as quite different from those of a conventional bank which simply lends money to the client to buy the good.

Islamic banks have also been resorting to purchase and resale of properties on a deferred payment basis, which is termed bai’ muajjal. It is considered lawful in fiqh (jurisprudence) to charge a higher price for a good if payments are to be made at a later date. According to fiqh, this does not amount to charging interest, since it is not a lending transaction but a trading one.

Leasing or ijara is also frequently practised by Islamic banks. Under this mode, the banks would buy the equipment or machinery and lease it out to their clients who may opt to buy the items eventually, in which case the monthly payments will consist of two components, i.e., rental for the use of the equipment and instalment towards the purchase price.

Reference must also be made to pre-paid purchase of goods, which is termed bai’salam, as a means used by Islamic banks to finance production. Here the price is paid at the time of the contract but the delivery would take place at a future date. This mode enables an entrepreneur to sell his output to the bank at a price determined in advance. Islamic banks, in keeping with modern times, have extended this facility to manufactures as well.

It is clear from the above sketch that Islamic banking goes beyond the pure financing activities of conventional banks. Islamic banks engage in equity financing and trade financing. By its very nature, Islamic banking is a risky business compared with conventional banking, for risk-sharing forms the very basis of all Islamic financial transactions. To minimize risks, however, Islamic banks have taken pains to distribute the eggs over many baskets and have established reserve funds out of past profits which they can fall back on in the event of any major loss.

 

Literature: Theory

It is not possible to cover in this survey all the publications which have appeared on Islamic banking. There are numerous publications in Arabic and Urdu which have made significant contributions to the theoretical discussion. A brief description of these in English can be found in the Appendix to Siddiqi’s book on Banking without Interest (Siddiqi l983a). The early contributions on the subject of Islamic banking were somewhat casual in the sense that only passing references were made to it in the discussion of wider issues relating to the Islamic economic system as a whole. In other words, the early writers had been simply thinking aloud rather than presenting well-thought-out ideas. Thus, for example, the book by Qureshi on Islam and the Theory of Interest (Qureshi l946) looked upon banking as a social service that should be sponsored by the government like public health and education. Qureshi took this point of view since the bank could neither pay any interest to account holders nor charge any interest on loans advanced. Qureshi also spoke of partnerships between banks and businessmen as a possible alternative, sharing losses if any. No mention was made of profit-sharing.

Ahmad, in Chapter VII of his book Economics of Islam (Ahmad l952), envisaged the establishment of Islamic banks on the basis of a joint stock company with limited liability. In his scheme, in addition to current accounts, on which no dividend or interest should be paid, there was an account in which people could deposit their capital on the basis of partnership, with shareholders receiving higher dividends than the account holders from the profits made. Like Qureshi, above, Ahmad also spoke of possible partnership arrangements with the businessmen who seek capital from the banks. However, the partnership principle was left undefined, nor was it clear who would bear the loss if any. It was suggested that banks should cash bills of trade without charging interest, using the current account funds.

The principle of mudaraba based on Shariah was invoked systematically by Uzair (l955). His principal contribution lay in suggesting mudaraba as the main premise for ‘interestless banking’. However, his argument that the bank should not make any capital investment with its own deposits rendered his analysis somewhat impractical.

Al-Arabi (l966) envisaged a banking system with mudaraba as the main pivot. He was actually advancing the idea of a two-tier mudaraba which would enable the bank to mobilize savings on a mudaraba basis, allocating the funds so mobilized also on a mudaraba basis. In other words the bank would act as a mudarib in so far as the depositors were concerned, while the ‘borrowers’ would act as mudaribs in so far as the bank was concerned. In his scheme, the bank could advance not only the capital procured through deposits but also the capital of its own shareholders. It is also of interest to note that his position with regard to the distribution of profits and the responsibility for losses was strictly in accordance with the Shariah.6 Irshad (l964) also spoke of mudaraba as the basis of Islamic banking, but his concept of mudaraba was quite different from the traditional one in that he thought of capital and labour (including entrepreneurship) as having equal shares in output, thus sharing the losses and profits equally. This actually means that the owner of capital and the entrepreneur have a fifty-fifty share in the profit or loss as the case may be, which runs counter to the Shariah position. Irshad envisaged two kinds of deposit accounts. The first sounded like current deposits in the sense that it would be payable on demand, but the money kept in this deposit would be used for social welfare projects, as the depositors would get zero return. The second one amounted to term deposits which would entitle the depositors to a share in the profits at the end of the year proportionately to the size and duration of the deposits. He recommended the setting up of a Reserve Fund which would absorb all losses so that no depositor would have to bear any loss. According to Irshad, all losses would be either recovered from the Reserve Fund or borne by the shareholders of the bank.

A pioneering attempt at providing a fairly detailed outline of Islamic banking was made in Urdu by Siddiqi in l968. (The English version was not published until l983.) His Islamic banking model was based on mudaraba and shirka (partnership or musharaka as it is now usually called). His model was essentially one based on a two-tier mudaraba financier-entrepreneur relationship, but he took pains to describe the mechanics of such transactions in considerable detail with numerous hypothetical and arithmetic examples. He classified the operations of an Islamic bank into three categories: services based on fees, commissions or other fixed charges; financing on the basis of mudaraba and partnership; and services provided free of charge. His thesis was that such interest-free banks could be a viable alternative to interest-based conventional banks.

The issue of loans for consumption clearly presents a problem, as there is no profit to be shared. Siddiqi addressed this problem, but he managed only to scratch the surface. While recognizing the need for such interest-free loans (qard hasan), especially for meeting basic needs, he seemed to think it was the duty of the community and the State (through its baitul mal or treasury) to cater to those needs; the Islamic bank’s primary objective, like that of any other business unit, is to earn profit. He therefore tended to downplay the role of Islamic banks in providing consumption loans, but he suggested limited overdraft facilities without interest. He even considered a portion of the fund being set aside for consumption loans, repayment being guaranteed by the State. He also suggested that consumers buying durables on credit would issue ‘certificates of sale’ which could be encashed by the seller at the bank for a fee. It was then the seller not the buyer who would be liable as far as the bank was concerned. However, the principles of murabaha and bai’ muajjal were not invoked.

Strangely, Siddiqi favoured keeping the number of shareholders to the minimum, without advancing any strong reasons. This is contrary to the general consensus which now seems to have emerged with reference to Islamic banks operating on a joint stock company basis, a consensus which incidentally is also in line with the Islamic value attached to a broad equity base as against heavy concentration of equity and wealth. Ironically, Siddiqi thought that interest-free banking could operate successfully ‘only in a country where interest is legally prohibited and any transaction based upon interest is declared a punishable offense’ (l983b:l3). He also thought it important to have Islamic laws enforced before interest-free banking could operate well. This view has not gained acceptance, as demonstrated by the many Islamic banks which operate profitably in ‘hostile’ environments, as noted earlier.

Chapra’s model of Islamic banking (Chapra l982), like Siddiqi’s, was based on the mudaraba principle. His main concern, however, centered on the role of artificial purchasing power through credit creation. He even suggested that ‘seigniorage’ resulting from it should be transferred to the public exchequer, for the sake of equity and justice. Al-Jarhi (l983) went so far as to favor the imposition of a l00 per cent reserve requirement on commercial banks. Chapra was also much concerned about the concentration of economic power private banks might enjoy in a system based on equity financing. He therefore preferred medium-sized banks which are neither so large as to wield excessive power nor so small as to be uneconomical. Chapra’s scheme also contained proposals for loss-compensating reserves and loss-absorbing insurance facilities. He also spoke of non-bank financial institutions, which specialize in bringing financiers and entrepreneurs together and act as investment trusts.

Mohsin (l982) has presented a detailed and elaborate framework of Islamic banking in a modern setting. His model incorporates the characteristics of commercial, merchant, and development banks, blending them in novel fashion. It adds various non-banking services such as trust business, factoring, real estate, and consultancy, as though interest-free banks could not survive by banking business alone. Many of the activities listed certainly go beyond the realm of commercial banking and are of so sophisticated and specialized a nature that they may be thought irrelevant to most Muslim countries at their present stage of development. Mohsin’s model clearly was designed to fit into a capitalist environment; indeed he explicitly stated that riba-free banks could coexist with interest-based banks. The point that there is more to Islamic banking than mere abolition of interest was driven home strongly by Chapra (l985). He envisaged Islamic banks whose nature, outlook and operations could be distinctly different from those of conventional banks. Besides the outlawing of riba, he considered it essential that Islamic banks should, since they handle public funds, serve the public interest rather than individual or group interests. In other words, they should play a social-welfare-oriented rather than a profit-maximizing role. He conceived of Islamic banks as a cross-breed of commercial and merchant banks, investment trusts and investment-management institutions that would offer a wide spectrum of services to their customers. Unlike conventional banks which depend heavily on the ‘crutches of collateral and of non-participation in risk’ (p. l55), Islamic banks would have to rely heavily on project evaluation, especially for equity-oriented financing. Thanks to the profit-and-loss sharing nature of the operations, bank-customer relations would be much closer and more cordial than is possible under conventional banking. Finally, the problems of liquidity shortage or surplus would have to be handled differently in Islamic banking, since the ban on interest rules out resort to the money market and the central bank. Chapra suggested alternatives such as reciprocal accommodation among banks without interest payments and creation of a common fund at the central bank into which surpluses would flow and from which shortages could be met without any interest charges.

The literature also discusses the question of central banking in an Islamic framework. The general opinion seems to be that the basic functions of a modern central bank are relevant also for an Islamic monetary system, although the mechanisms may have to be different. Thus, for example, the bank rate instrument cannot be used as it entails interest. Uzair (l982) has suggested adjustments in profit-sharing ratios as a substitute for bank rate manipulations by the central bank. Thus, credit can be tightened by reducing the share accruing to the businessmen and eased by increasing it. Siddiqi (l982) has suggested that variations in the so-called ‘refinance ratio’ (which refers to the central bank refinancing of a part of the interest-free loans provided by the commercial banks) would influence the quantum of short-term credit extended. Siddiqi has also proposed a prescribed ‘lending ratio’ (i.e., the proportion of demand deposits that commercial banks are obliged to lend out as interest-free loans) that can be adjusted by the central bank according to changing circumstances. In this context, reference may also be made to a proposal by Uzair (l982) that the central bank should acquire an equity stake in commercial banking by holding, say, 25 per cent of the capital stock of the commercial banks. The rationale behind this proposal was that it would give the central bank access to a permanent source of income so that it could effectively act as lender of last resort. The discussion of central banking in an Islamic context is somewhat scanty, presumably because Islamic central banking is viewed as too far-fetched an idea, except in Iran and Pakistan.

It emerges from all this that Islamic banking has three distinguishing features: (a) it is interest-free, (b) it is multi-purpose and not purely commercial, and (c) it is strongly equity-oriented. The literature contains hardly any serious criticism of the interest-free character of the operation, since this is taken for granted, although concerns have been expressed about the lack of adequate interest-free instruments. There is a near-consensus that Islamic banks can function well without interest. A recent International Monetary Fund study by Iqbal and Mirakhor (l987) has found Islamic banking to be a viable proposition that can result in efficient resource allocation. The study suggests that banks in an Islamic system face fewer solvency and liquidity risks than their conventional counterparts. The multi-purpose and extra-commercial nature of the Islamic banking operation does not seem to pose intractable problems. The abolition of interest makes it imperative for Islamic banks to look for other instruments, which renders operations outside the periphery of commercial banking unavoidable. Such operations may yield economies of scope. But it is undeniable that the multipurpose character of Islamic banking poses serious practical problems, especially in relation to the skills needed to handle such diverse and complex transactions (Iqbal and Mirakhor l987).

The stress on equity-oriented transactions in Islamic banking, especially the mudaraba mode, has been criticized. It has been argued that the replacement of pre-determined interest by uncertain profits is not enough to render a transaction Islamic, since profit can be just as exploitative as interest is, if it is ‘excessive’ (Naqvi l98l). Naqvi has also pointed out that there is nothing sacrosanct about the institution of mudaraba in Islam. Naqvi maintains that mudaraba is not based on the Qur’an or the Hadith but was a custom of the pre-Islamic Arabs. Historically, mudaraba, he contends, enabled the aged, women, and children with capital to engage in trade through merchants for a share in the profit, all losses being borne by the owners of capital, and therefore it cannot claim any sanctity. The fact remains that the Prophet raised no objection to mudaraba, so that it was at least not considered un-Islamic.

The distribution of profit in mudaraba transactions presents practical difficulties, especially where there are multiple providers of capital, but these difficulties are not regarded as insurmountable. The Report of Pakistan’s Council of Islamic Ideology (CII l983) has suggested that the respective capital contributions of parties can be converted to a common denominator by multiplying the amounts provided with the number of days during which each component, such as the firm’s own equity capital, its current cash surplus and suppliers’ credit was actually deployed in the business, i.e., on a daily product basis. As for deposits, profits (net of administrative expenses, taxes, and appropriation for reserves) would be divided between the shareholders of the bank and the holders of deposits, again on a daily product basis.

Literature: Practice

Recent years have brought an increasing flow of empirical studies of Islamic banking. The earliest systematic empirical work was undertaken by Khan (l983). His observations covered Islamic banks operating in Sudan, United Arab Emirates, Kuwait, Bahrain, Jordan, and Egypt. Khan’s study showed that these banks had little difficulty in devising practices in conformity with Shariah. He identified two types of investment accounts: one where the depositor authorized the banks to invest the money in any project and the other where the depositor had a say in the choice of project to be financed. On the asset side, the banks under investigation had been resorting to mudaraba, musharaka and murabaha modes. Khan’s study reported profit rates ranging from 9 to 20 per cent which were competitive with conventional banks in the corresponding areas. The rates of return to depositors varied between 8 and l5 per cent, which were quite comparable with the rates of return offered by conventional banks.

Khan’s study revealed that Islamic banks had a preference for trade finance and real estate investments. The study also revealed a strong preference for quick returns, which is understandable in view of the fact that these newly established institutions were anxious to report positive results even in the early years of operation. Nienhaus (1988) suggests that the relative profitability of Islamic banks, especially in the Middle East in recent years, was to a large extent due to the property (real estate) boom. He has cited cases of heavy losses which came with the crash of the property sector.

The IMF study referred to earlier by Iqbal and Mirakhor (l987) also contains extremely interesting empirical observations, although these are confined to the experience of Iran and Pakistan, both of which have attempted to islamize the entire banking system on a comprehensive basis. Iran switched to Islamic banking in August l983 with a three-year transition period. The Iranian system allows banks to accept current and savings deposits without having to pay any return, but it permits the banks to offer incentives such as variable prizes or bonuses in cash or kind on these deposits. Term deposits (both short-term and long-term) earn a rate of return based on the bank’s profits and on the deposit maturity. No empirical evidence is as yet available on the interesting question as to whether interest or a profit-share provides the more effective incentive to depositors for the mobilization of private saving. Where Islamic and conventional banks exist side by side, central bank control of bank interest rates is liable to be circumvented by shifts of funds to the Islamic banks.

Iqbal and Mirakhor have noted that the conversion to Islamic modes has been much slower on the asset than on the deposit side. It appears that the Islamic banking system in Iran was able to use less than half of its resources for credit to the private sector, mostly in the form of short-term facilities, i.e., commercial and trade transactions. The slower pace of conversion on the asset side was attributed by the authors to the inadequate supply of personnel trained in long-term financing. The authors, however, found no evidence to show that the effectiveness of monetary policy in Iran, broadly speaking, was altered by the conversion.

The Pakistani experience differs from the Iranian one in that Pakistan had opted for a gradual islamization process which began in l979. In the first phase, which ended on l January l985, domestic banks operated both interest- free and interest-based ‘windows’. In the second phase of the transformation process, the banking system was geared to operate all transactions on the basis of no interest, the only exceptions being foreign currency deposits, foreign loans and government debts. The Pakistani model took care to ensure that the new modes of financing did not upset the basic functioning and structure of the banking system. This and the gradual pace of transition, according to the authors, made it easier for the Pakistani banks to adapt to the new system. The rate of return on profit-and-loss sharing (PLS) deposits appears not only to have been in general higher than the interest rate before islamization but also to have varied between banks, the differential indicating the degree of competition in the banking industry. The authors noted that the PLS system and the new modes of financing had accorded considerable flexibility to banks and their clients. Once again the study concluded that the effectiveness of monetary policy in Pakistan was not impaired by the changeover.

The IMF study, however, expressed considerable uneasiness about the concentration of bank assets on short-term trade credits rather than on long-term financing. This the authors found undesirable, not only because it is inconsistent with the intentions of the new system, but also because the heavy concentration on a few assets might increase risks and destabilize the asset portfolios. The study also drew attention to the difficulty experienced in both Iran and Pakistan in financing budget deficits under a non-interest system and underscored the urgent need to devise suitable interest-free instruments. Iran has, however, decreed that government borrowing on the basis of a fixed rate of return from the nationalized banking system would not amount to interest and would hence be permissible. The official rationalization is that, since all banks are nationalized, interest rates and payments among banks will cancel out in the consolidated accounts. (This, of course, abstracts from the banks’ business with non-bank customers.) There are also some small case studies of Islamic banks operating in Bangladesh (Huq l986), Egypt (Mohammad l986), Malaysia (Halim l988b), Pakistan (Khan l986), and Sudan (Salama l988b). These studies reveal interesting similarities and differences. The current accounts in all cases are operated on the principles of al-wadiah. Savings deposits, too, are accepted on the basis of al-wadiah, but ‘gifts’ to depositors are given entirely at the discretion of the Islamic banks on the minimum balance, so that the depositors also share in profits. Investment deposits are invariably based on the mudaraba principle, but there are considerable variations. Thus, for example, the Islamic Bank of Bangladesh has been offering PLS Deposit Accounts, PLS Special Notice Deposit Accounts, and PLS Term Deposit Accounts, while Bank Islam Malaysia has been operating two kinds of investment deposits, one for the general public and the other for institutional clients.

The studies also show that the profit-sharing ratios and the modes of payment vary from place to place and from time to time. Thus, for example, profits are provisionally declared on a monthly basis in Malaysia, on a quarterly basis in Egypt, on a half-yearly basis in Bangladesh and Pakistan, and on an annual basis in Sudan.

A striking common feature of all these banks is that even their investment deposits are mostly short-term, reflecting the depositors’ preference for assets in as liquid a form as possible. Even in Malaysia, where investment deposits have accounted for a much larger proportion of the total, the bulk of them were made for a period of less than two years. By contrast, in Sudan most of the deposits have consisted of current and savings deposits, apparently because of the ceiling imposed by the Sudanese monetary authorities on investment deposits which in turn was influenced by limited investment opportunities in the domestic economy. There are also interesting variations in the pattern of resource utilization by the Islamic banks. For example, musharaka has been far more important than murabaha as an investment mode in Sudan, while the reverse has been the case in Malaysia. On the average, however, murabaha, bai’muajjal and ijara, rather than musharaka represent the most commonly used modes of financing. The case studies also show that the structure of the clientele has been skewed in favor of the more affluent segment of society, no doubt because the banks are located mainly in metropolitan centres with small branch networks.

The two main problems identified by the case studies are the absence of suitable non-interest-based financial instruments for money and capital market transactions and the high rate of borrower delinquency. The former problem has been partially redressed by Islamic banks resorting to mutual inter-bank arrangements and central bank cooperation, as mentioned earlier. The Bank Islam Malaysia, for instance, has been placing its excess liquidity with the central bank which usually exercises its discretionary powers to give some returns. The delinquency problem appears to be real and serious. Murabaha payments have often been held up because late payments cannot be penalized, in contrast to the interest system in which delayed payments would automatically mean increased interest payments. To overcome this problem, the Pakistani banks have resorted to what is called ‘mark-down’ which is the opposite of ‘mark-up’ (i.e., the profit margin in the cost-plus approach of murabaha transactions). ‘Mark-down’ amounts to giving rebates as an incentive for early payments. But the legitimacy of this ‘mark-down’ practice is questionable on Shariah grounds, since it is time- based and therefore smacks of interest.

In the Southeast Asian context, two recent studies on the Bank Islam Malaysia by Man (l988) and the Philippine Amanah Bank by Mastura (l988) deserve special mention. The Malaysian experience in Islamic banking has been encouraging. Man’s study shows that the average return to depositors has been quite competitive with that offered by conventional banks. By the end of l986, after three years of operation, the bank had a network of fourteen branches. However, 90 per cent of its deposits had maturities of two years or less, and non-Muslim depositors accounted for only 2 per cent of the total. Man is particularly critical of the fact that the mudaraba and musharaka modes of operation, which are considered most meaningful by Islamic scholars, accounted for a very small proportion of the total investment portfolio, while bai’muajjal and ijara formed the bulk of the total. It is evident from Mastura’s analysis that the Philippine Amanah Bank is, strictly speaking, not an Islamic bank, as interest-based operations continue to coexist with Islamic modes of financing. Thus, the PAB has been operating both interest and Islamic ‘windows’ for deposits. Mastura’s study has produced evidence to show that the PAB has been concentrating on murabaha transactions, paying hardly any attention to the mudaraba and musharaka means of financing. The PAB has also been adopting unorthodox approaches in dealing with excess liquidity by making use of interest- bearing treasury bills. Nonetheless, the PAB has also been invoking some Islamic modes in several major investment activities. Mastura has made special references to the qirad principle adopted by the PAB in the Kilu-sang Kabuhayan at Kaunlaran (KKK) movement launched under Marcos and to the ijara financing for the acquisition of farm implements and supplies in the Quedon food production program undertaken by the present regime. So far no reference has been made to Indonesia, the largest Muslim country in the world, with Muslims accounting for 90 per cent of a population of some 165 million. The explanation is that a substantial proportion, especially in Java, are arguably nominal Muslims. Indonesians by and large subscribe to the Pancasila ideology which is essentially secular in character. The present regime seems to associate Islamic banking with Islamic fundamentalism to which the regime is not at all sympathetic. Besides, the intellectual tradition in Indonesia in modern times has not been conducive to the idea of interest-free banking. There were several well respected Indonesian intellectuals including Hatta (the former Vice President) who had argued that riba prohibited in Islam was not the same as interest charged or offered by modern commercial banks, although Islamic jurists in Indonesia hold the opposite view. The Muslim public seems somewhat indifferent to all this. This, however, does not mean that there are no interest-free financial institutions operating in Indonesia. One form of traditional interest-free borrowing is the still widely prevalent form of informal rural credit known as ijon (green) because the loan is secured on the standing crop as described by Partadireja (1974). Another is the arisan system practiced among consumers and small craftsmen and traders. In this system, each member contributes regularly a certain sum and obtains interest-free loans from the pool by drawing lots. The chances of an Islamic bank being established in Indonesia seem at present remote (cf. Rahardjo 1988).

Finally, in the most recent contribution to the growing Islamic banking literature, Nien-haus (l988) concludes that Islamic banking is viable at the microeconomic level but dismisses the proponents’ ideological claims for superiority of Islamic banking as ‘unfounded’. Nienhaus points out that there are some failure stories. Examples cited include the Kuwait Finance House which had its fingers burned by investing heavily in the Kuwaiti real estate and construction sector in l984, and the Islamic Bank International of Denmark which suffered heavy losses in l985 and l986 to the tune of more than 30 per cent of its paid-up capital. But then, as Nienhaus himself has noted, the quoted troubles of individual banks had specific causes and it would be inappropriate to draw general conclusions from particular cases. Nienhaus notes that the high growth rates of the initial years have been falling off, but he rejects the thesis that the Islamic banks have reached their ‘limits of growth’ after filling a market gap. The falling growth rates might well be due to the bigger base values, and the growth performance of Islamic banks has been relatively better in most cases than that of conventional banks in recent years.

According to Nienhaus, the market shares of many Islamic banks have increased over time, notwithstanding the deceleration in the growth of deposits. The only exception was the Faisal Islamic Bank of Sudan (FIBS) whose market share had shrunk from l5 per cent in l982 to 7 per cent in l986, but Nien-haus claims that the market shares lost by FIBS were won not by conventional banks but by newer Islamic banks in Sudan. Short-term trade financing has clearly been dominant in most Islamic banks regardless of size. This is contrary to the expectation that the Islamic banks would be active mainly in the field of corporate financing on a participation basis. Nien-haus attributes this not only to insufficient supply by the banks but also to weak demand by entrepreneurs who may prefer fixed interest cost to sharing their profits with the banks.

 

Conclusion

The preceding discussion makes it clear that Islamic banking is not a negligible or merely temporary phenomenon. Islamic banks are here to stay and there are signs that they will continue to grow and expand. Even if one does not subscribe to the Islamic injunction against the institution of interest, one may find in Islamic banking some innovative ideas which could add more variety to the existing financial network.

One of the main selling points of Islamic banking, at least in theory, is that, unlike conventional banking, it is concerned about the viability of the project and the profitability of the operation but not the size of the collateral. Good projects which might be turned down by conventional banks for lack of collateral would be financed by Islamic banks on a profit-sharing basis. It is especially in this sense that Islamic banks can play a catalytic role in stimulating economic development. In many developing countries, of course, development banks are supposed to perform this function. Islamic banks are expected to be more enterprising than their conventional counterparts. In practice, however, Islamic banks have been concentrating on short-term trade finance which is the least risky.

Part of the explanation is that long-term financing requires expertise which is not always available. Another reason is that there are no back-up institutional structures such as secondary capital markets for Islamic financial instruments. It is possible also that the tendency to concentrate on short-term financing reflects the early years of operation: it is easier to administer, less risky, and the returns are quicker. The banks may learn to pay more attention to equity financing as they grow older.

It is sometimes suggested that Islamic banks are rather complacent. They tend to behave as though they had a captive market in the Muslim masses who will come to them on religious grounds. This complacency seems more pronounced in countries with only one Islamic bank. Many Muslims find it more convenient to deal with conventional banks and have no qualms about shifting their deposits between Islamic banks and conventional ones depending on which bank offers a better return. This might suggest a case for more Islamic banks in those countries as it would force the banks to be more innovative and competitive. Another solution would be to allow the conventional banks to undertake equity financing and/or to operate Islamic ‘counters’ or ‘windows’, subject to strict compliance with the Shariah rules. It is perhaps not too wild a proposition to suggest that there is a need for specialized Islamic financial institutions such as mudaraba banks, murabaha banks and musharaka banks which would compete with one another to provide the best possible services.

 

References

Abdallah, A., 1987. ‘Islamic banking’, Journal of Islamic Banking and Finance, January-March, 4(1): 31-56.

Abdeen, A.M. and Shook, D.N., 1984. The Saudi Financial System, J. Wiley and Sons, Chichester.

Abdel-Magib, M.F., 1981. ‘Theory of Islamic banks: accounting implications’, International Journal of Accounting, Fall: 78-102.

Aftab, M., 1986. ‘Pakistan moves to Islamic banking’, The Banker, June: 57-60.

Ahmad, Sheikh Mahmud, l952. Economics of Islam, Lahore.

____, n.d. ‘Interest and Unemployment’, Islamic Studies, Islamabad, VIII (l): 9-46.

Al-Arabi, Mohammad Abdullah, l966. ‘Contemporary banking transactions and Islam’s views thereon’, Islamic Review, London, May l966: l0-l6.

Al-Jarhi, Ma’bid Ali, l983. ‘A monetary and financial tructure for an interest- free economy, institutions, mechanism and policy’, in Ziauddin, Ahmad et al. (eds.), Money and Banking in Islam, International Centre for Research in Islamic Economics, Jeddah, and Institute of Policy Studies, Islamabad.

Ali, M. (ed.) l982. Islamic Banks and Strategies of Economic Cooperation, New Century Publishers, London.

____ (ed.) 1984. Papers on Islamic Banking, New Century Publishers, London.

Ariff, M. l982. ‘Monetary policy in an interest-free Islamic economy – nature and scope’ in M. Ariff, (ed.), Monetary and Fiscal Economics of Islam, International Centre for Research in Islamic Economics, Jeddah.

____ 1988. Islamic Banking in South-east Asia, Institute of Southeast Asian Studies, Singapore.

Bruce, N.C., 1986. ‘Islamic banking moves east’, Euromoney, July: 142-5.

Chapra, M. Umer, l982. ‘Money and banking in an Islamic economy’ in M Ariff (ed.), above.

____ l985. Toward a Just Monetary System, The Islamic Foundation, Leicester.

Choudhury, Masul Alam, l986. Contributions to Islamic Economic Theory: A Study in Social Economics, St Martin Press, New York.

Council of Islamic Ideology (CII), Pakistan, l983. ‘Elimination of interest from the economy’, in Ziauddin, Ahmed et al. (eds.).

El-Asker, A.A.F., 1987. The Islamic Business Enterprise, Croom Helm, London.

El-Din, A.K., 1986. ‘Ten years of Islamic banking’, Journal of Islamic Banking and Finance, July-September, 3(3):49-66.

Halim, Abdul, l986. ‘Sources and uses of funds: a study of Bank Islam Malaysia Berhad,’ paper presented to the Seminar on Developing a System of Islamic Financial Instruments, organized by the Ministry of Finance Malaysia and the Islamic Development Bank, Kuala Lumpur.

Hjarpe, Jan, l986. ‘Mudaraba banking and taka-ful insurance: the question of “Islamic Banks”, their significance and possible impact’, in Jan Selmer, and Loong Hoe Tan, Economic Relations between Scandinavia and ASEAN: Issues on Trade, Investment, Technology Transfer and Business Culture, University of Stockholm and Institute of South-east Asian Studies, Singapore.

Homoud, S.H., 1985. Islamic Banking, Arabian Information, London. Huq, Azizul, l986. ‘Utilization of financial investments: a case study of Bangladesh’, paper submitted to the Seminar on Developing a System of Islamic Financial Instruments, organized by the Ministry of Finance Malaysia and the Islamic Development Bank, Kuala Lumpur.

Iqbal, Zubair and Mirakhor, Abbas, l987. Islamic Banking, International Monetary Fund Occasional Paper 49, Washington D.C.

Irshad, S.A., l964. Interest-Free Banking, Orient Press of Pakistan, Karachi.

Kahf, Monzer, l982a. ‘Saving and investment functions in a two-sector Islamic economy’, in M. Ariff (ed.) , above.

____ l982b. ‘Fiscal and monetary policies in an Islamic economy’, in M. Ariff (ed.),above.

Karsten, I., 1982. ‘Islam and financial intermediation’, IMF Staff Papers, March, 29(1):108-42.

Khan, Abdul Jabbar, l986. ‘Non-interest banking in Pakistan: a case study’, paper presented to the Seminar on Developing a System of Islamic Financial Instruments, organized by the Ministry of Finance Malaysia and the Islamic Development Bank, Kuala Lumpur.

Khan, M. Fahim, l983. ‘Islamic banking as practised now in the world’ in Ziauddin, Ahmad et al. (eds.).

Khan, M. S.,1986.’Islamic interest-free banking’, I M F Staff Papers, March, 33(1):1-27.

____, 1987 ‘Principles of monetary policy in an Islamic framework’, paper presented to the International Institute of Islamic Economics, Islamabad, Pakistan, July.

____, and Mirakhor, A., 1986. ‘The frame-work and practice of Islamic banking’, Finance and Development, September.

____ and ____, 1987. Theoretical Studies in Islamic Banking and Finance (Book Distribution Centre, Houston.

____ and ____ forth-coming (1988). ‘The financial system and monetary policy in an Islamic economy’, Journal of Research in Islamic Economics.

Khan, Muhammad Akram, l968. ‘Theory of employment in Islam’, Islamic Literature, Karachi, XIV (4): 5-l6.

____ n.d. ‘International monetary crisis, causes and cure’, The Criterion, Karachi, 6 (2): 5-l9.

Khan, W.M., l985. Towards an Interest-Free Islamic Economic System, The Islamic Foundation, Leicester.

Man, Zakariya, l988. ‘Islamic banking: the Malaysian experience’, in M. Ariff (ed.), above.

Mannan, M.A., l970. Islamic Economics, Lahore.

Mastura, Michael O., l988. ‘Islamic banking: the Philippine experience’, in M. Ariff (ed.), above.

Mirakhor, Abbas, 1986. ‘Some theoretical aspects of an Islamic financial system’, paper presented at a Conference on Islamic Banking sponsored by the Central Bank of the Islamic Republic of Iran, Tehran, 11-14 June.

Mohsin, M., l982. ‘Profile of riba-free banking’, in M. Ariff (ed.), above. Naqvi, S.N.H., l98l. Ethics and Economics: An Islamic Synthesis, The Islamic Foundation, Leicester.

____, l982. ‘Interest rate and intertemporal allocative efficiency in an Islamic economy’, in M. Ariff (ed.), above.

Naughton, S.A.J. and Tahir, M.A., 1988. ‘Islamic banking and financial development’, Journal of Islamic Banking and Finance, 5 (2).

Nienhaus, V., l983. ‘Profitability of Islamic PLS banks competing with interest banks: problems and prospects’, Journal of Research in Islamic Economics, l(l):37-47.

____, l986. ‘Islamic economics, finance and banking – theory and practice’, Journal of Islamic Banking and Finance, 3(2):36-54.

____, l988. ‘The performance of Islamic banks – trends and cases’, paper presented to the Conference on Islamic Law and Finance, convened in the University of London, 8 April.

Partadireja, Ace, 1974. ‘Rural credit: the Ijon system’, Bulletin of Indonesian Economic Studies, 10 (3): 54-71.

Qureshi, Anwar Iqbal, l946. Islam and the Theory of Interest, Lahore.

Rahardjo, Dawam, 1988. ‘Islamic banking in Indonesia?’ in M. Ariff (ed.), above.

Rahman, Fazalur, n.d. ‘Riba and interest’, Islamic Studies, Karachi, 3(l):l-43.

Ready, R.K., l98l. ‘The march toward self-determination’, paper presented at the First Advanced Course on Islamic Banks, International Institute of Islamic Banking and Economics, Cairo, 28 August – l7 September.

Rosa, D.A., 1986. ‘Islamic financial policies and domestic resource mobilisation’, Savings and Development, 2:143-53.

Salama, Abidin Ahmad, l986. ‘Utilisation of financial instruments: a case study of Faisal Islamic Bank (Sudan)’, paper submitted to the Seminar on Developing a System of Islamic Financial Instruments, organized by the Ministry of Finance Malaysia and the Islamic Development Bank, Kuala Lumpur.

Scharf, T.W., 1983. Arab and Islamic Banks, OECD, Paris.

Siddiqi, M.N., l982. ‘Islamic Approaches to Money, Banking and Monetary Policy: A Review’, in M. Ariff (ed.), above.

____, l983a. Banking Without Interest, The Islamic Foundation, Leicester.

____, 1983b. Issues in Islamic Banking, Islamic Foundation, Leicester.

____, 1985. Partnership and Profit-Sharing in Islamic Law, Islamic Foundation, Leicester.

____, l988. ‘Islamic banking: theory and practice’, in M. Ariff (ed.), above.

Su’ud, M. Abu, n.d. ‘The economic order within the general conception of the Islamic way of life’, Islamic Review, London, 55 (2): 24-26 and (3): ll-l4. Udovitch, Abraham L., l970. Partnership and Profit in Medieval Islam, Princeton University Press, Princeton, N.J.

Uzair, Mohammad, l955. An Outline of `Interestless Banking’, Raihan Publications, Karachi.

____, l982. ‘Central banking operations in an interest-free banking system’, in M. Ariff (ed.), above.

Zaidi, N.A., l987. ‘Profit rates policy for PLS depositors’, Journal of Islamic Banking and Finance, 4 (4): 35-46.

1 Surah al-Rum (Chapter 30), verse 39; Surah al-Nisa (Chapter 39), verse l6l; Surah al-Imran (Chapter 3), verses l30-2; Surah al-Baqarah (Chapter 2), verses 275-8l. See Yusuf Ali’s Translation of the Qur’an.

2 Hadith compiled by Muslims (Kitab al-Musaqat).

3 This refers to a Hadith compiled by Muslims (Kitab al-Musaqat).

4 Bank Islam Malaysia Berhad has been offering a 70:30 profit-sharing ratio in favour of depositors (Man l988).

5 In l984 the Islamic Bank of Bangladesh offered rates of return ranging from 4.95 per cent to l4.l3 per cent. The Faisal Islamic Bank of Egypt, Cairo, gave a 9 per cent rate of return on deposits in the same year (Afkar Inquiry, December l985).

6 According to Sharia, profits arising from a mudaraba arrangement can be divided in any proportion between the two contracting parties as agreed upon at the time of the contract, but losses, if any, will fall on the financier only.

7 Some Muslim countries have recently introduced what are called ‘Muqarada Bonds’, the proceeds of which are to be used for income-yielding public utility projects such as the construction of bridges and roads. The bond holders will have a share in the collection of tolls and other receipts.

8 Qirad, sometimes also called muqarada, refers to a financial arrangement whereby the financier gets a share in the output, as in the case of Muqarada Bonds (see footnote 7). In the literature, the terms qirad and mudaraba are often used interchangeably.

9 The market shares of the Islamic banks are close to 20 per cent in Egypt, Kuwait and Sudan and roughly l0 per cent in Jordan and Qatar. By contrast, in Turkey, Islamic banks account for less than 1 per cent of the market (see Nienhaus 1988).

Islamic Banking – Literature

The early contributions on the subject of Islamic banking were somewhat casual in the sense that only passing references were made to it in the discussion of wider issues relating to the Islamic economic system as a whole. In other words, the early writers had been simply thinking aloud rather than presenting well-thought-out ideas. Thus, for example, the book by Qureshi on Islam and the Theory of Interest (Qureshi 1946) looked upon banking as a social service that should be sponsored by the government like public health and education. Qureshi took this point of view since the bank could neither pay any interest to account holders nor charge any interest on loans advanced. Qureshi also spoke of partnerships between banks and businessmen as a possible alternative, sharing losses if any. No mention was made of profit-sharing.

Ahmad, in Chapter VII of his book Economics of Islam (Ahmad 1952), envisaged the establishment of Islamic banks on the basis of a joint stock company with limited liability. In his scheme, in addition to current accounts, on which no dividend or interest should be paid, there was an account in which people could deposit their capital on the basis of partnership, with shareholders receiving higher dividends than the account holders from the profits made. Like Qureshi, above, Ahmad also spoke of possible partnership arrangements with the businessmen who seek capital from the banks. However, the partnership principle was left undefined, nor was it clear who would bear the loss if any. It was suggested that banks should cash bills of trade without charging interest, using the current account funds.

The principle of mudaraba based on Shariah was invoked systematically by Uzair (1955). His principal contribution lay in suggesting mudaraba as the main premise for ‘interestless banking’. However, his argument that the bank should not make any capital investment with its own deposits rendered his analysis somewhat impractical.

Al-Arabi (1966) envisaged a banking system with mudaraba as the main pivot. He was actually advancing the idea of a two-tier mudaraba which would enable the bank to mobilize savings on a mudaraba basis, allocating the funds so mobilized also on a mudaraba basis. In other words the bank would act as a mudarib in so far as the depositors were concerned, while the ‘borrowers’ would act as mudaribs in so far as the bank was concerned. In his scheme, the bank could advance not only the capital procured through deposits but also the capital of its own shareholders. It is also of interest to note that his position with regard to the distribution of profits and the responsibility for losses was strictly in accordance with the Shariah (6).

Irshad (1964) also spoke of mudaraba as the basis of Islamic banking, but his concept of mudaraba was quite different from the traditional one in that he thought of capital and labour (including entrepreneurship) as having equal shares in output, thus sharing the losses and profits equally. This actually means that the owner of capital and the entrepreneur have a fifty-fifty share in the profit or loss as the case may be, which runs counter to the Shariah position. Irshad envisaged two kinds of deposit accounts. The first sounded like current deposits in the sense that it would be payable on demand, but the money kept in this deposit would be used for social welfare projects, as the depositors would get zero return. The second one amounted to term deposits which would entitle the depositors to a share in the profits at the end of the year proportionately to the size and duration of the deposits. He recommended the setting up of a Reserve Fund which would absorb all losses so that no depositor would have to bear any loss. According to Irshad, all losses would be either recovered from the Reserve Fund or borne by the shareholders of the bank.

A pioneering attempt at providing a fairly detailed outline of Islamic banking was made in Urdu by Siddiqi in 1968. (The English version was not published until 1983.) His Islamic banking model was based on mudaraba and shirka (partnership or musharaka as it is now usually called). His model was essentially one based on a two-tier mudaraba financier-entrepreneur relationship, but he took pains to describe the mechanics of such transactions in considerable detail with numerous hypothetical and arithmetic examples. He classified the operations of an Islamic bank into three categories: services based on fees, commissions or other fixed charges; financing on the basis of mudaraba and partnership; and services provided free of charge. His thesis was that such interest-free banks could be a viable alternative to interest-based conventional banks.

The issue of loans for consumption clearly presents a problem, as there is no profit to be shared. Siddiqi addressed this problem, but he managed only to scratch the surface. While recognizing the need for such interest-free loans (qard hasan), especially for meeting basic needs, he seemed to think it was the duty of the community and the State (through its baitul mal or treasury) to cater to those needs; the Islamic bank’s primary objective, like that of any other business unit, is to earn profit. He therefore tended to downplay the role of Islamic banks in providing consumption loans, but he suggested limited overdraft facilities without interest. He even considered a portion of the fund being set aside for consumption loans, repayment being guaranteed by the State. He also suggested that consumers buying durables on credit would issue ‘certificates of sale’ which could be encashed by the seller at the bank for a fee. It was then the seller not the buyer who would be liable as far as the bank was concerned. However, the principles of murabaha and bai’ muajjal were not invoked.

Strangely, Siddiqi favoured keeping the number of shareholders to the minimum, without advancing any strong reasons. This is contrary to the general consensus which now seems to have emerged with reference to Islamic banks operating on a joint stock company basis, a consensus which incidentally is also in line with the Islamic value attached to a broad equity base as against heavy concentration of equity and wealth. Ironically, Siddiqi thought that interest-free banking could operate successfully ‘only in a country where interest is legally prohibited and any transaction based upon interest is declared a punishable offence’ (1983b:l3). He also thought it important to have Islamic laws enforced before interest-free banking could operate well. This view has not gained acceptance, as demonstrated by the many Islamic banks which operate profitably in ‘hostile’ environments, as noted earlier.

Chapra’s model of Islamic banking (Chapra 1982), like Siddiqi’s, was based on the mudaraba principle. His main concern, however, centred on the role of artificial purchasing power through credit creation. He even suggested that ‘seigniorage’ resulting from it should be transferred to the public exchequer, for the sake of equity and justice. Al-Jarhi (1983) went so far as to favour the imposition of a l00 per cent reserve requirement on commercial banks. Chapra was also much concerned about the concentration of economic power private banks might enjoy in a system based on equity financing. He therefore preferred mediumsized banks which are neither so large as to wield excessive power nor so small as to be uneconomical. Chapra’s scheme also contained proposals for loss-compensating reserves and loss-absorbing insurance facilities. He also spoke of non-bank financial institutions, which specialize in bringing financiers and entrepreneurs together and act as investment trusts.

Mohsin (1982) has presented a detailed and elaborate framework of Islamic banking in a modern setting. His model incorporates the characteristics of commercial, merchant, and development banks, blending them in novel fashion. It adds various non-banking services such as trust business, factoring, real estate, and consultancy, as though interest-free banks could not survive by banking business alone. Many of the activities listed certainly go beyond the realm of commercial banking and are of so sophisticated and specialized a nature that they may be thought irrelevant to most Muslim countries at their present stage of development. Mohsin’s model clearly was designed to fit into a capitalist environment; indeed he explicitly stated that riba-free banks could coexist with interest-based banks.

The point that there is more to Islamic banking than mere abolition of interest was driven home strongly by Chapra (1985). He envisaged Islamic banks whose nature, outlook and operations could be distinctly different from those of conventional banks. Besides the outlawing of riba, he considered it essential that Islamic banks should, since they handle public funds, serve the public interest rather than individual or group interests. In other words, they should play a social-welfare-oriented rather than a profit-maximizing role. He conceived of Islamic banks as a crossbreed of commercial and merchant banks, investment trusts and investment-management institutions that would offer a wide spectrum of services to their customers. Unlike conventional banks which depend heavily on the ‘crutches of collateral and of non-participation in risk’ (p. l55), Islamic banks would have to rely heavily on project evaluation, especially for equity-oriented financing. Thanks to the profit-and-loss sharing nature of the operations, bank-customer relations would be much closer and more cordial than is possible under conventional banking. Finally, the problems of liquidity shortage or surplus would have to be handled differently in Islamic banking, since the ban on interest rules out resort to the money market and the central bank. Chapra suggested alternatives such as reciprocal accommodation among banks without interest payments and creation of a common fund at the central bank into which surpluses would flow and from which shortages could be met without any interest charges.

The literature also discusses the question of central banking in an Islamic framework. The general opinion seems to be that the basic functions of a modern central bank are relevant also for an Islamic monetary system, although the mechanisms may have to be different. Thus, for example, the bank rate instrument cannot be used as it entails interest. Uzair (1982) has suggested adjustments in profit-sharing ratios as a substitute for bank rate manipulations by the central bank. Thus, credit can be tightened by reducing the share accruing to the businessmen and eased by increasing it. Siddiqi (1982) has suggested that variations in the so-called ‘refinance ratio’ (which refers to the central bank refinancing of a part of the interest-free loans provided by the commercial banks) would influence the quantum of short-term credit extended. Siddiqi has also proposed a prescribed ‘lending ratio’ (i.e., the proportion of demand deposits that commercial banks are obliged to lend out as interest-free loans) that can be adjusted by the central bank according to changing circumstances. In this context, reference may also be made to a proposal by Uzair (1982) that the central bank should acquire an equity stake in commercial banking by holding, say, 25 per cent of the capital stock of the commercial banks. The rationale behind this proposal was that it would give the central bank access to a permanent source of income so that it could effectively act as lender of last resort.

The discussion of central banking in an Islamic context is somewhat scanty, presumably because Islamic central banking is viewed as too farfetched an idea, except in Iran and Pakistan.

It emerges from all this that Islamic banking has three distinguishing features: (a) it is interest-free, (b) it is multi-purpose and not purely commercial, and (c) it is strongly equity-oriented. The literature contains hardly any serious criticism of the interest-free character of the operation, since this is taken for granted, although concerns have been expressed about the lack of adequate interest-free instruments. There is a near-consensus that Islamic banks can function well without interest. A recent International Monetary Fund study by Iqbal and Mirakhor (1987) has found Islamic banking to be a viable proposition that can result in efficient resource allocation. The study suggests that banks in an Islamic system face fewer solvency and liquidity risks than their conventional counterparts.

The multi-purpose and extra-commercial nature of the Islamic banking operation does not seem to pose intractable problems. The abolition of interest makes it imperative for Islamic banks to look for other instruments, which renders operations outside the periphery of commercial banking unavoidable. Such operations may yield economies of scope. But it is undeniable that the multipurpose character of Islamic banking poses serious practical problems, especially in relation to the skills needed to handle such diverse and complex transactions (Iqbal and Mirakhor 1987).

The stress on equity-oriented transactions in Islamic banking, especially the mudaraba mode, has been criticized. It has been argued that the replacement of predetermined interest by uncertain profits is not enough to render a transaction Islamic, since profit can be just as exploitative as interest is, if it is ‘excessive’ (Naqvi 198l). Naqvi has also pointed out that there is nothing sacrosanct about the institution of mudaraba in Islam. Naqvi maintains that mudaraba is not based on the Qur’an or the Hadith but was a custom of the preIslamic Arabs. Historically, mudaraba, he contends, enabled the aged, women, and children with capital to engage in trade through merchants for a share in the profit, all losses being borne by the owners of capital, and therefore it cannot claim any sanctity. The fact remains that the Prophet raised no objection to mudaraba, so that it was at least not considered un-Islamic.

The distribution of profit in mudaraba transactions presents practical difficulties, especially where there are multiple providers of capital, but these difficulties are not regarded as insurmountable. The Report of Pakistan’s Council of Islamic Ideology (CII 1983) has suggested that the respective capital contributions of parties can be converted to a common denominator by multiplying the amounts provided with the number of days during which each component, such as the firm’s own equity capital, its current cash surplus and suppliers’ credit was actually deployed in the business, i.e., on a daily product basis. As for deposits, profits (net of administrative expenses, taxes, and appropriation for reserves) would be divided between the shareholders of the bank and the holders of deposits, again on a daily product basis.

– Mohamed Ariff, University of Malaya

TAKAFUL: Objectives and Methodology

images10By : Atiquzzafar Khan

 

Introduction:

 

Insurance is the most important sector in present day modern economies after banking. In fact, banking and insurance go Hand-in-Hank and greatly complement and support each other’s operations. Almost all large scale business activities are bound to arrange insurance cover in one way or the other. Insurance business is an important contemporary issue which has attracted so many debates and discussions. Muslim scholars have been writing on this issue since the introduction of this business in the Muslim societies. In sixties and seventies the issue of insurance business came on the agenda of many conferences and seminars and consensus was emerged after long discussions that although the concept of insurance is not contradictory to Islamic principles but its present practice involves some elements such as interest, Gharar, Unlawful appropriation of others’ property etc. which are forbidden in Islam. Cooperative insurance has been suggested as an alternate to the present commercial insurance. Some scholars presented the concept of Takaful as an alternative scheme for running the insurance business in private sector. Involvement of Mudarabah and Tabarru’ (gift) in this scheme removes the objectionable elements from the business. On these lines many Islamic insurance (Takaful) companies were established in eighties and nineties in various Muslim countries and performing their business successfully.

 

The objective of this paper is to give an introduction of Islamic insurance (Takaful) business by mentioning its objectives, principles and operational mechanism. The arrangement of the paper is follows: The second section of the paper provides a brief introduction of contemporary insurance. Section three analysis the major points for and against commercial insurance to determine its Shariah position. Section four lists the basic Shari’ah principles of business in general and insurance business in particular and gives a brief introduction of Takaful scheme. The final section describes the operational mechanism of Takaful business in the light of Takaful experience of Malaysia.

 

 

Section 2.

Contemporary Insurance: Nature, History and Management

 

2.1. Introduction of Conventional Insurance and its Mechanism:

 

All human activities are subject to risk, which may lad to financial or physical losses to him. Insurance is a device to covers the loss arise due to occurrence of some undesired event. There are many possible ways of handing the risk. We can briefly mention some important ones as follows:

1. Risk Avoidance 4. Risk Transfer

2. Risk Retention 5. Risk Sharing

3. Risk Reduction

The last two methods provide the possibility of insurance business and naturally the third method is also used by insurance companies through instructing the policy holders to adopt suitable safety measures for reducing the risk.

Insurance is a complicated and intricate mechanism, and it is consequently difficult to define. However, in its simplest, it has two fundamental characteristics.

Transferring or shifting risk from one individual to a group.

Sharing losses by all members of the group on some equitable basis.

 

The term insurance, in its real sense, is community pooling to alleviate the burden of the individual, lest is should be ruinous to him. More precisely it can be defined as, “The simplest and most general conception of insurance is a provision made by a group of persona, each singly in danger of some loss, the incidence of which cannot be foreseen, that when such loss shall occur to any of them it shall be distributed over the whole group.”1

Insurance has a very long history. There is evidence of many practices resembling insurance in the ancient world. As early as 3000 B,C. Chinese merchants utilized the technique of sharing risk..2 The practices similar to insurance were in vogue in pre-Islamic Arab Society. 3 Some of the known practices were A’qila, Qasama Mawalat, and Willa’. The institutions were allowed to work in Islam due to there usefulness and some other institutions of the similar nature were established under Islamic state. Although these were insurance of sort, the modern insurance business did not begin until the commercial revolution in Europe. Marine insurance appears to have been started in Italy sometime during the thirteenth century. 4 Fire insurance in the modern era can be traced to Germany, where a fire association known as the Feuer Casse was organized in 1591. In 16666 the great fire of London broke out and an English Physician named Nicholas Barbon formed a stock company in 1680 with several associates called “The first life insurance policy was issued on June 18, 1536 by a group of underwriters in London.

Objectives of Insurance Business

The major objectives of insurance business, as gi en in the printed material of insurance, are the following:

Provision for the necessities of life of heirs as a result of sudden death of head of the family.

Security from economic loss in case of some accident such as fire, burglary etc.

Provision beforehand for the payment of any unforeseen financial liability or penalty.

Provision for inevitable needs of the future like after retirement, Provision beforehand for children’s education or marriages.

Increase in capital.

Provision against unforeseen business loss due to sudden fluctuations in money market, international market, or stock market etc.

 

Insurance business is broadly classified into two groups: Life insurance and General insurance. The latter has three main branches Marine, Fire, and Accident. The last mentioned type includes insurance of Motor Vehicles and Aero plane etc. Life insurance is also broadly classified as Whole Life policies and Endowment policies. Annuities come in the later group. Annuity in periodic payment to commence at a stated or contingent date and to be continued to be paid, to a designated persons(s), for a fixed period or for the life or lives of the person or persons entitled to receive payment

 

Classification of Insurance Business

Insurance Pricing:

The pricing of insurance policies is same as pricing policies for other commodities. In either case the seller must charge enough to cover all his costs and give some reasonable profit. But beyond this basic similarity there are some major differences. Two of them are particularly important: First, when an insurer sells a policy it has no way of knowing what its costs for that particular policy will be. It cannot just add up the cost of labor, rent, and so forth. Instead, the insurer must estimate the cost, basing its estimate upon what it has cost to provide similar policies in the past. The second difference is that the cost to the seller depends partly on who the buyer is. The insurer’s cost depends largely upon whether or not the policy buyer has losses and, it so, how many and how large they are. Of course, this is the reason that different people are charged different prices for policies providing the same kind and amounts of insurance. It is among the statutory requirements that the insurance rates must “discriminate fairly”, which means that proper distinctions should be made among various insured’s. Those who are alike should be charged the same rate; those who are different should be charged different rates.

There are three basic elements that premium must cover. The first component, the amount needed to pay policyholders’ losses, is the pure premium. The second part of the premium pays for the operating expenses of insurance company. These include the sales commission and other marketing costs, administrative costs, taxes, and the cost of handling claims. The third part of the premium is classed the margin, which includes an allowance for (a) contingencies, and (b) underwriting gain or profit.

 

Premiums, Rates, and Exposure Units:

As we know, insurance price is called premium; premiums are based on rates; and rates are prices per unit of exposure. As total price for any commodity is determined by multiplying the price per unit times the number of units of that commodity, the premium in case of insurance policy is the rates times the number of exposure units.

Pure Premium = rates * exposure units

Where exposure units

are the quantitative units used in insurance pricing. As gallons are the quantitative units in gasoline pricing, the quantitative units in automobile insurance are cars; the rates apply on a per car basis. In life insurance, for instance, the rates apply per $1,000 of insurance, and in workers’ compensation the rates apply per $100 of payroll.5

The final premium that the insured pays is called the gross premium or gross rate. For converting the pure premium into a gross rate requires addition of the loading, which is intended to cover the expenses of operation. The final gross rate is derived by dividing the pure premium by a permissible loss ratio, defined as t he percentage of the premium that will be available to pay losses after provision of expenses. It is equal to (1 – Expense ratio). Thus gross rate is defined as,

Gross Rate = Pure Premium /(1 – Expense ratio) 6

 

 

 

Section 3:

Arguments For and Against Insurance

Muslim scholars are writing on the issue of insurance and their opinion is sharply divided on the issue. Generally these views of the Muslim scholars could be classified into three groups:

Both the concept and the practice of insurance is contradictory to Islamic principles. According to them insurance involves Riba gambling and uncertainty, and is opposed to the concept of predestination (Taqdeer).This view is held by Dr. Hussain Hamid Hussan7 , Mufti Wali Hasan8 , Sheikh Abu Zahra9 and many other Shari’ah scholars.

Other group while appreciating the philosophy and rationale of insurance disapprove most of the forms of insurance contracts undertaken by commercial insurance companies. They see in them elements of risk, uncertainty, ignorance, usury which are inalienably associated with contemporary insurance. Among the prominent scholars of this group are Muft Muhammad Shafi10, Maulana Maudui11, Sheikh Ahmad Ibrahim12, Mustafa Zaid713, Sheikh Mohammad Bakheet14,, Issa Abduho15, Ahmad Fahmi16, Dr. Muslehuddin17, Dr. Mustafa Sayyad18 and many other distinguished scholars.

Third group of Muslim scholars maintains that insurance is permissible since it is based upon the principles of mutual assistance an reciprocal responsibility which Islam wants to promote among the Muslims. Further, the uncertainty involved in insurance is not of a sufficiently high degree to warrant its prohibition. This viewpoint is held by Mustafa Zarqa19, Sheikh Ali al Khafif20, Dr. Yousuf Musa21, Muhammad Ali Bahi22, Dr. Nijatullah Siddiqui23, Ahmad Taha Al-Sannusi24. Gharib Jamal25, and some other scholars.

In this section we ill briefly present the major arguments of both the proponents and the opponents of existing insurance in some detail and evaluate them in the light of Shari’ah

 

3.1. Arguments of opponents

 

Shari’ah scholars have raised many objections in contemporary insurance business. Some major objections are as follows:

 

3.1.1. Elements of Gharar (Uncertainty)

 

According to various Ahadith of the Prophet (SAW) any sale involving Gharar is prohibited whereas the insurance contract involves an element of Gharar of a high degree. The attribute of Gharar exists in insurance in four kinds.

 

 

 

 

 

Gharar in existence:

The existence of the amount of compensation is doubtful since it is paid only at the occurrence of the event which is uncertain.

Gharar of quantum:

The insured does not know at the time of the contract how much compensation he will get in case of any damage to his property.

Gharar with regard to time of payment:

It suggests that the time of payment of compensation in case of insurance is unknown and uncertain.

 

3.1.2. Element of Gambling

: In the contracts of insurance the insured loses his premium if the event does not happen, and in the other situation the company pays his several time more than what he has paid as premium. This clearly amounts to gambling as one party loses by more chance and the other gains undeservedly.

 

3.1.3. Element of Interest:

The opponents argue that the element interest is found in insurance in two ways. The first is that insurance companies invest the collected amounts in interest-oriented government securities and businesses for earning purposes. The second is the difference between what company receives from the policy holders and what it pays back as compensation as contractual objection comes under the definition of Riba.

 

3.1.4 Unlawful Appropriation of Other’s Properties

:

Islam enjoins upon believers not to devour other people’s properties wrongfully. 25 In most contracts of insurance the insured does not get anything from the company because the event never occurs during the period of contract. The premium money is thus wasted without any material benefit. All the money on account of premium goes to the company without any effect on its part..

 

3.2. Arguments of the Proponent

:

We also find scholars who consider contemporary insurance desirable from Islamic point of view and they don’t see any major problem into this business. There arguments are briefly stated below.

3.2.1 Principle of Mutual Assistance

:

Insurance encourages and promotes mutual assistance and reciprocal responsibility which are an indispensable part of the teachings and value system of Islam. 26

3.2.2. Non Resemblance with Gambling

:

The advocates of insurance deny the presence of gambling in insurance. They distinguish between the risk taken by the gambler and the risk in insurance which is a necessary part of living. The gambler takes up a risk voluntarily. The hope for gain is the only motivation of the taking of risk in his case. This risk contained in insurance, on the other hand, is indispensable and a useful social process conducive to productivity. 27 The objective of the insured person behind insurance is not to gain the amount of compensation. He does not intend the event to happen. His interest lies in the incident not taking place. He contracts only for peace of mind derived from the knowledge that whenever a catastrophe takes place, he will be indemnified. Gambling upsets the normal system based on work and reward and is inimical to equitable distribution of income and wealth, whereas insurance protects the disruption of the system by accidents and events beyond human control.28

 

3.2.3. Low degree of Gharar:

 

Insurance does not contain a high degree of Gharar. An insurance company can predict the chance of actual occurrence. The law of large number helps the company to calculate the number of likely happenings with some accuracy. This law points to the fact that some quantities which are uncertain and changing in individual cases, being different for each one, are certain and remain constant for a large group of similar persons. There, the element of Gharar is negligible in the contracts of insurance.

 

3.2.4. Analogy between Insuracne and the Institution of A’qila:

 

It is argued by the supporters of insurance that insurance resembles the institution of A’qila of early Islam. A’qila is an adult and sane male clan of an offender or convict from whom he receives help to pay blood money in culpable homicide.29

 

3.2.5. Insurance and Suretyship of Unknown Thing or Event:

 

It is allowed for a person in Shari’ah to be surety for an unknown and unspecified thing30. In insurance each policy holder becomes a surety for the other for an uncertain happening. The company also assumes the role of surety and compensates the loss incurred by a policy holder by way of being a surety.

 

3.3. Evaluation of the Argumetns:

 

If we examine the arguments of both the groups, we reach the conclusion that the insurance business as it is practiced today b the insurance companies, contains elements of uncertainty, deceit, usury and many other objectionable features. It contains Gharar of the highest degree. The elements of gambling and interest are also present in the contracts of insurance. The claim of the proponents that the element of uncertainty is negligible since the company has the ability to predict for event with some accuracy does not carry much weight. The event may be certain for the company but it remains quite uncertain for the policy holder. It is also a fact that a large amount of collected money by the company is invested in interest bearing assets. It does not resemble “Aqila of the early ages of Islam, since the purpose of the institution is to help and assist a person and share his burden by way of assistance, sympathy, benevolence, whereas the objective of insurance company is to earn profit. It is also not analogous to kafala contract because kafala is a contract of Tabarru’ and mutual assistance and not a contract to gain money.

As regards the concept and philosophy of insurance there seems to bean agreement of opinion among Muslim jurists, which emerged after many conferences and discussions at various forums, that the concept and objectives of insurance business in no way opposed to the injunctions and value system of Islam since it promotes mutual help, assistance, and cooperation. We can trace from the practice of the Prophet (SAW) and the companions (RAA) that all the needs mentioned in previous section under objectives of insurance, were recognized by Shari’ah.31 There is no doubt about the utility of the institution for society. The only thing required to be done is that the business of insurance should be brought in conformity with the tenets of Shari’ah. The elements of uncertainty, ignorance, gambling, and usury inherent in the business of insurance, need to be removed. The best method to run this business, as suggested by a large number of scholars, is to run this business on the basis of mutual suretyship and reciprocal responsibility. Islamic models of investment such as Musharaka and Mudharaba should be observed while investing the money collected by the company. Mutual insurance has been commonly suggested as a substitute for commercial insurance.32

 

Section 4: Islamic Guiding Principles4.1. General Principles governing Financial Contracts

 

Before discussing the Islamic model of insurance it will be quite appropriate to first mention the fundamental Islamic principles governing contracts in general. These principles are as follows:

1. The subject matter of the contract should not be unlawful in Islam.
2. The intended objectives of the contract should not be contradictory to the will of
the law- giver.

3. The contract should be free from the following elements,

i) Qimar (Gambling),

ii). Gharar (Aleatory),

Hi). Ghaban-al-Fahish (Grave Deception), and

iv). Ikrah (Coercion)

4.2. Principles Governing the Islamic Insurance Businessi). It should be based on Mutual Guarantee and Co-operation.

The objectives for which the institution of insurance initially started were very noble. The philosophy underlying insurance was that the consequences of an unhappy event will be shared by a large number of people and will not be left for a single individual to bear. It goes without saying that mutual guarantee and solidarity are integral parts of the value system of Islam.

The present state of this institution is that it does not contain any attribute of mutual co-operation, and guarantee. It is now a business through which a small group of capitalists attempts to attract the wealth of the society to use it for its own benefit and to shift the losses to others. Mufti Muhammad Shaft highlights this situation in the following words:

The prevalent insurance system cannot be described as a cooperative one. It is a misleading device to let the nation face the ill effects of interest-based insurance and speculation. If we analyze this system it will be established that insurance and speculation are in fact the supplements of the same interest- based business by means of which we try to feather our own nest without caring for the profit and loss of the entire nation. It is also used as a means of diverting one’s impending liabilities towards others through the cleaver use of the pharases of “national solidarity” and “cooperatives.^ Therefore, it is suggested that the Islamic insurance should be established on mutual or cooperative bases and preferably run by the government for keeping the spirit of solidarity and cooperation alive. Even if it is in the private sector, help should be provided from a common pool (a Trust fund), meant for this purpose and not for earning profits. The company can earn profits by investing the amount given in investment account

ii) Islamic Modes of Investment should be adopted.

At present many types of investments are being employed in the insurance business without any distinction between the lawful modes and forbidden ones. Most of them contain the element of Riba which is strictly prohibited in Islam. Some of these are founded on gambling and Gharar. Quite apparently all these three elements are unlawful according to Shari’ah. As such, any business or forms of investment which contains any one of these, will be unlawful in Islamic Shari’ah.

An Islamic insurance company is supposes to invest the funds in Islamically approved investments, such as stocks of companies, real estate, and participatory financing (Musharakah, Maudarabah).

Section 5: Islamic Alternative to insurance business:

 

Muslim Jurists have devoted much time and energy in their efforts to find an Islamic alternative to the existing insurance business. They have discussed the issue in a number of conferences. After extensive deliberations they have reached the conclusion that cooperative insurance provides the Islamic substitute for the prevalent unlawful insurance practices because profits are shared by the policy holders themselves. But this suggestion waslittle restrictive as it did not allowed the private sector to perform any role. Some Muslim scholars offered the scheme of Takaful, based on the elements of Tabarru1 and Mudharabah as the basis for a lawful insurance business35. The word Takaful1 means joint guarantee. The objective of Takaful is cooperation and mutual help among the members of a defined group. In a practical sense Takaful can be visualized as a method of joint guarantee among a group of members or participants against loss or damage that may inflict upon any of them. The members of the group agree to guarantee jointly that should any of them suffer a catastrophe or disaster, he would receive certain sum of money to meet the loss or damage. All members of the group pool together their efforts to support the needy 35.

Under Takaful scheme the participants deposit annually an agreed sum of money with the company. This contribution is divided into two parts. A larger portion goes into investment fund and remains the property of the contributor. The other part which is nearly 2 to 5 percent of the contribution goes into a Waqf fund and considered as Tabarru1 (Donation). The company invests the available funds in mudarabah ventures or some other approved modes. The profits, if any, are added into the investment and Waqf funds according to the previous ratios. The purpose of Takaful may be life insurance and it may also be risk insurance of property. If the insured person dies before the end of the covered time in case of life insurance or if an insured risk on the property materializes, then the company will pay back the amount deposited in investment account by the policy-holder along with profits earned during that period. The other component of compensation will come from the Waqf fund to satisfy the need or to make the compensation up to a certain level.

As company uses Islamically approved modes of investment and distribute profit among the policy holders, element of Riba is eliminated. The other objectionable element, Gharar is still there but as the company manages a separate Waqf fund from donationes of the policy holders, for providing support to the needy member(s) of the group, this Gharar will not invalidate the insurance contract. According to Malki Fuqaha Gharar in Uqood al Tabarru1 (Donation contracts) is acceptable and does not invalidate the contract. The other objectionable elements such as violation of Islamic law of inheritance, confiscating the previously deposited money after a non payment of contribution etc. can easily be corrected as they are not the integrated part of the contract. This is a brief introduction of Takaful scheme suggested as a substitute for commercial insurance. There are many Takaful companies operating in various Muslim countries. To have a better understanding of this scheme it would be appropriate to see the actual functioning of a Takaful company. For this purpose, the structure and functioning of Sharikat Takaful Malaysia is presented as follows.

5.1. Sharikat Takaful Malaysia Sendirian Berhad

In Malaysia the operation of Takaful is licensed and regulated by the Takaful Act 1984. Sharikat Takaful Malaysia Sendirian Berhad was incorporated on 29 November 1984, with an authorized capital of RM 100 million and a paid-up capital of RM 10 million. It officially commenced business operation on 1 August 1985. Sharikat Takaful Malaysia is a subsidiary of the Malaysian Islamic Bank, Bank Islam Malaysia Berhad with, 87.15% of its equity held by the Bank. Other shareholders are States Islamic Councils and Bait-ul-mals of various states in Malaysia. Types of Takaful Business

The commercial activity of Takaful is reflected in two basic types of business that it undertakes,

Family Takaful Business (Islamic life insurance)

General Takaful Business (Islamic general insurance)

The fundamental objective and basic working operation differ between these two types of business. Under the Family Takaful Business, Sharikat Takaful Malaysia provides various types of Family Takaful Plan, which generally, are long-term al-Mudharabah contracts. Basically, a Family Plan provides cover of mutual aid among its members or participants expressed in the form of financial benefits paid from a defined fund should any of its members be inflicted by a tragedy.

For the General Takaful Business, Sharikat Takaful Malaysia manages various types of General Takaful Scheme, such as Fire Takaful Scheme, Motor Takaful Scheme, Marine Takaful Scheme, and Engineering Takaful Scheme etc, usually on a short-term basis. These schemes provide protection in the form of mutual financial help to compensate its members or participants for any material loss, damage or destruction suffered out of any catastrophe, disaster or misfortune that falls on a member’s property or belongings.

 

 

Working of the Takaful BusinessTakaful Business is based on the concepts of Al-Mudarabah and Tabarru1. Involvement of these two Islamic forms of business eliminates the elements of Riba and Gharar from the insurance contract.The operational details of different Takaful Businesses are as follows:

Family TakafulAny individual between the ages of 18 to 55 years can participate in the Family Takaful business. Participants are required to pay Sharikat Takaful Malaysia regularly. The Takaful installments are then credited into a defined fund known as the Family Takaful Fund. Each Takaful instalment is divided and credited into two separate Accounts namely, the Participants’s Account (PA) and the Participants Special Account (PSA). A substantial proportion of the installments is credited into the PA solely for the purpose of savings and investment. The balance of the installments is credited into the PSA as tabarru1 for Sharikat Takaful Malaysia to pay the Takaful benefits to the heir(s) of any participant who may die before the maturity of the Family Takaful Plan. The amount accumulated in the PA is invested in various businesses according to Islamic financing techniques, and the resultant profits are divided betweer the Sharikat and the participants according to an agreed ratio, e.g., 30-70. The participants’ shares are calculated according to their individual shares in the PA, and credited into their respective accounts, the PA and the PSA.

In case of occurrence of some unfortunate event like death or disability, the
Sharikat makes payment to the policy holder or his heirs. The amount deposited in the
PA along with the profits plus some amount from the PSA according to a formula is paid
by the company. For example if the person die or suffer permanent and the total
disability (PTD) in the fifth year of participation, Takaful benefits will be paid in the
following manner:
i. From Participant’s Account RM 4,890.00

= RM 978 x 5 (i.e. installments paid by the Participant

in his Participants Account from the date of entry

up to the date of death or suffering of PTD) together

with profit, if any, which have been earned from

investment for during the same period, say RM 400.00

ii. From Participants Special Accounts RM 5,000.00

= RM 1000 x 5 yearly payment (i.e. outstanding

amount of Takaful installments that would have been

paid should the Participant survive).

Total Takaful Benefit Payable ( i + ii ) RM 10,290.00

For the Permanent Total Disability (PTD) cover Takaful benefit shall be paid in ten equal installments annually.
If the Participant is still alive at maturity of his FTP, payment of Takaful benefit will be
made to him as follows:-

i. From his Participant’s Account RM 9,780.00

= RM 978 x 10 (i.e. total amount installments credited into his Participant’s Account from date of entry to the maturity) together with the profit from investment if any, accumulated during the same period. RM 1,800.00

ii. From Participants Special Accounts, RM XXXX

Total Takaful Benefit = RM 11,580.00 + surplus as determined by Sharikat Takaful.

General Takaful Business

 

In consideration for participating in the various schemes of General Takaful Business, participants agree or undertake to pay Takaful contributions as tabarru1 for the purpose of creating a defined asset as illustrated in the ‘General Takaful Fund’. The amount of Takaful contributions will vary according to the value of property or asset to be covered under the Scheme. It is from this Fund that mutual compensation would be paid to any participant who suffers a defined loss or damage arising from a catastrophe or disaster affecting his property or belonging.

As the Mudharib, Sharikat Takaful Malaysia will invest the Fund. All returns on the investment will be pooled back to the Fund. In line with the virtues of mutual help, shared responsibility, and joint guarantee as embodied in the concept of Takaful, compensation or indemnity will be paid to any participant who suffers a defined loss or damage consequent upon the occurrence of a catastrophe or a disaster. Other operational costs to manager the General Takaful Business such as the cost for arranging retakaful programme and setting-up of reserve shall also be deducted from the Fund.

After satisfying all the claims and deducting the operational costs, if the Fund registers a surplus shall be shared between the participants and Sharikat Takaful Malaysia. The sharing of such surplus will be at an agreed ratio as expressed in the principle of al-Mudharabah such as 6:4, 5:5, etc. Profits attributable to the participants are paid on expiry of their respective General Takaful Schemes provided they have not received or incurred claims during the period of participation.

The General Takaful Business is different from Family Takaful, as all the payments are credited to only Tabarru account, and not divided into two separate accounts. One problem which we can feel here is the distribution of surplus among the policy holders. If the payments were given as Tabarru, then they should not bring any profit and if these were given as loan even then providing any share from the profit will not be appropriate and bring the element of Riba in the contract. Therefore, the company should divide the available funds into two separate accounts as the case of Family Takaful Business. If due to short period of policy it is not feasible to make investment and earn some profit then the payments from the policy holders should be considered as Tabarru and no return should be given to them. If the Fund registers surplus, the management can decide to reduce the amount of premium for the renewal of policy which will indirectly help and encourage the policy holders.

References:

 

Encyclopedia Britannica (11 th Ed.), Cambridge, 1911.

Frank H. Knight, “Risk, Uncertainty, and profit”, Houghton Mifflin, Boston, 1921,
pp. 233.

Dr. M. Muslehuddin, “Insurance and Islamic Law”, Islamic Publications Ltd.
Lahore, 1978, pp. 19.

Emmett J. Vaugnan, “Fundamentals of Risk and Insurance”, John Wiley & Sons,
New York, U.S.A. 1986, pp. 64.

Crane G. Frederick, “Insurance Principles & Practices”, John Wiley & Sons, New
York, 1980, pp. 383.

E. F. Brigham, “Financial Management: Theory and Practice”, 4th ed., Dryden
Press, Chicago, 1985, pp. 53.

Hussain Hamid Hassan, “Al-Ta’min wa Mauqif al-Shariah Minhu,

Mufti Mohammad Shafi, “Bima-e- Zindagi(Life Insurance)”, Dar-ul-lsha’at
Karachi, pp. 40-44.

Mustafa Zaid, “al-Tamin”, Majallah al-Buhuth al-lslamiyyah, ldarat al-Buhoth al-
lluiyyah, Riyadh, Vol. 19-20, July 1995.

Mufti Mohammad Shafi, op.ct. pp. 17-23.

Abul A’la Maududi, Ma’ashiat-e-lslam, Islamic Publications Limited, Lahore,
1988, pp.408.

Siddiqi, M. Nijatullah, “Muslim Economic Thinking”, International Centre for
Research in Islamic Economics, Jeddah, 1981, pp. 26.

Mustafa Zaid, op.ct.

Ibid

Ibid

Ahmad Fahmi, “Al-Tamin” I’nd al-Nawazil wa-al-hawa’ij”, paper presented at the
First International Conference on Islamic Economics, Makkah, 1976.

Dr. M. Muslihuddin,” Insurance and Islamic Law”lslamic Publications Limited,
Lahore, 1979.

Jalal Mustafa, “Al-Ta’min wa ba’dh al-Shubhat”, paper presented at First
International Conference on Islamic Economics, Makkah, 1976.

Mustafa Ahmad Zarqa, “Nizam al ta’min wa Mawqif al Shari’ah minhu” paper
presented at First International Conference on Islamic Economics, Makkah,
1976.

Shaikh Ali al-Khafif, “al-Tamin wa hukmuho ala Mabadi’ al-Shari’yyah wa
Usuliyyha al-a’mmah, paper presented at First International Conference on
Islamic Economics, Makkah, 1976.

Majallah al-Buhuth al-lsmiyyah, op.cit. Vol.19, 20.

Siddiqi, M. Nijatullah, “Muslim Economic Thinking”, op.ct. pp. 26.

Siddiqi, M. Nijatullah , “Insurance in an Islamic Economy”, Islamic Foundation,
U.K. 1985.

Siddiqi, M. Nijatullah, “Muslim Economic Thinking”,op.ct. pp. 26.

Ibid.

The Qur’an 5 : 2.

Mufti Muhammad Shafi, op.ct. pp.22.

Siddiqi, M. Nijatullah, “Insurance in Islamic Economy”, op.cit. pp.40-41.

Ibid.

Majallah al Buhuth al-lslamiyyah, op.cit. vol.20, pp.46.

Council of Islamic Ideology, “Report on Islamic Insurance System”, 1992, pp.47.

ibid, pp.31.

Mufti Mohammad Shafi, op.ct. pp.21.

ibid. pp. 24-26.

M. Fadzli Yousof, ‘Takaful: An Islamic Alternative to Insurance”, Islamic Banking
and Insurance, Islamic Bank Bangladesh Limited, Dhaka, 1990, p.61-75

Billah M. Masum, “Islamic Insurance: Its original sketch and Development
Scenario”, Journal of Islamic Banking and Finance, Volume 14, Aprail-June
1997, pp. 24.

Islamic Finance : Going Strong

Can Islamic law incorporate modern investment theory? This possibility, being explored by a new generation across the Islamic world, is taking a shape now. It’s already a way of life in parts of the Middle East. The OER team revisits the concept, with special focus on the GCC

By MEHRE ALAM
(With Clarence Michael in Dubai, Dr Jasim Husain Ali in Manama and Vani Saraswathi in Doha)

Can Islamic law incorporate modern investment theory? This possibility, being explored by a new generation across the Islamic world, is taking a shape now. It’s already a way of life in parts of the Middle East. The OER team revisits the concept, with special focus on the GCC

It was an interesting disclosure by any yardstick. Talking to OER on December 11, 2005 (the day Sohar Aluminium’s equity and technical partners had gathered in Muscat to put their seal of approval to go ahead with the development of the project in Sohar), Tony Kinsman, the CEO, declared his company had the distinction of bringing in Islamic finance to the shores of Oman.

The comment, coming from a top CEO, perhaps, was a pointer to a probable paradigm shift. Is this to be a trend? Is Islamic finance (IF) on its way to Oman?
If we talk of the Muslim world, IF has been wildly successful in Malaysia, accounting for 10 per cent of all banking operations there. In the GCC region, Bahrain was the first to catch on to the trend and promote the concept. And the UAE has seen a renewed push in this sector in the recent times.

Formally, Oman is not into IF. The Central Bank of Oman (CBO) does not allow the local banks to deal in Islamic finance, banking or insurance products. On that count, the Sultanate has a different policy compared to its GCC peers like Bahrain, Saudi Arabia, Qatar or the UAE. But companies operating in the Sultanate are increasingly climbing on to the IF bandwagon. There is heightened interest in IF in Oman. As of now, the regional banks have moved in to fulfil this need.

Sohar Aluminium’s case is, probably, a pointer to the shape of things to come. The first Greenfield aluminium smelter project in over a quarter century in the entire Middle East, Sohar Aluminium is raising US$260 million of the total US$ 1.58 billion project, from the IF route. This makes up for around 15 per cent of the total project finance. For the first time in Oman, a capital project is probably availing of IF of this size.

What made Sohar Aluminium approach the IF route? OER raised this question to Musab Abdullah Al Mahruqi, the Deputy Chief Financial Officer of Oman Oil Company (the local sponsors of Sohar Aluminium). Musab says: “We wanted to tap the other markets too. We wanted to expand our options. We were confident that such a scheme would work in the Omani environment. As for the future, we do not have any problem in approaching the IF route.”

Clearing the cloud further is Usman Ahmed, Deputy CEO of Citi Islamic Investment Bank E. C. (CIIB) in Dubai, a 100 per cent-owned subsidiary of Citigroup. He reveals to OER that his bank has recently closed the first Islamic tranche for the Omani issuer — the US$ 260 million Islamic facility for the Sohar Aluminium project.

There are other examples as well. One of the reasonably large diversified groups in the oil and gas sector in the Sultanate is reported to have borrowed money for a transaction on an Islamic basis. AES Barka, the 427 MW gas fired power plant and 20 MIGD desalination plant, is also reported to have borrowed some of its project finance through IF. A real estate sector company, and some leasing companies are also reported to be interested in considering the IF route.

Rajeev Singh, Partner, Ernst & Young, Oman, informs that his firm was approached by a consortium of developers bidding to the government on the Sohar Independent Water and Power Project. (They did not go on to win the bid). Ernst & Young, Oman, were their financial advisors and had approached an IF institution to put in almost US$200 million worth of project finance.

This brings us to the issue of the market appetite for IF. Khalid Ahmed Alhosni, Managing Director & CEO, InfoMart (Commercial Information Market LLC), Muscat, feels the market appetite has always been there. “Call it Islamic finance or traditional funding, corporates need funds. Many companies in Oman would like to avail themselves of IF,” says Khalid.

Has IF arrived in Oman? “I think it has definitely arrived,” argues Rajeev. “It has been a force in the region for sometime. Oman government has been very pragmatic in consciously trying to avoid linking religion with business. We understand that the regulator doesn’t have a problem if you have these (IF) products without specifically marketing it under that tag. IF transaction and lending has been taking place in Oman for the past few years, but quietly, and without a lot of publicity. But businessmen continue to use that. It’s now a way of life in the Middle East.”

Is the trend likely to pick up in the future? Rajeev believes it has to; it’s a fact of life across the region. A big development for Islamic banks, points out Rajeev, is that while in the past it was confined to retail business, and later corporate, the recent times have seen the arrival of the Islamic component for project finance. “You now see sizeable IF component forming part of project finance tranches. Anything between 20 per cent and 35 per cent of project finance transactions now comprise of Islamic tranches,” he informs.

However, Khalid sees the non-standardization of IF banking procedures as the biggest hurdle for its growth in Oman. This, he views, as a problem with the structural element of the IF concept. The Abu Dhabi Commercial Bank or the Dubai Islamic Bank have their in-house Shariah boards, he points out. Malaysia, where IF is breaking new ground, has set the benchmark for standardization. “We don’t have this,” he says.

Khalid then points to the problem relating to the marketability of IF products. Here, he sees a big problem with liquidity, which he says, is an issue with both IF and conventional products. The primary market is low. However, change of hands is not taking place in the secondary market. Khalid cites the example of Sukuk (Islamic leasing bonds), which has done extremely well in the primary market. In the secondary market, Sukuk has the attractiveness but not the liquidity. Khalid says the prospect of IF looks bright in the short-term. Petrodollars have made the market more attractive. “But only when the secondary market sees transactions taking place, that liquidity and attractiveness will come to the IF market.”

Rajeev, on the other hand, sees a silver lining with regard to the IF terms and conditions, which have been improving in recent times, for example the tenure of the loan, the sort of paperwork and documentation required, and the level of compliance etc. “In recent times, IF has become easier to understand and easier to facilitate. IF now has standard packages so there is no need to bother about checking compliance from scholars. Bankers arrange all that. The transaction process has become very smooth now,” says Rajeev.

The eased procedures and the heightened interest bring us to back the basic question: what is happening on the regional and global maps? How far has IF’s reach grown?

IF: Third Generation
In fact, Muslim societies have always looked to means of conducting their banking and investment affairs according to the Shariah, the sacred law of Islam. However, the discovery of oil in the Arab world in the 1930s brought about radical changes, stepping up the challenge of compliance in the global economy.

Today, there seems to be a growing interest in IF even in such parts of the globe as Europe and North America, where Muslims are a minority. And in the Middle East, IF may become a way of life! A recent study illustrates that the Asia-Pacific region looks promising as well, following estimates that Islamic banks will account for 40 per cent to 50 per cent of total savings of the Muslim population worldwide within the next eight to 10 years.

Modern Islamic finance, clearly, has come a long way since it appeared on the scene some 30 years ago. The industry is now seeing a third generation of evolution. The concept as such started with the creation of Islamic banks in the Middle East in the mid-1970s. However, majority of their assets were either real estate or very short-term, trading-type activities.

The second generation lasted from the mid-1980s to mid-1990s. Now, Islamic banks were developing a bit more sophisticated corporate and retail banking structures, trying to come up with better products and a better level of service. From the mid-to late 1990s to the present day, is the time for the third generation of IF institutions. Sophisticated product offerings mark this phase.

The first Islamic investment bank was founded in Bahrain in 1997. Since then, several Western banks have set up Islamic windows, including UBS Group’s Noriba Bank, Citigroup’s Citi Islamic Investment Bank, and HSBC Amanah Finance. It is not unusual, now, to find conventional banking models operating side by side with Islamic banking systems.

What They Offer
Islamic financial institutions typically offer such traditional Islamic banking services as investments in Murabaha (instalment sales), equity investments that conform to Shariah precepts, real estate investment programs, treasury products, foreign exchange, and private wealth, and portfolio management. An Islamic fund of hedge funds is only the latest milestone in the development of Islamic finance, an opportunity lying somewhere between US$200 billion and US$300 billion.

Islamic financing in the GCC in general, and Dubai in particular, has seen a surge recently following the launch of Islamic banking services by regional and international banks.

“In fact, Islamic financing has grown in double digits from a low statistical base. At some point in the future, growth rates will be slower because the industry is maturing,” points out Dr. Eckart Woertz, Program Manager, Economics, of the Dubai-based Gulf Research Center.

Adds Dr. Woertz: “Islamic financing has quite some potential in the Islamic countries and among migrant communities in the West. But much of its future growth depends on how it will be able to copy conventional banking products, including project financing, options, short selling.”

“This in turn might raise discussions about its specific Islamic identity, as boundaries to conventional banking become increasingly blurred.”

For example one can argue whether murahaba constructions are some kind of disguised interest and in fact treasury departments of Islamic banks, which invest in such vehicles use the LIBOR (London Inter-bank Offered Rate) of conventional banking as a benchmark.

That may be so for now. But in future Islamic financial institutions will come under increasing competition. Will they be able to withstand such competition from the likes of Citigroup, HSBC and Deutsche Bank?

They could, says Dr. Woertz.
It is not too difficult for a conventional bank to ease into Islamic financing. The similarities are greater than the differences, says Dr. Woertz, who says it is about risk management and the time value of money… “Once a Shariah board is in place and there is administrative separation of Islamic/non-Islamic accounts, there is no problem. All the bigger banks, including Citi, HSBC, Deutsche etc are venturing into the field since there is increasing business.”

But Islamic banks will have to keep initiating new measures with products that will be able to maintain profitability.
“The huge profit margins of Islamic Banks will decline once investors become more sophisticated and demand some kind of profits or ‘disguised interest’ on their current accounts. So far, the Islamic Banks mostly get deposits at essentially no cost while operating profitably with them on the consumer financing and murahaba markets.”

But what needs to be done in order for the industry to expand and still corner more share of the international finance is to integrate value with sustainable growth.

The Islamic finance sector needs to do more to encourage socially responsible investing (SRI), a recent forum in Dubai was told.

Of particular interest and key to the moral dimension of investing will be the parallels drawn between Islamic Finance and Socially Responsible Investing (SRI), a strong and growing force in Europe and the US, which aims to balance sustainable value to both society at large and the shareholders by investing in companies who meet their exacting standards of Corporate Social Responsibility (CSR).

“Islamic finance is rapidly maturing into a mainstream and powerful financial industry, and Shariah-compliant disciplines are accelerating into many new sectors,” according to Christianna Tsiterou, Conference Director at IIR Middle East, organizers of the 9th International Islamic Finance Forum (IIFF) in Dubai.

Probably the Dubai International Financial Centre (DIFC), which plans to list Islamic instrumnets at some stage can play a key role in the development of Islamic financing.

Islamic banking and financial institutions intending to operate out of Dubai International Financial Centre (DIFC) must ensure a clear division between senior management and company-appointed Shari’a Supervisory Boards (SSBs), according to Hari Bhambra, Senior Manager – Supervision at DIFC Financial Services Authority (DFSA).

While a company’s board would hold ultimate responsibility for the organisation’s operations, including its general compliance with DIFC’s regulatory framework, as well as its Shari’a aspects, the SSB would be responsible for approving the Shari’a aspects and reporting to DFSA, adds Bhambra.

But future growth in the GCC Islamic financial services industry hinges on developing and introducing standardisation and innovation of products and services.

Says Dr. Habib Al Mulla, Chairman, Dubai Financial Services Authority (DFSA), ‘The Islamic financial services industry should seek to be as innovative as possible in terms of products and services that they offer. The industry would greatly benefit from standardisation of Islamic services and products, and this would promote greater consistency across the industry.”

Industry experts point out Islamic firms would greatly benefit by being able to respond more quickly to the needs of clients, and not be delayed by the legal and Shariah approval process.

The DFSA considered many jurisdictions when devising its regime for the DIFC as a whole and specifically Islamic finance. With respect to Shari’a, the DFSA chose to act as a Shari’a Systems Regulator rather than a Shari’a Regulator.

”For the future, the DIFC has established the Islamic Finance Advisory Council its responsibility is to begin work with the industry to identify the gaps and issues in the market, and then set realistic timetables with a view to improving the operating environment for Islamic finance. This is just a start. As a regulator, we recognise that we along with the market have to continue to evolve,” adds Dr. Al Mulla. Of equal importance is the Citigroup Dow Jones Islamic bond index recently launched, to help create a benchmark for Sukuks“But Sukuks as such are far from constituting a benchmark, most of the time they are 5-year floating rate notes and fixed coupon and government sukuks are rare. Thus a benchmark all across the yield curve is not possible yet,” said Dr. Woertz of GRC.

The Dow Jones Citigroup Sukuk Index includes investment-grade, US dollar-denominated Islamic bonds-also known as Sukuk-issued in the global market. The Index tracks seven issues: Islamic Development Bank, Solidarity Trust Services Ltd, BMA International Sukuk, Qatar Global Sukuk, Malaysia Global Sukuk, Sarawak Sukuk and Dubai Global Sukuk.

To be included in the Index, an Islamic bond must comply with both Shariah law and the Bahrain-based Auditing & Accounting Organization of Islamic Financial Institutions (AAOIFI) standards for tradable Sukuk. Once a bond meets these criteria, Dow Jones Indexes and Citigroup will apply market-based criteria such as minimum maturity of one year, minimum issue size of US$250 million, and an explicit or implicit rating of at least BBB-/Baa3 by leading rating agencies.

Bahrain is increasingly emerging as the undisputed capital of Islamic finance. This notion is supported by continued advances made in the sector.

To begin with, some 30 Islamic financial institutions (IFIs) operate in Bahrain. These include investment IFIs like Gulf Finance House (GFH) or commercial banking entities such as Shamil Bank. Still, other leading banks such as Citibank and Arab Banking Corporation have dedicated units catering to Islamic finance in Bahrain.

Supportive Institutions
To be sure, Bahrain is well placed to lay claim on being the primary hub for Islamic finance by virtue of supportive institutions in place. Already, Bahrain plays host to numerous institutions promoting and organising Islamic banking activities, like the International Islamic Financial Market (IIFM). Set up in November 2001 by several Muslim countries and Saudi-based Islamic Development Bank, IIFM serves as a money market for Islamic institutions worldwide. In turn, this is sustained through Liquidity Management Centre (LMC), which helps realising IIMF’s objective.

Set up in July 2002, LMC provides a platform for IFIs to manage their day-to-day liquidity requirements. In particular, LMC manages the sale of Islamic leasing bonds, better known as Sukuks. In short, LMC intends to develop an active secondary market for short-term Shariah-compliant treasury products.

To add to it all, the International Islamic Rating Agency (IIRA) is based in Bahrain. Set up in 2002 as a pioneering project, IIRA extends ratings to IFIs and other Shariah-compliant products. As such, the global banking industry’s necessary infrastructure is based in Bahrain.

Serious Regulations
Financial authorities in Bahrain regard Islamic banking sector as one with extraordinary growth potential. Not surprisingly, the government is keen to promote Islamic banking by providing a supportive regulatory environment, with emphasis placed on high standards, transparency and accountability.

The Prudent Information and Regulatory Framework for Islamic Banks (Piri) came into effect in 2002. Piri requires Islamic banks to maintain a capital-adequacy ratio of 12 per cent. In fact, the Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI) is based in Bahrain too. According to International Monetary Fund (IMF), Islamic finance houses anywhere are mandated to follow standards set by AAOIFI.

Other regulations are in place in dealing with asset quality, management of investment accounts and liquidity. In 2003, BMA signed a memorandum of understanding with the London Metal Exchange (LME) to develop contracts and documents that abide by Islamic law. The final aim of the deal is to assist IFIs conduct transactions on the LME.

Innovative Businesses
In many respects, Bahrain-based IFIs are noted for their innovative business ideas. They are credited for standing behind a number of property-related projects across the region.

For example, GFH is leading force behind Bahrain Financial Harbour, the US$1.3 billion project, set to become the country’s main financial district by 2007. Also, GFH is the financial advisor to the newly launched Qatar Energy City. In fact, Essam Janahi, Chief Executive Officer of GFH, serves as chairman on the board of Qatar Energy City, whose first phase will be built at the cost of US$1.6 billion. Besides, promoters expect to launch a stock market dedicated to trading in oil and gas derivatives, as part of Qatar Energy City project.

Also, GFH shows that IFIs can be profitable — it posted net profit of US$57 million in the first quarter of 2006, up 75 per cent from the same period in 2005.

Bright Future
The IMF believes that Islamic banking extends opportunities to Bahrain’s financial services sector. The point was made during the financial sector assessment programme (FSAP) review of Bahrain, released in March. Says IMF: “The variety and popularity of Islamic instruments has surged in recent years, driven mainly by the supply of funds from savers who wish to invest in Islamic vehicles, and to a lesser extent, by entrepreneurs seeking financing using Islamic instruments. The growth is likely to remain rapid over the near term.”

In fact, according to FSAP’s report, Islamic banking is assisting Bahrain remain an attractive location for financial institutions. Likewise, the IMF’s report noted growing demand for Islamic insurance in Bahrain. Islamic insurance activity is known as Takaful.

Suffice to say that the financial services sector, which includes Islamic banking, is the main contributor to Bahrain’s gross domestic product (GDP). In 2004, the sector accounted for 24. 2 per cent of the GDP in constant prices, up from around 19 per cent in 2003. Activities related to the financial services sector, namely investment banking, advisory and management services, grew by a hefty 35 per cent in 2004.

The challenge to financial authorities in Bahrain lies in continuing the drive to encourage development and introduction of innovative Islamic banking products. And there are numerous indications that Islamic financial institutions operating in Bahrain plan to remain innovative while taking calculative risk. For instance, Kuwait Finance House (Bahrain) has recently revealed plans to set up KFH Industrial Oasis within Bahrain International Investment Park (BIIP). KFH’s project intends to stimualte diversification within Bahrain’s industrial sector by building on growing demand for indudstrial-based real estate projects in the country.

In short, Islamic finance is bound to remain an agent of change in Bahrain’s vital financial servcies sector.

It has never been this good for Islamic finance in Qatar. In recent times, three local conventional banks have branched out and launched Islamic financial entities. Qatar market is witnessing an escalation in competition in this area — in providing Shariah-compliant products and services to the local clientele.

Qatar Islamic Bank (QIB), that started its operations in 1983, is the pioneer in the field. Its local investments exceed 70 per cent of its gross investments. With assets standing at QR8.294 billion, QIB’s success is proof of the readiness of the market for competition.

And that’s why conventional banks have joined the bandwagon. QNB Al Islami, Al Safa (Commercialbank) and Doha Islami (Doha Bank) join Qatar Islamic and Qatar International Islamic Banks. “In countries such as the UAE and Saudia Arabia, both such models of banking have simultaneously existed for a long time. It should be construed as ‘healthy competition’ as it keeps everybody on their toes in terms of coming up with offerings that are value packed. Qatar is now experiencing the same and I am optimistic that it will contribute positively in all aspects,” says Mohammad I Mandani, Deputy CEO and Head of Islamic Banking, Al Safa Islamic Banking. “Conventional banks opening up Islamic branches only proves how popular the concept has become. And this increased competition will only being about improved quality in products and services,” according to a QIB spokesperson.

Islamic finance is indeed coming of age in Qatar. It is no longer a unique or niche service, as its appeal crosses religious and national boundaries. It is probably a little intriguing why this concept of banking had not found wider favour earlier here.

QIB, the leading Islamic bank in Qatar, has ventured overseas in its expansion. It has stepped forward to lead the establishment of three finance houses in Europe, Asia and the USA. Musadag El Melik, Head of QNB Al Islami, says the basic concept of Islamic banking is something that is built on the ethical beliefs or principles of not just Muslims, but also of the two other major religions — Judaism and Christianity. “Usury is banned in all three religions. So we are providing a service that is interest-free. So we can simply look at this form of banking as ‘interest-free banking’ — as one economic concept. Yes, there is more than just being interest-free, we will not invest in what is prohibited — alcohol, tobacco, gambling etc. But those may well be the principles of those who are not Muslims too.”

Businesses Seek It Too “The Qatari market has become so appealing that there is excellent opportunity for investing locally in Shariah-compliant projects. That is why so many new players are entering the market,” says the QIB official.

Recently, Dolphin Energy Limited signed what is considered the biggest Shariah-compliant financing agreement ever. Dolphin Energy signed an Islamic financing agreement with 14 financial institutions that will provide $1 billion to finance a portion of the Dolphin Gas Project. Dolphin had earlier appointed five banks with Shariah Supervisory Committees to lead the financing.

Dolphin also invited other banks, including a number that had never invested in Islamically structured financing facilities before, to join the financing.

Key Challenges
The Islamic finance industry is comparatively young. Therefore, the there will be challenges.

One of the key challenges is the relatively small talent pool of qualified personnel to run Shariah-compliant programs.

Another obstacle is the lack of uniform standards. Differences in approach can make it difficult for professionals who try to adapt their financial business practices in one Islamic country to another.

Islamic banks looking to compete in the global economy must eventually align themselves with Basel II, the international banking standard. This means developing the necessary technological capability and operating procedures. However, conventional banks that already comply with Basel II and decide to enter the Islamic banking business, must reengineer their processes to make their activities Shariah-compliant.

Then, assessing the performance of Islamic banks is often confounding for experienced regulators, let alone newcomers to the sector. The problem is a lack of adequate transparency and disclosure. This is the other big challenge.

Finally, there is the persistent skepticism that interest in IF is being driven by marketing needs rather than the sector’s own merits.

source : oer

Lloyds launches Islamic banking products

Lloyds launches Islamic banking products

 

The products have been specially designed for Britain’s Muslim community, whose religion does not allow them to earn interest on their savings.

It is the second major high street bank, after HSBC, to offer Islamic banking products, which are also available from the Islamic Bank of Britain and the West Bromwich building society.

Until recently, Muslims have either had the choice of opting out of the mainstream banking system altogether or just resorting to conventional interest-based accounts.

Shariah law forbids the charging or receiving of interest (riba), making not only bank accounts off limits for many, but mortgages and investments as well.

Lloyds TSB is initially launching two Shariah compliant products – an Islamic current account and an Islamic mortgage – and plans to launch a student account later in the year.

The products have been developed in consultation with a board of Islamic scholars to ensure they are complaint with all aspects of the law.

Paul Sherrin, head of Islamic Financial Services at Lloyds TSB, said: “Having spoken to Muslims across the country we know that more than three-quarters want current accounts and mortgages that fit with their faith.

“By making these products available nationwide we’re bringing Islamic banking into the mainstream and we’re giving the Muslim community access to financial services that meet their needs without compromising their religion.”

The current account comes with a debit card, but it does not offer interest, have an overdraft facility, charge a fee or require a minimum balance.

Funds held by Lloyds TSB for the Islamic current accounts will only be invested in industries that are permitted under Islamic law, which excludes alcohol, gambling and tobacco, among others.

Under the Islamic mortgage, the bank will buy the home on behalf of the customer – instead of lending money for a property – contributing up to 90 per cent of the purchase price. The customer will pay the remaining amount upfront, and repay the outstanding balance over an agreed term, along with a rental payment.

The products provide Muslims with access to Lloyds TSB’s network of 2,000 branches and 4,000 ATMs, along with its internet and telephone banking services

 

source : Myfinance.co.uk