CIMA launches Islamic Finance Qualification

cima_logoThe islamic finance industry is growing at the rate of 20 percent per year with $500 billion worth. This has created in new job opportunities in islamic finance market. To meet this market the Chartered Institute of Management Accountant (UK) and International Institute of Islamic Finance launched first qualification in Islamic Finance in December 2007.

 

This will be valuble for those who seeking accrediated qualification in Islamic Finance. This will be called as Certificate in Islamic Finance (Cert IF). The certificate has four compulsory study modules. Each is covered by a detailed study guide that will take you through to the final assessments.

Cert IF is a self study, distance learning qualification, and is available for study across the globe. Each module is independent. We recommend that you complete the Islamic Commercial Law module first as it includes knowledge and skills you will require for the three remaining modules.

Robert Jelly, Director of Education at CIMA, says:

‘CIMA has identified that there is considerable demand from the global business community to develop the knowledge and skills required to service this increasingly important market. The CIMA Islamic Finance qualification is the first to be created in conjunction with an Advisory Group made up of academics, practitioners and scholars of Shari’ah, and will assist employers in the City of London and other major financial centres throughout the world in equipping their employees to develop financial products.’.

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The growing importance of Islamic finance in the global financial system

Remarks by Mr Malcolm D Knight, General Manager of the BIS, at the 2nd Islamic Financial Services Board Forum, Frankfurt, 6 December 2007.

Abstract

Although there are differences between Islamic banking and “conventional” banking, there are some fundamental principles that apply equally to both. In particular, rigorous risk management and sound corporate governance help to ensure the safety and soundness of the international banking system. In the light of the growing importance of Islamic banks and Sharia-compliant financial innovation, the increasing integration of Islamic financial services into global financial markets serves to strengthen this point.

The Basel II framework improves the risk sensitivity and accuracy of the criteria for assessing banks’ capital adequacy. This framework is fundamentally about stronger and more effective risk management grounded in sound corporate governance and enhanced financial disclosure, the importance of which has been underscored by the recent problems that have arisen in the banking industry worldwide. The guidance provided by the Islamic Financial Services Board (IFSB) is a useful contribution to the realisation of these global goals. It will support the establishment of resilient financial market infrastructures and sound and robust core Islamic financial institutions operating according to safe and sound risk management practices.

 

Full speech

Introduction

Good morning. I am pleased and honoured to address the 2nd Islamic Financial Services Board Forum today. As the General Manager of the Bank for International Settlements, I am particularly pleased to be here today to discuss Islamic finance and its growing importance in the global financial system. But let me start by commending Professor Rifaat Ahmed Abdel Karim of the Islamic Financial Services Board and Josef Tošovský of the BIS Financial Stability Institute for putting together such a comprehensive programme. It is entirely appropriate that the IFSB and the FSI should join forces to organise this conference. After all, the IFSB’s mission is to promote the soundness and stability of the Islamic financial services industry. It does so by issuing global prudential standards for the industry. Likewise, the FSI’s mission is also to promote sound supervisory standards and practices globally.

BIS and BCBS support for the IFSB

As an associate member of the IFSB, the BIS has been actively supporting the IFSB’s mission and initiatives since the Board began operations in 2003. The Basel Committee on Banking Supervision, which is hosted by the BIS, is increasingly looking beyond its membership to enhance cooperation with non-member countries and organisations with related interests and similar goals. The Committee’s outreach to non-member countries is part of an initiative to promote the development of sound supervisory practices and to accommodate the growing importance and sophistication of non-member banks.

The BIS and the Basel Committee have been strong supporters of the IFSB through participation in IFSB working groups, such as the capital adequacy group, and by providing speakers for conferences and other events. I believe that the active and productive dialogue between the Basel Committee and the IFSB will continue to benefit both of our organisations. Professor Rifaat and members of the Basel Committee’s Secretariat have recently held fruitful discussions, and continue to strengthen the cooperation between the IFSB and the Committee.

In my remarks today, I will not address the specifics of Islamic finance and how it differs from conventional banking. Instead, I would like to focus on two elements of banking supervision that Islamic and conventional banking have in common. That is, appropriate levels of risk management and corporate governance, which help to ensure the safety and soundness of the international banking system.

Growth in Islamic finance

As I am sure you heard yesterday and will also hear today, there has been significant growth in Islamic financial services in recent years and there is every reason to expect that this growth will continue at a rapid pace. Clearly, there is expanding demand for these products, and a closely associated desire on the part of banks, including non-Islamic banks, to provide Islamic financial services.

Although it is still modest in size relative to conventional retail banking, Islamic retail banking is rapidly becoming more visible. This is particularly true in the Middle East and Asia Pacific regions, where a number of Islamic banks and banking units have been opened in recent years. There are also Islamic banks and asset managers in key international financial centres of the United Kingdom and the United States.

The growth in Islamic finance is also visible in the expanding range of services and products that comply with the basic precepts of Sharia law. One example is the burgeoning global market interest in Islamic bonds – Sukuks – many of which are increasingly being issued and bought outside the Islamic world. This suggests that non-Islamic investors in general are becoming comfortable with Sukuks. The broadening appeal of Islamic finance is also evident in the move by large international banks and other private sector financial institutions to provide Islamic financial services. This includes the establishment of exchange-traded funds that are screened to ensure their conformity with Islamic investment principles, as well as offering “takaful” – or Islamic insurance.

Although the elements that are usually emphasised at conferences like this are differences between Islamic banking and “conventional” banking, there are some fundamental principles that apply equally to both. For example, I can point to the necessity of strong corporate governance, rigorous risk management and sound capital adequacy requirements as essential ingredients to ensure the safety and soundness of any financial system. The increasing integration of Islamic financial services into the global financial fabric only strengthens this point.

What about risk management and corporate governance?

The issuance of the revised Basel II framework for bank capital adequacy not only improves the risk sensitivity and accuracy of the criteria for assessing capital adequacy, but it is fundamentally about stronger and more effective risk management grounded in sound corporate governance and enhanced financial disclosure. I should acknowledge that the special features of Islamic banking may not always be adequately addressed by broad international standards for conventional banking contained in the Basel II framework. Nonetheless, the IFSB considers carefully the global banking standards that have been and are being developed for conventional banking. The IFSB’s capital adequacy standard, for instance, draws to a large extent on Pillar 1 of the Basel II framework (the minimum capital adequacy requirements). It has also released an exposure draft on the supervisory review process (consistent with the principles of Basel’s Pillar 2) and another on disclosure and market discipline (Pillar 3).

As interest in Islamic finance grows, the importance of the IFSB’s role increases. The importance of the fundamental elements of banking – conventional or Islamic – cannot be emphasised enough. Topics such as corporate governance, risk management and capital adequacy are key elements that underpin sound financial practices. The guidance provided by the IFSB in these areas helps to ensure that there are resilient financial market infrastructures and robust core financial institutions operating according to safe and sound risk management practices. It is important that the same degree of supervisory oversight is applied to Islamic financial institutions, to ensure the continuing acceptance of their instruments and services in international markets and conventional banking systems . In addition, the guiding principles and standards developed by the IFSB are assisting supervisors globally to better understand and supervise institutions providing Islamic financial services.

This is why I am particularly pleased to see the issuance by the IFSB, over the last couple of years, of its capital adequacy standards and guiding principles on corporate governance and risk management. The issuance of these prudential standards and guiding principles helps to enhance the soundness and stability of the Islamic financial services industry and helps fill an important niche, as will the recent exposure draft on market discipline.

The importance of robust risk management systems and corporate governance cannot be overstated. Many of the recent problems that have arisen in the banking industry worldwide, such as losses due to accounting improprieties, low underwriting standards and inappropriate valuation methodologies – particularly when applied to complex financial instruments, are primarily due to poor corporate governance and inadequate risk management. Given these shortcomings, what then are the implications for banks and supervisors?

Risk management

First and foremost, with respect to risk management banks must have policies and procedures in place that enable them to identify, measure, control and report all material risks. Bank management is primarily responsible for understanding the nature and degree of the risks being undertaken by the institution. This was not necessarily the case with respect to subprime residential mortgages, mainly packaged by conventional banks in the United States, which were then securitised and resold as mortgage-backed securities and collateralised debt obligations. Investors at large, and the managements of even some of the largest internationally active banks, did not fully appreciate the risk inherent in the subprime mortgages embedded in the structured securities they had purchased. Instead, many relied too heavily on the credit ratings that the specialised credit rating agencies established for the various branches of the resulting structured products. While Basel II provides a better framework for supervisors to focus discussions with banks on the robustness of their risk measurement and management of complex financial instruments, banks’ risk management systems need to be constantly adapted to better address the effects of innovation in the financial markets and increased complexity and opacity of financial activities in which banks are engaged. While weaknesses in these areas have focused on conventional banking instruments and institutions, Islamic instruments are not immune to them.

Strong risk management is a critical component of a bank’s ability to withstand adverse conditions. And this is certainly as important for Islamic banks as for other types of financial institutions. One element that is essential is comprehensive stress testing that can capture the effects of a downturn on market and credit risks, as well as on liquidity. This helps ensure that banks have a sufficient capital buffer to carry them through difficult periods. In the events of last summer and this autumn, it became clear that many banks’ stress tests did not anticipate the degree and breadth of illiquidity that resonated throughout the credit markets. Stress tests must consider the effects of prolonged market tensions and illiquidity, and must reflect the nature of institutions’ portfolios and realistic assumptions about the amount of time it may take to hedge out risks or manage them in severe market conditions.

Corporate governance

The necessity of a robust corporate governance framework has long been recognised by bank supervisors around the world. Indeed, supervision would not be possible without sound corporate governance in place. Over the years, experience has highlighted the need for banks to have the appropriate levels of accountability, as well as sufficient checks and balances. In general, sound corporate governance effectively addresses the manner in which the decision-making process in the organisation is structured, the respective responsibilities and accountability of senior management and the board of directors, and the control functions that ensure the accuracy of the monitoring processes.

Of course, when supervisors review an institution’s risk management system and corporate governance framework, they must consider the system’s appropriateness in relation to the bank’s size, its risk exposures and the nature and complexity of the financial instruments it deploys.

Market disclosure

I have already noted the IFSB’s exposure draft on disclosure and market discipline that was released for comment late last year. This interest in promoting increased transparency and market discipline is especially important, particularly given the recent difficulties experienced by banks and investors alike with respect to complex structured products. Much of the current turmoil in the credit markets has related to questions about the soundness of certain types of collateralised debt obligations (CDOs) and asset-backed commercial paper. These problems might well have been avoided or at least mitigated if there had been greater transparency both about the products themselves and the commitments made by the banks that originated them. Again, this problem has thus far been concentrated in conventional banks in the key financial countries. A crucial area where more transparency has proved necessary has been in the exposures of some large financial institutions to CDOs of securities backed by subprime mortgages in the United States.

Basel II and the IFSB’s exposure draft on transparency both seek to raise the bar on the quality of financial disclosures by providing clearer industry benchmarks. Enhanced financial disclosure that improves the transparency of banks and complex structured products, valuation, and the measurement of risk exposure can certainly help to improve overall risk management. In addition, requiring enhanced qualitative disclosures will permit all banks to put their quantitative disclosures into better context and assist them in explaining their approach to risk management.

Conclusion

Let me conclude by emphasising that rigorous risk management and sound corporate governance are key elements of any bank’s ability to understand and manage its risks. With the growing importance of Islamic banks and Sharia-compliant financial innovation, it will be increasingly important to ensure sound Islamic financial institutions going forward. Supervisors must work together to encourage all banks to improve their risk management systems, controls and transparency. Such improvements will help ensure the stability and soundness of the international banking system. Thank you very much.

soure : bis.org

Institute of Islamic Banking and Insurance – United Kingdom

logoMission

The mission of the Institute of Islamic Banking and Insurance London is to be a centre of excellence for professional education, training, research and related activities to build a wider knowledge base and deeper understanding of the world of finance promoting the Islamic principles of equity, socio-economic justice and inclusiveness. The Institute is also committed to making contributions, donations and other payments to empower people to improve lives and contribute responsibly in the global community, and to encourage debate on the relationship between ethics, morality and finance in such a manner as the Institute shall from time to time direct.

The IIBI new identity – DISCOVER NEW PERSPECTIVES
IIBI’s new logo represents a more contemporary edge as well as greater visual impact for the brand overall…. more

Background

What was dubbed a “utopian dream” over three decades ago has become a reality in this short period. Islamic banking today is accepted worldwide as an ethical and a viable financial system. It is presently managing funds of over six hundred billion dollars. This is only the tip of the iceberg.

Islamic banking does not only consist of Islamic bodies. Major international financial organisations also are involved. This has led to an active interaction between the two, which is a good omen.

Islamic banking was pioneered with the setting up of two conglomerates:
Dar Al-Maal Al-Islami (DMI) and Al-Baraka. The DMI with its headquarters in Geneva, and Al-Baraka with its headquarters in Jeddah.

Prince Mohammad Al-Faisal was the chairman of the DMI group and Muazzam Ali its vice-chairman.

Ali took up development of Islamic Banking as a mission and remained associated with DMI for 19 years.

Appreciating that the system could develop and progress only if supported by well-qualified personnel, Ali set up the Institute of Islamic Banking and Insurance in London in 1991.

The Institute has come a long way. It is the only organisation of its kind in the west, and has made a significant contribution to the education and training of people in Islamic banking and Insurance through a post-graduate diploma course, publications, lectures, seminars, workshops, research, Shariah advisory services and a highly informative user-friendly web site. The Institute is intending to introduce other courses by distance-learning in 2009, such as a Certificate for beginners and two Graduate Diplomas.

Equal Opportunity
The Institute does not discriminate on the basis of race, class, poverty, colour, culture, religion, national origin, age, gender, sex, disability and sexuality in admission to, access to, treatment in, or employment in its programmes and activities.

Present Activities:

  • A distance learning Post-Graduate Diploma in Islamic banking and insurance.
  • Publication of a monthly journal: New Horizon.
  • Consultancy Services.
  • A program of monthly lectures.
  • An Executive Development Program for middle and senior level banking executives.
  • Endorsing, co-operating and participating in international conferences organised by other bodies in various countries.
  • Publication of books, including an encyclopedia and directories on Islamic finance.
  • Advising and assisting students pursuing Master’s and doctoral study programs in Islamic banking and finance.
  • Membership of the Institute at various grades.
  • Promotion of research and development in the field of Islamic finance.
  • Monitoring developments in information technology, especially relating to finance.
  • Producing an Islamic banking databank on CD-ROM.
  • Answering queries and responding to various inquiries concerning Islamic finance.
  • Serving as a professional club.

Mudaraba-based Investment and Finance

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A.L.M. Abdul Gafoor*

Groningen, the Netherlands

CONTENTS:

 

In any economy, private investment occurs in two different ways: active investment, where one or more persons put their own capital into a project, manage it themselves and enjoy the fruits of their labour and capital themselves; and passive investment, where the investor provides the capital and receives a return but takes no further part in the project.  Broadly speaking, a passive investor has three options: one, buy shares in a company and receive a dividend; two, buy bonds or securities and receive interest; three, deposit in a bank and receive interest.  In an Islamic economy, active investment and the first option are permissible while the last two options would be regarded as riba (interest) income and therefore prohibited.  On the entrepreneur side, he may finance his project using his own capital, by selling shares in his enterprise, or by borrowing on interest (from a bank or by issuing bonds/securities).  In an Islamic setting, the first two methods are permissible while the last is not.  For clarity the scenarios are depicted in Tables 1 and 2.

 

Table 1.  Investment options for capital-holders

Type of investment

Mode of investment

Type of return on capital

Islamic position

Active investment

In own enterprise

Profit or loss from the enterprise

Allowed

Passive investment

Shares in a company

Dividend (profit or loss) from the company

Allowed

Bonds/securities

Fixed positive return (riba)

Prohibited

Bank deposit

Fixed positive return (riba)

Prohibited

 

 

Table 2.  Financing options for entrepreneurs

Type of  financing

Mode of financing

Type of return on capital

Islamic position

Active finance

Own funds

Profit or loss from the enterprise

Allowed

Passive finance

Share capital

Dividend (profit or loss) from the company

Allowed

Bonds/securities

Fixed positive return (riba)

Prohibited

Bank loans

Fixed positive return (riba)

Prohibited

 

 

Both conventional and Islamic systems permit and encourage active investment, which rewards labour and capital from realised profits.  Both also permit and encourage passive investment in shareholder companies, which too reward capital from realised profits in the form of dividends.  In both cases any realised loss is borne by the capital-providers.  But any investment that brings in riba income or financing that involves the payment of riba is prohibited in an Islamic system.  This leaves the Muslim passive investors who cannot or will not buy shares in a company and Muslim entrepreneurs who do not have their own capital or cannot raise share capital but need seed capital and/or additional funds in a difficult situation.  If not for their religious convictions, they would resort to bonds and securities or fixed deposits and bank loans.  Since this category of investors and entrepreneurs form a large section of the Muslim investor-entrepreneur community, it is necessary to address their difficulty.  This essay explores the options available to this group within an Islamic setting.  Participatory Financing explained in the following paragraphs is a system developed to address this special concern of Muslims.  It is based on the ancient concept of mudaraba.

Brief history

Mudaraba is an ancient form of financing practised by the Arabs since long before the advent of Islam.  It suited the Meccan Arabs because of their location at the cross roads of the ancient trade caravans.  They themselves were merchants carrying goods north to Syria in the summer and south to the Yemen in winter.  They took goods from their homeport to sell at their destination, and with the proceeds bought other goods and brought them back to sell at home and/or to re-export to another destination.  When a trading caravan is organised it was the practice of the Meccans either to join it with their own goods and money or to send such through agents who did the business on their behalf.  When a caravan returned home and the goods were all sold, the mission was complete and it was time to prepare the ‘balance sheet’ and calculate the profit/loss. 

Traders who took their own money and goods assessed the success of the mission by the profit/loss they made and enjoyed the fruits of their labour or mourned their loss on their own.  Those who combined their fortunes with that of one or more of their colleagues and undertook the project together had to go one step further and divide the fortune or loss among the partners, according to a pre-agreed pattern.  The rules of this pattern had long been established by custom and had been known by the name musharaka.   The agents who carried others’ goods and/or money had to give accounts to their principals and claim their share of the profit/loss according to a pre-arranged pattern.  This too had rules assigned by custom and was known by the name mudaraba.

When Muhammad (Peace be upon him) began his prophetic mission he did one of three things with regard to the practices of the Arabs:  1) if it involved the denial of the existence or the uniqueness the one God (Allah) or associating anything or anyone with Him or was against any command of God, he prohibited it outright;  2) if it did not involve any such action he did not interfere with it;  3) if some useful or essential practice involved some elements of the first, and if that could be removed, he removed the offending elements and allowed the modified version to be practised.  Mudaraba and musharaka belonged to the second group. 

Nabil A. Saleh in his authoritative and very readable book, Unlawful Gain and Legitimate Profit in Islamic Law (1986), gives detailed descriptions of the rules relating to mudaraba and musharaka, including the differences of opinion in the interpretation of these rules by the later schools of Islamic Law.  A recent (1999) publication by Justice Taqi Usmani is a very useful contribution to Islamic finance.  It is useful to students and teachers of Islamic banking and finance on account of the authoritative definitions given of the terms and concepts used in the field, and because of the detailed explanations and background information provided.  It also describes how these concepts are currently implemented, and points out the shortcomings and gives suggestions for improvements.  Though the present author does not, with all respects, agree with all the suggestions, the book is perhaps a must in the library of every student of Islamic banking and finance.  In it he singles out mudaraba and musharaka as the only true modes of financing.  The others such as murabaha, ijara, salam, istisna are modes of trade which are presently being used as modes of financing. 

Islamic financial institutions assume the role of traders and use the modes of trade but remain financiers.  This metamorphosis is achieved by ‘legal’ documentation and some self-persuasion.  It does not, however, convince many; and the root of the problems faced by Islamic banking and finance today lies in this split personality.  The theme of this article is: let the financiers be financiers, and the traders and entrepreneurs be traders and entrepreneurs. 

Social context: past and present

The Mecca of 1400 years ago was a small city (of possibly a few thousand inhabitants), practically everyone of any significance was known to everyone else, and the assembling of a trade caravan was a great public event that took place twice a year.  The Who’s Who? of the financiers and the agents, their character and abilities, who took what, what was sold for what price, what was bought for what price and the sale price were all public knowledge.  There was little room for misbehaviour and the price for it in terms of social ostracism was very high. 

Today, in the modern world, especially in large cities, practically everyone is a stranger to his neighbour.  Financial affairs are strictly private.  Who has money, who needs it, and to do what are all generally unknown to any other.  But the bank has become privy to this information, including the amounts, and has established itself as an intermediary between the owner of funds and the entrepreneur who needs it. 

The reality today is that there are many capital-holders who wish to earn an income from their capital but have neither the time nor the skills necessary to embark on a project.  They may range from simple wage earners who have saved some money, pensioners, widows or orphans who have received a lump sum payment, trusts and institutions with whom some capital has been entrusted, to insurance companies and individuals who have inherited a fortune.  The size of their capital too may vary from hundreds and thousands to millions.  They need to invest their capital in a profitable undertaking, but may not know any entrepreneurs who wish to embark on a project and are looking for financiers.  Even if they find one they may not have the necessary skills to assess the viability of the project or the ability and integrity of the entrepreneur.  On the other hand, entrepreneurs who have viable project proposals may not know those who have the required funds and are willing to invest in their projects. 

This is where, in the context of the present-day, the need arises for a financial intermediary who could bring the investor/financier and the entrepreneur together.  Conventional banks do perform this role very effectively and efficiently.  Capital holders deposit their funds with the bank, and entrepreneurs submit their project proposals to the bank, the bank examines the business plan and if it is satisfied that the project could bring in sufficient income to allow the repayment of the principal and interest, and provided sufficient collateral is also available, the bank advances a loan.  The bank does not get involved in the project; whether the entrepreneur/borrower makes a profit or loss he pays the principal and interest on due dates, or the bank has recourse to the collateral.  The bank accepts the depositor’s capital, guarantees its full return, and pays him an interest (or return on his ‘investment’) at a fixed rate, and uses the capital to grant loans to borrowers.  But the interest rate given to the depositor is always smaller than the rate the bank charges the borrower, and the difference goes to cover its own expenses and profits. 

This seems to work very well if people have no qualms about paying or receiving interest, despite the built-in injustice to both the entrepreneurs and the depositors.[1]  But some people are beginning to have qualms, and Muslims are prohibited from earning an income in this fashion.[2]  Islamic banking is a response to their concern ¾ an alternative method to address the need, minus the injustice. 

Islamic banking

Mudaraba is essentially an agreement between a financier and an entrepreneur the principals.  However, taking account of the modern social structure and context, the pioneers of Islamic banking brought in an intermediary between the principals and created a two-tier mudaraba.  This modified form of mudaraba was introduced into conventional commercial banking in the form of profit-and-loss-sharing (PLS) investment accounts and financing arrangements.  The earned profit (which is an uncertain and unpredictable return on capital) was to replace the interest (a pre-determined fixed return) in the conventional setting.  This, however, was not acceptable to the conventional banking authorities.  Therefore, except in a few countries where rules were relaxed or special banking laws were enacted, it was not possible to establish and operate Islamic banks in most countries of the world.  In such countries Islamic financial institutions, which did not come under deposit bank regulations, were introduced.  In both cases, while the deposit/investment side worked on mudaraba basis, mudaraba was only one of several modes used for financing.  Though a preferred one in theory, in practice it became one of the least used.  The most used forms are modes of trade, and this has led to questions of morality and ethics.   In addition, Islamic banks are unable to provide all the financing services expected of a commercial bank.[3] 

One of the very serious consequences of using modes of trade as modes of financing is that Islamic financial institutions are confined to financing short-term trade, and are unable to finance long-term projects in industries, agriculture, services, etc.[4]  The latter are equally important, if not more, to any country except perhaps for some few raw materials exporting countries which import all other products.  But this situation too cannot continue for long.  Many, including Dr. Ali Yasseri in a recent (August 2000) article, cry out for a new approach.  The question is: is there a viable alternative methodology?   A comprehensive new methodology has been developed in a series of three books published in the last few years, and an overview of the salient features of the new approach is given in a recent publication.[5]

The author argues that, “In Islam, there is a clear difference between lending and investing ¾ lending can be done only on the basis of zero interest and capital guarantee, and investing only on the basis of mudaraba.  Conventional banking does not ¾ and need not ¾ make this differentiation.”  But a system catering to Muslims “has to take this into consideration” and “…provide for two sub-systems ¾ one to cater to those who would ‘lend’ and another for those who wish to invest.”  The first sub-system would cater to those who wish to put their money into a bank for safety and transaction convenience; and the bank would provide all current account facilities and short-term loans and advances.   This is explained in a 1995 publication ¾ Interest-free Commercial Banking.  The 1996 publication ¾ Participatory Financing through Investment Banks and Commercial Banks ¾ describes the second sub-system, where both investment and financing are strictly on the basis of mudaraba.    Though the title mentions only banks, the methodology can be used by investment companies as well.  In this article we propose to bring out the salient features of the second sub-system.[6]

[In the present era inflation is an important consideration where money is involved, and this has serious consequences in a riba-free system.  An attempt at dealing with it in the context of banking and finance is presented in the third book: Commercial Banking in the presence of Inflation (1999).] 

Participatory financing

The central idea in the concept of mudaraba is that two parties, one with capital and the other with know-how, get together to carry out a project.  The financier provides the capital and plays no further part in the project; specifically, he does not interfere in its execution, which is the exclusive province of the entrepreneur.  If the project ends in profit they share the profit in a pre-arranged proportion.  If it results in loss the entire loss is borne by the financier, and the entrepreneur gains no benefit out of his effort, which was his part of the investment.  There are many variations of this simple model but this is the basic concept.  Mudaraba is usually translated as profit-and-loss-sharing but, as far as the financier is concerned, it is in fact profit-sharing-and-loss-absorbing. 

In participatory financing, as envisaged in the present discussion, there are three important additions to this basic concept.   One, there are many investors and many entrepreneurs.  Two, an intermediary comes in with whom investors deposit their funds and the intermediary finances projects put forward by entrepreneurs.  In this investors-intermediary-entrepreneurs triangle, the investor is essentially a sleeping partner.  He provides capital and then shares the profit or absorbs the loss.  It is the responsibility of the entrepreneur to present a good proposal, convince the financier that it is viable and profitable, and provide proof that he is able, qualified and experienced to carry out the project successfully.  The intermediary is both an entrepreneur and a financier.  When he accepts funds from an investor, he is an entrepreneur; and when he finances a project submitted by an entrepreneur, he is a financier. 

Three, individual investors and individual entrepreneurs have no direct contact/relationship with each other.  The investor does not know which project is financed by his capital, and the entrepreneur does not know whose money is financing his project ¾ a pool of funds from several investors finances a series of projects from several entrepreneurs.  When it comes to profit/loss sharing too it is the net profit/loss from all the projects that is shared among the investors (and the intermediary).  The individual entrepreneur, however, shares with his financier (the intermediary, in the first instance) the profit/loss from his own project only.

It is appropriate at this point to state that in the above scenario, the financiers ¾ both the investors and the intermediary ¾ operate purely on the basis of mudaraba while the entrepreneur is free to choose any mode of practice (such as murabaha, ijara, salam, istisna, etc.) appropriate to his trade, business, industry, agriculture, etc. to run his enterprise.  Thus the proposed method simply avoids the need to devise dubious “financial instruments” which have brought the very concept of Islamic banking and finance into disrepute.  This also nullifies the need for “Shari’a Boards” in these institutions.

Another important characteristic of ancient mudaraba was that it was a one-project, time-limited contract.  That is, the contract (between the two principals) began with the assembling of a particular caravan and ended with its return — each new caravan started with new contracts, whether with the same partners or with new ones.  Today no trade caravans ply between distant lands, assembling anew and dismantling each season; but businesses, industries and all kinds of other enterprises are established and run on a long-term basis.   Therefore, in the modified version this time-limited, single-project characteristic has also been removed.  This enables the basic concept of mudaraba to be applied to all kinds enterprises on a long-term basis. 

The function of the intermediary is very important.  He is responsible for identifying good projects for financing as well as for monitoring their progress and ensuring proper accounting and auditing.  But he (the intermediary) plays no part in managing the project or in making policy decisions — that is the exclusive domain of the entrepreneur.  The intermediary is a separate physical and legal entity, independent of both the investors and the entrepreneurs.  But he (she/it) is an equal partner in every project he finances so that he has full legal right to the physical and financial assets of all the projects and has full access to all the books.  This is very important, and it is here that participatory financing differs from conventional financing practices; in this respect it differs from the current practices of Islamic banks too.  This allows the intermediary to have a true picture of the health of the projects at all times.   He can then take any preventive or corrective action (in extreme cases), and, in the event of failure of a project, he can recover whatever is left of it.  This possibility gives assurance to the investors that their investment is safe, albeit within limits which they are aware of, and that the profit and loss account given to them is reliable and transparent.  The fact that the investors’ confidence in the intermediary and the intermediary’s own profit depend on the number and size of successful projects should ensure that the intermediary seeks out good projects and closely monitors their progress.

One important feature of participatory financing is that the entrepreneur need not provide security for the financing he receives.  The project itself is the security, and the intermediary, being an equal partner in the enterprise, is its guardian.  This should play a very constructive role in discovering and developing new entrepreneurial and other talents in the society, especially at the micro level, otherwise unearthed on account of the unavailability of collateral/security.

The proposed scheme provides for two types of investments: one called Participatory Financing (PF) stocks and the other PF shares.  These are essentially stocks and shares in the intermediary’s PF scheme (which is a collection of all (or a group of) the projects financed by the intermediary).  PF shares correspond to unit shares because every PF share contains a tiny portion of every project in the scheme.  PF stocks roughly correspond to fixed deposits in a bank.[7]  The main difference between the conventional fixed deposits and the PF stocks is that the return in the latter is computed from the profit and loss statements of all the projects in the PF scheme (and the profit/loss shared among the participants) at the end of the accounting period.  Therefore the profit/loss is a realised one, and not an anticipated or pre-fixed one.  Thus neither speculation, nor uncertainty, nor riba is involved in the operation.  But the PF stockholders will have to wait till the end of the accounting period to collect their returns.

The status of each of the three participants in this scheme is as follows.  The intermediary (an investment bank or an investment company) is a holding company with the legal status of a (public) limited liability company.  The investor may either hold a PF Share or a PF Stock.  The PF shareholders are like ordinary shareholders in the holding company’s PF scheme.  The PF stockholders are like the time-deposit holders in a bank.  Each project is a partnership limited liability company where the entrepreneur and the holding company are the two partners.  PF shares provide the equity capital for the PF projects, while the PF stocks cater to the short-term cash requirements (which are normally met by loans and advances from commercial banks).

In essence, participatory financing combines features of time deposits, business organisations (partnerships, shareholder companies and holding companies), and unit trusts on the one hand, and equity capital and commercial bank loans and advances on the other.  It makes use of well-known rules and techniques of financing, company laws and accounting procedures.  That makes it easy to implement, but the combination of all these in one single system within an entrepreneurial environment is a new formulation.  That makes it a challenging one, requiring new attitudes and a comprehensive approach.  We will briefly touch on these issues in the next section. 

The theory of participatory financing has been fully developed and presented in the book.  The depth of the theory can be gauged from the details given in the appendices, one of which is reproduced below (with slight explanatory modifications to suit this article) to help better understand the system.

Issues in implementation

The implementation of this system requires the cultivation of new attitudes on the part of all the participants.  This is a tall order but is an absolute necessity if we are to create a truly riba-free economy.  It requires more from each participant, but it also offers more both to the individual and to the society as a whole.  From the investor it requires the full understanding that he/she/it may incur loss and that he will have to wait longer to know the results, but it promises a truly riba-free income and possibly better profits.  From the entrepreneur it requires complete and accurate bookkeeping and full disclosure of all his/her/its accounts and the sharing of his bounty with his financiers, but it provides him with capital without collateral and the guarantee that in case there is a loss he will not be required to make it up, provided he had been honest in his dealings and his books will substantiate it.  The intermediary is both a banker and an entrepreneur.  As an entrepreneur, he too is required to be honest in his dealings, and accurate and transparent as to his bookkeeping and accounts. 

Bankers are trained to be very cautious, because their first concern is to guarantee the safety of the funds deposited with them.  But in this system they are relieved of that concern because the investors have agreed to take the risk, and therefore if they persist with the banker’s attitude they will miss many opportunities at the investors’ expense.  On the other hand, too much adventurism can bring about low profits or even loss, and that may lead to the loss of customers.  They must have an entrepreneur’s natural talent to spot profitable projects and to avoid bad ones, and should develop it into a professional tool.  The intermediary’s staff will have to be carefully picked and trained to bring out inherent entrepreneurial talent.  Such intermediaries will have ample reward, as they will share in the profits.  It requires a new culture, a culture of entrepreneur-financiers and of professionally run partnership companies. 

The system is heavily dependent on proper and accurate bookkeeping, accounting and auditing.  That requires the availability of trained bookkeepers and their wide use, as well as professionally responsible and well-trained accountants and auditors.  They are the bedrock of the system.  The system requires a high level of integrity from these personnel, and it is in the interest of all the participants in the system to respect it.  Substantial investment is necessary in the training of such personnel, and legal protection is necessary to safeguard the independence of the auditors. 

The comprehensive system presented in the four books groups the entire spectrum of business activities into three broad categories: at one end is the one-man-owned-and-operated small enterprises, including the ones financed or supported by loans and advances from commercial banks, and at the other end are the large enterprises financed entirely by shareholders and managed by professionals.  In between are the proposed participatory-financed enterprises.  The size of the enterprise is an important factor in this categorisation, and the type of financing and the type of organisation must generally match the size.  Presently in all developing countries ¾ to which group most of the Muslim economies belong ¾ the distribution is highly skewed towards the smaller end.  To achieve a better and stable economy, it is necessary to bring about a more even distribution. 

The mudaraba principle is applicable to a range of situations, from a simple local two-person partnership to a multiparty international corporation.  A shareholder company works essentially on the mudaraba principle.  But the participatory financing scheme envisaged in this article aims at the middle section of this range. It brings in the intermediary, and provides the investors with a unit trust type of investment opportunity.  The scheme is ideally suited to medium scale new enterprises.  However, it is possible to modify it slightly and bring in some of the running businesses too into the participatory financing system.  This will help expedite bringing about the even distribution mentioned earlier. 

This can be done as follows.  There are two possibilities.  One, the enterprise is a running business and has no debts, and wishes to expand its activities.  In this case, first the present worth of the enterprise (property, equipment, stocks, receivables, etc. including goodwill) must be determined.  This is the capital of the enterprise in monetary terms.  The investment bank/company brings in the necessary additional capital, and both go into a partnership (preferably by establishing a new private limited liability company) as before.  However, in the present instance the original enterprise has two roles, as an entrepreneur and as a financier, while the investment bank/company is only a financier.  Accordingly, when the profit/loss is computed, the financiers (both the enterprise in its role as a financier and the investment bank/company) will first share the profit/loss with the “entrepreneur” on mudaraba terms.  Next, the two financiers will share the financiers’ share between themselves in proportion to their capital contribution.  Finally, the bank/company will credit its share from this project to the bank/company’s PF pool of profit/loss.  The procedure from here on is the same as previously described.

Two, the enterprise is a running business and has debts owing to, say, a commercial bank.  In this case, the investment bank/company will pay up all the debts and go into partnership with the enterprise, as in the first case, with this amount as its capital contribution.[8] 

In establishing the new institution of mudaraba-based investment and finance, using the participatory financing scheme as described above, it is preferable to start with medium size running businesses.  This will provide a stable base for the new institution to test the theory and to gain experience.

Conclusion  

In order to bring about a riba-free economy, the country’s banking system has to be riba-free, its commercial enterprises have to be financed by equity capital, and its investments have to be on a profit and loss sharing basis.  This article has dealt with investment and financing, and has introduced a mudaraba-based system called participatory financing that takes into account present-day realities.  This is a new institution specifically developed to address the concerns of Muslims.  It has no parallel in the conventional economy, but the individual tools and techniques it uses are ones tested and proved in the conventional setting.  Thus, while re-invention of the wheel has been avoided, proving the viability of the new institution and benefiting from it are challenges specific to Muslims.  It is for the Muslim intellectuals, professionals, investors, entrepreneurs, and other concerned individuals, institutions and organisations to take up the challenge.

*******

 

Appendix

Terms and procedures relating to PF stocks and shares

 

In this appendix we present working definitions of some terms and procedures, which can be used as a basis for the development of an operational model.  The main purpose here is to indicate the many issues that should be addressed in devising such a model.

The definitions of stocks and shares have not remained unchanged over time, the distinctions have become blurred, and they have acquired different meanings and connotations in different countries.  For example, what were known as stocks in the UK are now bonds in the USA, and shares have become stocks.  The stocks and shares under the PF scheme have much in common with the original British definitions of the terms, but they have also some special characteristics of their own.  Therefore we have to define what we mean by PF shares and PF stocks.

1.  PF Shares

Participatory Financing Shares are ordinary shares in the “company”, which consists of all the PF projects the bank[9] is currently financing or hopes to finance in the near future.  Funds obtained by selling new PF shares are to be used as venture capital for new projects.  On account of the fact that every project will have a gestation period, the “company” will not be able to post a profit or loss statement on these projects until they become operational.   Therefore PF shares cannot expect to earn a profit or loss during this period.  However, since different projects will have different gestation periods and because the PF shares are not directly connected to any particular project, we have to find a way of saying when a PF share begins to earn a profit or loss.  One way of doing it is for the bank to determine a common average gestation period for the projects expected to come under the PF scheme and to announce this period when the PF shares issue is advertised.  The shares will not earn any profit or loss in this period of, say, one to three years.  The PF shares will mature at the end of this gestation period.  And all mature PF shares will be entitled to a share in the profit/loss of all the operational projects of the “company”.   The “dividend” on these shares is determined on the basis of the net returns of all the PF projects of the “company” operational during the bank’s accounting period, say, annually. 

Profit and loss accounting is done at the end of the year. Therefore the final “dividend” awarded to PF shareholders is a realised profit/loss and not an estimated or pre-fixed one.  Hence there is no room for uncertainty, speculation or riba.  This is very important.

PF shares are transferable and have no termination points.  PF shares will also have a stake in the assets of the projects.  However, since the investors have no direct connection with any particular project, the claims of the PF shares are on all the projects of the “company”.  Thus, if, for example, a project ends and the assets are sold off or the bank sells off its shares in a project (perhaps to the entrepreneur or to an outside investor) the proceeds from such sales will accrue to all the PF shares of the “company” (providing interim dividends, additional PF shares or increasing their value).

Whether the PF shares are issued periodically, as and when necessary or are available throughout the year, are all operational concerns and are matters for individual bank’s decision. The bank may also consider issuing separate shares to different groups of projects.  In this instance each group will come under the purview of a separate “company”.

2.  PF Stocks

Participatory Financing Stocks are funds deposited with the bank for a fixed period of time, to be invested in their Participatory Financing projects.  The return on these investments are determined on the basis of the net returns of all the PF projects of the bank operational during the bank’s accounting period, as computed at the end of that period.  And the bank will use these funds mainly to advance further credits to operational projects.  In effect, PF stocks are like fixed-term deposits except that neither the capital nor the return are guaranteed or fixed in advance.

The special characteristics of the PF stocks would be that: 1) PF stocks will not bear any fixed rate of return or interest, 2) the return will be determined at the end of each accounting period, and no attempt will be made to make any estimates in advance, 3) PF stocks are for a defined period, but they may be reinvested for another defined period, 4) PF stocks have no priority claims over PF shares, and 5) PF stocks share in profit and loss, but they have no claims on the assets of the projects.

3.  PF Projects, the PF “Company” and profit/loss sharing

Now we have to explain what we mean by projects and the “company” in the foregoing paragraphs, in the context of participatory financing.  Also how the profit/loss from the projects is shared among the participants.

3.1  PF Projects

Each PF Project is an independent business entity whose legal status in the eyes of the Company Law may be a private limited liability company.  The project can be anything from a large manufacturing concern to a small medical laboratory.  There are two main and essential partners in each project: the participate-financing bank and the concerned entrepreneur.  The entrepreneur is the active partner and the bank is the “sleeping” partner. 

3.2  PF “Company”

The PF “company” is an internal arrangement within the bank in order to keep PF funds and profits separate from the bank’s own capital and profits.  Thus the PF “company” consists of all the PF projects of the bank and all the PF investors whose funds are financing these projects.  When the bank has more than one group of projects, each group (with its own investors) will form a separate PF “company”. 

3.3  Profit/loss sharing

The net profit/loss of each PF project operational during the accounting period is obtained from its Profit and Loss accounting statement.  Each PF project is a mudaraba partnership with the bank as the financier.  Therefore, if there is profit it is shared between the bank and the entrepreneur according to the pre-agreed proportion.  If there is loss, the entrepreneur neither receives nor pays anything, while the bank takes the entire loss.  This is the first stage of the profit/loss sharing process.

The PF “company” consists of all the PF projects of the bank.  Therefore the total net profit/loss of the “company” is obtained by summing up the bank’s share of the net profit/loss from all the individual projects.   

Two observations need be made here.  1) All the projects – both profit-making and loss-making – will have their capital investment intact, because the loss of the loss-making ones would be made up by the financier (this is the meaning of loss absorbing) using the profits accruing to the “company” from the profit-making projects.  This means that the value of the PF shares of the “company” will remain unaffected at this stage.  2) Since fewer projects are expected to make loss, the net result for the “company” is likely to be positive.  However, there is always the possibility that the net result can turn out negative. 

The next stage is the sharing of the net profit/loss of the “company” between the bank and the investors.  Their relationship is also a mudaraba partnership.  But here the investors are the financiers and the bank is the entrepreneur.  Hence when there is a profit it is shared between the bank and the investors according to the pre-agreed ratio.    If there is loss it is absorbed entirely by the investors – PF shareholders and PF stockholders – and the bank pays or receives nothing.  The investors’ share of the “company’s” profit/loss is the PF dividend, and it can be positive or negative.

4.  PF Dividends

The “dividend” we have been talking about has one major difference as compared to other conventional company dividends.  Unlike them, as seen above, the PF dividend can be positive or negative.  This needs some explanation, but it is important to note the difference.  Its computation and disbursement are also different.  Therefore we will examine them below in some detail.

4.1  Disbursement

The entire net profit or loss of this “company” will be first distributed as “dividends” to all mature PF shares and all the PF stocks immediately after the announcement of accounts.  If the outcome is a net profit, it will be credited to the account of the shares and stocks.  No part of this profit will be held back at this stage for future investment or as buffer against future losses.  That is, there is no retained profits or reserves at this stage.  If the outcome is negative, it will, similarly, be debited from the account of the shares and stocks.  This is necessary because in the PF scheme both the stocks and shares participate in the profit/loss of the enterprises, unlike in the case of conventional companies where only the shareholders participate in the company’s profit/loss while the stockholders’ (preference shares, bonds, debentures, etc.) capital and return are guaranteed.  Otherwise, if, for example, some (or all) of the profits were held back, the PF shares would rise in value at the expense of the profits of PF stocks.  On the other hand, if a loss is realised and it is compensated by previously held profits, the PF stocks will escape loss at the expense of PF shares, which will fall in value. 

However, while the PF shareholders and the PF stockholders will be treated equally in the computation of their “dividends” they will find themselves in different situations when it comes to the disbursement of it.  If the “dividend” is positive the PF stockholder will find his capital increased; but decreased if negative.  He is free to do what he will with his capital — reinvest it or take it away.  On the other hand, the PF shareholders may not be so free.  For the bank may decide to retain all or part of the “dividend” due to them.  If the “dividend” was positive and part of it is held back, they will receive some profit out of their investment and, at the same time, the value of their shares would rise.  If negative, they would receive no profits and, in addition, their shares would fall in value.

4.2  Computation

The net profit/loss of each PF project operational during the accounting period is obtained from its Profit and Loss account.  The total net profit/loss of the “company” is obtained by summing up the profit/loss of all the individual projects.   So far so good.  The problem is how do we distribute the profits among the shareholders and stockholders?  Do the stocks and shares have equal standing?  Suppose the answer is yes, then what is the relationship between a stock and a share?  Are they counted in terms of units or in terms of currency?  Some meaningful solution has to be found.

One way of doing it would be to first count the stocks in terms of units as we do of the shares, and equate one unit of stock to one unit of share.  Then every unit of stock will earn profit/loss the same as one unit of share.   Now how do they stand in terms of currency?  Is the price of a stock the same as that of a share?  Which price are we talking about?  The nominal value of a share, its market value or its book value?   Without going into the details of why the former two are not quite suitable, let us settle down for the third — the book value of a share — and see how this can be computed and fixed in advance.

When the annual (or quarterly, half-yearly) account is made up and the “dividends” are disbursed, the shares of the “company” will have a book value as at the beginning of the next year.  The price of one stock in that year can be fixed equal to this book value of one share.  Thus the stocks in the “company” will be sold in integer multiples, their unit price will be the same throughout the current year (or accounting period), and every unit of stock will earn the same “dividend” as a unit of share.  The price of a stock, however, may vary from year to year depending on the performance of the “company” but will be equal to the book value of the share at the beginning of the year and will remain the same throughout that year.

Consequently, as far as the computation of “dividend” is concerned, the company has a total of this many units of “shares” and the “dividend” per unit is obtained by dividing the total net profit/loss of the “company” by this number of “shares”.   This “dividend” per unit is then the same for both PF shares and PF stocks.

5.  Inflation and value erosion of capital

Inflation is currently a fact of life and it erodes the value of capital as time passes.   Since the capital involved in Participatory Financing projects are long-term investments we have to take into account the value erosion of capital in computing profit/loss. Considering the space and time limitations, we need to mention here only that the value loss of the project’s capital due to inflation will be separately computed (using the methodology described in the third book, Gafoor (1999)) and deducted from the project’s gross profit/loss and credited to the project, before the resulting net profit/loss is shared between the financier (the bank) and the entrepreneur.   Thus the capital of the enterprise will be restored to its original real value at the end of each accounting period.  This also means that the paid out dividend would seem less, because it will not include the amount eroded from the value of capital, but the value of the PF shares will appreciate in monetary terms.   The rationale for this approach is presented in Chapter 5 of the second book, Gafoor (1996). 

 

*****

 

 

References

 

1.       Ahmad, Ausaf, Contemporary experiences of Islamic banks: a survey.  In: Elimination of Riba from the Economy.  Islamabad: Institute of Policy Studies, 1994. pp.369-393.

2.       Gafoor, A.L.M. Abdul, Interest-free Commercial Banking.  Groningen, the Netherlands: Apptec Publications, 1995.

3.       ¾¾ , Participatory Financing through Investment Banks and Commercial Banks. Groningen, the Netherlands: Apptec Publications, 1996.

4.       ¾¾ , Commercial Banking in the presence of Inflation.  Groningen, the Netherlands: Apptec Publications, 1999.

5.       ¾¾ , Islamic Banking and Finance: Another Approach. Groningen, the Netherlands: Apptec Publications, 2000.

6.       Saleh, Nabil A., Unlawful Gain and Legitimate Profit in Islamic Law.  Cambridge, UK: Cambridge University Press, 1986.

7.       Usmani, Taqi M., An introduction to Islamic Finance.  Karachi: Idaratul Ma’arif, 1999.

8.       Yasseri, Ali, Islamic banking contracts as enforced in Iran: Implications for the Iranian banking practices.  Paper presented at the Fourth International Conference on Islamic Economics and Banking, held at the Loughborough University, UK, August 13-15, 2000.

 

 

© A.L.M. Abdul Gafoor 2001

January 2001.

Revised October 2001

 

Note: 1. A shorter version of this article appears in New Horizon (the monthly publication of the Institute of Islamic Banking & Insurance, London), Issue no. 119, July 2001.

 

Note: 2. A modified version of his article is also to be presented at The First International Conference on: The Role of Islamic Banking & Finance in Socio-economic Development & The Introduction of Innovative Financial Instruments, 29-30 October 2001, Kuala Lumpur, Malaysia.

Developing Islamic money market

Interest-free liquidity management is the major concern for Islamic banks. The State Bank of Pakistan (SBP) requires Islamic banks and conventional banks to maintain the same Cash Reserve Requirement (CRR) of five per cent and Statutory Liquidity Requirement (SLR) of eight per cent.

Islamic banks can hold their required reserver in special current accounts with SBP or with the National Bank of Pakistan. Any return on these accounts is the absolute discretion of the SBP. Recently, the SBP has introduced new SLR policy for the Islamic banks allowing them to invest in Wapda Sukuk but not exceeding five per cent of their investment potfolio.

Efforts are being made since 1979 to Islamise the financial system for which . the SBP initially introduced 12 Islamic modes of financing to replace interest-based instruments. The Council of Islamic Ideology (CII) in a separate report in 1980 advised the SBP to replace the money market discount rate with the arrangement whereby the SBP would be empowered to finance the banks on profit and loss sharing basis. Among other recommendations one was to set up interest-free ‘common pool of funds’ on cooperative basis to replace the existing interest bearing government securities.

The SBP initially took drastic steps towards the development (and implementation) of financial instruments based on Islamic principles. Later the whole process came to a standstill. No effort had been made towards the elimination of interest from inter bank transactions; inter-government transactions and foreign currency accounts.

Pakistan has witnessed the second wave of Islamisation of financial system since 1999. This time the Supreme Court of Pakistan asked the government to take steps towards the elimination of interest from the economy. A meeting held under the chairmanship of the president of Pakistan decided to allow Islamic banks to operate parallel to conventional banks. In addition, conventional banks were also allowed to offer Islamic banking services through dedicated Islamic windows.

Now, six Islamic banks and 13 conventional banks with a total network of 200 branches offer Islamic banking products and services. In addition, non-bank financial institutions such as Islamic Mutual Funds, Takaful companies, Mudaraba companies, House Building Finance Corporation etc. are also the active participants. Efforts are also been made for the development of Islamic Sukuk (bond) market. Islamic banking is targeting to capture 10 per cent of the total financial sector in the years to come.

Islamic banking is asset-based banking. History proves that assets prices increase with the increase in GDP while the interest rate decreases at the same time. In other words, interest rate and the assets prices have inverse relationship with each other. Concerns are raised then how can the Islamic money market operate as efficiently as the interest based money market under the current parallel banking concept. Here an attempt has been made to develop a conceptual framework to address this important issue.

Conventional banks operate under the concept of lender-borrower relationship where interest is considered as the rental income on capital. The depositors are assumed to be capital providers. Profits of the banks are distributed at the discretion of the bank managements.

But the Islamic banks follow the concept of Mudaraba (profit sharing) based on investor-entrepreneur relationship. Here Islamic banks consider depositors as entrepreneurs. The profits generated through this relationship are divided between the two parties as per agreed ratio.

Further, researchers divide Islamic bank customers into three broader categories (a) religiously motivated customers (b) high profit motivated customers (c) customers who are religiously motivated but also expect returns at least similar to conventional banks. Customers of second and third categories generally dominate in terms of numbers in any Islamic bank. They expect returns on deposits similar to conventional banks.

In the money market, the main objective is to meet short-term liquidity requirements. The market facilitates banks with deficit in cash to borrow from the banks having surplus money. Islamic money market conducts a similar function of meeting the short-term liquidity needs. Instead of interest, it allows Islamic banks to share surplus capital on profit -sharing basis.

Islamic and conventional money markets can be assumed to offer similar returns on investments. Low returns in Islamic money markets may badly affect the overall profitability of Islamic banks in the initial stages of their development. Even if, Islamic money market offers returns higher than conventional market, the Islamic banks may still not enjoy an advantageous position.

The present parallel banking set-up allows conventional banks to transact in the Islamic money market through their separate Islamic branches and earn returns equal to Islamic banks. Existing Islamic banking arrangement thus puts Islamic banks in a disadvantageous position as they would transact only in the Islamic money market. But at the same time, other banks through their Islamic and conventional branches can deal in both Islamic and the conventional money markets. The scenario leaves the SBP with no option but to manage the Islamic and conventional money markets returns at the same level.

Special attention should also be paid for developing Islamic money market instruments to meet the liquidity requirements plus to match the current market financing rates on constant basis. Current available Islamic financial instruments are either long-term or fixed in nature which create funding mismatch problem.

At present, Islamic banks use short- term deposits on variable rates to finance medium and long-term projects. The situation leads Islamic banks either to maintain high liquid ratios or to avoid long-term financing that can affect the overall profitability.

Various Islamic countries have developed Islamic money market instruments under the concepts of Wakala (agent), short-term Sukuk (bonds), and securitisation of assets etc. There are many others short- term instruments which are acceptable in one Muslim country but are subjected to some restrictions in other Muslim countries— especially those issued under the concept of buy-back agreements and Bai Al-Inah (sale of debt).

Likewise, Islamic money market is also facing serious research deficiencies in the area of oversight of financial instruments. Innovations are needed to facilitate Islamic banks to manage their liquidity gap as efficiently as the conventional banks.

By Dr Ahmad Kaleem
The writer is an Associate Professor at Lahore School of Economics, Lahore.
source : dawn.com

Islamic Banking: Problems and Prospects

Definition:

An Islamic Banking is a financial institution that operates with the objective to implement and materialise the economic and financial principles of Islam in the banking arena.

The Organisation of Islamic conference (OIC) defined an Islamic Bank as ” a financial institution whose statutes, rules and procedures expressly state its commitment to the principles of Islamic Shariah and to the banning of the receipt and payment of interest on any of its operations.”

According to Islami Banking Act 1983 of Malaysia, an Islamic Bank is a “company which carries on Islamic Banking business……. Islamic Banking business means banking business whose aims and operations do not involve any element which is not approved by the religion Islam.”

Objectives:

The objective of Islamic Banking is not only to earn profit, but to do good and bring welfare to the people, Islam upholds the concept that money, income and property belong to Allah and this wealth is to be used for the good of the society.

Islamic Banks operate on Islamic principles of profit and loss sharing and other approved modes of Investment. It strictly avoids interest which is the root of all exploitation and is responsible for large scale inflation and unemployment.

An Islamic Bank is committed to do away with disparity and establish justice in the economy, trade, commerce and industry; build socio-economic infrastructure and create employment opportunities.

History and Present Status of Islamic Banking around the World

The History of Islamic Banking :

The History of Islamic Banking could be divided in to two parts. First When it still remained an Idea, Second-When it become a reality-by private initiative in some counties and by law in others.

Islamic Banking as an Idea :

The scholar of the recent past in early fifties started writing for Islamic Banking in place of Interest Free Banking. In the next two decades Islamic Banking attracted more attention.

Early seventies saw the institutional involvement. Conference of the Finance Ministers of the Islamic Countries was held. The involvement of institutions and Government led to the application of theory to practice and resulted in the establishment of the Islamic Banks. In this process the ‘Islamic Development Bank (IDB)’ was established in 1975.

The coming into being of Islamic Banks:

The first private Islamic Bank, the ‘Dubai Islamic Bank’ was also set up in 1975 by a group of Muslim businessmen from several countries. Two more private banks were founded in 1977 under the name of ‘Faisal Islamic Bank’ in Egypt and Sudan. In the same year the Kuwaiti Government set up the ‘Kuwait Finance House’.

In the ten years since the establishment of the first private commercial bank in Dubai, more than 50 Islamic Banks have come into being. Though nearly all of them are in Muslim countries, there are some in Western Europe as well : in Denmak, Luxembourg, Switzerland and the UK.

In most countries the establishment of Islamic banking had been by private initiative and were confined to that bank. In Iran and Pakistan, however, it was by government initiative and covered all banks in the country. The Governments in both these counties took steps in 1981 to introduce Islamic Banking.

 

Problems being faced by Islamic Banking in the world in general

Most of the Islamic Banks operate on Bai- Murabaha, Bai Muazzal, Bai- Salam, Istisna, Hire Purchase/ Leasing mode of Investment i.e. Islamic Banks always prefer to run on markup/ guaranteed profit basis having Shariah coverage. For this reason some times the conventional Economists and General people failed to understand the real difference between Islamic Banking and conventional Banking.

Mudaraba and Musharaka modes of Investment are ideal but Islamic Banks are not going in these two modes, the reasons for the above are as follows:

i) There is no systemic analysis and research and no real efforts to introduce above mentioned two modes but the practitioners blame the following factors:-

a) There is lack of committed entrepreneur

b) There is lack of committed professional who can create new

c) instruments.

d) There is lack of committed sponsors who can pressurize the professionals

e) There is shortage of skilled professionals.

2. The problem of forward contact/booking of foreign currency.

The value of US Dollars ($), Pound Sterling, Euro and others are not fixed in Bangladesh, they are fluctuating from time to time Most of our imports and exports are made in USD and USD being a strong currency always moves upward and the exporters are in better position than the importer in our country. In Bangladesh Forward Booking is required to check the exchange fluctuation for import of heavy/project Machineries where it take long time say one year or six months to produce the same.

But due to the restrictions of Shariah we can not cover the risk of Exchange fluctuation by forward contract as Forward Booking is not permitted by Shariah. As per Shariah, currency, transaction is to be made under certain terms and conditions laid down for “sarf” by Shariah, such as spot possession of both the currencies by both the parties which is not available in forward Booking. It is also prohibited to deal in the forward money market even if the purpose is hedging to avoid loss of profit on a particular transaction effected in a currency whose value is expected to be declined. This problem requires a solution by Shariah experts.

3. Inland Bill Purchase/Foreign Bill Purchase :

This is another problem of Islamic Bank where the exporters immediately after export of the goods approach to the bank for fund before maturity of the bills to meet their daily needs. Here the Bank has to deploy billions of Taka each year but how and on what mode of investment ? The Bank can not take anything by providing fund to the exporter except collection fee for collection of the Bill, which is very poor.

4. Unfamiliarity with the Islamic Banking System

The first problem, is that despite the growth of Islamic banks over the last 30 years, many people in the Muslim and non-Muslim world do not understand what Islamic banking actually is. The basic principle is clear, that it is contrary to Islamic law to make money out of money and that wealth should accumulate from trade and ownership of real assets. However, there does not appear to be a single definition of what is or not an Islamic-banking product; or there is not a single definition of Islamic banking. A major issue here is that it is the Shariah Councils or Boards at individual Islamic banks that actually define what is and what is not Islamic banking, and what is and what is not the acceptable way to do business, which in turn can complicate assessment of risk for both the bank and its customer. More generally, the uncertainty over what is, or is not, an Islamic product has so far prevented standardization. This is difficult for regulators as they like to know exactly what it is they are authorising. It is also an added burden on the banks that have to educate customers in new markets.

5. Portfolio Management :

The behavior of economic agents in any country is determined partly by past experience and present constraints. The Islamic banks are still growing in experience in many countries. Regarding constraints, Islamic banks in different countries do not freely choose arrangements, which best suit, their need. As a result, their activities are not demand-oriented and do not react flexibly to structural shifts in the economic setting as well as to changes in preferences It is known to the bank management that a certain portion of the short-term fund is normally not withdrawn at maturity; these funds are used for medium or long-term financing. However, a precondition for this maturity transformation is that the bank be able to obtain liquidity from external sources in case or unexpected withdrawals. Islamic banks, without having an interest-free Islamic money and capital market, have no adequate instruments to meet this pre-condition for effective maturity transformation. On the other hand, Islamic banks can enhance term transformation if there is an interest-free bond market or a secondary market for Islamic financial papers. Adequate financial mechanism still has to be developed, without which financial intermediation, especially the risk and maturity transformation, is not performed properly.

6. The Regulatory environment

The relationship between Islamic banks and monetary authorities is a delicate one. The central bank exercises authority over Islamic banks under laws and regulations engineered to control and supervise both traditional banks. Whatever the goals and functions are, Islamic banks came into existence in an environment where the laws, institutions training and attitude are set to serve an economy based on the principles of interest. The operations of Islamic banks are on a profit and loss share basis (PLS), which actually do not come fully under the jurisdiction of the existing civil laws. If there are disputes to be handled, civil courts are not sufficiently acquainted with the rationale of the operations of Islamic Banking. Regarding the protection of depositors, Islamic Banks are required to let the authorities know the difference between money paid into current accounts and money paid into investment accounts. Islamic banks operate two broad types of deposits:

a) Deposits, which cover transaction balance. These have a 100 percent reserve requirement and completely safe, thus satisfying the needs of risk averters, and

b) The PLS or equity account, in which depositors are treated exactly as if they were shareholders in the bank. There is no guaranteed rate of return or nominal value of the share.

In non-Muslim counties (i.e., the countries with less than 50% Muslim population) the central banks are very stringent in granting licenses for Islamic banks to operate. In order to be established in those countries Islamic banks must also meet the additional requirements of other government and non-government authorities. (So, apart from legal constraints there are economic measures that result operations of Islamic banks in the non-Muslim world difficult). In Muslim countries also they face economic restrictions. Besides funding, acceptable investment outlets is a major challenge for Islamic financial institutions.

7. Absence of Liquidity Instruments

Many Islamic banks lack liquidity instruments such as treasury bills and other marketable securities, which could be utilised either to cover liquidity shortages or to manage excess liquidity. This problem is aggravated since many Islamic banks work under operational procedures different from those of the central banks; the resulting non-compatibility prevents the central banks from controlling or giving support to Islamic banks if a liquidity gap should occur. So the issue of liquidity management must come under active discussion and scrutiny by the authorities involved is Islamic banking.

8. Use of Advanced Technology and Media

Many Islamic banks do not have the diversity of products essential to satisfy the growing need of their clients. The importance of using proper advanced technology in upgrading the acceptability of a product and diversifying its application cannot be over emphasized. Given the potentiality of advanced technology, Islamic banks must have to come to terms with rapid changes in technology, and redesign the management and decision-making structures and, above, all introduce modern technology in its operations. Many Islamic banks also lack the necessary expertise and institutional capacity for Research and Development (R & D) that is not only necessary for the realization of their full potential, but also for its very survival in this age of fierce competition, sophisticated markets and an informed public. Islamic banking cannot but stagnate and wither without dynamic and ongoing programmes. In addition, Islamic banks have so far not used the media appropriately.

Even the Muslims are not very much aware that the Islamic banking is being practiced in the world. Islamic banks have not ever used an effective media to publicise their activities. The authorities concerned in Islamic banks should address these issues on a priority basis.

9. Need for Professional Bankers

The need for professional bankers or managers for Islamic banks cannot be over emphasized. Some banks are currently run by direct involvement of the owner himself, or by managers who have not had much exposure to Islamic banking activities, nor are conversant with conventional banking methods. Consequently, many Islamic banks are not able to face challenges and stiff competition. There is a need to institute professionalism in banking practice to enhance management capacity by competent bankers committed to their profession. Because, the professionals working in Islamic banking system have to face bigger challenge, as they must have a better understanding of industry, technology and the management of the business venture they entrust to their clients. They also have to understand the moral and religious implications of their investments with the business ventures. There is also a need for banking professionals to be properly trained in Islamic banking and finance. Most bank’s professionals have been trained in conventional economics. They lack the requisite vision and conviction about the efficiency of the Islamic banking.

10. Blending of Approach of Islamic Scholars with the Approach of the Conventional Bankers

Bankers, due to the nature of their jobs have to be pragmatic or application-oriented. There is and will be tendency in the bankers practicing in Islamic banks to mould or modify the Islamic principles to suit the requirement for transactions at hand. Additionally, being immersed in the travails of day to day banking, they find little time or inclination to do any research, which can make any substantial contribution to the Islamic banking. Islamic Scholars active in researching Islamic Banking and finance, on the other hand, typically have a normative approach, i.e. they are more concerned with what ought to be. A very few of them are knowledgeable about banking or the needs of the customers.

(ii) Problem Specific to Islamic Banking in Bangladesh

1. Absence of Islamic Money Market

In the absence of Islamic money market in Bangladesh, the Islamic banks cannot invest their surplus fund i.e., temporary excess liquidity to earn any income rather than keeping it idle. Because all the Government Treasury Bills, approved securities and Bangladesh Bank Bills in Bangladesh are interest bearing. Naturally, the Islamic banks cannot invest the permissible part of their Security Liquidity Reserve and liquid surplus in those securities. As a result, they deposit their whole reserve in cash with Bangladesh Bank. Similarly, the liquid surplus also remains uninvested. On the contrary, the conventional banks of the country do not suffer from this sort of limitations. As such, the profitability of the Islamic banks in Bangladesh is adversely affected.

2. Absence of Suitable Long-term Assets

The absence of suitable long term assets available to Islamic banks is mirrored by lack of short term tradable financial instruments. At present there is no equivalent of an inter-bank market in Bangladesh where banks could place, say, over night funds, or where they could borrow to satisfy temporary liquidity needs. Trading of financial instruments is also difficult to arrange when rates of return are not know until maturity. Furthermore, it is not clear whether Islamic banks in Bangladesh can utilise more exotic instruments, such as derivatives, that are becoming increasingly popular with conventional banks. Obviously, these factors place Islamic banking in Bangladesh at a distinct disadvantage compared to its conventional banking counterpart.

3. Shortage of Supportive and Link Institutions

Any system, however well integrated it may be, cannot thrive exclusively on its built-in elements. It has to depend on a number of link institutions and so is the case with Islamic banking. For identifying suitable projects, Islamic banking can profitably draw the services of economists, lawyers, insurance companies, management consultants, auditors and so on. They also need research and training forums in order to prompting entrepreneurship amongst their clients. Such support services properly oriented towards Islamic banking are yet to be developed in Bangladesh.

4. Organizing Relationship with Foreign Banks

Another important issue facing Islamic banks in Bangladesh is how to organise their relationships with foreign banks, and more generally, how to conduct international operations. This is, of course, an issue closely related to the creation of financial instruments, which would be simultaneously consistent with Islamic principles and acceptable to interest-based banks, including foreign banks.

5. Long-term Financing

Islamic Banks stick very closely to the pricing policies of the government. They can not benefit from hidden costs and inputs, which elevate the level of prices by certain entrepreneurs without any justification. On the other hand, Islamic banks as financial institutions are even more directly affected by the failure of the projects they finance. This is because the built in security for getting back their funds, together with their profits, is in the success of the project. Islamically, it is not lawful to obtain security from the partner against dishonesty or negligence, both of which are very difficult if not impossible to prove.

Prospects

In my understanding the prospect of Islamic Banking is very bright. Muslim people everywhere want Islamic Banking. In Bangladesh, to give an example, 4/5 conventional Banks have opened separate Islamic branches recently. Five hundred applications are pending with Islamic Bank Bangladesh Ltd. for opening of new braches. IBBL has already 132 branches in the country.

The position may not be same in all countries. But if Islamic Banking succeeds in any country, the position will same in every Muslim country in my judgment. This means, that first Islamic Bank in any country should be well managed and successful so that people have faith in this system. Established Islamic Banks should co-operate by lending competent officials in setting up new Islamic Banks.

The problems mentioned in the preceding pages are not insurmountable. Most of them can be solved with more research and dedicated efforts. IDB, OIC Fiqh Academy, Internatinal Islamic Banking organizations and individual Islamic banks should put more resources in research in Islamic Banking, Finance and Economic issues. Cooperation of Central Banks and the Governments. will be needed in some areas. I have no doubt in mind that Islamic banking will expand more and more in the entire world.

source : shah aabdullah foundation