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AccountantMagazine of the Institute of Chartered Accountants of Pakistan

The Pakistan July-August 2007

IslamicEconomic

System

IslamicEconomic

System


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3 Editor's Letter

5 President's Page

6 Faith and Finance

9 Islamic Finance - EmergingChallenges of SupervisionDr. Shamshad Akhtar

12 The Facets of Islamic EconomyAbdulwahid, FCA

14 Financial CorruptionSadia Kaleem, ACA

16 Wealth DistributionNadia Azhar, ACA

18 AgricultureMehreen Wahid

20 The Rise and Fall of Structured CreditDanish Ahmed Siddiqui, ACA

23 Credit Risk ManagementAbdul Razzaq, ACA

28 Reverse Mortgage Loan in IndiaDr. Pradeep Kumar Singh

32 Open Letter - Why it is Important to Maintain Audit Quality

34 View Point: In Conversation with Richard Dyson, President ICAEW

In-House

37 The Fall of The Soviet Union and The Rise of Russia

39 People

42 World in Focus

43 Books

Students Section

44 What is a Corporate Credit Rating

July- August 2007Issue # 3Vol # 41

Contents

The Pakistan Accountant can be downloaded from Institutes website at www.icap.org.pkThe views expressed here do not necessarily represent the official policy of the Institute.

EDITORIAL OFFICE

Publications Coordinator

Asad Shahzad

PresidentImran Afzal, FCA

Vice PresidentsRafaqat Ullah Babar, FCAShaikh Saqib Masood, FCA

MembersShahzad Hussain, FCANasim Hyder, FCASyed Shahid Husain Jafri, FCAFarrukh Viqaruddin Junaidy, FCARazi-ur-Rahman Khan, FCARashid Rahman Mir, FCAAhmad Saeed, FCAAsad Ali Shah, FCAAbdul Rahim Suriya, FCAMohammad Abdullah Yusuf, FCASyed Mohammad Shabbar Zaidi, FCA

Arif Mansur (Deceased)Dr. Faizullah Khilji (Retired)

Executive DirectorMoiz Ahmad, FCA

SecretaryF. H. Saifee, FCA

The Pakistan AccountantChartered Accountants Avenue, Clifton,Karachi-75600 (Pakistan)Phone: 9251636-39 Fax: 9251626E-mail: [email protected]: www.icap.org.pk

Chairman and Chief EditorAbdul Rahim Suriya, FCA

MembersAbdulwahid, FCAAbdul Rab, ACA

Adnan Ahmad Mufti, ACA

Ahmad Saeed, FCAAhsan Ghaffar Mehanti, ACA

Asif Jamal, FCAFaisal Habib, FCA

Faisal Imran Hussain, ACA

Fazal Mahmood, FCAHena Sadiq, ACA

Jehan Zeb Amin, ACAJunaid Haji Zikar, ACA

Kashif Ilyas, ACA

M. Arshad Siddiqui, FCAMuhammed Amin Bhimani, ACA

Muhammed Mahmood Marfatia, ACAOmar Mustafa Ansari, ACA

Raheel Abbas Rizvi, ACA

Rahil Rafiq, ACAShakil Akhtar Qureshi, FCA

Sophia Ahmed, ACA

PUBLICATIONS COMMITTEE

AccountantAccountantThe Pakista n July-August 2007

Cover StoryAn Islamic economic system seeks

to implement an economic system

based on the equitable distribution of

wealth, payment of zakat, and

banking without interest. The launch

of Islamic bonds in the international

market that comply with a variety of

Shariah based criteria, and the

recent rise in Islamic financial

products and services offered in the

West, further establish the growing

popularity of Islamic finance and

economics.

THE COUNCIL


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The Pakistan Accountant 3July-August 2007

Editor's LetterT

he fact that conventional financial

institutions all over the globe are

now recognizing Shariah compliant

products as a valid category of their overall

investment portfolios signals the growing

maturity of the Islamic financial sector.

Swiss and German banks are making efforts

to implement elements of Islamic finance in

their systems. The Japanese Governmenthas recently announced issuance of sukuk

bonds for infrastructure development,

which indicates that Islamic financial

products are attracting non-Muslims and

even corporations seeking new means of

acquiring capital.

The first Islamic bond was sold by Shell

Malaysia in 1990. Since then, the demand

for sukuk has skyrocketed.To date, most

sukuk have been corporate, but the potential

for a sovereign Islamic bond market could

be huge. The UK Treasury and Japanesegovernment are preparing to launch debut

sovereign sukuk in 2008 representing

growing worldwide popularity in Shariah-

compliant debt issuance.

The global outstanding sukuk issues totaled

US$82.2 billion by the end of July 2007,

and close to 62 percent of these were

denominated in Malaysian ringgit. T h e

growth of the sukuk market is expected to

rise from US$600 million in 2002 to a

staggering $70 billion in 2007, andaccording to ratings firms Bloomberg and

Standard & Poor's, will rise to $100 billion

in 2010. The growing popularity of sukuk

owes itself to the fact that sukuk offer a

share in the proceeds of a business venture

rather than paying out interest. Sukuk

replace coupons by payouts and are backed

by tangible assets.

In order to maintain its popularity this

sector must now seek integration in the

em erging and developing economies of

Southeast and South Asia. 'The Malaysian

market accounts for most outstanding

sukuk, but interest is growing in the rest of

Asia, obviously in jurisdictions such as

Indonesia and Pakistan.' This recent

statement by the Assistant Vice President ofMoody's Corporate Finance is ample

evidence of the fact that Pakistan's potential

as a center for Islamic finance is growing.

Dr Ishrat Hussain, former Governor, State

Bank of Pakistan, and Chairman of the

National Commission for Government

Reforms in Pakistan has noted that 'Islamic

finance has to become part of global finance

to survive, or risk catering only to a niche

market.' The Muslim world, including

Pakistan, must concentrate all efforts to

implement and integrate an Islamicfinancial market into local markets. If

Islamic finance is to become a major

alternative in the global financial market, it

must constantly innovate and modify itself

to conform to global standards.

In Pakistan's context, policy stability, sound

regulatory framework, strong economic

fundamentals, a thriving private sector and

advanced communication infrastructure

will be needed to boost the growth of the

Islamic fund management industry in the

country..

Abdul Rahim Suriya


4/41

The Pakistan Accountant 5

President's PageThe Islamic banking and finance industry hasseen tremendous growth in the recent years -not just in Pakistan or other Muslim countriesbut in fact through out the world. Currently, overUS$400 billion worth of funds are being managed bythis industry via approximately 250 Islamic banks andinstitutions operating across the globe - a 45 foldgrowth since 1982 - and the figures are continuing toimprove at an impressive rate of fifteen to twentypercent per annum.

The products offered are not just used by the Muslimpopulation, but an increasing number of non-Muslimsare also being attracted to the ethical values of theseproducts as more and more investors begin to realizethat ethics and profitability in banking and finance donot have to be mutually exclusive. The productsoffered by the industry are also revolutionizing frombeing Shariah compliant products to Shariah basedproducts. Introduction of such products has enabledthe industry to seek its unique identity and to providea credible alternative to conventional bankingproducts.

In order to keep up with the growing demand forIslamic financial products, conventional banks arebranching out towards Islamic products, while Islamicbanks are continuing to expand their product base.The Development Bank of Singapore (DBS) hasrecently established its Islamic banking and financesubsidiary, the Islamic Bank of Asia, to focus onwealth management and capital market instrumentsfor corporate and private banking clients in theMiddle East and Asia. The Reserve Bank of India(RBI) is exploring the possibility of setting up Islamicbanks in India as a viable alternative to commercialbanks, to attract even the non-Muslim majority to parktheir funds with these banks. The Unit Trust of India(UTI) is already running a $250 million fund forMuslim Non Resident Indians (NRIs) in the Gulf.

Realizing the growing popularity of Islamic Banking,the central banks and other regulatory authoritiesthroughout the world are trying to incorporate theproducts offered by this industry into their regulatoryframework. In 2005, in an effort to align the Islamicand western fund concepts, the UK Tr e a s u r yintroduced similar tax treatment and relief for Islamicmortgages based on Ijara and Musharaka and forprofit rates on Islamic savings accounts, as thoseenjoyed by conventional products. This important stepby the UK Treasury has considerably improved the

attractiveness of the industry in the UK.London, today is becoming the centerof Islamic finance outside of Gulf.

Important steps are being taken inPakistan as well to increase theacceptability of Islamic banking bythe masses. State Bank of Pakistan(SBP) has played an active role instreamlining the adoption of Islamic Standards andhas issued instructions and guidelines for Shariah

compliance in Islamic Banking institutions from timeto time. The Institute's Committee on Accounting andAuditing Standards for Interest Free Modes ofFinancing and Investments has developed twoStandards - IFAS 1 Murabaha and IFAS 2 Ijarah -which have been notified by the Securities andExchange Commission of Pakistan (SECP).

Standards on 'Diminishing Musharaka', 'Profit andLoss Sharing on Deposits' and General Presentationof Financial Statements of Islamic FinancialInstitutions are also being developed to help theindustry.

The future of Islamic banking and finance looksbright. Strong, sensible regulation and continuedgovernmental support would ensure sustainablegrowth of the industry. There is a need for rapidconvergence of regulatory and auditing standards forIslamic banking and their products. We need bigger,more consolidated, convergent Islamic banks that canhandle larger projects and compete successfully giventhat the emphasis in a non-interest based bankingsystem is not so much on the size of the collateral thanon the viability and success of the project itself. Inorder to compete globally, Islamic banks will have tolook beyond short-term trade finance towards long-term equity financing. Of course, this would requireexpertise beyond conventional banking and the

institutional infrastructure to support the growth ofIslamic financial instruments.

Given the enthusiasm being show by all concerned wecan hope for a better tomorrow of Islamic banking inPakistan.

Imran Afzal

July-August 2007


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Islamic finance is essentially a contract-based system of

financing, practiced according to the Islamic principlesprescribed in the Shariah known as Fiqh Al-Muamalat (or

Islamic Commercial Jurisprudence). Islamic banking and

Finance (IB&F) operates on the principle of sharing of

both profit and loss by the borrower.

The first modern Islamic savings bank was set up by

Ahmad El Najjar in the Egyptian town of Mit Gharnr in

1963. By the year 1967, nine such banks were operative

in Egypt, investing mostly in trade and industry, without

charging or paying interest, and sharing their profits with

their depositors. These banks were essentially savings

investment institutions. In 1971 The Nasir Social Bank

was declared the first interest-free commercial bank

though the bank's charter made no reference to Islamic

Shariah law.

In 1974 the Organization of Islamic Countries (OIC)

established the Islamic Development Bank (IDB) to

provide interest free, fee based financial services and

profit sharing financial assistance to member countries.

The mid 70s witnessed the establishment of several

Islamic banks in the Middle East, notably the Dubai

Islamic Bank (1975), the Faisal Islamic Bank of Sudan

(1977), the Faisal Islamic Bank of Egypt (1977), and the

Bahrain Islamic Bank (1979).

Malaysia is another country with a strong presence of

Islamic banking and financial system alongside aconventional banking system working in a competitive

environment. The share of Islamic banking operations in

Malaysia grew from zero in 1983 to above 8 percent of

the total financial system in 2003. The Government has

plans to enhance this share to 20 percent by the year

2010. Standard & Poors has assigned a BBB+ rating to

the US$600 million Shariah compliant Sukuks (trust

certificates) issued by Malaysia Global Sukuk Inc. Bank

Negara Malaysia (BNM) has announced issue of new

Islamic Bank licences to foreign players. The Financial

Sector Master plan maps out the liberalization of

Malaysia's banking and insurance industry in three

phases during the next decade.

Origins of Islamic Banking in PakistanIn Pakistan the legal framework of the country's financial

and corporate system was amended on June 26, 1980 to

permit issuance of a new interest-free instrument of

corporate financing named Participation Term Certificate

(PTC). An Ordinance was promulgated to allow the

establishment of Mudaraba companies and floatation of

Mudaraba certificates for raising risk based capital.

Amendments were also made in the Banking Companies

Ordinance, 1962 (The BCO, 1962) and related laws to

Cover Story

Faith and

FinanceThe Evolution of Islamic Bankingand Finance (IB&F)


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Cover Story

include provision of bank finance through PLS, mark-up in

prices, leasing and hire purchase.

Separate interest-free counters started operating in all the

nationalized commercial banks, and one foreign bank

(Bank of Oman) on January 1, 1981

to mobilize deposits on profit and

loss sharing basis. From July 1,

1982 banks were allowed to provide

finance for meeting the working

capital needs of trade and industry

on a selective basis under the

technique of Musharaka.

By January 1985 domestic bankswere operating both 'interest-free'

and 'interest-based' windows. From

July 1, 1985 all commercial banking

in Pak Rupees was made interest-

free. However, foreign currency

deposits in Pakistan and interest on

lending of foreign loans continued

as before. In November 1991 the

Federal Shariat Court (FSC)

declared the procedure adopted by

the banks, based largely on mark-

up with or without buy-back

arrangement, as un-Islamic. T he

Government and some banks/DFIs

preferred appeals to the Shariat

Appellate Bench (SAB) of the

Supreme Court of Pakistan.

On December 23 1999, the Shariat

Appellate Bench (SAB) of the

Supreme Court of Pakistan gave its

landmark judgment banning interest

in all its forms and directed that laws

involving interest would cease to

have effect finally by June 30, 2001

with exemption for dealing with foreign parties. Thus

ensued the partial transformation of Pakistan's financial

system from interest based to Shariah compliant. Islamic

banking and finance have since been operational in

Pakistan parallel to conventional banking.

SBP's Commission for Transformation

of Financial System (CTFS)The Commission for Transformation of Financial System

(CTFS) was constituted in January 2000 in the State

Bank of Pakistan under the chairmanship of I.A. Hanfi, a

former Governor State Bank of Pakistan. According to the

Commission, it was essential for the introduction of a

Shariah compliant financial system to have a legalinfrastructure conducive to the working of an Islamic

financial system through launching a massive education

and training program for bankers and their clients, and

through an effective media

campaign to create public

awareness about the Islamic

financial system.

The CTFS constituted a Committee

for Development of Financial

Instruments and Standardized

Documents in the State Bank to

prepare model agreements andfinancial instruments for the new

system.

A Taskforce was set up in the

Ministry of Finance to suggest ways

to eliminate interest from

Government financial transactions.

Another Taskforce was set up in the

Ministry of Law to suggest

amendments in legal framework to

implement the Court's judgment.

This Taskforce proposed

amendments in the House BuildingFinance Corporation (HBFC) Act to

make it Shariah compliant by

shifting back its rent sharing

operations to a non-interest based

system. The amendment was

promulgated, and in 2001 HBFC

launched its Asaan Ghar Scheme

based on Diminishing Musharakah.

A Committee was constituted in the

Institute of Chartered Accountants

of Pakistan (ICAP), wherein the

State Bank of Pakistan (SBP) was also represented, for

development of accounting and auditing standards forIslamic modes of financing. The Committee is reviewing

the standards prepared by the Bahrain based Accounting

and Auditing Organization for Islamic Financial

Institutions (AAOIFI) with a view to adapt them to our

circumstances and if considered necessary, to propose

new accounting standards.

In September 2001 it was decided that the shift to interest

free economy would be made in a gradual and phased

manner and that the State Bank of Pakistan would

consider:

July-August 2007

A Committee was

constituted in the Institute

of Chartered Accountants of

Pakistan (ICAP), wherein

the State Bank of Pakistan

(SBP) was also represented,for development of

accounting and auditing

standards for Islamic

modes of financing. The

Committee is reviewing the

standards prepared by the

Bahrain based Accounting

and Auditing Organization

for Islamic FinancialInstitutions (AAOIFI) with a

view to adapt them to our

circumstances and if

considered necessary, to

propose new accounting

standards.


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Cover Story

w setting up subsidiaries by the commercial banks for the

purpose of conducting Shariah compliant transactions;

w specifying branches by the commercial banks

exclusively dealing in Islamic products; and

w setting up new full-fledged commercial banks to carry

out exclusively, banking business based on proposed

Islamic products.

Accordingly, the State Bank issued detailed criteria inDecember 2001 for establishment of full-fledged Islamiccommercial banks in the private sector.Al Meezan Investment Bank receivedthe first Islamic commercial banking

license from SBP in January 2002 andMeezan Bank Limited (MBL)commenced full-fledged commercialbanking operation from March 20,2002.

Private sector Islamic banks havebeen established and existingcommercial banks have establishedsubsidiaries and stand-alone branchesto conduct Islamic banking. The StateBank of Pakistan houses a full fledgedIslamic Banking Department and aShariah Board comprising two Shariahscholars and three experts in banking,accounting and legal framework toadvise the SBP on Shariahcompliance.

Subsidiaries & Stand-alone Islamic BankingBranches (IBBs)In January, 2003 the State Bankissued BPD Circular No. 01 outliningdetailed instructions on setting up ofsubsidiaries and stand-alone branchesfor Islamic Banking by existingcommercial banks. The criteria for

subsidiaries are almost similar to thecriteria for setting up scheduled Islamiccommercial banks with emphasis oncomplete segregation of accounts ofIslamic banking subsidiaries and the parent banks doingconventional banking. The subsidiaries shall haveminimum paid up capital of Pak Rs. 1,000 million that isequal to the capital requirement for full-fledgedcommercial banks.

The criteria for opening stand-alone branches pertain tofinancial strength of the applicant bank as evident from itscapital base, adequacy of its capital structure, record of

earning capabilities, future earning prospects of the bank,managerial capabilities, bank's liquidity position, trackrecord of the bank's adherence to prudential regulations,credit discipline, quality of customer services and theconvenience and the needs of the population of the areato be served by the proposed branches.

SBP's Musharakah based Islamic

Export Refinance Scheme (IERS)State Bank of Pakistan has introduced a Musharakah-based Islamic Export Refinance Scheme (IERS) to meetthe export financing requirements of banks conducting

operations under Islamic Modes.Islamic Banking Institutes (IBIs)can avail this facility under both

parts of SBP's Export FinanceScheme (EFS). The frameworkof the IERS is based on theconcept of Profit & Loss Sharing.The State Bank shares theactual profit of the Musharakahpool of the Islamic Bank.However, in case the actual profitof the pool is more than ongoingrates under conventional EFS,the excess profit so received bySBP would be credited to theTakaful fund, a reserve fund tobe maintained by SBP u nd e r

Islamic modes for risk mitigationthat would be used to meetfuture losses arising onimplementation of IERS.

Future of IslamicBankingWith the refining of Islamicfinancing techniques and theneed for infrastructuredevelopment in Muslimcountries, Islamic banks are nowparticipating in Shariah-

compliant retail products tohighly complex structuredfinance and large-scale projectlending including power stations,

water plants, roads and bridges.

While functioning within the framework of Shariah, Islamicbanks can perform a crucial task of resource mobilization,their efficient allocation on the basis of both PLS(Musharakah and Mudaraba) and non-PLS (trading andleasing) based categories of modes and strengtheningthe payments systems to contribute significantly toeconomic growth and development.

July-August 2007

While functioning

within the framework

of Shariah, Islamic

banks can perform a

crucial task of resource

mobilization, their

efficient allocation on

the basis of both PLS

(Musharakah and

Mudaraba) and non-

PLS (trading and

leasing) based

categories of modes

and strengthening the

payments systems to

contribute significantly

to economic growthand development.


8/41


I. BackgroundDiversification and structural transformation in financialsector has been accompanied by increasing integrationamong different segments of the financial sector. Thetraditional boundaries between banks and non-bankfinancial institutions are eroding and we are witnessingthe growth of universal banking and/or mergers amongdifferent segments of sectors.

This trend has its benefits but has associated risks aswell. Supervisors face a dual challenge. On one hand,supervisors are promoting financial diversification andconsolidation to achieve market development andinnovation. On the other hand, supervisors have toposition themselves to recognize the new dimensions andtypes of risks and encourage appropriate risk mitigation.

These considerations have triggered world wide debateon how to effectively supervise different segments offinancial sector in conglomerate and universal structure.

So far these debates had been concentrated aroundconventional banking but now it is widely gripping theworld of Islamic Finance (IF). Stronger inter-dependencies among different segments of IF areemerging largely because Islamic Financial Institutions(IFIs), in principle, have features and inherentcharacteristics and more compulsion, than conventionalbanking, to conform to universal banking or to evolveinter-linkages among different market segments.

II. Factors driving cross-sectorlinkages and interdependenciesFirst and foremost, IFIs' depositors/borrowers desire toconduct financial transactions that are Shariah compliant.It can be assumed that a person preferring to bank withan Islamic bank will also seek to use other faith-basedfinancial services such as Takaful and Islamic mutualfunds. This faith-driven feature in itself forces andincentivizes IFIs to offer, along side bank-based services(i.e. deposit and loans), a wide range of financial services.As a result, Islamic banks end up undertaking non-corebanking activities such as fund management, capitalmarket operations, securitization, leasing, and housingfinance. This has enhanced the degree of integrationbetween various segments of IF. For example: Islamicbanks are likely to be strongly integrated with the Shariahcapital markets since on credit portfolio side, Islamicbanks do not have the same investment avenues asthose available to their conventional counterparts. Theoutcome is that Islamic banks either end up taking largeexposure in the capital markets directly or acquiresubsidiaries which primarily engage in such businesses.

Second differentiating aspect is the nature of contractualarrangements that drive deposits mobilized byconventional banks as compared to Islamic banks.Conventional bank deposits are interest based contracts

Cover Story

Islamic Finance -Emerging Challenges

of Supervision D r. Shamshad A k h t a rG o v e r n o r, State Bank of Pakistan

July-August 2007

As traditional boundaries between banks and non-bank financial institutions

erode, supervisors face a dual challenge of promoting financial diversifiction,

on the one hand, and encouraging appropriate risk mitigation on the other.


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Cover Story

with guaranteed interest return whereas Islamic banksraise deposit on a profit and loss sharing basis in either aMudaraba or Musharaka structure. Mudaraba/Musharakacontracts transform the Islamic banks' deposits intoessentially a fund management product (althoughcurrently most regulators recognize these as equivalent toconventional deposit contracts) and this impacts thecorresponding asset portfolio. There is a need thereforethat Islamic banks acquire assets on a PLS basis as welland eventually move beyond fixed return products, likeMurabaha and Ijara. This pushes an Islamic bank towardsuniversal banking since in order to manage the portfolioprofitability; it needs to invest across sectors inbusinesses based on Shariah principles, like equity andSukuks in the capital market and trade contracts likecommodity Murabaha, Musharaka, Ijara and Takaful.

Thirdly, further development of Islamic banking itselfdepends on concurrent development of Islamic capitalmarket. For instance, development of Islamic debt marketis key to the provision of adequate liquidity support whileproviding additional investment avenues. Likewise,Takaful development is critical to provide insurancecoverage to Islamic banking products, like auto andconsumer financing, while strengthening secondarycapital and Islamic bond markets by being a major buyerof Islamic instruments. It is the confluence of these factorsthat have induced regulators to encourage and IFs topromote rapid and deeper financial inter-linkages andintegration.

III. Supervisory challenges posed bycross-sector developmentsIt is some of these above considerations that haveaugmented strategic alliances and linkages of varioustypes among IFIs, both within country and cross borders.As such, IFIs are evolving either as part of a globalfinancial concern or as a domestic bank acquiring orestablishing subsidiaries and/or the two arms, i.e. Islamicand conventional banks coexist. Moreover, as theconventional parts of financial institutions move towardscross-sector integration, their Islamic counterparts (eitheras specialized window or as independent entities) willalso follow eventually.

While it has by now been well established that there aresignificant benefits of enhanced integration and inter-linkages or conglomeration in IF, such as the economiesof scale, operational synergies and effective use of scarcehuman resource, there are definitely certain risks1. In thisarea, I would like to offer few basic observations.

Firstly, it is inevitable that enhanced exposure of Islamicbanks into capital markets exposes them to the volatilityin associated businesses. Likewise, conglomeration,whether through universal banking or through parentsubsidiary model2, exposes them to a variety of issuessuch as contagion risk, regulatory arbitrage, high groupexposures, conflict of interest etc.

These risks apply equally to both Islamic andconventional modes of finance. However, Islamic bankshave thus far not erected firewalls, like conventionalbanks, to separate legally, financially and manageriallytheir investment and commercial banking activities.Obviously these risks pose a challenge to the supervisorsand necessitate that appropriate changes be made in thesupervisory regime.

Secondly, Shariah compliance issues necessitate takinga more aligned view across IF businesses as user ofIslamic products may be oblivious of ideologicald i fferences as well as varying perceptions andinterpretation of the Shariah advisors or boards and/or byregulators. Since institutions being supervised by oneregulatory authority may be offering products of

institutions being supervised by a different regulatoryb o d y, this could introduce complications and thechallenge of ensuring uniform Shariah compliance acrossfinancial institutions and products.

T h i r d l y, traditionally different segments have beenregulated by their specialized supervisory authorities.These authorities have adopted risk managementprinciples and supervisory stances which are strictly inline with the risk profile of supervised sectors in isolation.With sector integration, supervisors have to coordinateclosely in policy formulation and regulation as well as on-site supervision. They have to coordinate creation ofnecessary firewalls, remove moral hazards and govern

the degree of cross segment exposure. This may evencall for institutional restructuring through merging varioussupervisory bodies into a single entity or for closercoordination between supervisors through creation of athird coordinating body.

IV. Sector inter-linkages of Pakistan'sIslamic finance systemIn Pakistan, besides offering trade loans, like Murabaha,Islamic banks are offering equity and quasi equityproducts, such as Musharaka and diminishingMusharaka, and investment banking activities such asloan syndication, structured finance, etc. The six fullfledged Islamic banks with a network of 108 branches and

another 58 stand alone Islamic branches of 13conventional banks have registered phenomenal growthand as of April 2007, the Islamic banking sectorconstituted 3.3 percent of total banking assets. In view ofthe equity based nature of Islamic banking and lack ofShariah compliant financial instruments, central bank hasallowed Islamic banks a relatively higher exposure (35percent direct and 10 percent future of their equity) incapital markets compared to conventional banks (20percent direct and 10 percent future). In addition, theState Bank of Pakistan (SBP) has relaxed statutoryreserve requirement (SLR) for Islamic banks at 8 percentversus industry norm of 18 percent.

July-August 2007


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Cover Story

Furthermore, Islamic banks are allowed to nurture parent-subsidiary/affiliate model whereby Islamic banks are byand large setting up asset management companies,brokerage firms and, now, Takaful businesses. Thus farthe supervision of IFIs is bifurcated, with Islamic banksbeing regulated by SBP and non-bank IFIs, namely,Modarabas, Islamic mutual funds, Takaful companies andsecurities operations under the regulatory oversight ofSecurities and Exchange Commission of Pakistan(SECP).

Sector specific supervisory approach is alsocharacterized by varying regulatory requirements vis--vis operational matters, governance framework andShariah compliance across the range of IFIs. T h edifferences extend to minimum capital requirements

ranging from Rs.6 billion for Islamic banks (by the year2009), Rs.500 million for family Takaful operators (by theyear 2011), Rs.300 million for general Takaful operators(by the year 2011) and Rs.30 million for Islamic fundmanagers to Rs.2.5 million for Modaraba managementcompanies. The low capital base of financial institutions,engaged in the business of Takaful or fund management,poses a significant risk to the solvency of financialconglomerates that characterize the Islamic financialmarkets. In terms of financial reporting, Ta k a f u lcompanies are not required to circulate quarterlyaccounts among shareholders whereas all other Islamicfinancial institutions are required to do so in terms of thelegal and regulatory framework.

The segregated supervisory approach has resulted incarving of legal framework specific to each sector for bothconventional banks and IFIs3 but eventually there is aneed for addressing the idiosyncratic nature of IF industry,products and market players. Moreover, with regard to IF,both the regulators are following different approachestowards Shariah compliance in the institutions regulatedby them. SBP requires Islamic banks to appoint Shariahadvisors according to a prescribed fit and proper criteriaand a Shariah Board has been constituted at the level ofSBP to deal with issues relating to Shariah interpretationand compliance among Islamic banks. SECP's approachvaries across different segments of IF.A Religious Board,constituted by the government, is responsible for

approving the prospectus of each Modaraba containingthe types of business to be conducted, management, etc.While the Religious Board has a significant role, there isno requirement for Modarabas or their managementcompanies to appoint Shariah advisers at individual fundlevel. Islamic mutual funds and Takaful operators, on theother hand, are required to appoint Shariah Council/Boardsbut no explicit fit and proper criteria has been laid down bySECP in this regard. SECP is also authorized to appoint aCentral Shariah Board under the Takaful Rules, 2005,which has not been established as yet.The greatest challenge resulting from different Shariahcompliance practices followed by Islamic banks, Modarabas,Takaful companies, etc. is the reputational risk faced by IFIs

and misperceptions in the minds of public about Shariahcompliance. This issue, therefore, needs to be addressedthrough coordination amongst the supervisors.

Another issue arises from overlapping supervisory jurisdiction. The Banking Company Ordinance allowsbanks to act as Modaraba management companies forfloatation of Modarabas. In terms of ModarabaCompanies Ordinance, Modarabas can be formed toconduct any type of business, which is permitted underShariah, be it trading, manufacturing, airline, financing,leasing, services, etc. and these are regulated by SECP.Due to overlapping regulatory jurisdictions, banks arefloating modarabas through separate subsidiaries4

resulting in higher administrative, set up and regulatorycosts. For sometime (from 1991-1997), these Modarabaswere under the regulatory control of SBP, but the powers

relating to licensing, winding up, etc. were retained bySECP; consequently the regulatory authority has beenreverted to SECP. Again, this highlights the need for crosssector regulation of IFIs.

Eventually there is a need to develop mechanisms foroversight of financial sector in an integrated manner.Besides coordination and cooperation among regulators,there is a need for consolidated supervision framework forfinancial institutions, guidelines for consolidated publicfinancial statements and application of regulatoryprudential limits on group wide basis and coordination toexamine the intra group linkages with industrial andcommercial entities. While conventional and Islamicfinancial industry would have to adopt similar approachesto integrated supervision, it has to be recognized that the

latter is a relatively nascent industry and hence thetargets should be modified to match the ground realities.

V. ConclusionIFSB's ten year roadmap has highlighted the cross sectornature of IFIs and the resultant need for supervision toevolve accordingly. It is in recognition of these factors thatIFSB has sought to broaden its membership to securitiesand insurance supervisory authorities as Full Members ofIFSB. IFSB's efforts for developing Islamic regulations aswell as accounting, auditing and governance standardswill facilitate adoption of unified principles for thedevelopment, operation and regulation of Islamic financialservices.

----------------------------------------------------------------------------1. Financial Sector Regulation: Issues and Gaps, IMF 2004

2. Universal Banks: First structure is of universal bank, in which all financial operations

are conducted within a single corporate entity. The second model is the parent-

subsidiary or operating subsidiary model, in which operations are conducted in and

regulated as subsidiaries of another financial institution, usually (but not

necessarily) a bank. Finally, in a holding company model activities are conducted in

legally distinct entities, each with separate management and capital but all owned

by a single financial or sometimes (unregulated) non-financial institution

3. Fund management, as used here, refers to management of Islamic mutual funds

and Modarabas.

4. A number of banks have formed subsidiaries and floated modarabas like NBP, HBL,

ABL, Habib Metropolitan Bank, etc. No Islamic bank has yet floated a Modaraba.

July-August 2007


11/41


By the middle of the 20th century, many Muslim countries

had been freed from the shackles of colonial rule. These

countries were looking for development and improvementin every field, specially their economies. Being

predominantly Muslim, they were naturally inclined to

adopt the Islamic Economic System. Consequently, a lot

of literature was produced in a short time on the subject

of Islamic Economics.

Several institutions, universities, and research centers

are involved in carrying out research work on various

aspects of an Islamic Economy. This article summarizes

some of the key issues in an Islamic economy.

Economics, as one of the social sciences, needs to resort

to history in order to derive the long-term trends ofeconomic variables. History provides economics with two

major indispensable aspects, namely, the history of

economic thought and the history of economic units such

as individuals and firms. Little has been done to present

the history of Islamic economic thought. There is no

documented 'Economic Theory of Islam' and not much

formal writing in the area of Islamic economics. This is

unfortunate and the need of the hour is to bring to light the

economic theories of great Islamic thinkers.

The first attempt to demarcate the boundaries between

the economic philosophy of Islam and subsequent

economic theories was made by Al_Sadr in 1964,

followed by Muhammad Najatullah Siddiqi in 1971.

Islamic BankingIslamic banking is the most popular and well-known

instrument of Islamic economics. It is prevalent in both

Muslim and non-Muslim countries. Main reason for its

success is the belief of Muslims that the profits derived

are interest free and allowed in Islam. If there is any

defect or fault in this, the onus is on the religious scholars

who are certifying them as Shariah compliant.

Muslims in the oil producing and developed countries

hold substantial cash and liquid assets. To attract their

deposits conventional banks have also established theirbranches or at least counters for Islamic banking.

Many Muslim scholars have argued that borrowing for

expansion of business is a commercial deal and the

borrower must pay some share of the profit to the lender.

Profit sharing in a business is a sharing in the net profit.

Islamic bankers and scholars do not openly define the

factors involved in interest bearing. They try to convince

customers that every sort of financing scheme provided

by these titled Islamic banks falls within the gambit of

Cover Story

The Facets of

Islamic EconomySeveral institutions, universities, and research centers are involved incarrying out research work on various aspects of an Islamic Economy.This article summarizes some of the key issues in an Islamic economy.

Abdulwahid, FCA


12/41


Cover Story

Islamic banking, which is not the fact. They also claim that

any agreement between the borrower and lender alsomakes it Islamic. Over a period of time, measures taken

to promote Islamic banking have not been very ethical.

For instance, in 1979, when profit loss sharing (PLS)

banking accounts were introduced to replace Savings

Bank (SB) accounts in Pakistan, the rate of profit for the

first half year was 9 percent per annum which went on

decreasing till it came down to 1 percent last year. What

could be the justification for such a big dip. Was this

merely a ploy to attract the public towards PLS by offering

a very high rate of profit?

Theory of ConsumptionThis theory has developed in the capitalist economy. In

the Islamic way of life, social values and consumerideology are much different. Islamic economists have

criticized the prevailing theory of consumption, but have

failed to provide an alternative. This theory can be split up

into three parts:

a. Rationalization of consumer behaviour

b. Concept of goods and services

c. Ethical considerations for Muslim consumers

Consumer behaviour in the West developed on the basis

of utility, capitalism, and with an eye on commercial

success and concentration of wealth.

The theory of consumption in capitalism is based on

maximum acquisition. The traditionalism of consumer in

an Islamic system has the following elements:

(i) Concept of Progress

Islam does not allow for selfishness and the concept

of success depends on the welfare of every one

irrespective of their financial or social status. Islamdoes not restrict material progress, but desires that

everyone's basic necessities be met.

(ii) Concept of Wealth:

Wealth in Islam is only God given. Holy Qur'an

provides us with a unique concept of products and

commodities; the word Al Tayabat meaning good,

pure, clean and wholesome things has appeared in

Quran 18 times, the second word Ar-arizq reported

in Holy Qur'an 120 times, means godly or divine. It

means that all commodities are God given.

(iii) Ethics of Consumption:

All the consumables are God given and for everyone.

It is only by chance that few are holding more than

their share. In Qur'an, Allah rejects the argument that

the rich do not owe to the poor.

Theory of Production

The production theory in a capitalist economy encouragesproduction from cheaper sources, with highest possible

profit margins. In a socialist economy, production should

be based on the requirements of the public. In Islamic

economics, it is a combination of both; production should

be based on the requirement of the masses at a cost

affordable to them.

Motives of ProductionIslamic view of man and universe is that man should

derive all possible advantages from God's universe.

There are two ways to regularize these, first by ethics and

secondly by legislation. Ethics are teachings of Islam from

Qur'an and Sunnah, while legislation is man made in theform of rules and regulations. Every entrepreneur wants

to make profit and if he does not follow the ethics of the

Qur'an and Sunnah, government is bound to limit his

profit.

Objectives of ProductionUnder an Islamic economy, a Muslim producer shall not

make a heavy profit; his goal is the Hereafter. This has

three important implications:

a. Moral values as established in the Holy Qur'an -

prohibited items and industrial activities that are not

allowed are specified.

b. Social aspect in the production process and

distribution of benefits in the most equitable manner

are the prime economic objectives.

c. The problem is not shortage of production or supply,

but human inefficiency in reaping the full benefits of

God's benevolence. Islam recognizes the right of the

less able in the wealth of those who have greater

ability or the opportunity to produce greater wealth

(Mirakhor,1989).

Macro EconomicsIslam has the most efficient system of Macro Economics.

Zakat can alleviate poverty. Qarze Hasna or Interest free

loan can meet the financial requirements of all. Interest /

profit on capital is included in the cost of production. If it

is reduced, cost shall be reduced and prices will come

down for the benefit of the public.

The Islamic system of economics is based upon the

balance between personal benefit and the benefit of

society as a whole.

July-August 2007


13/41


Like other religions Islam also dislikes and loathes frauds,

financial scandals, cheating, bribery, or taking undue

advantage of one's position. According to Sunnah:

"Bribe payer, receiver and the middle man, all shall go to

Hell."

No country is completely free from the evil of corruption.

Generally speaking, the poorer a country the more

corrupt it is. A political system, which is unrepresentative

and unaccountable, makes it worse. Corruption does not

mean bribery alone.

To counter this problem in Pakistan, the federal and

provincial arms of the National Accountability Bureau(NAB) are functioning. They deal with cases referred to

them. These cases generally involve huge amounts of

money and are against government officials, politicians

and businessmen.

Financial Corruption is not a new phenomenon. In the

days of Akbar, the great Mughal Emperor, one of his

courtiers was notorious for corruption. After receiving

numerous complaints against him, Akbar assigned the

corrupt man the duty of counting the waves of the River

Jamuna near Delhi. Akbar then forgot about this

assignment. After two years the emperor happened to

visit the site and was surprised to see a big palace on thebank of the river, while the corrupt man was still

performing his duty of counting the waves of the river. The

emperor appointed an investigation committee, as is

done these days after some unsavory incident has

occurred, to investigate the matter. Next day he was told

that people crossing the river, washing their clothes,

taking baths, cleaning their buffaloes, and passing boats

etc. had to pay a few coins, because by their acts they

were disturbing the waves, while according to the

emperor's orders, the waves had to be correctly counted.

Financial corruption at lower level, involving petty

amounts of cash, may be on account of the following

reasons:

1. Income is limited while expenditure is unlimited.

People resort to corruption to meet their needs.

2. In old age, future is neither safe nor secure, and so

everyone plans to save for the future. When pension

may be the only source of income and needs would go

up- medical expenses, higher food costs, daughters'

marriages, house rent if currently living in government

Cover Story

Financial

Corruption Sadia Kaleem, ACA


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Cover Story

provided housing, would become an extra financial

burden. This uncertain situation may induce somepeople to resort to corruption.

3. Undue comparison with others. People compare

themselves with others in many aspects, say

ownership of mobile phones, cars, clothes, residence,

furniture, electronic equipment and even in the number

of servants, drivers, babysitters, maid servants,

guards, gardeners etc. that they employ. People may

resort to financial corruption to meet their exaggerated

needs.

A person may pay bribe for the following reasons:

1. In government offices, there is pending work at every

desk and so every visitor is asked to come after four or

five days. The visitor has spent time and money on

conveyance and so to save that expense at a later

date, he would be willing to pay the bribe.

2. Sometimes a public person is in urgent need of a

matter and has to pay bribe as urgent service charges.

3. To receive undue favours - to outclass others and to

get what they are not entitled to.

Now the question arises where and how these corrupt

people keep their unlawful bribe collection. The following

might be used singly or jointly with one another:

1. The first use of bribe money is at home, in domestic

expenditure on both consumable and durable items.

Consumable items are not visible to outsiders while the

durable items come to the knowledge of the public or

at least to visitors, guests and relatives.

2. Prize bonds. At present prize bonds are for maximum

of Rs 40,000 each, purchasable and sellable at thebank counter without any questions asked.

3. Other bearer items like shares, with open transfer

deed, foreign exchange viz. euro, dollar, sterling

pound, and yen etc.

4. Real estate is the main item where the value of

property shown is hardly 20 to 25 percent of the actual

value and therefore 75 to 80 percent is paid off the

record i.e. through black money.

5. Benamis and Power of Attorneys are the other modes

of investment of black money. In big towns, smallhouses and bearer files for plot schemes exchange

hands. These are also financed by black money.

6. Illegal money collected through financial corruption is

also a source of capital, out of which new businesses,

industries, buildings are acquired or expanded.

To control bribery or palm greasing, following measures

may be considered:

1. Bearer investments (prize bonds, shares with bearer

transfer deeds, bearer real estate documents etc.)should be totally discontinued.

2. Every citizen with wealth, at present market value

above a figure, say in Pakistan, Rs. 1 million, must

compulsorily declare his wealth on the closing of the

government financial year whether his income is

exempted from income tax or not, like agriculturists.

Such persons should also file their expenditure

statements for the year.

3. Lockers should be made transparent to the tax

authorities.

4. Money laundering is the main source of movement of

black money. Foreign exchange agents are very much

available almost in every country. Their transactions

are not recorded. Bank accounts in foreign countries,

specially Switzerland, also need to be checked.

5. Size of currency notes should be bigger and thicker.

Credit Cards and Debit Cards should be encouraged

and their usage should be made common. Any bank

charges should be on the seller and not the cardholder.

6. For real estate, owners should be allowed to declare

the actual value of their property and the rate of stampduty and court fees be reduced proportionately.

7. Currency notes of big denomination should be

discontinued.

8. Cheque payments should be made reliable and safe.

July-August 2007

Sadia Kaleem, ACA, is also Chartered Secretary

(England) and has passed Chartered Cost &

Management, UK.


15/41


By and large, the main source of wealth is inheritance.Other sources could be windfall, and an individual's ownlabour and hard work.

According to Islamic teachings the factors of productionare to be paid immediately and equitably. Therefore,Islamic principles of factors' pricing are basically based onthese teachings, and are geared towards avoidingconcentration of wealth in few hands.

In the early days of Islam, Hazrat Usman (RTA) was avery successful and wealthy businessman who madegood profits from his business deals. As such it can besaid that Islamic principles do not prohibit creation oraccumulation of wealth, provided it is through clear andclean business deals.

Islam desires equity in the distribution of wealth.However, in-equality is not taken care off by functionaldistribution of income, but is through transfer payments,that is, the transfer of income and wealth from the well-offpeople to those living below the poverty line. T hephilosophy is that wealth is created by Allah and belongsto Him. The right to property granted to a person is just adelegation by Allah, its Owner, to His agent (man), andthe agent has to use it only as per His orders andinstructions.

Distribution of wealth, in Islam, is through three types oftransfers:

1. Compulsory2. Recommended3. Inheritance

1. Compulsory transfers: There are several compulsorylevies, ranging from 20 percent of the output (Ushr) to2.5 percent of wealth (Zakat). Sadaqah tul Fitr,although very negligible in value, is also a compulsorylevy for the benefit of poor on Eid ul Fitr.

w Zakat: It is a well-known subject among Muslims.No doubt, different scholars have different views onvarious provisions of Zakat such as assets on

which Zakat is levied and assets exempted fromZakat. There is also some difference of opinionabout who is eligible for Zakat, and the method ofdistribution and disposal of Zakat. In the HolyQuran, the order to the Prophet (PBUH), who wasalso the chief of government, was:

" Take from their wealth to clean it."

This practice of centralized collection continued forabout seven centuries. After Chingez Khanconquered Baghdad, Zakat came to be disbursedthrough mosques, and is now mostly paidindividually.

In the Quran, Allah's directive to the government isto collect Zakat. In Pakistan, it is in practice formore than 25 years, but the public's perception isthat it is not being properly distributed.

w Ushr: It is levied not on wealth, but on production.Its dictionary meaning is one-tenth. On agriculturalproduction by own cultivation it is mostly one- tenth,and if it is due to rain then one-fifth. Similarly,fishing, mining, fruit gardening, sea products, etc.are also liable to Ushr at different rates of up to 20percent.

Zakat is to be distributed among:

w poor persons;w miskeen, who are poor, but don't look like fakirs;

w employees of Zakat collection and administration;w converts to Islam to foster friendship and

cooperation that might strengthen Islam and newly

converted Muslims;

w for the purpose of freeing slaves;

w those under debt and loan;

w in the way of Allah, which may include printing and

distribution of Islamic literature, publicity, salaries of

Islamic movement workers, etc.;

w wayfarer

Cover Story

WealthDistribution

Nadia Azhar, ACA


16/41


Cover Story

Ushr collection is to be utilized for providing financialassistance and food to the poor.

1. Recommended transfers: Apart from zakat Muslimshave been directed by the Prophet (PBUH) to not eat afull meal if their neighbor is hungry. There is no limit onpayment to meet such needs. Such payments are notout of mercy or kindness but are the right of the needyand poor.

Hazrat Ali (RAT), the fourth caliph, put it in the followingwords:

"Allah has ordained that the rich are to pay out of theirwealth to the extent which is sufficient for the needs ofthe poor, so that if they do not find food or clothing, orstruggle (unsuccessfully for their living) it would be

because the rich are not doing their duty, and Allah willtake them to task on the Day Of Judgment and willpunish them.

2. Inheritance: In the Holy Quran and Sunnah, distributionof inheritance and its ratio and proportion are given indetail.

According to Sunnah, if a pious man dies withoutproper distribution of his inheritance, all his good deedsshall go to waste. On the other hand, a man with notmany good deeds to his credit, or who is not of areligious persuasion, shall go to Heaven if hedistributes his inheritance properly.

In different religions and cultures, different ways ofdistribution of inheritance are practiced. In one, only theeldest son is entitled to the whole wealth of the deceased.In the other, only sons are entitled to it while daughtersare deprived of it. In Islam, the Quran outlines theprinciples as follows:

"Allah enjoins you concerning your children's(inheritance), to the male (son), a portion equal to thatof two females (daughters); but if there be onlydaughter, two or more, two-thirds of what the deceasedleaves is theirs; and if there be one, for her is the half.For his parents, to each of them is the sixth share ofwhat he leaves, if he has children; but if he has no childand (only) his parents inherit from him, for his mother isthe third; but if he has brothers (or sisters), to his

mother is the sixth, after (payment of a bequest, hemay have bequeathed, or a debt); your parents andyour children, you don't know which of them is nearerto you in benefit; this is an ordinance from Allah. Allahis surely all-knowing and all-wise."

The heirs may be grouped in various ways and theprinciples of distribution amongst them are mostlyexplained in the Holy Quran. Parents should notdifferentiate among their children. They are allowed to giftthem. They can also make bequest in favour of a personnot a legal heir, not more than one-third of his assets. Allthese conditions are imposed to avoid concentration ofwealth in a few hands.

State and Wealth Distribution:

Our Prophet (PBUH) was the head of the governmentalso and so all directives and instructions to him are alsoto be followed by Muslim governments.

In the last fourteen centuries, the financial position,importance of money, sources of income, concentrationand collection of wealth, social status, rights of neighborsand family members have all changed.

Looking towards other religions, we see that in all threereligious books followed by the Jews and Christians, asthey exist today, the direction of God is to bring 10 percentof the income to one's own household. It appears that thisformula was the basis of introducing the income tax as thenoble men, two or three centuries ago, in this field wereJews or Christians and they must have derived the

formula for charging income to meet governmentexpenses, from these Holy Books.

It is the responsibility of the government to reduce thedifference in income and wealth of the rich and poor bylevying taxes on income and wealth, except those assetson which Zakat has been paid.

Islam does not impose any restriction on setting upfactories and business units that are not against publicinterest and Islamic teachings. Government may alsohave some industries in the public sector, particularlypublic utilities, defense industries, heavy industries, etc.where private establishments are risky or are againstpublic interest. To achieve this objective government may

prohibit certain industries for the private sector and evennationalize some of the private established industriesthrough payment of compensation, which it considers tobe run well under the public sector.

The basic needs of the public are the responsibility of thegovernment. According to Hazart Umar (RAT) everyonehas equal rights in the wealth of the community. Poor,unemployed, handicapped etc. are the responsibility ofthe government. According to the second Caliph, he (theCaliph) will be questioned on the Day of Judgment, if adog dies of hunger on the side of the River Nile.

Conclusion:

Concentration of wealth is not allowed in Islam. Poor,unemployed, widows, handicapped etc., as per Islamicteachings, have a right to the wealth of the rich people.Laws of inheritance, compulsory collection of Zakat, othermoral obligations, as per Islamic teachings, are to meetthe requirements of the poor, which at present is beingundertaken by various NGOs in different fields anddifferent areas. However, in an Islamic economy the basicresponsibility to maintain equity in income and wealth fallson the government.

July-August 2007

Nadia Azhar ACA is also ACCA. She is apartner in a professional firm.


17/41


The main ingredient for agriculture is land since withoutland there can be no agriculture.

At the beginning of human civilization, population waslittle and land was in abundance so there was no questionof ownership of land. Till a few centuries ago, cultivationon any land was not a problem i.e. whosoever cultivated,harvested, and whatever one sowed or reaped.

Man is not the creator of anything. Allah has createdeverything for him. Ownership is a trust vested in theowner by God. According to Surah Al-Baqarah:

He it is Who created for you all that is on earth. (2:29)

On earth will be a dwelling place for you and an

enjoyment for a time (2:36)

Who has made the earth a resting place for you and thesky as a canopy and sent down water from the sky andbrought forth therewith fruits as a provision to you. (2:22)The Holy Quran describes the personal and individualownership of everything consumable or durable orproductive.

In short, Allah has created all these for the benefit ofhuman beings and not only for the owner. Islam permitsall types of commercial activities and creation of wealth,but does not allow for it to be held for the benefit of

oneself only. The poor of the nation are also theresponsibility of the rich and they have a right to theirwealth.

Land is of different types viz. owners' land, trust land,government land, uncultivated land, bordered land,surrendered land, and residential area.

1.Owners' LandIt is owned by someone, inherited, or purchased or itsownership is due to any other reason.

2. Trust Land

It is land which the owner has assigned for charitablepurposes, for example, education, mosque, publicity,Islamic workers, etc.

3.Government Land

It is land that is owned, controlled and retained bygovernment.

4.Uncultivated Land

It is away from the cultivated area

5. Bordered Land

If someone raises the borders by constructing astonewall around an area by preserving it for himself forcultivation at a later date.

Cover Story

Agriculture Mehreen Wahid


18/41


Cover Story

6.Surrendered LandIf any cultivator or owner is not in a position to keep itup, he may surrender it for the use and benefit ofothers.

7.Residential AreaIt is the part of the village which has been used forresidential purposes like school, playground, hospitaland such other amenities.

No doubt individual or a group of persons on joint basiscan own the land. However, it should be used for thebenefit of general public and its use must not beharmful to others.

Sharing CultivationIf one owns the land and the other cultivates it, it is calledSharing Cultivation. Several verses of Sunnah are in itsfavour and some are against it.

Land taken on rent for agriculture is different from otherassets taken on rent. There can be unforeseen damagesthat can destroy the total crop. If it is rain cultivated areaand there is no rain, there will be no production and so thetenant will be totally in loss. The land which iswaterlogged or saline, in other words, is not fit forcultivation. Letting it out on rent is not allowed. If there isno crop for reasons beyond the tenant's control, no rentshall be payable. Fixing of rent subject to certainconditions is not justified. Similar to other assets on rent,

land rent should also be free from the condition of earningprofit by the tenant. The tenant may sell the product athigh profit, low profit, at cost, or at loss. It does not affectthe owner or the rent agreed. The cost of natural acts likefloods, locust swarms, or insecticides destroying the cropin full or in part is borne by the tenant. It is up to thelandlord to forego or discount the rent.

In certain cases, land revenue, water charges, agriculturaltaxes, etc. are payable on the land so rented out. It maybe clarified at the time of making the rent agreement as towho shall bear how much of these taxes.

According to the scholars the Prophet (PBUH), himself,cultivated on sharing basis. Thereafter several examplesof such cultivators by his followers are confirmed. Thereare many types of cultivation on sharing basis, some ofwhich are:

1. Landowner provides only land while the farmer useshis owns seeds and equipment. According to ImamHanifa, it is not allowed but Imam Muhammad andImam Abu Yusuf allow it. Imam Malik and ImamShafaee disallow it.

2. The other type is that the landlord provides the seedsalso and the product is shared at an agreed ratio.Hanafi scholars confirm it. Imam Muhammad and

Imam Abu Yusuf are also in favour of it, but Imam AbuHanifa and Imam Shafaee do not consider it proper.Maliki scholars allow it with some more conditions.

3. The third situation is when land is of owner, cultivationis by farmer, both provide seeds and agriculturalequipment and the product is shared at an agreedratio. Imam Shafaee has not allowed it. Imam Malikallows it with some more conditions.

4. The fourth position is when the land, seeds andequipment all are provided by the landlord and thefarmer puts in labour only and the crop is shared at anagreed ratio. Imam Hambal, Imam Abu Yusuf andImam Muhammad support this situation but Imam AbuHanifa, Imam Malik and Imam Shafaee do notconsider it proper.

5. According to the scholars following Imam Malik, landrent, labour wages and rent of agricultural equipmentshould all be fixed in terms of money beforehand. Bothprovide equal quantity of seeds and when the crop isready they shall first get compensation for itemsprovided as agreed and in cash. Then the balanceshould be shared as agreed.

The basic conditions for sharing cultivation as plannedare:

a. Land is fit for cultivation;

b. Area is fixed;

c. Situation and location of the land is defined;

d. Farmer should have a free approach to the site;

e. The period should be fixed, at least sufficient for anentire crop. Agreement may be for the crop if not forthe fixed period i.e. from sowing to harvesting.

Sharing agriculture is just like Modaraba where one hascapital and the other is working on it. But the difference is

that in shared farming the capital which is land will neverbe lost. While in Modaraba, the whole investment may belost. Landlords are sure to get some profit but not to sharethe losses, while in Modaraba the financier may have toloose his capital.

According to Sunnah and the practice of our Prophet(PBUH), ownership of land is allowed. Cultivation onsharing basis which is very much beneficial for poorlandless farmers is also allowed in Sunnah and Fiqh.

July-August 2007

Mehreen Wahid, is a CA finalist.


19/41


In recent months financial markets of the world witnessedanother episode of credit related problems. While this is not

something completely new or unexpected, this is peculiar inthe sense that the markets had largely ignored the warningsigns flashed near the end of the last year by various bankswhen they issued profit warnings on the back of expectedlosses from the sub prime lending in the US.

The wave started in the US by March this year and,despite reassurances from the Federal Reserve (Fed),continued to grow stronger as the economic data startedto show signs of economic slow down. It continued to gainmomentum and by June Merrill Lynch sold collateral torecover its investments in two hedge funds managed byBear Sterns that had invested in securities backed by subprime loans. However, US markets still remained positive

of the future and Dow Jones gained 2.2 percent on 6August despite the country's 10th largest mortgage lenderAmerican Home Mortgage Investment Corporation's filingfor Chapter 11* bankruptcy protection on the same date.The reason for the filing was inability of the company torenew existing funding or raise new funds for its business.----------------------------------------------------------------------------* Chapter 11 is a chapter of the United States BankruptcyCode under which a troubled business or its creditors canfile with a federal bankruptcy court for protection. AChapter 11 filing is usually an attempt to stay in businesswhile the court supervises the 'reorganization' of thecompany's contractual and debt obligations.

The fear of losses from the sub prime credit started to

manifest itself into a liquidity crunch as investors decided

to cut their losses and move on to other sectors whichlooked more promising. On 8 August a $4.9 billion merger

deal was put off because the acquirer suffered a billion

dollar losses in its mortgage subsidiary which faced

problems in financing its operations. On 9 August BNP

Paribas stopped valuing its three funds and suspended all

withdrawals by investors considering the evaporation of

liquidity. Goldman Sachs's largest fund reported 26%

losses in 2007, later it announced that another if its funds

lost 28% of its value in one week and was bailed out by

investors who put in $3 billion. By this time investors had

started to move away from the credit market, share prices

of mortgage lenders and investors in those lenders

around the world fell and liquidity started to dry up. Thecrisis hit Europe and reached as far as Japan and China,

stressing the global nature of the economy.

As could have been predicted, the Fed, European Central

Bank (ECB) and Bank of Japan (BOJ) stepped in to bail

out the markets and injected billions in the bond markets

to provide much needed liquidity. The Fed went as far as

cutting the discount rate by 50 basis points while keeping

the Fed rate same and temporarily allowing Citibank and

Bank of America to support their investment banking arms

using the federally insured retail bank money.

The Rise and Fall ofStructured Credit

How the Sub Prime Mortgage Crisis in the USbecame a global financial crisis

Danish Ahmed Siddiqui, A C A


20/41


The crisis posed a threat to the global economy and hashighlighted various market related issues and the debatemay lead to interesting conclusions. Many have blamed iton the sustained level of high liquidity in the market whichwas supported at least in part by the structured credit andmarkets, a lack of market's detailed understanding of therisks of structured credit products and the role of rating

agencies in incorrect pricing of the structured creditproducts.

Fostering liquidityThe recent liquidity crunch in the markets has ironicallybeen attributed by some to a prolonged period of highliquidity in the market which was fostered by low interestrates, growth in the foreign exchange reserves of thegrowing Asian economies and healthy corporate sector.Low interest rates encouraged consumers to borrowspecially as house prices increased consistently over thelast few years. This created demand for credit whichmight not have been met equally by the supply if it wasnot for a lack of profit opportunities elsewhere in the debt

market. As the booming Asian economies invested theirforeign exchange reserves in the risk free USGovernment bonds they drove the prices up and loweredthe yields which made them less attractive for the profitseeking investors. In search of profits, investors turned torisky alternatives which put a similar pressure on theprices and yields of the non investment grade debt andsoon the spread between the investment and noninvestment grade bonds narrowed to a level where thereturns on non investment grade bonds no longer seemedattractive. The financial markets responded to thissituation by creating structured products that promisedbetter returns.

A liquid market searching for profitable venues respondedpositively to these structures. A key feature of thesestructures was the ability to issue investment grade debtbacked by non investment grade assets whichencouraged banks to flex the lending criteria applied toretail borrowers which in turn helped to sustain theliquidity in the economy despite the rate increases in

2006.

Many of these structures are set up by larger banks whichalso provide some contingency liquidity line or guaranteeto help these through difficult conditions. However, if thesituation becomes very bad, as has been noted recently,the level of liquidity support required may affect the ratingdowngrades or compulsory winding up under theinvestment agreements. In some cases the parent maynot be willing or able to provide the support.

As a short term measure, central banks took steps toprovide liquidity by injecting funds, cutting rates andallowing deviations from the regulations. However, if

macro economic factors that lead to the higher liquiditye.g. emerging market growth and corporate profits stillremain positive investors may soon be lured again intoinvesting in high yield assets - probably a different classof assets, but may as well be in the structured productsafter the prices reflect the fundamentals and there isbetter awareness of the true exposures.

Promise of returnsStructured credit products generally offered high returnscompared to other instruments with the same rating andalso allowed investors to take derivative exposure butpresent it as investment in bonds in their accounts. The

July-August 2007

Sub prime Mortgage Crisis in US

w The sub prime mortgage financial crisis refers to the sharp rise inforeclosures in the sub prime mortgagemarket that began in the United States in 2006 and became a global financial crisis in July 2007. Rising interest

rates increased newly-popularadjustable rate mortgages (ARMs) and property values suffered declines from

the demise of the housing bubble, leaving home owners unable to meet financial commitments and lenderswithout a means to recoup their losses.

w The effects of the meltdown spread beyond housing and disrupted global financial markets as investors, largely

deregulated foreign and domestic hedge funds, were forced to re-evaluate the risks they were taking and

consumers lost the ability to finance further consumer spending, causing increased volatility in the fixedincome, equity, and derivative markets.

w Sub prime woes have been blamed for causing the U.S. dollar to continue its decline.

w Sub prime mortgage refers to a loan to a borrower who does not qualify for market interest rates because ofpoor credit history, or the inability to prove that he has enough income to support the monthly payment on the

loan for which he is applying. Since the borrower is considered sub prime, lenders charge a greater interestrate to make up for possible default on the loan. Sub prime loans or mortgages are risky for both creditors and

debtors because of the combination of high interest rates, bad credit history, and murky financial situations

often associated with sub prime applicants.


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ease of selling a structured credit product encouragedlenders to create more assets which, combined withcontinually rising house prices in the US lead to relaxedattitudes towards credit risks in respect of mortgages.Lenders accepted higher loan to value ratios and higherloan to income multiples when issuing mortgages. Lastlythey tapped into the sub-prime sectorwhich means lending money toindividuals with bad credit history orlow income.

Rising interest rates environment overthe last few months, coupled with highrepossession rates and a declininghousing market meant low recoveryrates and high losses for the

mortgage lenders. Lending to the sub-prime sector in some aspects issimilar to a bet on the real estate thanpure credit lending. The bet was thathouse prices will continue to rise inthe US and current expectations ofthe housing markets in the US offerno comfort as the prices are fallingand might take a long time to get backto the levels seen in the recentmonths.

Fairer values and truerexposuresMarket's uncertainty as to the trueexposures of the market participantsto the sub-prime lending alsocontr ibuted to the chaos. T h i shighlighted the need for better andtimely disclosures on risk exposuresespecially for complex structures.

Accounting standards allow the use ofvaluation models if a market price isnot available. Although variousdisclosures are required to explain the assumptions andmodels used to determine the values, these disclosuresmight not have attracted due attention in the past. This

may change and investors may demand moreexplanation of the management judgement applied indetermining the fair values and risk estimates.

Rating agenciesRating agencies have survived the criticism for qualityand relevance of the information they provide. This crisishas aggravated it for them as they downgraded billions ofdollars of securities in July in the middle of the crisis.Questions have been raised about the models used bythe agencies to assign investment grade ratings tosecurities that had sub prime backing and why they didnot downgrade these securities earlier. US Senate is

interested in the answers and this may lead to newlegislations.

Rating agencies maintain that they have to observe thedata before they take any downgrade actions and arelikely to support their ratings.

This has also focused attention on therisk management tools used by theissuers, investors and ratingagencies. This crisis may force themarket to invest in new systems andmodels to more accurately measureand report the credit risk.

Market adjustments

The crisis has jolted the financialmarkets and if investors' confidence inthe structured credit does not return,banks may have to find alternativeways to fund their assets or reducetheir funding needs by cutting supplyof credit.

Basel II will remove some of theincentives for taking assets off -balance sheet; this factor combinedwith investors wary of the traditionalstrucutures may force financialengineers to come up with newimproved structures of investment

vehicles or conduits.

Credit structures as an asset classallow investors to short credit,something which cannot be easilyachieved otherwise. Therefore, theseare not likely to fall out of favour withthe investors. However, the structuresmay need to address credit and otherrisk issues in a different manner ando ffer a much higher yield tocompensate for the perceived risk.

There may be additional regulations issued to addressinvestor concerns. Investment bankers are generally

against regulations and favour a free market; however,when there is a crisis they want the central bank to stepin and bail them out. In this recent episode, central bankshad to provide billions of dollars in order to support themarket. In order to avoid a repeat they may want to putsome checks in place.

The recent episode is likely to last for a short to mediumterm which is likely to lead to changes in investor attitude,risk management practices, funding structures, ratingprocesses and regulations. Financial markets are likely tocome out of this crisis better and stronger but it will takesome time before they get there - and when they get thereit may be a slightly different world.

July-August 2007

Many of these structures

are set up by larger

banks which also

provide some

contingency liquidity

line or guarantee to helpthese through difficult

conditions. However, if

the situation becomes

very bad, as has been

noted recently, the level

of liquidity support

required may affect the

rating downgrades or

compulsory winding upunder the investment

agreements. In some

cases the parent may

not be willing or able to

provide the support.


22/41


In the past decade, rapid innovations in financial marketsand the internationalization of financial flows havechanged the face of banking almost beyond recognition.Technological progress and deregulation have bothprovided new opportunities for and increased competitivepressures among banks. In the late 1980s, marginsattained from traditional banking business began todiminish and capital adequacy requirements began toincrease. Banks have responded to these new challengeswith vigor and imagination by forging ahead into newarenas. The growth in international financial markets anda greater diversity of financial instruments have allowedbanks wider access to funds. At the same time, marketshave expanded, and opportunities to design newproducts and provide more services have arisen. Whilethe pace of these changes appears to be quicker in some

countries than in others, banks everywhere are generallybecoming more involved in developing new instruments,products and services, and techniques. Tr a d i t i o n a lbanking practice - based on the receipt of deposits andthe granting of loans - is today only one part of a typicalbank's business, and is often its least profitable. Newinformation-based activities, such as trading in financialmarkets and income generation through fees, are now themajor sources of a bank's profitability. Financialinnovation has also led to the increased marketorientation and marketability of bank assets, in particularthrough the introduction of concepts such as loan swapsand sales. This process has been achieved using assets

such as mortgages, automobile loans, and export creditsas backing for marketable securities, a process known assecuritization. The correlation between different types ofrisk, both within an individual bank and throughout thebanking system, has increased and become morecomplex.

These developments have increased the need for andcomplicated the function of risk measurement,management, and control. The quality of corporategovernance of banks has become a much debated topic,and the approach to regulation and supervision haschanged dramatically. Within an individual bank, the newbanking environment and increased market volatility havenecessitated an integrated approach to asset-liability andrisk management techniques.

Amid changing banking environment, worldwide, theState Bank of Pakistan (SBP) has also recognized theimportance of risk management within financialinstitutions and has issued a set of guidelines on RiskManagement vide BSD Circular No. 7 dated August 15,2003, with an advice to the financial institutions to makeconcrete efforts to implement these guidelines in letterand spirit.

The risk management framework envisaged four majorcategories of risks that the banks are exposed to; vis--vis credit, market, liquidity and operational risks.

Credit RiskManagement

Guiding Principles for Implementation

Abdul Razzaq, ACA


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Since asset base of the financial institutions primarilycomprises loans and advances, management of creditrisk within the banks is of utmost importance for thesefinancial institutions.

Credit or counterparty risk - defined as the chance that adebtor or financial instrument issuer will not be able to payinterest or repay the principal according to the termsspecified in a credit agreement - is an inherent part ofbanking. Credit risk means that payments may bedelayed or ultimately not paid at all, which can in turncause cash flow problems and affect a bank's liquidity.Despite innovation in the financial services sector, creditrisk is still the major single cause of bank failures. Thereason is that more than 80 percent of a bank's balancesheet generally relates to this aspect of risk management.The three main types of credit (counterparty) risk are as

follows:

w personal or consumer risk;w corporate or company risk;w sovereign or country risk.

Because of the potentially dire effects of credit risk, it isimportant to perform a comprehensive evaluation of abank's capacity to assess, administer, supervise, enforce,and recover loans, advances, guarantees, and othercredit instruments. An overall credit risk managementreview will include an evaluation of the credit riskmanagement policies and practices of a bank. Thisevaluation should also determine the adequacy offinancial information received, from a borrower or the

issuer of a financial instrument, which has been used bya bank as the basis for investing in such financialinstruments or the extension of credit and the periodicassessment of its inherently changing risk.

Credit risk management in a financial institution primarilyconstitutes the following essential elements:

(a) Clearly defined lending policies(b) Credit portfolio quality review(c) Credit risk management policies(d) Policies to limit or reduce credit risk(e) Asset classification(f) Loan loss provisioning policy

(a) Clearly defined lending policiesFormal policies laid down by the board of directors inall pertinent areas are important. However, these areperhaps the most critical with regards to bank'slending function, which requires that the bank mustadopt a sound system for managing credit risk.

A lending policy should contain an outline of thescope and allocation of a bank's credit facilities andthe manner in which a credit portfolio is managed,i.e., how loans are originated, appraised, supervised,and collected. A good lending policy is not overlyrestrictive, but allows for the presentation of loans tothe board that officers believe are worthy of

consideration but which do not fall within theparameters of written guidelines. Flexibility mustexist to allow for fast reaction and early adaptation tochanging conditions in a bank's earning assets mixand market environment.

Considerations that form the basis for sound lendingpolicies include the following:

w Limit on total outstanding loansA limit on the total loan portfolio is usuallyexpressed relative to deposits, capital, or totalassets. In setting such a limit, factors such as creditdemand, the volatility of deposits, and credit risksshould be considered.

w Geographic limitsThese are usually a dilemma. If a bank lacksunderstanding of