1. Introduction

Islamic banking refers to a system of banking or banking activity that is

consistent with the principles of Islamic law (Shariah) and its practical

application through the development of Islamic economics. Shariah prohibits

the payment or acceptance of interest fees for loans of money (Riba, usury),

for specific terms, as well as investing in businesses that provide goods or

services considered contrary to its principles (Haraam, forbidden).

While these principles were used as the basis for a flourishing economy in

earlier times, it is only in the late 20th century that a number of Islamic

banks were formed to apply these principles to private or semi-private

commercial institutions within the Muslim community.

During the Islamic Golden Age, early forms of proto-capitalism and free

markets were present in the Caliphate, where an early market economy and

an early form of mercantilism were developed between the 8th-12th

centuries, which some refer to as "Islamic capitalism".

A vigorous monetary economy was created on the basis of the expanding

levels of circulation of a stable, high-value currency (the dinar) and the

integration of monetary areas that were previously independent.

A number of economic concepts and techniques were applied in early Islamic

banking, including bills of exchange, the first forms of partnership

(mufawada) such as limited partnerships (mudaraba), and the earliest forms

of capital (al-mal), capital accumulation (nama al-mal), cheques, promissory

notes, trusts (see Waqf) , transactional accounts, loaning, ledgers and

assignments.

Organizational enterprises independent from the state also existed in the

medieval Islamic world, while the agency institution was also introduced

during that time.

Many of these early capitalist concepts were adopted and further advanced

in medieval Europe from the 13th century onwards.

2. Riba

The word "Riba" means excess, increase or addition, which according to

Shariah terminology, implies any excess compensation without due

consideration (consideration does not include time value of money). The

definition of riba in classical Islamic jurisprudence was "surplus value without

counterpart", or "to ensure equivalency in real value", and that "numerical

value was immaterial." During this period, gold and silver currencies were

the benchmark metals that defined the value of all other materials being

traded. Applying interest to the benchmark itself (ex natura sua) made no

logical sense as its value remained constant relative to all other materials:

these metals could be added to but not created (from nothing).

Applying interest was acceptable under some circumstances. Currencies that

were based on guarantees by a government to honor the stated value (i.e.

fiat currency) or based on other materials such as paper or base metals were

allowed to have interest applied to them. When base metal currencies were

first introduced in the Islamic world, the question of "paying a debt in a

higher number of units of this fiat money being riba" was not relevant as the

jurists only needed to be concerned with the real value of money

(determined by weight only) rather than the numerical value.

For example, it was acceptable for a loan of 1000 gold dinars to be paid back

as 1050 dinars of equal aggregate weight (i.e., the value in terms of weight

had to be same because all makes of coins did not carry exactly similar

weight).

3. History of Islamic Banking

Modern banking system was introduced into the Muslim countries at a time

when they were politically and economically at low ebb, in the late 19th

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century. The main banks in the home countries of the imperial powers

established local branches in the capitals of the subject countries and they

catered mainly to the import export requirements of the foreign businesses.

The banks were generally confined to the capital cities and the local

population remained largely untouched by the banking system. The local

trading community avoided the “foreign” banks both for nationalistic as well

as religious reasons. However, as time went on it became difficult to engage

in trade and other activities without making use of commercial banks. Even

then many confined their involvement to transaction activities such as

current accounts and money transfers. Borrowing from the banks and

depositing their savings with the bank were strictly avoided in order to keep

away from dealing in interest which is prohibited by religion

Interest-free banking seems to be of very recent origin. The earliest

references to the reorganization of banking on the basis of profit sharing

rather than interest are found in Anwar Qureshi (1946), Naiem Siddiqi (1948)

and Mahmud Ahmad (1952) in the late forties, followed by a more elaborate

exposition by Mawdudi in 1950.

The writings of Muhammad Hamidullah 1944, 1955, 1957 and 1962 should

be included in this category. They have all recognized the need for

commercial banks and their perceived "necessary evil," have proposed a

banking system based on the concept of Mudarabha - profit and loss sharing.

In the next two decades interest-free banking attracted more attention,

partly because of the political interest it created in Pakistan and partly

because of the emergence of young Muslim economists. Works specifically

devoted to this subject began to appear in this period. The first such work is

that of Muhammad Uzair (1955). Another set of works emerged in the late

sixties and early seventies. Abdullah al-Araby (1967), Nejatullah Siddiqi

(1961, 1969), al-Najjar (1971) and Baqir al-Sadr (1961, 1974) were the main

contributors.

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The early 1970s saw institutional involvement. The Conference of the

Finance Ministers of the Islamic Countries held in Karachi in 1970, the

Egyptian study in 1972, the First International Conference on Islamic

Economics in Mecca in 1976, and the International Economic Conference in

London in 1977 were the result of such involvement. The involvement of

institutions and governments led to the application of theory to practice and

resulted in the establishment of the first interest-free banks. The Islamic

Development Bank, an inter-governmental bank established in 1975, was

born of this process.

The first modern experiment with Islamic banking was undertaken in Egypt

under cover without projecting an Islamic image—for fear of being seen as a

manifestation of Islamic fundamentalism that was anathema to the political

regime.

The pioneering effort, led by Ahmad Elnaggar, took the form of a savings

bank based on profit-sharing in the Egyptian town of Mit Ghamr in 1963. This

experiment lasted until 1967 (Ready 1981), by which time there were nine

such banks in country.

In 1972, the Mit Ghamr Savings project became part of Nasr Social Bank

which, currently, is still in business in Egypt. In 1975, the Islamic

Development Bank was set-up with the mission to provide funding to

projects in the member countries. The first modern commercial Islamic bank,

Dubai Islamic Bank, opened its doors in 1975. In the early years, the

products offered were basic and strongly founded on conventional banking

products, but in the last few years the industry is starting to see strong

development in new products and services.

Islamic Banking is growing at a rate of 10-15% per year and with signs of

consistent future growth. Islamic banks have more than 300 institutions

spread over 51 countries, including the United States through companies

such as the Michigan-based University Bank, as well as an additional 250

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mutual funds that comply with Islamic principles. It is estimated that over

US$822 billion worldwide Shariah-compliant assets are managed according

to The Economist. This represents approximately 0.5% of total world

estimated assets as of 2005. According to CIMB Group Holdings, Islamic

finance is the fastest-growing segment of the global financial system and

sales of Islamic bonds may rise by 24 percent to $25 billion in 2010.

The World Islamic Banking Conference, held annually in Bahrain since 1994,

is internationally recognized as the largest and most significant gathering of

Islamic banking and finance leaders in the world. The Vatican has put

forward the idea that "the principles of Islamic finance may represent a

possible cure for ailing markets.

Difference between Islamic and Conventional Banking

Islamic banking has the same purpose as conventional banking except that it

operates in accordance with the rules of Shariah, known as Fiqh al-Muamalat

(Islamic rules on transactions). The basic principle of Islamic banking is the

sharing of profit and loss and the prohibition of riba (usury).

Common terms used in Islamic banking include profit sharing (Mudharabah),

safekeeping (Wadiah), joint venture (Musharakah), cost plus (Murabahah),

and leasing (Ijarah).

In an Islamic mortgage transaction, instead of loaning the buyer money to

purchase the item, a bank might buy the item itself from the seller, and re-

sell it to the buyer at a profit, while allowing the buyer to pay the bank in

installments.

However, the bank's profit cannot be made explicit and therefore there are

no additional penalties for late payment. In order to protect itself against

default, the bank asks for strict collateral. The goods or land is registered to

the name of the buyer from the start of the transaction. This arrangement is

called Murabaha. Another approach is EIjara wa EIqtina, which is similar to

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real estate leasing. Islamic banks handle loans for vehicles in a similar way

(selling the vehicle at a higher-than-market price to the debtor and then

retaining ownership of the vehicle until the loan is paid).

An innovative approach applied by some banks for home loans, called

Musharaka al-Mutanaqisa, allows for a floating rate in the form of rental. The

bank and borrower form a partnership entity, both providing capital at an

agreed percentage to purchase the property. The partnership entity then

rents out the property to the borrower and charges rent. The bank and the

borrower will then share the proceeds from this rent based on the current

equity share of the partnership. At the same time, the borrower in the

partnership entity also buys the bank's share of the property at agreed

installments until the full equity is transferred to the borrower and the

partnership is ended.

If default occurs, both the bank and the borrower receive a proportion of the

proceeds from the sale of the property based on each party's current equity.

This method allows for floating rates according to the current market rate

such as the BLR (base lending rate), especially in a dual-banking system like

in Malaysia.

There are several other approaches used in business transactions. Islamic

banks lend their money to companies by issuing floating rate interest loans.

The floating rate of interest is pegged to the company's individual rate of

return. Thus the bank's profit on the loan is equal to a certain percentage of

the company's profits. Once the principal amount of the loan is repaid, the

profit-sharing arrangement is concluded. This practice is called Musharaka.

Further, Mudaraba is venture capital funding of an entrepreneur who

provides labor while financing is provided by the bank so that both profit and

risk are shared.

Such participatory arrangements between capital and labor reflect the

Islamic view that the borrower must not bear all the risk/cost of a failure,

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resulting in a balanced distribution of income and not allowing lender to

monopolize the economy.

Islamic banking is restricted to islamically acceptable transactions, which

exclude those involving alcohol, pork, gambling, etc. The aim of this is to

engage in only ethical investing, and moral purchasing.

In theory, Islamic banking is an example of full-reserve banking, with banks

achieving a 100% reserve ratio. However, in practice, this is not the case,

and no examples of 100 per cent reserve banking are observed.

Islamic banks have grown recently in the Muslim world but are a very small

share of the global banking system. Micro-lending institutions founded by

Muslims, notably Grameen Bank, use conventional lending practices and are

popular in some Muslim nations, especially Bangladesh, but some do not

consider them true Islamic banking.

However, Muhammad Yunus, the founder of Grameen Bank and microfinance

banking, and other supporters of microfinance, argue that the lack of

collateral and lack of excessive interest in micro-lending is consistent with

the Islamic prohibition of usury (riba).

Shariah Advisory Council (SAC)

Islamic banks and banking institutions that offer Islamic banking products

and services are required to establish a Shariah Supervisory Board (SSB) to

advise them and to ensure that the operations and activities of the banking

institutions comply with Shariah principles. On the other hand, there are also

those who believe that no form of banking that involves interest payments

can ever comply with the Shariah.

In Malaysia, the National Shariah Advisory Council, which has been set up at

Bank Negara Malaysia (BNM), advises BNM on the Shariah aspects of the

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operations of these institutions and on their products and services. In

Indonesia the Ulama Council serves a similar purpose.

A number of Shariah advisory firms have now emerged to offer Shariah

advisory services to the institutions offering Islamic financial services. Issue

of independence, impartiality and conflicts of interest have also been

recently voiced. The World Database for Islamic Banking and Finance

(WDIBF) has been developed to provide information about all the websites

related to this type of banking.

Fundamentals of Islamic finance

The term “Islamic banking” refers to a system of banking or banking activity

that is consistent with Islamic law (Shariah) principles and guided by Islamic

economics.

In particular, Islamic law prohibits usury, the collection and payment of

interest, also commonly called riba in Islamic discourse. In addition, Islamic

law prohibits investing in businesses that are considered unlawful, or haraam

(such as businesses that sell alcohol or pork, or businesses that produce

media such as gossip columns or pornography, which are contrary to Islamic

values). In the late 20th century, a number of Islamic banks were created to

cater to this particular banking market.

Usury in Islam

The criticism of usury in Islam was well established during the Prophet

Mohammed's life and reinforced by several of verses in the Holy Qur’an

dating back to around 600 AD. The original word used for usury in this text

was Riba, which literally means “excess or addition”.

This was accepted to refer directly to interest on loans so that, according to

Islamic economists Choudhury and Malik (1992), by the time of Caliph Umar,

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the prohibition of interest was a well-established working principle integrated

into the Islamic economic system.

It is not true that this interpretation of usury has been universally accepted

or applied in the Islamic world. Indeed, a school of Islamic thought which

emerged in the 19th Century, led by Sir Sayyed, still argues for an

interpretative differentiation between usury, which it is claimed refers to

consumptional lending, and interest which they say refers to lending for

commercial investment (Ahmed, 1958).

Nevertheless, there does seem to be evidence in modern times for what

Choudhury and Malik describe as “a gradual evolution of the institutions of

interest-free financial enterprises across the world” (1992: 104). They cite,

for instance, the current existence of financial institutions in Iran, Pakistan

and Saudi Arabia, the Dar-al-Mal-al-Islami in Geneva and Islamic trust

companies in North America.

Islamic Financial Instruments

A financial instrument is a certificate representing a common share in a fund

for investing and making a profit, issued by the body handling this

investment or the body acting on its behalf, which provides for its

negotiation and conversion into liquid money when required.

Following are the main modes of Islamic banking and finance:

Bai' al 'inah (Sale and Buy-back agreement)

Bai' al inah is a financing facility with the underlying buy and sell

transactions between the financier and the customer.

The financier buys an asset from the customer on spot basis. The price paid

by the financier constitutes the disbursement under the facility.

Subsequently the asset is sold to the customer on a deferred-payment basis

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and the price is payable in instalments. The second sale serves to create the

obligation on the part of the customer under the facility.

There are differences of opinion amongst the scholars on the permissibility of

Bai' al 'inah, however this is practised in Malaysia and the like jurisdictions.

Bai' Bithaman Ajil (Deferred payment sale)

This concept refers to the sale of goods on a deferred payment basis at a

price, which includes a profit margin agreed to by both parties. Like Bai' al

'inah, this concept is also used under an Islamic financing facility. Interest

payment can be avoided as the customer is paying the sale price which is

not the same as interest charged on a loan. The problem here is that this

includes linking two transactions in one which is forbidden in islam. The

common perception is that this is simply straightforward charging of interest

disguised as a sale

Bai' Muajjal (Credit sale)

Literally bai' muajjal means a credit sale. Technically, it is a financing

technique adopted by Islamic banks that takes the form of murabahah

muajjal. It is a contract in which the bank earns a profit margin on the

purchase price and allows the buyer to pay the price of the commodity at a

future date in a lump sum or in installments.

It has to expressly mention cost of the commodity and the margin of profit is

mutually agreed. The price fixed for the commodity in such a transaction can

be the same as the spot price or higher or lower than the spot price. Bai'

muajjal is also called a deferred-payment sale.

However, one of the essential descriptions of riba is an unjustified delay in

payment or either increasing or decreasing the price if the payment is

immediate or delayed.

Musharakah

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Musharakah (joint venture) is an agreement between two or more partners,

whereby each partner provides funds to be used in a venture. Profits made

are shared between the partners according to the invested capital.

In case of loss, each partner loses capital in the same ratio. If the Bank

provides capital, the same conditions apply.

It is this financial risk, according to the Shariah, that justifies the bank's claim

to part of the profit. Each partner may or may not participate in carrying out

the business. A working partner gets a greater profit share compared to a

sleeping (non-working) partner. The difference between Musharaka and

Madharaba is that, in Musharaka, each partner contributes some capital,

whereas in Madharaba, one partner, e.g. a financial institution provides all

the capital and the other partner, the entrepreneur, provides no capital. Note

that Musharaka and Madharaba commonly overlap.

Mudarabah (Profit-sharing)

"Mudarabah" is a special kind of partnership where one partner gives money

to another for investing it in a commercial enterprise. The investment comes

from the first partner who is called "rabb-ul-mal", while the management and

work is an exclusive responsibility of the other, who is called "mudarib" or

agent.

The Mudarabah (Profit Sharing) is a contract, with one party providing 100

percent of the capital and the other party providing its specialist knowledge

to invest the capital and manage the investment project.

Profits generated are shared between the parties according to a pre-agreed

ratio. Compared to Musharaka, in a Mudaraba only the lender of the money

has to take losses.

Murabahah (Cost + Profit)

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This concept refers to the sale of goods at a price, which includes a profit

margin agreed to by both parties. The purchase and selling price, other

costs, and the profit margin must be clearly stated at the time of the sale

agreement. The bank is compensated for the time value of its money in the

form of the profit margin.

This is a fixed-income loan for the purchase of a real asset (such as real

estate or a vehicle), with a fixed rate of profit determined by the profit

margin. The bank is not compensated for the time value of money outside of

the contracted term (i.e., the bank cannot charge additional profit on late

payments); however, the asset remains as a mortgage with the bank until

the default is settled.

This type of transaction is similar to rent-to-own arrangements for furniture

or appliances that are common in North American stores.

Musawamah

Musawamah is the negotiation of a selling price between two parties without

reference by the seller to either costs or asking price. While the seller may or

may not have full knowledge of the cost of the item being negotiated, they

are under no obligation to reveal these costs as part of the negotiation

process.

This difference in obligation by the seller is the key distinction between

Murabaha and Musawamah with all other rules as described in Murabaha

remaining the same. Musawamah is the most common type of trading

negotiation seen in Islamic commerce.

Bai Salam

Bai salam means a contract in which advance payment is made for goods to

be delivered later on. The seller undertakes to supply some specific goods to

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the buyer at a future date in exchange of an advance price fully paid at the

time of contract.

It is necessary that the quality of the commodity intended to be purchased is

fully specified leaving no ambiguity leading to dispute.

The objects of this sale are goods and cannot be gold, silver, or currencies

based on these metals. Barring this, Bai Salam covers almost everything that

is capable of being definitely described as to quantity, quality, and

workmanship.

Basic features and conditions of Salam

The transaction is considered Salam if the buyer has paid the purchase price

to the seller in full at the time of sale. This is necessary so that the buyer can

show that they are not entering into debt with a second party in order to

eliminate the debt with the first party, an act prohibited under Sharia.

The idea of Salam is to provide a mechanism that ensures that the seller has

the liquidity they expected from entering into the transaction in the first

place. If the price were not paid in full, the basic purpose of the transaction

would have been defeated.

Muslim jurists are unanimous in their opinion that full payment of the

purchase price is key for Salam to exist. Imam Malik is also of the opinion

that the seller may defer accepting the funds from the buyer for two or three

days, but this delay should not form part of the agreement.

Salam can be affected in those commodities only the quality and quantity of

which can be specified exactly. The things whose quality or quantity is not

determined by specification cannot be sold through the contract of salam.

For example, precious stones cannot be sold on the basis of salam, because

every piece of precious stones is normally different from the other either in

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its quality or in its size or weight and their exact specification is not generally

possible.

Salam cannot be affected on a particular commodity or on a product of a

particular field or farm. For example, if the seller undertakes to supply the

wheat of a particular field, or the fruit of a particular tree, the salam will not

be valid, because there is a possibility that the crop of that particular field or

the fruit of that tree is destroyed before delivery, and, given such possibility,

the delivery remains uncertain. The same rule is applicable to every

commodity the supply of which is not certain.

It is necessary that the quality of the commodity (intended to be purchased

through Salam) is fully specified leaving no ambiguity which may lead to a

dispute. All the possible details in this respect must be expressly mentioned.

It is also necessary that the quantity of the commodity is agreed upon in

unequivocal terms. If the commodity is quantified in weights according to the

usage of its traders, its weight must be determined, and if it is quantified

through measures, its exact measure should be known. What is normally

weighed cannot be quantified in measures and vice versa. The exact date

and place of delivery must be specified in the contract.

Salam cannot be affected in respect of things which must be delivered at

spot. For example, if gold is purchased in exchange of silver, it is necessary,

according to Shari'ah, that the delivery of both be simultaneous. Here, Salam

cannot work. Similarly, if wheat is bartered for barley, the simultaneous

delivery of both is necessary for the validity of sale. Therefore the contract of

Salam in this case is not allowed.

Hibah (gift)

This is a taken-given voluntarily by a debtor to a creditor in return for a loan.

Hibah usually arises in practice when Islamic banks voluntarily pay their

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customers a 'gift' on savings account balances, representing a portion of the

profit made by using those savings account balances in other activities.

It is important to note that while it appears similar to interest, and may, in

effect, have the same outcome, Hibah is a voluntary payment made (or not

made) at the bank's discretion, and cannot be 'guaranteed.'

However, the opportunity of receiving high Hibah will draw in customers'

savings, providing the bank with capital necessary to create its profits; if the

ventures are profitable, then some of those profits may be gifted back to its

customers as Hibah.

Ijarah

Ijarah means lease, rent or wage. Generally, Ijarah concept means selling the

benefit of use or service for a fixed price or wage. Under this concept, the

Bank makes available to the customer the use of service of assets /

equipments such as plant, office automation, motor vehicle for a fixed period

and price.

Advantages of Ijarah

Ijarah provides the following advantages to the Lessee:

Ijarah conserves the Lessee' capital since it allows up to 100% financing.

Ijarah gives the Lessee the right to access the equipment on payment of the

first installment. This is important as it is the access and use (and not

ownership) of equipment that generates income.

Ijarah arrangements aid corporate planning and budgeting by allowing the

negotiation of flexible terms. Ijarah is not considered Debt Financing so it

does not appear on the Lessee' Balance Sheet as a Liability. This method of

"off-balance-sheet" financing means that it is not included in the Debt Ratios

used by bankers to determine financing limits. This allows the Lessee to

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enter into other lease financing arrangements without impacting his overall

debt rating.

All payments towards Ijarah contracts are treated as operating expenses and

are therefore fully tax-deductible. Leasing thus offers tax-advantages to for-

profit operations.

Many types of equipment (i.e computers) become obsolete before the end of

their actual economic life. Ijarah contracts allow the transfer of risk from the

Lesse to the Lessor in exchange for a higher lease rate. This higher rate can

be viewed as insurance against obsolescence.

If the equipment is used for a relatively short period of time, it may be more

profitable to lease than to buy.

If the equipment is used for a long period but has a very poor resale value,

leasing avoids having to account for and depreciate the equipment under

normal accounting principles.

Ijarah Thumma Al-Bai' (Hire purchase)

Parties enter into contracts that come into effect serially, to form a complete

lease/ buyback transaction. The first contract is an Ijarah that outlines the

terms for leasing or renting over a fixed period, and the second contract is a

Bai that triggers a sale or purchase once the term of the Ijarah is complete.

For example, in a car financing facility, a customer enters into the first

contract and leases the car from the owner (bank) at an agreed amount over

a specific period.

When the lease period expires, the second contract comes into effect, which

enables the customer to purchase the car at an agreed to price.

The bank generates a profit by determining in advance the cost of the item,

its residual value at the end of the term and the time value or profit margin

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for the money being invested in purchasing the product to be leased for the

intended term. The combining of these three figures becomes the basis for

the contract between the Bank and the client for the initial lease contract.

This type of transaction is similar to the contractum trinius, a legal maneuver

used by European bankers and merchants during the Middle Ages to sidestep

the Church's prohibition on interest bearing loans.

In a contractum, two parties would enter into three concurrent and

interrelated legal contracts, the net effect being the paying of a fee for the

use of money for the term of the loan.

The use of concurrent interrelated contracts is also prohibited under Shariah

Law.

Ijarah-wal-iqtina

A contract under which an Islamic bank provides equipment, building, or

other assets to the client against an agreed rental together with a unilateral

undertaking by the bank or the client that at the end of the lease period, the

ownership in the asset would be transferred to the lessee.

The undertaking or the promise does not become an integral part of the

lease contract to make it conditional. The rentals as well as the purchase

price are fixed in such manner that the bank gets back its principal sum

along with profit over the period of lease.

Qardul Hassan (Good loan/Benevolent loan)

This is a loan extended on a goodwill basis, and the debtor is only required to

repay the amount borrowed. However, the debtor may, at his or her

discretion, pay an extra amount beyond the principal amount of the loan

(without promising it) as a token of appreciation to the creditor.

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In the case that the debtor does not pay an extra amount to the creditor, this

transaction is a true interest-free loan. Some Muslims consider this to be the

only type of loan that does not violate the prohibition on riba, since it is the

one type of loan that truly does not compensate the creditor for the time

value of money.

Sukuk (Islamic bonds)

Sukuk, plural of Sakk, is the Arabic name for financial certificates that صك

are the Islamic equivalent of bonds. However, fixed-income, interest-bearing

bonds are not permissible in Islam.

Hence, Sukuk are securities that comply with the Islamic law (Shariah) and

its investment principles, which prohibit the charging or paying of interest.

Financial assets that comply with the Islamic law can be classified in

accordance with their tradability and non-tradability in the secondary

markets.

Wadiah (Safekeeping)

In Wadiah, a bank is deemed as a keeper and trustee of funds. A person

deposits funds in the bank and the bank guarantees refund of the entire

amount of the deposit, or any part of the outstanding amount, when the

depositor demands it.

The depositor, at the bank's discretion, may be rewarded with Hibah (see

above) as a form of appreciation for the use of funds by the bank.

Wakalah (power of attorney)

This occurs when a person appoints a representative to undertake

transactions on his/her behalf, similar to a power of attorney.

Islamic equity funds

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Islamic investment equity funds market is one of the fastest-growing sectors

within the Islamic financial system.

Currently, there are approximately 100 Islamic equity funds worldwide. The

total assets managed through these funds currently exceed US$5 billion and

is growing by 12–15% per annum.

With the continuous interest in the Islamic financial system, there are

positive signs that more funds will be launched. Some Western majors have

just joined the fray or are thinking of launching similar Islamic equity

products.

Despite these successes, this market has seen a record of poor marketing as

emphasis is on products and not on addressing the needs of investors. Over

the last few years, quite a number of funds have closed down.

Most of the funds tend to target high net worth individuals and corporate

institutions, with minimum investments ranging from US$50,000 to as high

as US$1 million. Target markets for Islamic funds vary; some cater for their

local markets, e.g., Malaysia and Gulf-based investment funds.

Others clearly target the Middle East and Gulf regions, neglecting local

markets and have been accused of failing to serve Muslim communities.

Since the launch of Islamic equity funds in the early 1990s, there has been

the establishment of credible equity benchmarks by Dow Jones Islamic

market index (Dow Jones Indexes pioneered Islamic investment indexing in

1999) and the FTSE Global Islamic Index Series. The Web site failaka.com

monitors the performance of Islamic equity funds and provides a

comprehensive list of the Islamic funds worldwide.

Islamic derivatives

With help of Bahrain-based International Islamic Financial Market and New

York-based International Swaps and Derivatives Association, global

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standards for Islamic derivatives were set in 2010. The “Hedging Master

Agreement” provides a structure under which institutions can trade

derivatives such as profit-rate and currency swaps.

Islamic laws on trading

The Qur'an prohibits gambling (games of chance involving money) and

insuring ones' health or property (also considered a game of chance). The

hadith, in addition to prohibiting gambling (games of chance), also prohibits

bayu al-gharar (trading in risk, where the Arabic word gharar is taken to

mean "risk" or excessive uncertainty).

The Hanafi school of thought in Islam defines Gharar as "that whose

consequences are hidden."

The Shafi legal school defined gharar as "that whose nature and

consequences are hidden" or "that which admits two possibilities, with the

less desirable one being more likely." The Hanbali school defined it as "that

whose consequences are unknown" or "that which is undeliverable, whether

it exists or not." Ibn Hazm of the Zahiri school wrote "Gharar is where the

buyer does not know what he bought, or the seller does not know what he

sold."

The modern scholar of Islam, Professor Mustafa Al-Zarqa, wrote that "Gharar

is the sale of probable items whose existence or characteristics are not

certain, due to the risky nature that makes the trade similar to gambling."

Other modern scholars, such as Dr. Sami al-Suwailem, have used Game

Theory to try and reach a more measured definition of Gharar, defining it as

"a zero-sum game with unequal payoffs".

There are a number of hadith that forbid trading in gharar, often giving

specific examples of gharhar transactions (e.g., selling the birds in the sky or

the fish in the water, the catch of the diver, an unborn calf in its mother's

womb etc.). Jurists have sought many complete definitions of the term. They

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also came up with the concept of yasir (minor risk); a financial transaction

with a minor risk is deemed to be halal (permissible) while trading in non-

minor risk (bayu al-ghasar) is deemed to be haram.

What gharar is, exactly, was never fully decided upon by the Muslim jurists.

This was mainly due to the complication of having to decide what is and is

not a minor risk. Derivatives instruments (such as stock options) have only

become common relatively recently. Some Islamic banks do provide

brokerage services for stock trading.

Microfinance in Islamic

Microfinance is a key concern for Muslims states and recently Islamic banks

also. Microfinance is ideologically compatible with Islamic finance, capable of

Shariah-compliancy, and possesses a sizeable potential market.

Islamic microfinance tools can enhance security of tenure and contribute to

transformation of lives of the poor. The use of interest found in conventional

microfinance products and services can easily be avoided by creating

microfinance hybrids delivered on the basis of the Islamic contracts of

mudaraba, musharaka, and murabaha. Already, several microfinance

institutions (MFIs) such as FINCA Afghanistan have introduced Islamic-

compliant financial instruments that accommodate Shariah criteria.

Current practices of Islamic Banking

Generally speaking, all interest-free banks agree on the basic principles.

However, individual banks differ in their application. These differences are

due to several reasons including the laws of the country, objectives of the

different banks, individual bank’s circumstances and experiences, the need

to interact with other interest-based banks, etc. In the following paragraphs,

we will describe the salient features common to all banks.

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Deposit accounts

All the Islamic banks have three kinds of deposit accounts: current, savings

and investment.

Current accounts

Current or demand deposit accounts are virtually the same as in all

conventional banks. Deposit is guaranteed.

Savings accounts

Savings deposit accounts operate in different ways. In some banks, the

depositors allow the banks to use their money but they obtain a guarantee of

getting the full amount back from the bank.

Banks adopt several methods of inducing their clients to deposit with them,

but no profit is promised. In others, savings accounts are treated as

investment accounts but with less stringent conditions as to withdrawals and

minimum balance. Capital is not guaranteed but the banks take care to

invest money from such accounts in relatively risk-free short-term projects.

As such lower profit rates are expected and that too only on a portion of the

average minimum balance on the ground that a high level of reserves needs

to be kept at all times to meet withdrawal demands.

Investment account

Investment deposits are accepted for a fixed or unlimited period of time and

the investors agree in advance to share the profit (or loss) in a given

proportion with the bank. Capital is not guaranteed.

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Modes of financing

Banks adopt several modes of acquiring assets or financing projects. But

they can be broadly categorised into three areas: investment, trade and

lending.

Investment financing

This is done in three main ways: a) Musharaka where a bank may join

another entity to set up a joint venture, both parties participating in the

various aspects of the project in varying degrees. Profit and loss are shared

in a pre-arranged fashion. This is not very different from the joint venture

concept.

The venture is an independent legal entity and the bank may withdraw

gradually after an initial period. b) Mudarabha where the bank contributes

the finance and the client provides the expertise, management and labour.

Profits are shared by both the partners in a pre-arranged proportion, but

when a loss occurs the total loss is borne by the bank. c) Financing on the

basis of an estimated rate of return.

Under this scheme, the bank estimates the expected rate of return on the

specific project it is asked to finance and provides financing on the

understanding that at least that rate is payable to the bank. (Perhaps this

rate is negotiable.) If the project ends up in a profit more than the estimated

rate the excess goes to the client. If the profit is less than the estimate the

bank will accept the lower rate. In case a loss is suffered the bank will take a

share in it.

Trade financing

This is also done in several ways. The main ones are: a) Mark-up where the

bank buys an item for a client and the client agrees to repay the bank the

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price and an agreed profit later on. b) Leasing where the bank buys an item

for a client and leases it to him for an agreed period and at the end of that

period the lessee pays the balance on the price agreed at the beginning an

becomes the owner of the item. c) Hire-purchase where the bank buys an

item for the client and hires it to him for an agreed rent and period, and at

the end of that period the client automatically becomes the owner of the

item.

d) Sell-and-buy-back where a client sells one of his properties to the bank for

an agreed price payable now on condition that he will buy the property back

after certain time for an agreed price. e) Letters of credit where the bank

guarantees the import of an item using its own funds for a client, on the

basis of sharing the profit from the sale of this item or on a mark-up basis.

Lending

Main forms of Lending are: a) Loans with a service charge where the bank

lends money without interest but they cover their expenses by levying a

service charge. This charge may be subject to a maximum set by the

authorities. b) No-cost loans where each bank is expected to set aside a part

of their funds to grant no-cost loans to needy persons such as small farmers,

entrepreneurs, producers, etc. and to needy consumers. c) Overdrafts also

are to be provided, subject to a certain maximum, free of charge.

Services

Other banking services such as money transfers, bill collections, trade in

foreign currencies at spot rate etc. where the bank’s own money is not

involved are provided on a commission or charges basis.

Global Scenario of Islamic Banking

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Over the last three decades Islamic banking and finance has developed into

a full-fledged system and discipline reportedly growing at the rate of

15percent per annum. Today, Islamic financial institutions, in one form or the

other, are working in about 75 countries of the world. Besides individual

financial institutions operating in many countries, efforts have been

underway to implement Islamic banking on a country wide and

comprehensive basis in a number of countries.

The instruments used by them, both on assets and liabilities sides, have

developed significantly and therefore, they are also participating in the

money and capital market transactions. In Malaysia, Bahrain and a few other

countries of the Gulf, Islamic banks and financial institutions are working

parallel with the conventional system.

Bahrain with the largest concentration of Islamic financial institutions in the

Middle East region, is hosting 26 Islamic financial institutions dealing in

diversified activities including commercial banking, investment banking,

offshore banking and funds management.

It pursues a dual banking system, where Islamic banks operate in the

environment in which Bahrain Monetary Agency (BMA) affords equal

opportunities and treatment for Islamic banks as for conventional banks.

Bahrain also hosts the newly created Liquidity Management Centre (LMC)

and the International Islamic Financial Market (IIFM) to coordinate the

operations of Islamic banks in the world.

To provide appropriate regulatory set up, the BMA has introduced a

comprehensive prudential and reporting framework that is industry-specific

to the concept of Islamic banking and finance. Further, the BMA has

pioneered a range of innovations designed to broaden the depth of Islamic

financial markets and to provide Islamic institutions with wider opportunities

to manage their liquidity.

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Another country that has a visible existence of Islamic banking at

comprehensive level is Malaysia where both conventional and Islamic

banking systems are working in a competitive environment. The share of

Islamic banking operations in Malaysia has grown from a nil in 1983 to above

8 percent of total financial system in 2003. They have a plan to enhance this

share to 20 percent by the year 2010. However, there are some conceptual

differences in interpretation and Shariah position of various contracts like

sale and purchase of debt instruments and grant of gifts on savings and

financial papers.

In Sudan, a system of Islamic banking and finance is in operation at national

level. Like other Islamic banks around the world the banks in Sudan have

been relying in the past on Murabaha financing.

However, the share of Musharaka and Mudaraba operations is on increase

and presently constitutes about 40 percent of total bank financing. Although

the Islamic financial system has taken a good start in Sudan, significant

problems still remain to be addressed.

Like Sudan, Iran also switched over to Usury Free Banking at national level in

March 1984. However, there are some conceptual differences between

Islamic banking in Iran and the mainstream movement of Islamic banking

and finance.

Owing to the growing amount of capital availability with Islamic banks, the

refining of Islamic financing techniques and the huge requirement of

infrastructure development in Muslim countries there has been a large

number of project finance deals particularly in the Middle East region.

Islamic banks now participate in a wide financing domain stretching from

simple Shariah-compliant retail products to highly complex structured

finance and large-scale project lending. These projects, inter alia, include

power stations, water plants, roads, bridges and other infrastructure

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projects. Bahrain is the leading centre for Islamic finance in the Middle East

region.

The establishment of the Prudential Information and Regulatory Framework

for Islamic Banks (PIRI) by the BMA in conjunction with AAOIFI has gone a

long way towards establishing a legal and regulatory framework to meet the

specific risks inherent in Islamic financing structures. The BMA has quite

recently signed MoU with the London Metal Exchange (LME) to pool assets to

develop and promote Shariah compliant tradable instruments for Islamic

banking industry.

The arrangement is seen as a major boost for industry’s integration in the

global financial system and should set the pace for commodity-trading

environment in Bahrain. BMA has also finalized draft guidelines for issuance

of Islamic bonds and securities from Bahrain. In May 03, the Liquidity

Management Centre (LMC) launched its debut US$ 250 million Sukuk on

behalf of the Government of Bahrain.

National Commercial Bank (NCB) of Saudi Arabia has introduced an Advance

Card that has all the benefits of a regular credit card. The card does not have

a credit line and instead has a prepaid line. As such, it does not incur any

interest. Added benefits are purchase protection, travel accident insurance,

etc and no interest, no extra fees with no conditions, the card is fully Shariah

compliant. It is more secure than cash, easy to load up and has worldwide

acceptance.

This prepaid card facility is especially attractive to women, youth, self

employed and small establishment employees who sometimes do not meet

the strict requirements of a regular credit card facility.

Furthermore, Saudi Government has also endorsed an Islamic-based law to

regulate the kingdom's lucrative Takaful sector and opened it for foreign

investors. Islamic banks have also built a strong presence in Malaysia, where

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Standard & Poor's assigned a BBB+rating to the $600 million Shariah-

compliant trust certificates (called sukuk) issued by Malaysia Global Sukuk

Inc. Bank Negara Malaysia (BNM) has announced to issue new Islamic Bank

licenses 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. It lists incentives to develop the Islamic financial

sector and enlarge its market share to 20 percent, from under 10 percent

now.

A dedicated high court has been set up to handle Islamic banking and

finance cases. In United Kingdom, the Financial Services Authority is in final

stages of issuing its first ever Islamic banking license to the proposed Islamic

Bank of Britain, which has been sponsored by Gulf and UK investors. The

United States of America has appointed Dr. Mahmoud El Gamal, an eminent

economist/expert on Islamic banking to advise the US Treasury and

Government departments on Islamic finance in June 2004.

Conclusion

Considering the important role of Islamic Bankings in the mobilisation of

financial resources, Scholars, Ulemu' and Bankers with vision, courage,

imagination and above all, absolute conviction and commitment to the cause

of Islam, will have to work in tandem to examine the future prospects and

possibilities of diversifying and widening the scope, volume and size of

Islamic Banking of different maturities. Furthermore, Islamic banks mainly

deal with the area of an assets rather than liability, which make their

operations more diversify and complex.

It is also evident that there has no exhaustive funds standard in Islamic

banks. Therefore, effort should be made to harmonize the funds standard in

Islamic banks in Muslim Countries. It is also observed that Islamic banks tend

to be favour the murabahah technique rather than profit/loss sharing.

Therefore, Islamic banks should try to create a means to embark in profit

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and loss sharing techniques, such as venture capital and private equity, etc.

as it is true concept of Islamic banks.

References

1. Abu Musa, Md. Sadeque,& Efazuddin Mallick, (2006). Islamic Banking: It’s Operating

Mechanisms. In writings on Islamic banking , edited by Ataul Huq Pramanik, Kuala Lumpur,

Research centre, International Islamic University Malaysia

2. Contemporary Practices of Islamic financing Techniques, edited by Dr Ausaf Ahmad,

Jeddah, Saudi Arabia, IRTI

3. M.A. Mannan, A.K.M Fazlul Hoque and R.Z (2006). Functions of an Islamic bank. In

writings on Islamic banking. Edited by Ataul Huq Pramanik, Kuala Lumpur, Research

center, International Islamic University Malaysia.

4. Mei Pheng, LEE and Ivan Jeron DETTA, (2007). Islamic Banking and Finance Law, Kuala

Lumpur, Pearson Longman.

5. Islamic banking and Finance, (2004).edited by Salman Syed Ali and Ausaf Ahmad, Selecte

papers from Conference in Brunei, 5-7 January, 2004, organized by Islamic Research and

Training Institute and University Brunei Dar Salam.

6. Saiful Azhar Rosly, (2005). Critical Issues on Islamic Banking and Financial Markets, Kuala

Lumpur, Dinamas Publishing

7. Sudin Haron, A Comparative Study of Islamic Banking Practices, School of Management,

University Utara, Malaysia.

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