Islamic Banking and Finance

Islamic Banking and Finance

By

Mondher Bellalah

Islamic Banking and Finance, by Mondher Bellalah

This book first published 2013

Cambridge Scholars Publishing

12 Back Chapman Street, Newcastle upon Tyne, NE6 2XX, UK

British Library Cataloguing in Publication Data A catalogue record for this book is available from the British Library

Copyright © 2013 by Mondher Bellalah

All rights for this book reserved. No part of this book may be reproduced, stored in a retrieval system, or transmitted, in any form or by any means, electronic, mechanical, photocopying, recording or

otherwise, without the prior permission of the copyright owner.

ISBN (10): 1-4438-4770-4, ISBN (13): 978-1-4438-4770-4

It is with a considerable sense of pride and honour that I dedicate this book to the “Yasmine revolte” of the young people of the Tunisian Republic. This book is written to improve understanding about Islamic economics and the international Islamic community, and to convey the importance of both particularly during these days of crisis. I am delighted to note the unique efforts of the Tunisian Ministry of Higher Education and Scientific Research to enhance Islamic studies; these efforts are expansive and cover all fields of Islamic studies, including economics.

TABLE OF CONTENTS Preface ......................................................................................................... x Adnan Ahmed Yousif, President and CEO of Albaraka Banking Group, Chairman of the Board of Directors, Union of Arab Banks Introduction ............................................................................................... xii Chapter One ................................................................................................. 1 Introduction to Islamic Finance and Islamic Banking: From Theory to Innovations

Section 1: From a Conceptual Idea to an Evolving and Fast Growing Reality

Section 2: An Overview on the Framework of Islamic Finance and Banking13

Section 3: Islamic Financial Contracts and Products Conclusion: On the Challenges and Issues of Structuring Innovative

Shariah Compliant Products Chapter Two .............................................................................................. 71 Productivity Growth in the GCC Banking Industry 1999–2007: Conventional Versus Islamic Banks

Section 1. Introduction Section 2. Revue of Literature Section 3. Methodology Section 4. Data and Variables Section 5. Empirical Results and Analysis Conclusion

Chapter Three .......................................................................................... 109 An Analysis for the Growth and Rise of Smaller Islamic Banks in the Last Decade

Section 1. Introduction Section 2. Literature Review Section 3. Islamic Banking: an Overview Section 4. Methodology Section 5. Empirical Analysis Conclusions

Table of Contents viii

Chapter Four ............................................................................................ 126 Development and Scope of Islamic Bank Bonds (Sukuks)

Section 1. Introduction Section 2. Aims and Objectives Section 3. Cases of Non-Muslim Sukuk Issuers and Investors Section 4. Britain and Islamic finance Section 5. Islamic Home Financing Section 6. Methodology Section 7. Results Section 8.Discussion Conclusion Recommendations

Chapter Five ............................................................................................ 159 Iran’s Islamic Banking Experience and Future

Section 1. Introduction Section 2. The Islamic Banking Law—Did the Banking System

Implement It? Conclusion

Chapter Six .............................................................................................. 169 Islamic Banking Structure and Growth in the Sudanese Islamic Banking Sector

Section 1. Introduction Section 2. Sudanese Banking Industry Section 3. Research Methodology Section 4. Data Analysis and Findings Conclusion

Chapter Seven .......................................................................................... 196 Islamic Mortgages

Section 1. Introduction Section 2. Major Principles of Islamic Finance Section 3. The Islamic Mortgage Market in UK Section 4. Empirical Analysis Conclusion

Islamic Banking and Finance ix

Chapter Eight ........................................................................................... 221 Role of Islamic Mortgages in the UK

Section 1. Introduction Section 2. Uk Sharia-compliant Market Analysis Section 3. Islamic Modes of Financing Section 4. The Growth of Islamic Financial Instittions Section 5. Comparison between Islamic and Conventional Mortgages Conclusion

Chapter Nine ............................................................................................ 244 The “Islamic Bank of Britain”: Case Study Analysis

Section 1. Introduction Section 2. Objectives of thе Study Section 3. Islamic Banking in the United Kingdom Section 4. The Islamic Bank of Britain Section 5. Methodology Section 6. Results and Analysis Section 7. Author Findings Summary and Conclusions Recommendations

Chapter Ten ............................................................................................. 261 Growth of Islamic Banking and Employee Satisfaction in Bangladesh

Section 1. Introduction Section 2. Aims and Objectives Section 3. Literature Review for Bangladesh Section 4. Methodology Conclusions Policy and Recommendation

PREFACE Islamic banking has seen rapid growth during the last two decades. There are many contributory factors for such growth, most notable of which are the liberalisation of financial regulation; the globalisation of financial markets; changes in technology; product innovation; the birth of several new Islamic states; and the growing Islamic presence in the West. Product innovations have helped economists and religious scholars to bring new products to almost all areas of banking and insurance, some of which were previously thought to be extremely controversial. There is no accurate data on the extent and volume of Islamic banking. Islamic banking assets are currently estimated at being between USD 500 and 800 Billion, and there are nearly three hundred Islamic Financial Institutions worldwide, including “Islamic windows” of conventional banks. The Islamic sukuk, (equivalent to bonds in Western finance) are the fastest growing product on the financial market, and the sukuk market has increased at an average annual rate of 40 per cent, with a current size of more than USD 82 billion. In Pakistan and Malaysia, Sharia-compliant funds have exceeded over 50% of total market capitalization. Today, Islamic banking is growing at approximately 15% per annum, as a result of economic expansion in the Islamic world, fuelled primarily by oil wealth. This growth has created a expanding middle-wealth segment and hence made banking a necessary service to a larger segment of the population rather than a service for a minority, as had been the case for the preceding ten to fifteen year period. The Islamic banking system is popular with not only Islamic banks themselves, but also well-known international and other conventional banks. Presently the majority of international banks are adopting Islamic banking to serve their new clients and their specific needs. Examples of such banks are Citibank and HSBC, both of which have started Islamic operations worldwide to expand their businesses.Although interest in Islamic banking has grown considerably during the last decade, Islamic banking today continues to evolve as an industry. The financial world has set conventional banking as a standard practice driven mainly by the profit maximisation principle. However, Islamic banking principles have attracted attention from academic researchers and regulators both in developing and developed countries as a result of their distinguished micro-operating fundamentals. The prohibition of interest payments by Islamic Sharia (Islamic law) has instead made equity and profit sharing the

Islamic Banking and Finance xi

cornerstones of its operational structure activities. This ban on interest does not mean that capital is costless in an Islamic system; in fact, it recognises funds as a factor of production but does not allow the fund-providers to make a prior or pre-determined claim in the form of interest. This risk-sharing principle provides theoretically better long-term allocation of funds to investments with higher risk-return profiles and subsequently greater economic growth.

This book addresses the main issues of concern within Islamic banking, namely the conceptual framework and viability of interest-free banking and the assessment of its performance and future. In a world where conventional interest-based finance is the dominant framework, Islamic banking faces many challenges that must be addressed. This book discusses the contemporary issues and challenges confronting the Islamic banking system and was written for both researchers and practitioners. It analyses the past experiences of Islamic banks worldwide and provides an objective assessment of their successes and failures.

Adnan Ahmed Yousif President and CEO of Al Baraka Banking Group President of Union des Banques Arabes

INTRODUCTION

General Introduction

What distinguishes Islamic finance and banking from the conventional financial system is based on a comprehensive system of ethics and moral values stemming from the Islamic religion. Unlike conventional finance, Islamic finance is founded on overarching principles that constitute the guidelines governing any Islamic economic or financial dealings.

The principles that underline the distinguishing features of Islamic finance and banking as well as Islamic economics as a whole stem from the Sharia of Mu’amalat or Islamic law governing human relationships. Islamic Law refers to the divine injunctions in the Koran and the prophet’s (PBUH) traditions that regulate the conduct of human beings in their individual and collective lives. In this regard, it is worth pointing out that Islam does not refer only to the Islamic religion but encompasses a comprehensive social system where people live in accordance with divine guidance.

Islamic finance was developed from a conceptual idea in regard to an evolving and fast reality. With the involvement of many actors in the industry and the culmination of economic, political and demographic factors, Islamic Finance has shown a strong growth.

Basic Sharia-compliant contracts have been used innovatively in structuring various Islamic financial and deposit products for banking, project finance, capital market, insurance products and risk management instruments. The structuring of innovative finance and derivative Sharia-compliant instruments plays an important role in the enhancement of Islamic financial markets and Islamic risk-management practices.

For future challenges, the immediate need is to develop instruments that enhance liquidity, and to develop secondary, monetary and inter-bank markets; and to perform asset liability and risk management.

My personal view is that it is a “huge mistake” to use the LIBOR as a benchmark. The benchmark must be the “real cost”’ or “Actual costs” incurred by Islamic banks and mainly information costs to which a margin must be added. These costs are well known in the literature (the reader can refer to Bellalah [2008, 2009]). These costs are defined in Appendix 1 of Chapter 1.

Islamic Banking and Finance xiii

This Book is organized as follows. Chapter one draws attention to the important development that Islamic

Finance and banking have known from a conceptual idea to an evolving and fast reality. It deals with the different principles governing Islamic financial dealing and transactions and gives an overview of the added value of Islamic finance to the international financial system. The chapter covers the main Sharia-compliant structured project finance solutions and the sukuk market, and presents new practices in the industry such as sukuk restructuring, credit enhancement, redemption and convertibility.

Chapter two studies the productivity growth in the GCC Banking Industry for the period 1999-2007. It compares conventional versus Islamic banks. This study examines the impact of financial liberalization on banking productivity growth in the Gulf Cooperation Council (GCC) countries during the period 1999–2007. Employing a non-parametric approach (DEA), productivity change has been measured by computing total factor productivity index for two groups of banks: conventional and Islamic. The findings indicate that during the period of deregulation, GCC banks have experienced a gain in productivity change of about 1.8%, attributed mainly to the progress of technical change rather than increase in efficiency change. We also found that conventional banks tend to outperform Islamic banks in most productivity measures. In this chapter, we also investigate the determinants of bank productivity. The results show that bank size has a positive impact on productivity growth for all models, while capitalization is related negatively to efficiency change for the model of Islamic banks only. Finally, the regression findings also demonstrate the strong links of macroeconomic and financial sector indicators with bank productivity.

Chapter three presents an analysis for the growth and rise of smaller Islamic banks in last decade. Chapter four studies the development and scope of Islamic bank bonds (known as Sukuks).

Raising finance through investment Sukuks is becoming more and more popular in the Middle East, Europe and the Far East. Sukuk is a thriving new market in many Islamic Economies, especially in GCC countries and Malaysia This is attracting a lot of interest from European countries like the UK, Portugal and some other major countries like Japan and Singapore.

Given their novelty and unique characteristics and varieties, Sukuks can be researched extensively and discussed from various angles. However, under this heading, the focus will be on the definition of Sukuk types, nature and salient features distinguishing each type of Sukuk from

Introduction xiv

others, and consequently offering a critical appraisal of Sukuk as Islamic alternatives to conventional Bonds or securitization.

The other chapters investigate Islamic banking and finance in several countries.

Chapter five develops Iran’s Islamic banking experience. The practice began in Iran in 1984, and the transformation from a conventional form of banking has been a subject of debate among scholars. Analysis of Islamic modes of financing shows that bank authorities and economic policy makers have followed the same path of traditional banking and switch their funds towards a more profitable type of contract. This chapter describes that due to the heavy concentration of the banking assets on short term deposits, and the private sector’s reluctance to commit funds for long term financing, bank loans were also utilized to mainly finance short-term trade transactions, for example hire purchases, forward purchases and service contracts. Long-term partnerships for project financing and direct investment by the banking system in the long term undertakings constituted a small percentage of the total operation.

Chapter six studies the Islamic banking structure and growth in the Sudanese Islamic banking sector. Goes back to 1977 when the Faisal Islamic bank of Sudan was established in the country. With the introduction of Sharia law in 1984, the entire banking industry converted to Islamic Sharia principles. The Sudanese Islamic banking industry now encompasses more than thirty banks, and some of them, like the Faisal Islamic bank of Sudan, have twenty-eight branches alone.

This chapter seeks to analyze the financial performance of selected Sudanese Islamic banks and highlight their growth using financial statement analysis (FSA). The procedure involves calculating numerous financial ratios and categorizing them into five key groups in order to examine profitability, earning potential, liquidity, credit risk, and assets activity.

Findings revealed that the Sudanese Islamic banks are doing very well in terms of generating reasonable profits. In addition we discovered that the liquidity earning performance and assets activity performance of the three selected bank was satisfactory. Finally, while analyzing credit risk we found that Sudanese Islamic banks are taking excessive risks.

Chapter seven looks at Islamic mortgages. Mortgages are considered to be a major determinant factor not only for the UK, but for other Western economies as well. Therefore, we thought it fit to conduct an empirical study on Islamic mortgages in the UK. In this chapter, we critically analyse the Islamic mortgage system in the UK and also find out if it might help to create a stable financial environment. The chapter gives a

Islamic Banking and Finance xv

preliminary empirical assessment of role of Sharia board and corporate governance with reference to the UK. The information was gathered through a well-designed questionnaire assessing a professional banking point of view on Islamic mortgage. This study also sought two important answers to: (1) whether Islamic banking is based on Islamic economic principles or is just a replica of conventional banking, and; (2) if we would still be facing a financial crisis if the market was regulated by Islamic Sharia.

Chapter eight investigates the role of Islamic mortgages in the UK. Mortgages are considered a major determinant factor not only for the UK, but for other Western economies as well. Therefore, we thought it fit to conduct an empirical study on Islamic mortgages in UK. In this chapter we study and elaborate principles behind the overall Islamic banking system, main focus in the role of Islamic mortgages in the UK. This chapter gives a preliminary empirical assessment of the role of sharia board and corporate governance with reference to the UK. This study also sought to find out whether Islamic banking is based on Islamic economic principles or just a replica of conventional banking.

Chapter nine studies the “Islamic bank of Britain” in a case study analysis. There is no specific difference between Islamic and conventional banking on a functions basis. Both provide and perform almost the same functions. The only difference between them is for the Islamic bank to follow the rules and principles of Islam in all their transactions (Henry and Wilson 2004; Iqbal and Mirakhor 2007). Many conventional banks also have started to open branches, which operate in accordance with Islamic Sharia principles. The Islamic banking system is expected to face strong competition not only from the Islamic banks but also from well-established conventional banks offering Islamic products and services. In this study, we focus on the Islamic Bank of Britain, the only indigenous bank of its kind in United Kingdom. An assessment of the degree of customer awareness satisfaction is made, as well as selection criteria. A sample of two hundred respondents took part in this study. The responses show a certain degree of satisfaction, and a few respondents also expressed their dissatisfaction with some of the Islamic bank's services. Chapter ten studies the growth of Islamic banking and employee satisfaction in Bangladesh.

Twenty-five years ago, Islamic banking was virtually unknown. Now, fifty-five developing and emerging market countries have some involvement with Islamic banking and finance. In Bangladesh, the Islamic banks are in a minority and operate alongside conventional banks. The objective of this research is to provide a brief analysis of the performance

Introduction xvi

of Islamic banks in Bangladesh. The Islamic banks in Bangladesh show strong growth. The products range from consumer credit to long-term finance for big investment projects using Islamic modes of financing such as Marahaba, Bia-Muazzal and Ijarah. Currently, in Bangladesh, the higher import cost of commodity prices, price hike in international oil market as well as money and credit growth resulted in higher inflation. As a result, the economy of the country showed every sign of recession. Despite numerous adversities, Islamic banks made significant pre-tax profit in the last few years. Islamic banks maintained and achieved a strong position in the key areas like capital adequacy, liquidity, assets quality, management and earnings. Moreover, Islamic banks in Bangladesh are keeping pace with the advancement of information technology by providing online banking, debit card facilities and money transfers. The research is based on primary data collected through a questionnaire to the employees of four selected banks on a random basis.

CHAPTER ONE

INTRODUCTION TO ISLAMIC FINANCE AND ISLAMIC BANKING:

FROM THEORY TO INNOVATIONS

Islamic finance is founded on overarching principles that constitute the guideline governing any Islamic economic or financial dealings. The reader can refer to the cited websites. This chapter is organized as follows. The first section tries to draw attention towards the important development that Islamic finance and banking have known from a conceptual idea to an evolving and fast reality. The second section deals with the different principles governing Islamic financial dealings and transactions and gives an overview of the added value of Islamic finance to the international financial system. The third section starts with a summary on the different basic Islamic financial contracts and points out the importance of financial innovation. We shed light on the main Sharia-compliant structured project finance solutions. Moreover, we focus on the sukuk market and present new practices in the industry such as sukuk restructuring, credit enhancement, redemption and convertibility. We point out the importance of the Waad as an interesting instrument, leading to the development of Islamic derivatives and innovative hedging and financing Sharia-compliant structures. We present the main Sharia-compliant derivative based on instruments along with recent Sharia-compliant portfolio insurance practices. Finally, we highlight the major challenges facing the development of Islamic capital market standing from the need for liquidity and risk management-innovative structures to the urgent need to an international central regulatory body ensuring international standardization and uniformity.1

1 This chapter is written partially by Chayeh Zeineb.

Chapter One 2

Section 1: From a Conceptual Idea to an Evolving and Fast Growing Reality

1.1. Islamic Finance Industry Growth

The infancy of the Islamic finance and banking was in Egypt and Malaysia during the 1960s. The establishment of the first Islamic bank, pioneered by the Mit Ghamr Local Saving Bank, can be traced back to 1963 in Egypt. In the same year, the first Sharia-compliant fund was established in Malaysia known as the Pilgrim’s Savings Corporation. According to the 2009 Banker report, the number of Islamic financial institutions worldwide is about 626 in approximately fifty countries in 2009, compared to 525 in 2007, with total balance sheet assets estimated to be about $822 million in 2009 compared to $500 million at 2007. The global total of Islamic assets grew at rate of 28.6% in 2009 for the preceding year. The Middle East and North Africa region accounts for the largest share at 81.3% of total global Islamic assets in 2009.

Islamic banking had a real boom at the beginning of the twenty-first century with an increasing number of Islamic banks and Islamic windows (see table. 1.1 above) and exponential growth of its geographical spread (see fig. 1.2 above). The top twenty banks in the GCC countries have seen their combined assets grow by 24% in 2008. The diversification of market players in the Islamic bank resulted in a growth of geographical reach and the emergence of new financial centres for Islamic banking, different from the historical ones such as Dubai, Bahrain and Kuala Lumpur. The emergence of an increasingly broad range of retail products and services has largely contributed to make Islamic banking as competitive as the conventional method.

The Takaful or Islamic Insurance industry, introduced in the 1990s, is expected to reach $8 billion by the end of 2012 at an annual growth rate of 35%, especially for the life takaful industry. The Gulf Countries council represents 60% of the market size followed by Malaysia with 21%. Gross takaful contributions have grown from $1.4 billion in 2004 to over $3.4 billion in 2007. There still exists a large, expanding and untapped Muslim population on almost every continent (the World Takaful Report 2009).

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Chapter One 6

choice of asset type with 40–60% depending on the region of the total assets.4 Several Islamic Equity funds emerged during the equities market boom of the 1990s and the introduction of the Islamic stock index in the 1999, the Dow Jones and FTSE Sharia index has largely contributed to this industry.

Conscious of the rapid growth and dynamic of the Islamic Finance sector, many large Western financial institutions including Citibank, Barclays Capital, Morgan Stanley, Merrill Lynch and HSBC have established subsidiaries that provide financial Islamic products. Moreover, the major French banks have also actively developed Islamic banking activities, mainly in the Gulf but also at a lesser scale on French territory. BNP Paribas, Credit Agricole and Societe Generale are the most advanced in this field. Today, the number of conventional financial institutions with Islamic windows is about 191 worldwide (The banker, 2009). Western regulators, investors and other agents have also shown a greater interest in and a receptive attitude towards Islamic banking and finance (M. Khan et al. 2008). It is interesting to note that among the top twenty-five countries by size of Sharia-compliant assets include such non-Muslim countries such as the United Kingdom in ninth place with $19.4 million and Switzerland in twentieth place with $4.6 million. Recently, France is gaining momentum in its bid to become a centre for Islamic finance. In fact, the French government has taken a comprehensive approach to understanding how to seamlessly assimilate Sharia-based finance into the existing regulatory and legislative structures. An amendment to article 2011 of the French Civil Code, passed on by the French National Assembly, shows the determination to adjust French legislation to the requirements of Islamic finance.

Many important players from both the conventional and Islamic finance stream have pooled their expertise and knowhow to devise more ethical and efficient Islamic financing and hedging solutions. For instance, the launch of the Tahawut (Hedging) Master Agreement (TMA) in March 2010 by the Bahrain-based International Islamic Financial Market (IIFM), in cooperation with the International Swaps and Derivatives Association, Inc. (ISDA), gives the global Islamic financial industry the ability to trade Sharia-compliant hedging transactions such as profit rate and currency swaps, which are estimated to represent most of today's Islamic hedging transactions.

While the first steps toward the materialization of the idea to pursue an Islamic mode of economic and financial dealings were taken by a minority community of Muslims in India in the early twentieth century (Interest 4 Ernst and Young 2009

Introduction to Islamic Finance and Islamic Banking 7

Credit Society 1923), real state sponsorship of the establishment of an interest-free institution can be traced back to the 1970s, mainly in Egypt and Iran when a presidential decree in 1971 in Egypt gave birth to the Nasir Social Bank. The introduction of President Zia UlHaq in 1977 was an important step in the process of establishing interest-free banking in Iran. These initiatives were followed in the 1980s by the Islamization of economies in the Islamic Republics of Iran, Pakistan and Sudan where banking systems are converted to interest-free banking systems. The GCC countries and Malaysia worked for the promotion of Islamic banking parallel with the conventional banking system. The Malaysian Islamic banking industry has seen the most spectacular expansion with the enactment of the Islamic banking act in 1983 and the establishment of the Bank Islamic Malaysia as well as important government involvement.

In 1974, the first Islamic modern commercial bank, the Islamic Dubai bank, was established. The Islamic Dubai bank, one of the earliest private initiatives in the UAE, could be considered one of the first proofs of the feasibility and efficiency of an Islamic banking system. The bank continues to prosper and be involved in the development of Islamic finance. The IDB is not a unique example in this regard, as the major Islamic banks have proved to be as efficient and profitable as conventional banks.

One year later, in 1975, the Islamic Development Bank was established in Jeddah. This institution has played a crucial role in expanding Islamic modes of finance and in fostering interesting research in Islamic economics, finance and banking.

In 1977, the Kuwait Finance House was founded as the first Islamic bank in the country. Recently, the KFH accounted for about a quarter of all deposits in the Kuwaiti market and continues to expand its overseas dealings.

1.2. Determinants of Islamic Finance and Banking Spread

Many factors have contributed to the development of Islamic finance and the spread of Islamic banking. The growth in Islamic financial services may be attributed to the important growth that the GCC countries and Asian economies have seen as well as the increasing numbers in the Muslim community. (IMF 2009) has investigated the determinants of the pattern of Islamic bank diffusion around the world using country-level data for 1992–2006. It was argued that the huge influx of petrodollars from the late 1970s, as well as the consistently high oil prices in international markets, has provided a strong impetus for the development of several Islamic banks in the Middle East. Islamic banking is spreading

Chapter One 8

wherever there is a sizable Muslim community and is not restricted to Muslim countries. The probability for Islamic banking to spread in a given country rises with the share of the Muslim population, income per capita, and whether the country is a net exporter of oil. Trading with the Middle East and economic stability are also conducive to the diffusion of Islamic banking. Proximity to Malaysia and Bahrain, the two Islamic financial centres, does matter. The interest rates’ decrease enhances the development of Islamic banking because they reduce the opportunity cost for less pious individuals to put their money in a conventional bank. According to the authors, the terrorist attacks of September 2001 were not important to the spread of Islamic banking. However, they coincided with rising oil prices, which are the real drivers of Islamic banking growth. Moreover, because the Islamic banking is guided by Sharia law, the quality of institutions, which traditionally count for conventional banking, is not important for the diffusion of Islamic banking.

In addition, the major determinants of the development of Islamic banking and finance include the continuation of serious conceptual and theoretical work both in academic and professional circles. The involvement of international institutions in the development of serious research in Islamic finance and banking was of great interest to the industry. Many well-regarded academic institutions in both Western countries such as Harvard University, Durham University, La Sapienza University & ISME and in Muslim countries such as the Cass Business school, the Faculty of Islamic Studies (Qatar), Effat Women’s University (Saudi Arabia), Bahrain Institute of Banking and Finance, International Institute of Islamic Finance Incorporated (Malaysia) organized seminars and conferences and offered degree programs and scholarships in postgraduate Islamic finance study.

1.3. Research Breakthrough

The emergence of an opposition and reluctance to the interest rate started in Egypt in the late nineteenth century when Barclays Bank was established in Cairo to raise funds for the construction of the Suez Canal (Iqbal at al. 1998, 2001). Several formal critiques have been conducted to highlight, on the one hand, the main critical areas where the conventional economic system conflicted with Islamic values, and on the other to lay out alternatives to interest-based financial systems and banking that have started to gain momentum in Muslim countries. The contributions of Qureshi 1967, Siddiqi (1983, 1985, 1988), were considered important in this regard. Their works focused on studying how Islam could propose a

Introduction to Islamic Finance and Islamic Banking 9

framework to organize an economy and providing a formal definition of Riba, as well as explanations and rationales behind the prohibition of interest. The main studies proposed a comparison framework between the economies based on Islamic tenets, socialism and capitalism and emphasized the operational and organizational model of an Islamic bank based on partnership.

Interest grew in undertaking theoretical work and research to understand the functioning of an economic and banking system designed to be an interest-free system, in line with the tenets of Islam, with the first international conference on Islamic economics held Saudi Arabia in 1976. The involvement of institutions and governments led to the application of theory 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. Parallel to the research initiatives taken by Islamic international institutions such as the IDB and its research arm the Islamic Research and Training Institute established in 1981, the World Bank as well as the International Monetary fund were among the first conventional institutions initiate research on understanding the macroeconomic efficiency and financial stability of an interest-free economic system as well as the financial implications of a loss and profit sharing mechanism (Khan 1986, Khan and Mirakhor 1990). There has also been an outpouring of continuous research on the nature and operation of interest free banks by Muslim economists such as Siddiqi (1983), Bashir (1983, 2000), Chapra 1982, 1985). By exploring the different Islamic contacts, these researches led to the laying out of alternatives to the conventional banking system. In fact, the main results of their efforts were to provide a framework to the early theoretical models of Islamic banking based on the concept of Profit and loss sharing through the Musharakah and Mudarabah contracts. The two-tier Mudarabah financial intermediary model was thus designed and its efficiency and performance assessed.

While academic research on Islamic economics has taken back seat and interest has increased toward the Islamic finance and banking field due to the growing demand for Islamic products and services and the important spread of Islamic banks all over the word, research on corporate governance, Islamic accounting, asset liability management, risk management, capital adequacy and regulation of Islamic banking as well as Islamic financial engineering and innovation in Sharia-compliant derivatives have drawn attention to what Islamic financial institutions and academic researchers need to watch out for in the rapidly changing and competitive financial world.

Chapter One 10

Chapra (1995) initiated discussions on corporate governance in Islamic financial institutions. They underlined that Sharia compliance in Islamic banks will lead to differences in governance mechanisms in Islamic banks compared to conventional banks. They pointed out that the core element of corporate governance framework for Islamic banks is the Sharia Supervisory Board (SSB) and the internal controls which support it. Chapra provided an overview of corporate governance from an Islamic perspective, focusing on the Islamic financial institution and presented a model defining stakeholders in Islamic banks. They argued that, in contrast with the conventional bank’s corporate governance mechanism where in the depositors’ interest does not receive much attention, Islamic banks’ corporate governance should give emphasis to protect depositors’ interest in their business. Z. Hasan (1996) brought out the basic elements of Islamic corporate governance with the Western counterpart in the aspects of conceptual definition, episteme, corporate objective, nature of management and corporate structure.

There is some need for special regulations for Islamic banks for special capital adequacy framework. Drawing from the specific features of Islamic finance and its inherent features of risk sharing, questioned the relevance of the Basle norms and d certain modifications and alternative ways to compute capital adequacy measures for Islamic financial institutions.

As Islamic financial institutions endeavour to cope with the challenges of globalization, efficient risk management has assumed particular importance. This requires the development of not only a more suitable regulatory framework, but also new financial instruments and institutional arrangements to provide an enabling operational environment for Islamic finance. The recent establishment of the Islamic Financial Services Board, facilitated by the International Monetary Fund, addresses this need.

han (2001) highlighted the unique risks of the Islamic financial services industry and the main regulatory concerns with respect to risks and their treatment. They identified a number of Sharia-related challenges concerning risk management.

As far as the asset liability management is concerned, interest toward the development of Sharia-compliant derivative, securitized and structured based instruments has gained momentum. Iqbal (1999) pointed out that the Islamic system of contracting allows for designing risk management solutions using the framework of financial derivative products. The paper analyzes and discusses the case of a specific Islamic contract, istijrar, and highlights its possible use in managing certain forms of risk. Iqbal (1999) argued that Islamic finance provides the basic building blocks that can be used to construct more complex financial instruments that will enhance

Introduction to Islamic Finance and Islamic Banking 11

liquidity and offer risk management tools. With the introduction of asset securitization and swap transactions conforming to Islamic principles, the issues of secondary markets and risk management can be addressed.

1.4. Regulating and Supervising Islamic Finance and Banking Industry

The Institutional Development

For the sake of supporting the development of Islamic banking and finance, an institutional infrastructure has been evolving since the emergence of the Islamic Development Bank in 1975 as one of the major actors in the enhancement of the Islamic financial industry.

The rapid expansion in the breadth and depth of Islamic banking and capital market activity as measured in terms of the number of institutions as well as by the variety, complexity and sophistication of products and services has triggered a strong awareness among scholars, professionals and regulators about the necessity to institutionalize Islamic finance through the establishment of international regulating and supervising organizations.

Undoubtedly, one of the biggest challenges for the Islamic financial system is the development of a framework for governing, supervising and regulating Islamic finance. For instance, Islamic banks have to be subject to a supervisory and regulatory regime of central banks that is entirely different from that of conventional banks as well as conventional central banks in order to promote a true and fair view of Islamic financial transactions.

The Islamic Development Bank

In this regard, it is meaningful to highlight the important role played by the Islamic Development Bank in developing internationally acceptable standards and procedures and strengthening the sector's architecture in different countries. The IDB was established in pursuance of the Declaration of Intent issued by the Conference of Finance Ministers of Muslim Countries held in Jeddah in December 1973.

Moreover, several other international institutions are working to enhance the regulatory framework and standardization of the Islamic finance and banking industry. These include the Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI), the Islamic Finance Service Board (IFSB), the International Islamic Financial Market

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(IIFM), the Liquidity Management (LMC), the International Islamic Rating Agency (IIRA), the Islamic Research and Training Institute (IRTI) and the International Sharia Research Academy for Islamic Finance (ISRA).

Auditing Organization for Islamic Financial Institutions

Thanks to the effort of the Islamic Development Bank, the Accounting and Auditing Organization for Islamic Finance was established and registered in 1991 in Bahrain as an international, autonomous self-regulation for the industry. The main objective of the organization is to prepare and develop accounting, auditing, governance and ethical standards relating to the activities of Islamic financial institutions, taking into consideration international standards and practices and the need to comply with Sharia rules.

The Islamic Finance Service Board

With the growth of the market, the IFSB was established in 2000 as a dedicated regulatory agency. The IFSB, together with the AAOIF, aims to promote the development of a prudent and transparent Islamic financial services industry and provides guidance on the effective supervision and regulation of institutions offering Islamic financial products. The IFSB has recently finalized standards on capital adequacy and risk management and has made progress in developing standards on corporate governance. Once developed and accepted, these international standards will assist supervisors in pursuing soundness, stability and integrity in the world of Islamic finance.

The Liquidity Management Center

As Islamic financial transactions increasingly become global in nature, there are concerns over the sufficiency of supply of appropriate instruments to address the global liquidity management needs of Islamic financial institutions. These concerns led to the establishment of the Liquidity Management Centre (LMC) in February 2002. The LMC is based in Bahrain and is part of a larger project to create an International Islamic Financial Market (IIFM). The LMC facilitates investment of the surplus funds of Islamic banks and financial institutions into quality short- and medium-term financial instruments. It aims to enhance the creation of

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an Islamic interbank money market that would enable Islamic financial institutions to manage their liquidity.

The International Sharia Research Academy for Islamic Finance

The International Sharia Research Academy for Islamic Finance was established by the Malaysian Central Bank in Mei 2008 with the vision and mission of Integration of Sharia experts and industry practitioners as well as synergizing total human capital development in Islamic Finance. Furthermore, the academy contributes to the study of the potential market needs and innovation in research findings.

Section 2: An Overview on the Framework of Islamic Finance and Banking

Referring to Islamic banking or Islamic financial system as simply an interest-free system does not reflect the real image of the Islamic financial system. Undoubtedly, prohibiting the receipt and payment of interest is the nucleus of the system, but is supported by other principles of Islamic doctrine advocating social justice and risk sharing.

Islam recognizes the role of Markets and freedom of individuals and trade. History cannot deny, as expressed by Gordon Brown, that: “it was mainly through peaceful trade that the faith of Islam arrived in different countries.” The profit motive and private ownership are acceptable, but to a reasonable extent. In fact, the Islamic finance defines this extent regarding the Islamic Law, which upholds the principles of integrity, transparency, justice, fairness, solidarity and good corporate governance in financial dealings.

2.1. Materiality and Validity of Economic and Financial Transaction and Dealing

2.1.1. Asset Backed or Based Finance

One of the most important features of Islamic finance, of which the economic crisis has demonstrated relevance, is that Islamic finance is based on an asset-backed financing principal. In fact, Sharia law, which grounds the principles of Islamic finance, encourages business and trade activities that generate fair and legitimate profit through which business dealings must be accompanied by an underlying genuine trade and business-related activity. Any transaction in the financial sphere must

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necessarily reflect a transaction in the economic sphere. The two spheres must increase or decrease in terms of value overall. This was not the case for the current financial crisis where the massive injections of money into the real economic sphere were not been able to cope with the enormous gap that stood between the two.

Thus, every financing mode5 in the Islamic financial system enforces the close link between financial and productive flows and hence ensures that funds are channelled into real financial business activities, thus entailing the appropriate due diligence. It is worth noting that the asset-backed financing principal has widely contributed to insulating the Islamic financial system from the risks associated with excessive financial leveraging and speculative activities that have characterized the recent crisis.

2.1.2. The Three Main Prohibitions in Islamic Finance: the Prohibition of Riba (interest), Gharar (uncertainty) and Maysir (gambling)

Islamic finance does not deny that the transfers of credit and risk are at the heart of finance, without which an economic system cannot function. However, it is wise to state that these two vehicles are a double-edged sword. Although they can be used judiciously to reduce risk and enhance welfare, they can easily entice otherwise cautious individuals to engage in ruinous gambling behaviour, such as what we have seen with the current financial crisis.

According to El-Gamal, the two main prohibitions of Riba as well as Gharar and its subsequent Maysir, in Islamic law, are best characterized as trading in unbundled credit and trading in unbundled risk, respectively. In this respect, Islamic jurisprudence uses those two prohibitions to allow only for the appropriate measure of permissibility of transferring credit and risk to achieve economic ends. Moreover, while financial secular regulators seek to limit the scope of credit and risk trading to prevent systemic failures, Islamic law provides injunctions that also aim to protect individuals from their own greed and the potentially addictive nature of living beyond one’s mean or addictive behaviour of gambling and corrupting intelligently.

5 The Islamic financing mode will be discussed in the next section, pointing out this prominent feature and how in spite of the fact that such financing modes as Murabaha and Leasing are not believed to be ideal they remain a real guarantee to keeping the two economic spheres synchronized.

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2.1.2.1. The Prohibition of Riba (Interest) or Trading in Credit One of the main features of the Islamic financial system is the

prohibition of the payment and receipt of Riba, which refers to any conditional increase in the principal of a loan or a debt in return for deferred payment. Generally, Riba includes all gains from loans and debts and anything over or above the principal of loans and debts, and covers all forms of interest on conventional commercial or personal loans. This does not mean by any means that Islamic finance does not recognize that time has a strong influence on economic activity and decisions. In fact, the juristic consensus permits the possibility of increasing the item’s price for deferred payment in the case of sale contract. However, the Islamic perception of the role of time differs from sale contract to loan or debt contract. This dual perception of time in financial transactions governed by Islamic law seems contrary to the uniform treatment of time in conventional finance that considers an instalment sale as a dual operation of sale-cum-loan.

2.1.2.1.1. The Concept of Time in Islam

In this regard, it is worthwhile to enlighten this different dual time perception and point out the rationale behind it.

On one hand, Islamic Law establishes the legitimacy of price increase in credit sale dealing by admitting that time has a value and recognizes the innate human preference of what is in hand to what is loaned and immediate to the deferred. In this respect, the justification of increasing price when payment is deferred is that the intervening time between passing on commodity and receiving its price involves possibilities of opportunity benefits which are waived in the interest of the buyer. Furthermore, the credit sale does not involve a contract or agreement to pay an equivalent to time as in the case of the credit loan. It is rather a contract to sell a commodity where time is observed as a factor in fixing the price. Here, time is dependent on the commodity and its presence contributes to the determination of the price, but is not, in itself, paid for. The equation in such a sale consists of a commodity tied to a time frame and a price which includes an element to compensate for time and that cannot be perceived as unjust as the dealing, concluded by mutual consent.

On the other hand, Islamic law bans dealing with Riba in the case of a loan contract. It is clear to see that the interdiction holds to the unproductive aspect of lending money for itself and adds an interest factor to it. Money, in Islam, is by no means a commodity and ought mainly to serve a productive means, the lender having to participate in the profit/losses from the money injection for a particular investment.

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(2.275) "Those who eat Riba (usury) will not stand (on the Day of Resurrection) except like the standing of a person beaten by Shaitan (Satan) leading him to insanity. That is because they say, "Trading is only like Riba or usury, whereas Allah has permitted sales and forbidden Riba. So whosoever receives an admonition from his Lord and stops eating Riba shall not be punished for the past; his case is for Allah (to judge): but whoever returns to Riba, are dwellers of the Fire - they will abide therein.”

From the above verse, we can touch the severity of the sin of Riba and to what extent Muslims are instructed by the Holy Qur’an to shun it. At the same time, however, they are encouraged by the Holy Qur’an to pursue trade. Furthermore, the word Riba, meaning “prohibited gain,” is explained in the Holy Qur’an by juxtaposing it against (profit form) sale. It explains that all income and earnings can be categorized either as profit from trade and business along with its liability or return on cash or a converted form of cash without bearing liability in term of the result of deployed cash or capital. The former kind of return is permitted and well encouraged in the Islamic financial framework and the latter is severely prohibited.

2.1.2.1.2. Rationale behind Interest Rate Prohibition 2.1.2.1.2.1. Ethical and Religious View

The rationale behind the ban of the interest is well clarified by Al-Razi in his exegesis of the Qur’an, considering Riba as a cause of injustice that consists in the unbalanced equation linked to the interest-based loan: the increase, on one hand, and the opportunity cost, on the other. The variance in certitude between the interest over the principal which is certain and its amount is known, and the yield resulting from investing the loan by the creditor, who is not sure it will materialize or its amount is not certain in advance constituting the essence of the injustice of imposing interest on loans. Justice requires that the provider of money capital should share the risk with the entrepreneur. Thus, there is a basic difference between principals of the Islamic economic system and the conventional one in regard to the treatment of money capital as a factor of production. Whereas in the conventional system, money is treated on a par with labour and land, each being entitled to return irrespective of profit or loss, this is not so in the Islamic system which treats money capital on a par with enterprise. Hence the interest of highlighting, in the next section, the prominent feature of loss profit sharing that distinguishes the Islamic financial system from the conventional one.

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Moreover, the prohibition of Riba aims to substantively protect individuals from getting excessively indebted and overwhelmed by interest payment, as well as paying for receipt or the extension of credit. Compared to the conventional regulators who also strive to prevent individuals from borrowing excessive amounts, or falling prey to unfair predatory lending, they care primarily about the general health of the financial system, and their concern about the financial health of specific individuals is secondary at best. Furthermore, this aim is among the interests of conventional bankers who work primarily for financial corporations that care little about systemic or individual financial health and care mostly about their own profitability. Thus, they generally permit customers to borrow excessively if the expected rate of repayment remains sufficiently high to ensure profitability.

As a whole, socio-economic and distributive justices as well as intergenerational equity are considered the basis of prohibition under Islamic law.

Al-Razi states that the illegality of Riba is proved by the text of Holy Qur’an, the real wisdom from the prohibition of Riba is known to God and we only apply our minds to deduce this Historically, interest was opposed on the grounds of the social divisions it creates. The Old Testament recommended loans without interest. Lending on interest is blame-worthy action and is often equated with the exploitation of those in need. According to Dar & Presley (1999), Judaea-Christianity recognizes economic brotherhood and the sharing of risks. Christianity teaches to “love thine enemies,” which is compliant with the prohibition of interest. Brunner (1937) regarded interest as encouraging a “parasitical existence” literature. Aristotle considered money as only a medium of exchange and not a store of value, as seen by Western literature.

2.1.2.1.2.2. On the Theory of Interest

While the original basis of the prohibition of interest was divine authority, Muslim economists and scholars have recently emphasized the lack of theory to justify interest. Existing theories of interest are attempts to rationalize an institution deeply entrenched in modern economies and brought out through a study of several theories of interest developed since Adam Smith of which there has been no satisfactory explanation of the fixed and predetermined rate of return. He stated that:

… leaving out some notable exceptions, like Bohm Bawerk’s Capital and Interest, significant parts of Keynes’ General Theory and parts of Harrod, Hawtey and Kurihara, questioning the validity of interest, bulk of the effort of economics has been to justify it, yet not a single argument

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advanced in favour of this institution has a leg to stand on. All theories of interest evolved till the time of Bohm Bawerk, including those resting on productivity, abstinence and demand and supply concepts, were unanswerably repudiated by him. Yet economics continues whipping these dead horses, without evolving any persuasive answers to his criticism.

In this respect, Muslim economists consider three main arguments in response to the typical justification for interest in conventional finance. Table 1.2 below presents the opposing arguments.

Western economists who had questioned the validity of interest and its consequences on economy and financial system held a reasonably strong conviction that a fixed and predetermined rate of interest constitutes a hurdle to economic development and financial instability. They shed light on the strong relationship between interest rates and the instability of economy through the inflation, unemployment, negative growth and blamed interest rates and associated bank credit expansions and contractions for many of the economic issues.

A bulk effort attempted to explain cyclical fluctuations in terms of a divergence between the natural and the market rate of interest. The difference between market and natural interest rates is that the former is determined by monetary forces in loanable funds market, e.g. money supply growth and bank credit creation, and the latter is determined by the profitability of investment and could be associated with profit rate at the microeconomic level. If market and natural rates of interest do not coincide over time, some claim that cyclical fluctuation must result.

Keynes (1931) criticized the role of interest rates and bank credit in cyclical process and emphasised the role of interest rates in promoting economic instability.

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Justification for interest Justification against interest Interest is a reward for saving Such a reward could only be

rationalized if savings were used for investment and to create a real additional value. Abstention from consumption is not entitled to a return.

Interest is considered as marginal productivity of capital

Interest per se has no relation with the productivity of capital. Interest is paid as a charge for the use on money and not as a yield from the investment of capital. Money is not capital. Money is potential capital needed to be invested. To transform money into capital requires the application of enterprise, that is risk taking and the knowledge required to bring factors of production together to create profit (or loss).

Interest is the time-value of money

Even if the basis for time preference is the difference between the value of commodities this year and the next, it seems more reasonable to allow next year’s economic conditions to determine the extent of the reward.

Interest is a reward to cost opportunity

As for the modern capital-holder, who has their capital deposited in a bank, money is available to them anytime they want. Lost opportunity is an illusory argument. Not only did they not lose any opportunity, their money was earning interest even when they had no opportunities. Moneylenders such as banks are generally not businessmen on the lookout for business opportunities that involve risk. The argument of opportunity cost is an unreal argument.

Table 1.2. Opposing arguments regarding interest rates and Money

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2.1.2.2. The Prohibition of Gharar and Maysir, or Trading in Risk 2.1.2.2.1. The Prohibition of Gharar (Uncertainty)

A second feature that is banned and severely condemned by Islamic law is economic dealings entailed uncertainty or Gharar. The latter includes ambiguity about the end result of a contract and the nature, quality and specification of the subject matter of the contract or the rights and obligations of the parties, possession and delivery of the item of exchange. Generally, it relates to uncertainty in the basic element of any agreement.

The prohibition of Gharar in Islamic economic transactions promotes business ethics and enforces justice among participants dealings, limits deception and leaves no space for speculation and asymmetry of information that contribute to the lack of confidence as well as to the deterioration of moral values, elements that were noticed during the current financial crisis. The injustice that underpins such prohibited transaction comes from the fact that the latter may lead one side to impose a burden on another or may cause a vendor to erode the property of others unlawfully.

Although Islamic law strongly denies the uncertainty related to the essential pillars of contract, it accepts its presence in some cases. In fact, scholars distinguish between excessive uncertainty that invalidates contracts and minor uncertainty, which is tolerated as a necessary evil. A canonical example to the latter situation is the Sharia law acceptance of the Salam and Istisna’a contract (prepaid forward sale), wherein the object of sale does not exist at contract inception, but since the contract allows for the financing of agricultural and industrial activities that cannot be financed otherwise, it is allowed despite this Gharar.

2.1.2.2.2. The Prohibition of Maysir (Gambling)

The rationale behind the prohibition of Gharar in Islam is by no means far from that for the forbidding of Maysir or gambling, as the former was often characterized by prominent scholars in the light of its similarity to gambling. In this respect, the forbidden trading in risk is defined as the sale of probable items whose existence or characteristics are not certain, the risky nature of which makes the transaction akin to gambling. In fact, the latter is a form of Gharar because the gambler is ignorant of the result of the gamble. A person puts their money at stake wherein the amount being risked may bring huge sums of money or may be lost

(5.90–91) In this regard, the Prohibition of Maysir or gambling constitutes another major principals of the Islamic Finance, as it is explicitly stated in the Holy Qur’an: “O ye who believe! Wine and

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gambling, (dedication of) stones, and (divination by) arrows, are an abomination, of Satan's handwork: eschew such (abomination), that ye may prosper.”

It uses the word Maysir for games of hazard, derived from Usr (ease and convenience), implying that the gambler strives to amass wealth without effort, and the term is now applied generally to all gambling activities. In Islamic jurisprudence, all kinds of gambling are strongly banned, from explicit forms of gambling to any business activities entailing any element of gambling, such as the conventional insurance contracts in which the uncertainty element is persistent, as well as futures and options contracts that are settled price differences only covered under gambling.

In this regard, it is worth noting the alternative given by Islamic finance to conventional insurance. This alternative is Takaful, which means guaranteeing each other. The takaful system embodies the element of shared responsibility, common benefit and mutual solidarity as well as avoiding the prohibited uncertainty in respect of rights and liabilities of the economic parties In practice, every policyholder pays their subscription or premium, considered as a donation or Tabarru, in order to assist those who need it. The collected premiums constitute the Takaful fund from which any damage giving rise to claim is covered. Indeed, at the end of each financial year, after the deduction of expenses, the remaining cash surplus will be returned to the policyholders in the form of dividends. In this respect, the conception of Islamic insurance is far from the conventional one in which the policyholders, rather than the shareholders, benefit from the surplus generated from the business and investment assets.

2.1.3. The Screening of Sector Activities

All activities in Islamic finance are permitted except those specifically forbidden by Sharia due to their harmful and destructive implications. The most fundamental pillar of this evolving but extensive industry is the concept of Sharia-compliance. This dictates that the financial approach of Muslims should be governed by two major sets of rules. Firstly, unlike conventional finance, Muslims are strictly prohibited from investing in or dealing with economic activities that involve interest, uncertainty and speculation, regardless of their form or shape or the pretexts often used to justify them. Furthermore, Muslims are not only discouraged but forbidden from investing in businesses engaged in illicit activities, such as the production and the distribution of goods and services that stand against

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the tenets of the Islamic value system such as alcohol beverages, pork-related products, drugs, gambling, conventional insurance and banking, war industry and indecent entertainment.

2.2. Mutuality of Risk Sharing

2.2.1. The Principal of Profit and Loss Sharing

This is also the essence of the principle of no profit sharing without risk sharing al-ghunm bi-‘l-ghurm6 (“no pain no gain”), and the earning profit is legitimized only by engaging in an economic venture and thereby contributing to the economic development. In this regard, the assumption of business risk is a precondition for the validity of entitlement to any profit over the principal. Profit has to be earned by sharing risk and reward of ownership through the pricing of goods, services or usufruct of goods.

Investment in the Islamic context is not merely a financial or monetary transaction in which transfer of funds is the only activity. Investment is considered only if it is a part of real activity or is itself a real activity. This is because money has the potential for growth when it joins hands with entrepreneurship. It is not recognized as capital and therefore it cannot earn a return.

The principle of fairness is also reflected in the risk and profit-sharing characteristics of Islamic financial transactions. This requirement must be clearly defined at the onset, and serves as an additional in-built mechanism that promotes the adoption of sound risk management practices by Islamic financial institutions. In particular, these features demand the exercise of appropriate due diligence and higher standards of disclosure and transparency to be observed by the Islamic financial institution, which in turn enforces market discipline and minimizes informational asymmetries. Terms and conditions need to be honestly and clearly laid out; ambiguity based on future events cannot be part of Islamic transactions to avoid potential conflicts in future.7

Thanks to this mechanism, Islamic banks are more involved in financed project profitability than conventional banks. The latter focus mainly on receiving interest payments as its profitability is directly linked to this payment. However, Islamic banks are concerned about the real rate of return and focus in the long term in their relationships with their clients. This partnership engagement obliged the Islamic bank to oversee and monitor projects as closely as possible. 6 A Shariah maxim. 7 Financial Stability and Payment Systems Report 2007.

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2.2.2. Business Ethics of Islamic Finance

Islamic Finance is a model "based on themes of Community Banking, Ethical and Socially Responsible Investments and Affinity Marketing."

2.2.2.1. Social Sphere

Kamla et al. (2009) argue that the philosophical reasoning underlying the principles of the Islamic financial system is the implementation of a financial system (wealth accumulation and wealth distribution) that is fair, just and unbiased towards the rich minority at the expense of the poor majority. The holy Qur’an and the Sunna refer to a number of norms and principals which govern the rights and obligations of parties to the contracts. Principles enunciating justice, mutual help, free consent and honesty on the part of the parties to a contract, transparency, fraud avoidance, mispresentation and misstatement and negation of injustice or exploitation provide grounds for actual sound governance. Indeed, the ultimate aim of Islamic law is to spread socio-economic justice amongst all people regardless of their whereabouts. Sharia-compliant debt financing and equity mode proposes a comprehensive moral guideline for dealing with money. Creating money, therefore, has to be in line with the prospects of real growth in the economy in order to provide a sustainable development and more equitable distribution of wealth.

Furthermore, it is worth noting that each of the Islamic finance principals demand the real exercise of appropriate due diligence by Islamic financial institutions and economic agents along with higher norms of disclosure and transparency which could enforce market discipline and mitigate informational asymmetry.

Collectively, these intrinsic features of Islamic finance act as natural stabilizers and restraints against the risks and excesses associated with excessive leverage, financial speculation and mis-selling that can threaten the effective functioning of financial systems.

The Zakat System—Income Redistribution Mechanism in Islam

According to the Holy Qur’an, God owns all wealth, and private property is seen as trust from God. Property has a social function in Islam and must be used for the benefit of society. Moreover, there is a divine duty to work. Social justice is the result of organizing society on Islamic social and legal precepts, including employment of productive labour and equal opportunities, such that everyone can use all of their abilities in work and gain just rewards from that work effort. Justice and equality in Islam means that people should have equal opportunity and does not imply that they should be equal either in poverty or riches (Chapra 1985).

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However, it is incumbent on the Islamic state to guarantee a subsistence level to its citizens in the form of a minimum level of food, clothing, shelter, medical care and education (Holy Qur’an 58, 11). The major purpose here is to moderate social variances in Islamic society and to enable the poor to lead a normal, spiritual and material life in dignity and contentment.8

A mechanism for the redistribution of income and wealth is inherent in Islam so that every Muslim is guaranteed a fair standard of living (nisab). Zakat is the most important instrument for the redistribution of wealth. This almsgiving is a compulsory levy, and constitutes one of the five basic tenets of Islam. The generally accepted amount of Zakat is a one-fortieth (2.5%) assessment on assets held for a full year (after a small initial exclusion), the purpose of which is to transfer income from the wealthy to the needy.

2.2.2.2. Environmental Sphere

In this regard, Al-Qaradawi9 (2000) elucidates that safeguarding, protecting and caring for the environment scarcely constitutes a new Western concept; rather, such concerns are deeply rooted in all fields of Islamic value. Furthermore, Islamic law has enunciated a set of principles that provide a basic framework for the conduct of economic activities in general, and financial and commercial dealings in particular. The most salient values of Islamic finance are fairness, socio-economic justice and its uncompromising commitment towards the well-being of future generations through caring for the environment and preserving earth's valuable resources. 10

8 Handbook Islamic banking (2007). 9 Al-Qaradawi, Y. (2000). “Safeguarding the environment in Islamic Shariah”. Al-Khaleej. 10 For further details, see Kamla et al. (2009) “Islam, nature and accounting: Islamic principles and the notion of accounting for the environment” point out that such concerns for the environment are deeply rooted in all fields of Islamic teaching and culture.

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2.3. The Added Value of Islamic Finance Principles to the Financial System

2.3.1. The Inherent Stability of Islamic Finance: Controlling Excessive Credit and Risk Trading in the System and Enhancing Real Economic Sphere

Over investment is important but would have far less serious results if it was financed by equity, as opposed to financing from borrowed money and leverage. Easy money that usually causes over indebtedness followed by deflation is one of the main factors of financial instability. Friedman et al. (1963) considered that faster money expansion resulting from unchecked credit expansion is the dominant cause of financial instability. Some authors prescribed the rule of setting fixed targets for the growth of monetary aggregates in line with economic growth. Through the expansion of money and credit supported by financial deregulation, speculation gathers speed and reinforces financial crisis. Moreover, unbacked credit expansion and money creation is conceived to be one of the main factors responsible for financial instability. Financial instability emerges when there are not sufficient real savings to support lending. These main factors are found to cause financial instability and are exactly the contrary of what distinguishes Islamic finance. Islamic finance fosters equity-based financing and investing instruments and enhances profit- and risk-sharing mechanisms. Islamic finance prohibits interest as well as speculation and promotes an important aspect often missing in conventional finance, which is asset backing.

Maurice Allais held the view of the inevitability of the current structural global economic crisis and warned against its consequences. He considered structural reforms that go far beyond addressing the symptoms of the crises by devising an efficient monetary system, capable of preventing such crises from happening in the future as the unique solution. The two basic components at the heart of the proposed system are adjusting the rate of interest to 0% and revising the tax rate to about 2%. Incidentally, these are the core elements of Islamic economics. Islam prohibits interest (Riba) and requires all Muslims who possess minimum net worth above their basic needs (Nisab) to pay Zakat (2.5% of their assets a year). Zakat is a major economic instrument premeditated to spread socio-economic justice amongst Muslims. Unsurprisingly, the US Federal Reserve announced the cut in lending rate to be between 0 and

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0.0025%, and the demand for meaningful tax cuts has also been building up.11

Khan (1987) investigated the stability of Islamic banking in comparison to the conventional system based on a mathematical approach and found that the Islamic system may turn out to better suit for adjusting to shocks that result in banking crises and disruption of the payments mechanism. The authors compared the application of the balance sheet characteristics of Islamic PLS banks with traditional banks. The balance sheet of the Islamic bank has no fixed liabilities and deposits are considered as shares. Any shock on the asset’s side would automatically be absorbed and adjusted on the liability side. This can lead to stability in Islamic banks. However, in conventional banks, when a crisis arises on the asset’s side the banks turn to liability management and this leads to instability. Bankruptcy is less likely to happen in Islamic banks, because PLS and mark-up operations are based on the solvency and trustee of partners. In the Islamic financial system, the term and structure of the assets and liabilities of the financial intermediary, as we will bring out the latter in the section which deals with Islamic banking, are closely matched through the profit sharing system and hence Islamic finance offers a “pass through” of risk to investors and depositors.

On the microeconomic level, all Islamic modes of trade financing are asset-backed and thus involve money on the one hand and goods or services on the other. Monetary flows would have to be tied directly to commodity flows. Changes in spending would be reflected in the supply and demand of goods and services, causing the quantities of output produced to respond more quickly to market forces. Islamic finance removes the dichotomy between financial and real activities.

2.3.2. Resource Allocation Efficiency

In this regard, Friedman (1969) conceived zero nominal interest as a necessary condition to achieve optimal allocation of resources. In general equilibrium models, a zero interest rate is both necessary and sufficient for allocative efficiency.

Instead of proposing an institutional monetary policy based on steady deflation, Islamic finance propose an alternative restructuring based on replacing interest rate with rate of profit and risk sharing framework through the profit and loss sharing mechanism. In fact, the cornerstone of the Islamic financial system is that any financial development should cause investment alternatives to be compared to one another, based only 11 Hassan (1998).

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on their productivity and rates of return. Such a condition is bound to produce improved allocation.

2.3.3. Velocity of Money in Islamic banking

Introducing interest-free banking in Iran and Pakistan in the last two decades has improved or at least did not hamper their overall macroeconomic performance. These structural changes have led to a smoother behaviour of money velocity, have provided policymakers with a more controllable monetary environment and strengthened the linkage between policy instruments and the main policy goal of price stability.

Section 3: Islamic Financial Contracts and Products

The application of the different Sharia principles seen above, which are prominent features in Islamic finance, has contributed to the emergence of a panoply of Islamic financial products and instruments. These latter are developed by applying or combining the appropriate Islamic financial contracts to cater to the financial needs of the investors and consumers. The range of Islamic financial products has broadened considerably in recent years thanks to financial engineering; however, much more effort is needed in this way. The Islamic economic system has a set of basic and core contracts which constitute pillars for designing more sophisticated financial products. Sharia-compliant contracts have to obey the bans on Riba, Gharar, Maysir, illicit activities and ignorance.

For the sake of responding to the more diverse and differentiated requirements of investors and clients, Islamic financial institutions have developed three kinds of Islamic financial instruments—derivative-based instruments, securitized-based instruments and structured-based instruments—by utilizing the set of basic Sharia-compliant contracts.

This section deals firstly with the set of core and basic contracts which are deemed legal and lawful by the Sharia as they are free from any prohibitions detailed above. Further attention will be paid to intermediation contracts in order to well understand how the function of intermediation is performed mainly by Islamic banking and to point out the nature of Islamic financial intermediation and its importance in designing the landscape of the Islamic financial system. As far as the critical role of the capital market in promoting an efficient financial system and enhancing the development of the financial intermediation by improving the resource allocation, providing liquidity and diversified investment opportunities, is considered, the second subsection focuses on

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the main developed and implemented securitized and derivative Sharia-compliant financial instruments and sheds light on the main features of Islamic equity-based securities.

Islamic financial contracts can be subdivided into four categories: transactional contracts, intermediation contracts, financing contracts and social welfare contracts. Transactional contracts concern transactions that deal with exchange and trading in goods and services and deals mainly with terms linked to the subject of the transaction or the underlying asset as well as to the delivery mode. The financing contracts include contracts which seek to define the terms relating to payment and financing mode of economic activities. The intermediation contracts promote the efficient and transparent execution of these transactional and financing contracts. The Islamic intermediation contracts offer a regulatory framework to propose fee-based service contracts based on the concept of trust and security, partnership-based contracts and takaful or insurance-based contracts. The social welfare contracts include gratuitous loans (Qard Hasan). Qard Hasan is an interest free loan and a kind of gratuitous loan given to the needy people for a fixed period without requiring the payment of interest or profit. The receiver of Qard Hasan is only required to repay the original amount of the loan. These contracts aim to promote the wellbeing of people in need. The institutionalizing of welfare contracts could be developed by intermediary institutions.

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Future Transactional Contract We can distinguish two transactional contracts where the general

condition under which the existence of the object of the contract is required to validate the latter, infringed in order to finance some activities as agriculture or industry that cannot be financed otherwise:

Bay Salam or advanced purchase is an ancient form of forward sale contract wherein the full price was paid in advance at the time of making the contract for prescribed goods to be delivered later. Salam has been permitted by the Sunna. The rationale for this permission is the concept of genuine need as clarified by Zaman (1991), both for the seller and the buyer. The basic difference between the bay Salam and the conventional forward is that in the former the payment of the full negotiated price is paid at the time of contract conclusion, which is not compulsory for the latter.

Istisna’a or Purchase order is a sale contract where the sale of commodity is transacted before the commodity comes into existence. In other words, it is an agreement culminating in a sale at an agreed price whereby the purchaser places an order to manufacture, assemble or construct anything to be delivered in the future. The Istisna’a contract has been legalized on the basis of the benefit analysis.12 It is very similar to the Salam contract as it shared with the latter the function of financing the production of non-existent items. However, it differs from Salam in a few points. Indeed, scholars did not require price in Istisna’a to be fully paid at contract inception to facilitate the financing of multistage manufacturing or construction projects, wherein the buyer may pay for each phase separately. Moreover, the term of deferment in an Istisna’a contract does not need to be fixed in the contract inception. Although the object of a Salam sale is a natural resource, the object of an Istisna’a contract is non-natural and is required to be manufactured or constructed (a public or corporate infrastructure).

Bay’al Muajjil (Deferred payment sale) refers to a sale contract wherein the payment is deferred in instalments or in a lump sum paymen