Shariah Final

8/7/2019 Shariah Final

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A concept note on

Islamic Financing

(Shariah Compliant Financing & Banking)

For Contemporary Issue in Finance

MBAII

Batch2009-11

Submitted to:

Prof. Dharmesh Shah

Prepared by:

Shivanshi Pandey (1984)

Nipun Bhatiya (1951)

Bhavesh Dhonde (1957)

Prakruti Chaudhari (1933)

B.K.School of Business Management

Gujarat University


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TABLE OF CONTENTS

Chapter

No.

Topic Page

No.

A SHARIAH FINANCING

1 INTRODUCTION 3

2 SHARIAH TERMS 4

3 KEY PRINCIPLES 5

4 SHARIAH FINANCING STRUCTURES 6

5 SHARIAH COMPLIANT FUNDS 14

6 SHARIAH FINANCING IN INDIA 17

B ISLAMIC BANKING

7 EVLOUTION 23

8 ANATOMY 24

9 LITERATURE : THEORY 26

10 LITERATURE IN PRACTICE 30

11 CONCLUSION 34

12 REFERENCES


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SHARIAH COMPLIANT FINANCING

What is SHARIAH?Shariah (or the Islamic Law) is defined as a body of divine laws, rules, code of conduct and

teachings which are intended to benefit the individual and society. It refers to the Islamic

canonical law based on the teachings of the Koran. This law imposes certain strictures on the

types of financial and commercial activities that Muslims can engage in. While trade and

investment are encouraged, Shariah investing rules prohibit involvement in businesses related

to certain haram (prohibited) activities.

Where are Shariah rules codified?

Interpretations of the Quran from various Islamic schools of thought Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI) The fact remains: Shariah mandates are not always consistently applied from Scholar

to Scholar. Information is asymmetric, and Shariah Advisers and lawyers skilled in

the area become useful to work through the counter-intuitive results

Who can invest in these funds ?

Though the funds are constituted and managed on the principles of Shariah, investment in

these funds is open to any individual irrespective of his religion. NRIs, HUFs, companies and

other institutions are also free to invest in these funds. There has been a recent surge in

demand for Shariah compliant investment instruments including institutional funds.

According to a recent survey there is growing demand from investors domiciled in the Gulf

Co-operative Council region for investment portfolios to include Shariah compliant

instruments. This outlook has spurred the growth of the Shariah compliant investment funds

that invest in a wide range of sectors - real estate, private equity, infrastructure (most notablypower projects) and equities. Some of these funds have been admitted to trading on the more

established stock exchanges, such as Dublin as well as the emerging stock exchanges of

Dubai and Bahrain. It is estimated that there are currently more than 100 Shariah compliant

investment funds with over US$5billion under their management


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Shariah terms

Riba

Shariah prohibits usury (Riba), which may be defined as exploitation by the owner of a

product which another requires. The payment or receipt of interest is usury and therefore

investment in entities involved in lending (or borrowing) is prohibited. This will preclude

investment in certain key sectors, such as conventional banking, even though the activity of

banking is not, in itself, contrary to Shariah. Debt is frowned upon in the same way as the

payment or receipt of interes t. As a result highly geared companies will not constitute

acceptable investments. It was once thought that an absolute ban on companies relying on

debt finance was a Shariah compliant investment fund's only way of ensuring compliance

with this tenet of Shariah. Clearly, such a hard- line approach dramatically reduces a fund's

investment pool. Shariah has evolved and such a blanket prohibition no longer applies.

Modern Islamic jurisprudence accepts a debt to equity ratio of 1:3 2 .A fund offering a fixedor guaranteed return on capital will be prohibited. Rather a fund must link profit to actual

earnings generated from the underlying assets. This should be made clear to potential

investors at the outset in any marketing material. Notwithstanding the prohibition against

Riba, investment funds can be structured which may make leveraged investments in

underlying assets. Such investments maybe made within the confines of Shariah by utilising

the diminishing Musharaka contract (see Lovells publication - Shariah, Sukuk and

Securitisation, for more information).

Haram

It is well-known that companies involved in certain products and industries will, as a rule,

constitute forbidden investments. These are, principally, alcohol and the gambling industry,

as well as entities engaged in illicit, immoral or dubious trade. Companies engaged in these

or related activities (e.g. a restaurant where alcohol is sold and which makes up a large

proportion of its revenue) may not form part of a Shariah compliant fund's investments

strategy.

Maisir

Shariah imposes an absolute prohibition on gambling. This may extend to futures and optionsin certain circumstances. However, this area is currently being revisited by Shariah scholars

to determine whether the traditional prohibition on futures and options is still justified.


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Key Principles

1) Prohibition on the payment or receipt of interestmoney itself is considered to have no intrinsic value, it is merely a store of wealth and

medium of exchange

2) Prohibition of uncertaintyeverybody participating in a financial transaction must be adequately informed - all

the fundamental terms must be certain at the outset

3) Prohibition of speculationinvestment returns must be based upon effort rather than chance or speculation -

normal commercial risk is permitted

4) Prohibition on financing certain economic sectorsinvestment is forbidden in what are considered to be socially detrimental activities -

these include gambling, pornography, alcohol and armaments

5) Importance of profit and loss sharingThe investor and the investee must share the risk of all financial transactions

6) Asset-backing principlefinancial transactions should be underpinned by an indefatigable and tangible

underlying asset.


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Shariah Finance Structures

Mudaraba Musharaka Murabaha Tawarruq (Reverse Murabaha) Ijara Ijara wa-iktina Bai salam Bai al inah Istisnaa Sukuk

Mudarabah (Capital Financing):

This type of partnership may be called trust financing or sleeping partnership. Mudaraba is anagreement between two parties where one party (known as Rabbul Maal), provides the capital

and the other known as 'Mudarib' brings his entrepreneurial capabilities in managing the fund

and the project. The profit arising from the project is shared according to a predeterminedformula. Losses if any are borne by the provider of capital. In this structure, the provider of

capital has no right to participate in the management of the project.

Salient Features:

1. One partner brings capital and the other partner brings labour2. Profits are shared between the parties in a pre-agreed ratio3. Entrepreneurs return is only through profit4. Losses are borne by capital provider (in the case of liquidation all assets belong to

capital provider).

5. Mudaraba could be restricted or unrestricted In restricted Mudaraba the managing partner (mudarib) is given instructions not

to invest the money except in a specified business and manner.

In unrestricted Mudaraba the managing partner has freedom to chose his/herinvestments in the manner he/she deems fit.


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Murabaha

A purchase and re-sale arrangement Used to provide trade finance and acquisition finance Bank purchases an asset from a supplier Bank sells the asset to the customer at a premium on deferred terms The repayment of the resale price is usually made in instalments

Salient Features:

a) Financing agency (upon request of the client) will buy the car with cash and sell it to theclient on credit with a mark-up.

b) This structure is tax inefficient and cannot be adopted by banks in countries where banksare not permitted to trade in goods.

c) In many of the secular countries this mechanism is accommodated through change in

regulation.

d) Countries looking at forms have accepted this as equivalent to interest-based financing.

e) In case of any delay in payment of installments, the finance agency cannot increase theamount due from the client


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Reverse Murabaha or Tawarruq

Used to raise cash Bank purchases a commodity in the market Bank sells the commodity to the customer at a premium on deferred terms Customer resells the commodity back into the market to realise the cash The debt to the bank is paid by the customer in instalments

Murabaha and Tawarruq

The bank must take actual ownership of the asset or commodity, even if only briefly

Both forms of murabaha can be syndicated, but typically involve one financierentering into the murabaha as agent for the syndicate members

Agency agreement will be governed by a separate agreement, commonly a mudaraba


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e) Partnership could be equal (Mufawada) or unequal (inan). In the former case each partner

is equal in rank with the others in terms of capital contribution, profit and privileges. In the

latter case, these rights are not same.

f) Partnership could also be perpetual or diminishing. In the latter case, the existing partner

slowly buys out the share of the other enabling him or her to eventually exit from the project.

g)There are two variants of partnership in Musharakah:

i Partnership of ownership (Shirkat al-Milk). This is a partnership based on joint ownership

of properties or assets. This could further be of two types

i.e. voluntary such as partners buying some asset together, or involuntary such as

brothers and sisters becoming partners after inheriting a property.

ii Partnership through contract (Shirkat al-Aqd). This partnership is effected through mutual

contract among the partners.

Bay al-Salam (Forward Purchase):

This is a contract for sale of goods where the price of the item is paid in advance. In this

system a buyer pays in advance for a specified quantity and quality of a commodity,

deliverable on a specific date, at an agreed price. This financing technique is similar to a

future or forward-purchase contract and is particularly applicable to seasonal agriculturalpurchases. Under Islamic banking this technique is generally used to buy goods, particularly

raw materials, in cases where the seller needs working capital before he can deliver the item.

Istisna (Manufacturing contract):

This is a contract of acquisition of goods by specification or order, where the price is paid

progressively in accordance with the progress of the work. This is practiced for purchasing an

item that is yet to be completed or produced, for example, a house. Payments are made to the

developer or builder according to the stage of work completion.


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Takaful (Shariah-compliant Insurance)

The word Takaful comes from the Arabic word (kafala) which means guarantee. Takaful

works on the principle of cooperation and mutual help among the members of a defined

group. In other words Takaful is a method of joint guarantee among a group of members or

participants against loss or damage that may befall any of them. The members of the group

pool their contributions and agree to jointly guarantee each other. Should any of them suffer a

catastrophe or disaster, he would receive a certain sum of money to meet the loss or damage.

Currently there are about 150 Takaful companies operating in about 40 countries. Business of

Takaful is growing at 20 percent per annum. Currently, Takaful premiums are estimated at

USD 3 billion of which 60 percent is in General Takaful and the remaining 40 percent in

Family Takaful. The largest market for Takaful is in South-East Asia, followed by the Middle

East, Africa, Europe and others. Actually Takaful or Islamic (i.e., Shariah-compliant)

insurance is a form of insurance which works in compliance with Shariah. It is important to

note that Shariah laws are not against the concept of insurance but some of the activities

undertaken by insurance companies make the insurance activities non-compliant under

Shariah and therefore Shariah scholars have come up with the concept of takaful that meets

the objective of insurance within the parameters set by Shariah. Some of the worlds topinsurance companies are also actively engaged in takaful.

Shariah Guidelines for Insurance

Prohibition of interest (Riba) is a crucial aspect that makes conventional insurance Shariah

non-compliant. Contributions (premia) collected from the policyholders are invested in

interest bearing/earning instruments. The second important prohibition is contractual

ambiguity which is classified as Gharar. Gharar implies the unavailability or non-

specification of certain key aspects or information of a contract For example, in an insurance

contract (say life) the policyholder (who is the subject matter of the contract) pays a premium

for an event (his own death) the timing of which is uncertain. In other words, the policyholder

is paying a definite price for a benefit which is contingent on an event which he cannot be

sure will occur. On the other side the insurance company is receiving a price for something


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which it is not sure it will be called upon to deliver. Often the relationship between the

insurer and the insured becomes fraught with moral hazards as ones loss becomes anothers

gain (and vice versa), thus leading to a conflict of interest situation. This in Shariah falls

under the category of gambling (Maysir) which is also prohibited. Takaful aims at meeting

the underlying socially and economically desired objective of financial protection and

wellbeing of the deceaseds family (which is likely to suffer due to his unexpected death),

while complying with all the above prohibitions.

Another consequential result of a conventional insurance policy that directly violates another

Shariah law is the nominee clause. A nominee in an insurance policy is the sole beneficiary in

the event of death of the policyholder whereas under Shariah law anything left behind by the

deceased would be required to be distributed in accordance with the Islamic law of

inheritance. Thus a nominee in a takaful policy is a trustee designated to receive the benefits

on behalf of all the inheritors of the deceased.

Life Insurance (Family Takaful)

A are the policyholders contributing premium B

B (the total contributions), is bifurcated into two parts C & D

C is the amount contributed (as donation) by each participant towards the pool for securing

them against the designated eventuality. Claims in the event of occurrence of the designated

eventualities are met from C. Policyholders forfeit their claim on their contributions to C

except to the residual part of it which remains till the maturity of their policy

D, the amount which goes into the investment account of each policyholder. Any net return

earned on this account is also added to the policyholders investment account

B, the total amount (of investable funds) comprising C&D is to be managed by the

insurance operator

F, the insurance operator, who for managing the fund (B) will charge a fee (in case of the

Wakala Model) or take a share in the profits (in case of the Mudaraba model). Losses (pro

rata) in both the models are borne by the insurance pool C.


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General (non-life) Insurance

In the case of General (non-life) insurance the whole contribution (B), without being

bifurcated goes into a common pool from which the risks are met

Claims are met by disinvesting B to the extent of the requirement

Here too operator F manages the fund either on Wakala or Mudaraba basis for which it is

remunerated in accordance with the respective agreement.

General Observations

Cost of managing the operations is met from the contributions (B) in case of Wakala modelwhereas in Mudaraba model it is borne by the operator (F). This is the reason why the

Mudaraba model is not so popular

Based on the actuarial calculation, operator (F) aims at keeping some surplus amount over

and above the expected requirement of claims (C) in the case of life policy and (B) in case of

general

Surplus over and above that expectation is either distributed back to the policyholders or

they are rewarded in the form of lower contributions in the future

Any shortfall in (C, Life) and (B, General) is met through interest-free loan from the

operator (F) which is recoverable in future years


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SHARIAH COMPLIANT FUNDS

There are several types of Shariah compliant fund which manage to operate within the

confines of Shariah. The most common forms of Shariah compliant funds and the techniquesthey utilise in their investment strategy are outlined below.

Commodity funds

A commodity fund derives income from the purchase and resale of commodities. However,

it is strictly prohibited by Shariah to sell a commodity before it is actually owned. Therefore,

short sales (as commonly entered into by traditional hedge funds) are not permissible. A

product must be held physically, or at least constructively, before it may be sold. Therefore,

forward sales are also forbidden in most cases. Nevertheless, the following contracts may

legitimately be used by a fund of this type (or indeed any Islamic investment fund) togenerate profits: (i) Istisna'a is a contract of exchange that allows the deferred delivery of

goods at a specified date. The contract relates to the production of made-to-order items and

allows a manufacturer to fund the production process by receiving the sale price of the

produce up front. A detailed specification of the item to be produced must be agreed between

the buyer and seller prior to the commencement of the production process. Once production

has commenced, the contract may not be unilaterally cancelled. The consideration must be

paid in full on the date the contract is entered into, otherwise the contract may be classified as

a future and consequently prohibited. (ii) Bay al-salam is a sale contract in which the buyer

pays immediately against the deferred delivery of a specified amount of fungible (notuniquely identifiable) goods of a given quality at a given date in the future. The contract is

most like a forward contract, but is different in two material respects. In a forward contract,

exchange of the underlying goods and cash are deferred to the maturity date. The seller in a

bay al-salam contract has full use of the cash from the time the bay al-salam contract is

agreed. Hence the credit risk is on the buyer, whose exposure relates to whether the seller

will fulfil its obligations the reverse of a conventional forward contract. The other

difference relates to pricing. In a forward contract prices are derived by considering, for

example, what the benefits are to the buyer/seller of the assets by deferring payment and

delivery rather than a contemporaneous deal in the cash market. However, the delivery price

in a bay al-salam contract is the spot price minus a discount. The rationale being that the

buyer must be compensated for credit r isk exposure as well as some performance flexibility.


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Equity Funds

Profits in equity funds are generally derived from capital gains and dividends paid by

investee companies. It is evident that on a strict interpretation of Shariah there are a limited

number of companies in which Shariah compliant fund may legitimately invest. Most

companies partake in interest-based debt finance and invest surplus cash in interest bearing

bank accounts and other investments. There are currently two schools of thought regarding

investments made in companies which, although predominantly Shariah compliant, may

incidentally breach Shariah (for example, the prohibition against Riba) from time to time as

the company carries on its principal activities. The traditional school of thought was that

every investor in a fund is a partner and impliedly consents to, and is responsible for, every

transaction. Unless a company was engaged exclusively in halal practices, the concern was

that each and every investor could be implicated by the dealings of the fund manager,

whether or not the investors actually consented to these (or were even aware of them in any

detail). The more contemporary school of thought adopts the view that investors are notpartners in a fund but are merely investors. Since no one investor has the power of veto, it

would be wrong to ascribe responsibility to an individual for any particular transaction. This

may allow some leeway to invest in entities which have merely incidental non-halal features,

since investors will not be deemed under Shariah necessarily to have authorised the

investment. Nevertheless, there is still a belief among Shariah scholars that investors should

raise any concerns- 9 - they have as to the running of the fund generally, or over specific

transactions, especially if the fund is thought to be straying away from Shariah principles.

Clearly, this raises a practical issue given that most funds will be involved in many different

trades on an ongoing basis and it will be impracticable for investors to be kept informed ofeach and every one. It is widely believed that if a company is engaged predominantly in halal

business, but earns interest on account, an equivalent proportion of any dividend paid to a

Shariah compliant fund must be given to charity (purification), be it at the fund or the

investor level. Some scholars believe the same concept of purification also applies to capital

gains, to the extent that the market price of the stock incorporates any discernible element of

interest. It is also important that the company invested in owns at least some non-liquid

assets, otherwise its securities will be classified as non-negotiable by Shariah. Opinion is

divided as to the appropriate ratio of non-liquid assets to liquid assets. It appears safe to say,

however, that a company with at least 51% of non-liquid assets will be suitable for these

purposes.


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Murabaha Funds

Murabaha is a type of 'cost-plus' financing. Typically the fund in question will acquire goods

and will resell them to a third party at their cost plus a fixed profit. As such the fund will not

own tangible assets but will instead consist of obligations owed to it by third parties. The

costs and profit margin must be agreed in advance. However, a Murabaha fund should

always be c losed-ended, since the fund will not

Ijara Funds

An Ijara fund will usually be established for the purpose of purchasing assets (property,

machinery etc) and then leas ing those assets to third parties in return for rental income. Wide

use of this structure is made by real estate funds. Legal ownership of the assets remains with

the fund as does responsibility for the management of such assets. A management fee will

normally be paid to the manager. It is important to bear in mind that with an Ijara fund, the

assets that are leased out must be used in a halal manner. Furthermore, the leasing

arrangement put in place between the fund and the lessees must comply with Shariah.

Actually own any tangible assets as such, and cash/debts are not classified as negotiable

instruments by Shariah.

CHARACTERISTIC OF SHARIAH FUNDS

Most funds target high net-worth clients because Middle Eastern countries, whichform the industry's primary clientele, have large wealth gaps and therefore a relative

minority of potential investors.

The funds, which are concerned primarily with asset inflows cater to individuals whocan help them grow into a globally competitive position, and thus have minimum

investments of around US$10,000 initially .

Since Islamic funds target their local communities, the obvious choice for marketingis in the Middle East. It is this discrepancy of wealth between Arab and poorerMuslim countries that has resulted in the latter being overlooked by funds, which

flock to oil magnates and wealthy inheritors for placements.

The market is young and does not boast a wide range of strategies or structuredproducts.

A small percentage of these equity funds have positions in North American orEuropean equities, while a still smaller portion sector specialisations (e.g.

technology).


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Many equity funds focus on emerging markets, which seems intuitive when oneconsiders the economic growth of many Islamic countries.

Outside the Middle East, Malaysia has an aggressive campaign to emerge as a leadingprovider of Islamic investments and has turned out its fair share of products.

Outside equities, however, the market remains limited. The very nature of Shariah compliance precludes riba, or interest-base income;

consequently, fixed income instruments are difficult to construct (let alone complex

strategies such as short selling).

Thus, only a few funds exist.

Shariah Finance in India

Shariah Finance is close to a trillion dollar industry today and is emerging as one of the

fastest growing areas of international finance. Currently its practices have spread to over 75

countries of the world, these include many secular countries of Europe, North America and

South East Asia. In the past few years, Indian regulators have approved schemes with

exclusive claims of Shariah compliance. The following table gives a glimpse of the importantactions that Indian government and institutions have taken in the recent past. These actions

are seen to have important ramifications for Shariah-compliant business in the country. Theabove actions indicate a cautious but systematic approach adopted by Indian policy makers

towards Shariah Finance. India Inc, having sensed the momentum building up in favour of

Shariah Finance, has started looking for strategic vantage positions to exploit the niche

opportunity. Many private sector players have come up with Shariah-

compliant/tolerant/friendly products abroad as well as in India. A leading private sector

player has created an entire vertical for distributing Shariah tolerant products


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Potential of Shariah Finance in India

Muslims are 13.4 percent of Indias total population. In absolute terms theirpopulation in India is second only to that of Muslims in Indonesia.

Indias Muslim population is close to 175 million. 60% percent of the communitys population is below 25 years of age and over 35 percent of the communitys total

population lives in urban areas, thus making Muslims one of Indias youngest and

most urbanized communities.

Economically, the Muslim community is not much dependent on agriculture. Muslim participation in the financial system of the country is minimal. 50 percent of the communitys population is excluded from the formal financial

sector. According to a Report by the countrys Central Bank (i.e. RBI), Credit :

deposit ratio of Muslims is 47 percent against the national average of 74 percent.

Another important study focusing on remittances coming from the Middle East to theIndian state of Kerala highlights that annually about INR 120,000 million (USD 2.4

billion) are sent back by expats of the community. A great majority of this money is

either lying idle in bank accounts (more popularly known as 786 accounts) or is

invested in real estate and jewellery.

These findings indicate the communitys indifference towards the financial system forreligious reasons.

Existing Shariah Finance Products and Opportunities for Shariah

Finance in India

Considering the countrys current banking regulation, Islamic Banking may be difficult in

India at the moment but there could be various other options available within the existing

regulations which can be utilized to launch Shariah-compliant products. Below are a few of

the products that could be availed within the available regulatory environment.

1. Shariah-compliant Mutual Fund2. Shariah-compliant Pension Plan3. Shariah-compliant Real Estate Venture Fund4. International Re-Takaful Operations on Shariah basis5. Shariah-compliant Leasing6. Musharaka and Mudaraba based Financing


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Open ended scheme which was launched in March 2009. It is a passively managed fund that invests in securities that constitute the S&P CNX

Nifty Shariah Index in the exact proportion as in the index.

A minimum 90% of its assets in securities which are constituents of S&P CNX NiftyShariah Index in the same proportion as in the Index.

98.89% of the total assets of the fund are allocated towards equity and the remaining1.11% are also not allocated towards debt. It has given a decent return of 10.41% p.a.

and a whooping return of 45.10% since its launch.

A minimum amount of Rs. 10,000 is required to start investing in this fund and nofacility of SIP (Systematic Investment Plan) is available.

Currently, it is managing assets worth Rs. 90 lakhs.


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It is an actively managed diversified equity fund launched in March 2009. TaurusEthical Fund invests in the stocks of those companies which are a part of the S&P

CNX 500 Shariah Index..

However, stocks of companies in the mid cap space are preferred more here. Also,91.07% of the total assets are allocated towards equity and the remaining, in areas

other than debt.

As the fund is actively managed, it has outperformed its category and has generated areturn of 23.79% p.a. as compared to its category return of 20.01%.

Also, it has grown by leaps and bounds and given a return of 66.15% since its launch. A minimum investment of Rs. 5,000 is required for this fund and an SIP can also be

started with a minimum amount of Rs. 1,000.

Its assets under management have seen a drastic increase and now stand at Rs. 25.40crores.


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BSE TASIS Shariah 50 Index

India has got its first Shariah compliant Index which strictly follows the ShariahGuidelines which are drafted by local India based Shariah Advisory board. The index

is called BSE TASIS Shariah 50 Index and will be available from 27th December

2010 onwards.

The screening of the constituent stocks in BSE TASIS Shariah 50 index will be doneon a monthly basis. Non compliant sotcks will be moved out and those which qualify

will be included.

Many shariah based investors are still not investing in the open market, havinginvestment products based on shariah guidelines will help them get these investors

and mean big business for them.

The index will be licensed for the construction of Shariah compliant financialproducts including mutual funds, ETFs, and structured products, and that is this

licence fee will generate the revenue for BSE. The index is being launched as a joint

partnership between BSE and Taqwaa Advisory and Shariah Investment Solutions

(TASIS).

NSE is also reported to have the S&P CNX 500 Shariah Index


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ISLAMIC MARKET CHARACTERISTICS

951 billions Shariah compliant assets 799 billions banking assets 152 billions under management

1 trillion target expected in 2010 20-30% annual growth rate


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ISLAMIC BANKING

Islamic Banking

Islamic banking is a new phenomenon that has taken many observers by surprise. The whole

banking system has been islamized in both Iran and Pakistan. In addition, there are some

thirty Islamic banks in operation in other parts of the globe, including the Jeddah-based

Islamic Development Bank (IDB) but excluding numerous non-bank Islamic financial

institutions. What is more, the speed with which Islamic banks have sprung up and the rate at

which they have progressed make it worth-while to study them systematically. An attempt is

made in this paper

Evolution

The first modern experiment with Islamic banking was undertaken in Egypt under cover,

without projecting an Islamic image, for fear of being seen as a manifestation of Islamic

fundamentalism which was anathema to the political regime. The pioneering effort, led by

Ahmad El Najjar, took the form of a savings bank based on profit-sharing in the Egyptian

town of Mit Ghamr in l963. This experiment lasted until l967 (Ready l98l), by which timethere were nine such banks in the country. These banks, which neither charged nor paid

interest, invested mostly by engaging in trade and industry, directly or in partnership with

others, and shared the profits with their depositors (Siddiqi l988). Thus, they functioned

essentially as saving- investment institutions rather than as commercial banks. The Nasir

Social Bank, established in Egypt in l97l, was declared an interest-free commercial bank,

although its charter made no reference to Islam or Shariah (Islamic law).

The IDB was established in l974 by the Organization of Islamic Countries (OIC), but it was

primarily an inter-governmental bank aimed at providing funds for development projects inmember countries. The IDB provides fee- based financial services and profit-sharing

financial assistance to member countries. The IDB operations are free of interest and are

explicitly based on


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which cannot be withdrawn before maturity. The profit-sharing ratio varies from bank to

bank and from time to time depending on supply and demand conditions.(4) In theory, the rate

of return could be positive or negative, but in practice the returns have always been positive

and quite comparable to rates conventional banks offer on their term deposits. (5)

At the investment portfolio end of the scale, Islamic banks employ a variety of instruments.

The mudaraba and musharaka modes, referred to earlier, are supposedly the main conduits

for the outflow of funds from the banks. In practice, however, Islamic banks have shown a

strong preference for other modes which are less risky. The most commonly used mode of

financing seems to be the 'mark-up' device which is termed murabaha. In a murabaha

transaction, the bank finances the purchase of a good or asset by buying it on behalf of its

client and adding a mark-up before re-selling it to the client on a 'cost-plus' basis. It may

appear at first glance that the mark-up is just another term for interest as charged by

conventional banks, interest thus being admitted through the back door. What makes the

murabaha transaction Islamically legitimate is that the bank first acquires the asset and in theprocess it assumes certain risks between purchase and resale. The bank takes responsibility

for the good before it is safely delivered to the client. The services rendered by the Islamic

bank are therefore regarded as quite different from those of a conventional bank which

simply lends money to the client to buy the good.

Islamic banks have also been resorting to purchase and resale of properties on a deferred

payment basis, which is termed bai' muajjal. It is considered lawful in fiqh (jurisprudence) to

charge a higher price for a good if payments are to be made at a later date. According to fiqh,

this does not amount to charging interest, since it is not a lending transaction but a tradingone.

Leasing or ijara is also frequently practised by Islamic banks. Under this mode, the banks

would buy the equipment or machinery and lease it out to their clients who may opt to buy

the items eventually, in which case the monthly payments will consist of two components,

i.e., rental for the use of the equipment and instalment towards the purchase price.

Reference must also be made to pre-paid purchase of goods, which is termed bai'salam, as a

means used by Islamic banks to finance production. Here the price is paid at the time of the

contract but the delivery would take place at a future date. This mode enables an entrepreneurto sell his output to the bank at a price determined in advance. Islamic banks, in keeping with

modern times, have extended this facility to manufactures as well. It is clear from the above

sketch that Islamic banking goes beyond the pure financing activities of conventional banks.

Islamic banks engage in equity financing and trade financing. By its very nature, Islamic

banking is a risky business compared with conventional banking, for risk-sharing forms the

very basis of all Islamic financial transactions. To minimize risks, however, Islamic banks

have taken pains to distribute the eggs over many baskets and have established reserve funds

out of past profits which they can fall back on in the event of any major loss.
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Literature: Theory

It is not possible to cover in this survey all the publications which have appeared on Islamic

banking. There are numerous publications in Arabic and Urdu which have made significant

contributions to the theoretical discussion. A brief description of these in English can be

found in the Appendix to Siddiqi's book on Banking without Interest (Siddiqi l983a). The

early contributions on the subject of Islamic banking were somewhat casual in the sense that

only passing references were made to it in the discussion of wider issues relating to the

Islamic economic system as a whole. In other words, the early writers had been simply

thinking aloud rather than presenting well-thought-out ideas. Thus, for example, the book by

Qureshi on Islam and the Theory of Interest (Qureshi l946) looked upon banking as a social

service that should be sponsored by the government like public health and education. Qureshi

took this point of view since the bank could neither pay any interest to account holders nor

charge any interest on loans advanced. Qureshi also spoke of partnerships between banks and

businessmen as a possible alternative, sharing losses if any. No mention was made of profit-sharing.

Ahmad, in Chapter VII of his book Economics of Islam (Ahmad l952), envisaged the

establishment of Islamic banks on the basis of a joint stock company with limited liability. In

his scheme, in addition to current accounts, on which no dividend or interest should be paid,

there was an account in which people could deposit their capital on the basis of partnership,

with shareholders receiving higher dividends than the account holders from the profits made.

Like Qureshi, above, Ahmad also spoke of possible partnership arrangements with the

businessmen who seek capital from the banks. However, the partnership principle was leftundefined, nor was it clear who would bear the loss if any. It was suggested that banks should

cash bills of trade without charging interest, using the current account funds.

The principle of mudaraba based on Shariah was invoked systematically by Uzair (l955). His

principal contribution lay in suggesting mudaraba as the main premise for 'interestless

banking'. However, his argument that the bank should not make any capital investment with

its own deposits rendered his analysis somewhat impractical.

Al-Arabi (l966) envisaged a banking system with mudaraba as the main pivot. He was

actually advancing the idea of a two-tier mudaraba which would enable the bank to mobilizesavings on a mudaraba basis, allocating the funds so mobilized also on a mudaraba basis. In

other words the bank would act as a mudarib in so far as the depositors were concerned,

while the 'borrowers' would act as mudaribs in so far as the bank was concerned. In his

scheme, the bank could advance not only the capital procured through deposits but also the

capital of its own shareholders. It is also of interest to note that his position with regard to the

distribution of profits and the responsibility for losses was strictly in accordance with the

Shariah.(6) Irshad (l964) also spoke of mudaraba as the basis of Islamic banking, but his

concept of mudaraba was quite different from the traditional one in that he thought of capital

and labour (including entrepreneurship) as having equal shares in output, thus sharing the
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losses and profits equally. This actually means that the owner of capital and the entrepreneur

have a fifty-fifty share in the profit or loss as the case may be, which runs counter to the

Shariah position. Irshad envisaged two kinds of deposit accounts. The first sounded like

current deposits in the sense that it would be payable on demand, but the money kept in this

deposit would be used for social welfare projects, as the depositors would get zero return.The second one amounted to term deposits which would entitle the depositors to a share in

the profits at the end of the year proportionately to the size and duration of the deposits. He

recommended the setting up of a Reserve Fund which would absorb all losses so that no

depositor would have to bear any loss. According to Irshad, all losses would be either

recovered from the Reserve Fund or borne by the shareholders of the bank.

A pioneering attempt at providing a fairly detailed outline of Islamic banking was made in

Urdu by Siddiqi in l968. (The English version was not published until l983.) His Islamic

banking model was based on mudaraba and shirka (partnership or musharaka as it is now

usually called). His model was essentially one based on a two-tier mudaraba financier-entrepreneur relationship, but he took pains to describe the mechanics of such transactions in

considerable detail with numerous hypothetical and arithmetic examples. He classified the

operations of an Islamic bank into three categories: services based on fees, commissions or

other fixed charges; financing on the basis of mudaraba and partnership; and services

provided free of charge. His thesis was that such interest-free banks could be a viable

alternative to interest-based conventional banks.

The issue of loans for consumption clearly presents a problem, as there is no profit to be

shared. Siddiqi addressed this problem, but he managed only to scratch the surface. Whilerecognizing the need for such interest-free loans (qard hasan), especially for meeting basic

needs, he seemed to think it was the duty of the community and the State (through its baitul

mal or treasury) to cater to those needs; the Islamic bank's primary objective, like that of any

other business unit, is to earn profit. He therefore tended to downplay the role of Islamic

banks in providing consumption loans, but he suggested limited overdraft facilities without

interest. He even considered a portion of the fund being set aside for consumption loans,

repayment being guaranteed by the State. He also suggested that consumers buying durables

on credit would issue 'certificates of sale' which could be encashed by the seller at the bank

for a fee. It was then the seller not the buyer who would be liable as far as the bank was

concerned. However, the principles of murabaha and bai' muajjal were not invoked.

Strangely, Siddiqi favoured keeping the number of shareholders to the minimum, without

advancing any strong reasons. This is contrary to the general consensus which now seems to

have emerged with reference to Islamic banks operating on a joint stock company basis, a

consensus which incidentally is also in line with the Islamic value attached to a broad equity

base as against heavy concentration of equity and wealth. Ironically, Siddiqi thought that

interest-free banking could operate successfully 'only in a country where interest is legally

prohibited and any transaction based upon interest is declared a punishable offense'

(l983b:l3). He also thought it important to have Islamic laws enforced before interest-free


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The literature also discusses the question of central banking in an Islamic framework. The

general opinion seems to be that the basic functions of a modern central bank are relevant

also for an Islamic monetary system, although the mechanisms may have to be different.

Thus, for example, the bank rate instrument cannot be used as it entails interest. Uzair (l982)

has suggested adjustments in profit-sharing ratios as a substitute for bank rate manipulationsby the central bank. Thus, credit can be tightened by reducing the share accruing to the

businessmen and eased by increasing it. Siddiqi (l982) has suggested that variations in the so-

called 'refinance ratio' (which refers to the central bank refinancing of a part of the interest-

free loans provided by the commercial banks) would influence the quantum of short-term

credit extended. Siddiqi has also proposed a prescribed 'lending ratio' (i.e., the proportion of

demand deposits that commercial banks are obliged to lend out as interest-free loans) that can

be adjusted by the central bank according to changing circumstances. In this context,

reference may also be made to a proposal by Uzair (l982) that the central bank should acquire

an equity stake in commercial banking by holding, say, 25 per cent of the capital stock of the

commercial banks. The rationale behind this proposal was that it would give the central bank

access to a permanent source of income so that it could effectively act as lender of last resort.

The discussion of central banking in an Islamic context is somewhat scanty, presumably

because Islamic central banking is viewed as too far-fetched an idea, except in Iran and

Pakistan.

It emerges from all this that Islamic banking has three distinguishing features:

a. it is interest-free,b. it is multi-purpose and not purely commercial, andc. it is strongly equity-oriented.

The literature contains hardly any serious criticism of the interest-free character of the

operation, since this is taken for granted, although concerns have been expressed about the

lack of adequate interest-free instruments. There is a near-consensus that Islamic banks can

function well without interest. A recent International Monetary Fund study by Iqbal and

Mirakhor (l987) has found Islamic banking to be a viable proposition that can result in

efficient resource allocation. The study suggests that banks in an Islamic system face fewer

solvency and liquidity risks than their conventional counterparts. The multi-purpose and

extra-commercial nature of the Islamic banking operation does not seem to pose intractableproblems. The abolition of interest makes it imperative for Islamic banks to look for other

instruments, which renders operations outside the periphery of commercial banking

unavoidable. Such operations may yield economies of scope. But it is undeniable that the

multipurpose character of Islamic banking poses serious practical problems, especially in

relation to the skills needed to handle such diverse and complex transactions (Iqbal and

Mirakhor l987).


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The stress on equity-oriented transactions in Islamic banking, especially the mudaraba mode,

has been criticized. It has been argued that the replacement of pre-determined interest by

uncertain profits is not enough to render a transaction Islamic, since profit can be just as

exploitative as interest is, if it is 'excessive' (Naqvi l98l). Naqvi has also pointed out that there

is nothing sacrosanct about the institution of mudaraba in Islam. Naqvi maintains thatmudaraba is not based on the Qur'an or the Hadith but was a custom of the pre-Islamic Arabs.

Historically, mudaraba, he contends, enabled the aged, women, and children with capital to

engage in trade through merchants for a share in the profit, all losses being borne by the

owners of capital, and therefore it cannot claim any sanctity. The fact remains that the

Prophet raised no objection to mudaraba, so that it was at least not considered un-Islamic.

The distribution of profit in mudaraba transactions presents practical difficulties, especially

where there are multiple providers of capital, but these difficulties are not regarded as

insurmountable. The Report of Pakistan's Council of Islamic Ideology (CII l983) has

suggested that the respective capital contributions of parties can be converted to a commondenominator by multiplying the amounts provided with the number of days during which

each component, such as the firm's own equity capital, its current cash surplus and suppliers'

credit was actually deployed in the business, i.e., on a daily product basis. As for deposits,

profits (net of administrative expenses, taxes, and appropriation for reserves) would be

divided between the shareholders of the bank and the holders of deposits, again on a daily

product bas is.


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Literature: Practice

Recent years have brought an increasing flow of empirical studies of Islamic banking. The

earliest systematic empirical work was undertaken by Khan (l983). His observations covered

Islamic banks operating in Sudan, United Arab Emirates, Kuwait, Bahrain, Jordan, and

Egypt. Khan's study showed that these banks had little difficulty in devising practices in

conformity with Shariah. He identified two types of investment accounts: one where the

depositor authorized the banks to invest the money in any project and the other where the

depositor had a say in the choice of project to be financed. On the asset side, the banks under

investigation had been resorting to mudaraba, musharaka and murabaha modes. Khan's study

reported profit rates ranging from 9 to 20 per cent which were competitive with conventional

banks in the corresponding areas. The rates of return to depositors varied between 8 and l5

per cent, which were quite comparable with the rates of return offered by conventional banks.

Khan's study revealed that Islamic banks had a preference for trade finance and real estateinvestments. The study also revealed a strong preference for quick returns, which is

understandable in view of the fact that these newly established institutions were anxious to

report positive results even in the early years of operation. Nienhaus (1988) suggests that the

relative profitability of Islamic banks, especially in the Middle East in recent years, was to a

large extent due to the property (real estate) boom. He has cited cases of heavy losses which

came with the crash of the property sector.

The IMF study referred to earlier by Iqbal and Mirakhor (l987) also contains extremely

interesting empirical observations, although these are confined to the experience of Iran andPakistan, both of which have attempted to islamize the entire banking system on a

comprehensive basis. Iran switched to Islamic banking in August l983 with a three-year

transition period. The Iranian system allows banks to accept current and savings deposits

without having to pay any return, but it permits the banks to offer incentives such as variable

prizes or bonuses in cash or kind on these deposits. Term deposits (both short-term and long-

term) earn a rate of return based on the bank's profits and on the deposit maturity. No

empirical evidence is as yet available on the interesting question as to whether interest or a

profit-share provides the more effective incentive to depositors for the mobilization of private

saving. Where Islamic and conventional banks exist side by side, central bank control of bank

interest rates is liable to be circumvented by shifts of funds to the Islamic banks.

Iqbal and Mirakhor have noted that the conversion to Islamic modes has been much slower

on the asset than on the deposit side. It appears that the Islamic banking system in Iran was

able to use less than half of its resources for credit to the private sector, mostly in the form of

short-term facilities, i.e., commercial and trade transactions. The slower pace of conversion

on the asset side was attributed by the authors to the inadequate supply of personnel trained in

long-term financing. The authors, however, found no evidence to show that the effectiveness

of monetary policy in Iran, broadly speaking, was altered by the conversion.


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The Pakistani experience differs from the Iranian one in that Pakistan had opted for a gradual

islamization process which began in l979. In the first phase, which ended on l January l985,

domestic banks operated both interest- free and interest-based 'windows'. In the second phase

of the transformation process, the banking system was geared to operate all transactions on

the basis of no interest, the only exceptions being foreign currency deposits, foreign loans andgovernment debts. The Pakistani model took care to ensure that the new modes of financing

did not upset the basic functioning and structure of the banking system. This and the gradual

pace of transition, according to the authors, made it easier for the Pakistani banks to adapt to

the new system. The rate of return on profit-and-loss sharing (PLS) deposits appears not only

to have been in general higher than the interest rate before islamization but also to have

varied between banks, the differential indicating the degree of competition in the banking

industry. The authors noted that the PLS system and the new modes of financing had

accorded considerable flexibility to banks and their clients. Once again the study concluded

that the effectiveness of monetary policy in Pakistan was not impaired by the changeover.

The IMF study, however, expressed considerable uneasiness about the concentration of bank

assets on short-term trade credits rather than on long-term financing. This the authors found

undesirable, not only because it is inconsistent with the intentions of the new system, but also

because the heavy concentration on a few assets might increase risks and destabilize the asset

portfolios. The study also drew attention to the difficulty experienced in both Iran and

Pakistan in financing budget deficits under a non-interest system and underscored the urgent

need to devise suitable interest-free instruments. Iran has, however, decreed that government

borrowing on the basis of a fixed rate of return from the nationalized banking system would

not amount to interest and would hence be permissible. The official rationalization is that,since all banks are nationalized, interest rates and payments among banks will cancel out in

the consolidated accounts. (This, of course, abstracts from the banks' business with non-bank

customers.) There are also some small case studies of Islamic banks operating in Bangladesh

(Huq l986), Egypt (Mohammad l986), Malaysia (Halim l988b), Pakistan (Khan l986), and

Sudan (Salama l988b). These studies reveal interesting similarities and differences. The

current accounts in all cases are operated on the principles of al-wadiah. Savings deposits,

too, are accepted on the basis of al-wadiah, but 'gifts' to depositors are given entirely at the

discretion of the Islamic banks on the minimum balance, so that the depositors also share in

profits. Investment deposits are invariably based on the mudaraba principle, but there are

considerable variations. Thus, for example, the Islamic Bank of Bangladesh has been offering

PLS Deposit Accounts, PLS Special Notice Deposit Accounts, and PLS Term Deposit

Accounts, while Bank Islam Malaysia has been operating two kinds of investment deposits,

one for the general public and the other for institutional clients.

The studies also show that the profit-sharing ratios and the modes of payment vary from

place to place and from time to time. Thus, for example, profits are provisionally declared on

a monthly basis in Malaysia, on a quarterly basis in Egypt, on a half-yearly basis in

Bangladesh and Pakistan, and on an annual basis in Sudan.


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A striking common feature of all these banks is that even their investment deposits are mostly

short-term, reflecting the depositors' preference for assets in as liquid a form as possible.

Even in Malaysia, where investment deposits have accounted for a much larger proportion of

the total, the bulk of them were made for a period of less than two years. By contrast, in

Sudan most of the deposits have consisted of current and savings deposits, apparentlybecause of the ceiling imposed by the Sudanese monetary authorities on investment deposits

which in turn was influenced by limited investment opportunities in the domestic economy.

There are also interesting variations in the pattern of resource utilization by the Islamic

banks. For example, musharaka has been far more important than murabaha as an investment

mode in Sudan, while the reverse has been the case in Malaysia. On the average, however,

murabaha, bai'muajjal and ijara, rather than musharaka represent the most commonly used

modes of financing. The case studies also show that the structure of the clientele has been

skewed in favor of the more affluent segment of society, no doubt because the banks are

located mainly in metropolitan centres with small branch networks.

The two main problems identified by the case studies are the absence of suitable non-interest-

based financial instruments for money and capital market transactions and the high rate of

borrower delinquency. The former problem has been partially redressed by Islamic banks

resorting to mutual inter-bank arrangements and central bank cooperation, as mentioned

earlier. The Bank Islam Malaysia, for instance, has been placing its excess liquidity with the

central bank which usually exercises its discretionary powers to give some returns. The

delinquency problem appears to be real and serious. Murabaha payments have often been

held up because late payments cannot be penalized, in contrast to the interest system in which

delayed payments would automatically mean increased interest payments. To overcome thisproblem, the Pakistani banks have resorted to what is called 'mark-down' which is the

opposite of 'mark-up' (i.e., the profit margin in the cost-plus approach of murabaha

transactions). 'Mark-down' amounts to giving rebates as an incentive for early payments. But

the legitimacy of this 'mark-down' practice is questionable on Shariah grounds, since it is

time- based and therefore smacks of interest.

In the Southeast Asian context, two recent studies on the Bank Islam Malaysia by Man (l988)

and the Philippine Amanah Bank by Mastura (l988) deserve special mention. The Malaysian

experience in Islamic banking has been encouraging. Man's study shows that the average

return to depositors has been quite competitive with that offered by conventional banks. By

the end of l986, after three years of operation, the bank had a network of fourteen branches.

However, 90 per cent of its deposits had maturities of two years or less, and non-Muslim

depositors accounted for only 2 per cent of the total. Man is particularly critical of the fact

that the mudaraba and musharaka modes of operation, which are considered most meaningful

by Islamic scholars, accounted for a very small proportion of the total investment portfolio,

while bai'muajjal and ijara formed the bulk of the total. It is evident from Mastura's analysis

that the Philippine Amanah Bank is, strictly speaking, not an Islamic bank, as interest-based

operations continue to coexist with Islamic modes of financing. Thus, the PAB has been

operating both interest and Islamic 'windows' for deposits. Mastura's study has produced


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evidence to show that the PAB has been concentrating on murabaha transactions, paying

hardly any attention to the mudaraba and musharaka means of financing. The PAB has also

been adopting unorthodox approaches in dealing with excess liquidity by making use of

interest- bearing treasury bills. Nonetheless, the PAB has also been invoking some Islamic

modes in several major investment activities. Mastura has made special references to theqirad principle adopted by the PAB in the Kilu-sang Kabuhayan at Kaunlaran (KKK)

movement launched under Marcos and to the ijara financing for the acquisition of farm

implements and supplies in the Quedon food production program undertaken by the present

regime. So far no reference has been made to Indonesia, the largest Muslim country in the

world, with Muslims accounting for 90 per cent of a population of some 165 million. The

explanation is that a substantial proportion, especially in Java, are arguably nominal Muslims.

Indonesians by and large subscribe to the Pancasila ideology which is essentially secular in

character. The present regime seems to associate Islamic banking with Islamic

fundamentalism to which the regime is not at all sympathetic. Besides, the intellectual

tradition in Indonesia in modern times has not been conducive to the idea of interest-free

banking. There were several well respected Indonesian intellectuals including Hatta (the

former Vice President) who had argued that riba prohibited in Islam was not the same as

interest charged or offered by modern commercial banks, although Islamic jurists in

Indonesia hold the opposite view. The Muslim public seems somewhat indifferent to all this.

This, however, does not mean that there are no interest-free financial institutions operating in

Indonesia. One form of traditional interest-free borrowing is the still widely prevalent form of

informal rural credit known as ijon (green) because the loan is secured on the standing crop

as described by Partadireja (1974). Another is the arisan system practiced among consumers

and small craftsmen and traders. In this system, each member contributes regularly a certainsum and obtains interest-free loans from the pool by drawing lots. The chances of an Islamic

bank being established in Indonesia seem at present remote (cf. Rahardjo 1988).

Finally, in the most recent contribution to the growing Islamic banking literature, Nien-haus

(l988) concludes that Islamic banking is viable at the microeconomic level but dismisses the

proponents' ideological claims for superiority of Islamic banking as 'unfounded'. Nienhaus

points out that there are some failure stories. Examples cited include the Kuwait Finance

House which had its fingers burned by investing heavily in the Kuwaiti real estate and

construction sector in l984, and the Islamic Bank International of Denmark which suffered

heavy losses in l985 and l986 to the tune of more than 30 per cent of its paid-up capital. But

then, as Nienhaus himself has noted, the quoted troubles of individual banks had specific

causes and it would be inappropriate to draw general conclusions from particular cases.

Nienhaus notes that the high growth rates of the initial years have been falling off, but he

rejects the thesis that the Islamic banks have reached their 'limits of growth' after filling a

market gap. The falling growth rates might well be due to the bigger base values, and the

growth performance of Islamic banks has been relatively better in most cases than that of

conventional banks in recent years.


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According to Nienhaus, the market shares of many Islamic banks have increased over time,

notwithstanding the deceleration in the growth of deposits. The only exception was the Faisal

Islamic Bank of Sudan (FIBS) whose market share had shrunk from l5 per cent in l982 to 7

per cent in l986, but Nien-haus claims that the market shares lost by FIBS were won not by

conventional banks but by newer Islamic banks in Sudan. Short-term trade financing hasclearly been dominant in most Islamic banks regardless of size. This is contrary to the

expectation that the Islamic banks would be active mainly in the field of corporate financing

on a participation basis. Nien-haus attributes this not only to insufficient supply by the banks

but also to weak demand by entrepreneurs who may prefer fixed interest cost to sharing their

profits with the banks.


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Conclusion for Islamic Banking

The preceding discussion makes it clear that Islamic banking is not a negligible or merely

temporary phenomenon. Islamic banks are here to stay and there are signs that they will

continue to grow and expand. Even if one does not subscribe to the Islamic injunction against

the institution of interest, one may find in Islamic banking some innovative ideas which could

add more variety to the existing financial network.

One of the main selling points of Islamic banking, at least in theory, is that, unlike

conventional banking, it is concerned about the viability of the project and the profitability of

the operation but not the size of the collateral. Good projects which might be turned down by

conventional banks for lack of collateral would be financed by Islamic banks on a profit-

sharing basis. It is especially in this sense that Islamic banks can play a catalytic role in

stimulating economic development. In many developing countries, of course, development

banks are supposed to perform this function. Islamic banks are expected to be moreenterprising than their conventional counterparts. In practice, however, Islamic banks have

been concentrating on short-term trade finance which is the least risky.

Part of the explanation is that long-term financing requires expertise which is not always

available. Another reason is that there are no back-up institutional structures such as

secondary capital markets for Islamic financial instruments. It is possible also that the

tendency to concentrate on short-term financing reflects the early years of operation: it is

easier to administer, less risky, and the returns are quicker. The banks may learn to pay more

attention to equity financing as they grow older.

It is sometimes suggested that Islamic banks are rather complacent. They tend to behave as

though they had a captive market in the Muslim masses who will come to them on religious

grounds. This complacency seems more pronounced in countries with only one Islamic bank.

Many Muslims find it more convenient to deal with conventional banks and have no qualms

about shifting their deposits between Islamic banks and conventional ones depending on

which bank offers a better return. This might suggest a case for more Islamic banks in those

countries as it would force the banks to be more innovative and competitive. Another solution

would be to allow the conventional banks to undertake equity financing and/or to operate

Islamic 'counters' or 'windows', subject to strict compliance with the Shariah rules. It isperhaps not too wild a proposition to suggest that there is a need for specialized Islamic

financial institutions such as mudaraba banks, murabaha banks and musharaka banks which

would compete with one another to provide the best possible services.


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References:

Shariah Financing

http://en.wikipedia.org/wiki/Islamic_banking

https://www.in.kpmg.com/SecureData/aci/Files/ISS.pdf

http://www.investindia.kotak.com/media/islamic-finance.html

http://www.tasis.in/images/ISFS.PDF

http://www.finance-trading-times.com/2011/02/2208-shariah-

compliant-islamic-banking.html

http://www.christianpost.com/news/growing-sharia-finance-in-

india-a-boon-or-bane-49621/

Islamic Banking

http://en.wikipedia.org/wiki/Islamic_banking

http://www.islamicbanking.nl/chap4.html

http://www.infosys.com/finacle/solutions/solutions_islamicbanking.

asp

http://www.islamic-banking.com/what_is_ibanking.aspx

http://economictimes.indiatimes.com/news/news-by-industry/banking/finance/banking/Experts-pitch-for-Islamic-

banking-in-India/articleshow/5535291.cms

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banking/679608/
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Shariah Final