Islamic Banking Collections

Knowledge

The Qur'an

"O my Lord! Increase my knowledge." [20:114]

"Are those equal, those who know and those who do not know?” [39:9]

One of the distinctive features of Islam is its emphasis on knowledge. The Qur'an and the Islamic tradition (Sunnah) invite Muslims to seek and acquire knowledge and wisdom and to hold men of knowledge in high esteem. The word al-Ilm, knowledge, and its derivatives are used more than 780 times in the Qur'an. The first few verses mention the importance of reading, pen, and teaching for human beings.

The Prophet Muhammad (pbuh) told Muslims “seek knowledge, even if it be in China.”

Preservation of Knowledge

Rarely is Islam viewed as a source of inspiration and enlightenment. It was the Muslims who preserved the knowledge of antiquity, elaborated upon it, and finally, passed it on to Europe. Islam had spread from Al-Andalus in Spain to the borders of China. Islam unified science, theology, and philosophy. Muslims were commanded to study, seek knowledge, and learn and benefit from others' experiences. This inspired the Muslims to great heights in sciences, medicine, mathematics, astronomy, chemistry, philosophy, art and architecture. Muslim scholars began obtaining Greek treatises and started their study and translation into Arabic a few centuries after the Hijrah (622 A.D.) They critically analyzed, collated, corrected and supplemented substantially the Greek science and philosophy.

During the time of Harun al-Rashid (786-809) the Muslims built a library which contained both originals and translations of almost any then known scientific work in Sanskrit, Persian and Greek. His son, Caliph al-Mamun continued the tradition of philosophy and science and established in Baghdad his Bayt al-Hikmah (House of Wisdom), a library and academy. Here the objective was to collect all scientific works, translate them into Arabic and copy and bind them into books to preserve them.

Islam and The West, HRH, The Prince of Wales

“. . . we have underestimated the importance of 800 years of Islamic society and culture in Spain between the 8th and 15th centuries. The contribution of Muslim Spain to the preservation of classical learning during the Dark Ages, and to the first flowerings of the Renaissance, has long been recognised. But Islamic Spain was much more than a mere larder where Hellenistic knowledge was kept for later consumption by the emerging modern Western world. Not only did Muslim Spain gather and preserve the intellectual content of ancient Greek and Roman civilisation, it also interpreted and expanded upon that civilisation, and made a vital contribution of its own in so many fields of human endeavour - in science, astronomy, mathematics, algebra (itself an Arabic word), law, history, medicine, pharmacology, optics, agriculture, architecture, theology, music. Averroes and Avenzoor, like their counterparts Avicenna and Rhazes in the East, contributed to the study and practice of medicine in ways from which Europe benefited for centuries afterwards.

Islam nurtured and preserved the quest for learning. In the words of the tradition, 'the ink of the scholar is more sacred than the blood of the martyr'. Cordoba in the 10th century was by far the most civilised city of Europe. We know of lending libraries in Spain at the time King Alfred was making terrible blunders with the culinary arts in this country. It is said that the 400,000 volumes in its ruler's library amounted to more books than all the libraries of the rest of Europe put together. That was made possible because the Muslim world acquired from China the skill of making paper more than 400 years before the rest of non-Muslim Europe. Many of the traits on which modern Europe prides itself came to it from Muslim Spain. Diplomacy, free trade, open borders, the techniques of academic research, of anthropology, etiquette, fashion, various types of medicine, hospitals, all came from this great city of cities.

Medieval Islam was a religion of remarkable tolerance for its time, allowing Jews and Christians the right to practice their inherited beliefs, and setting an example which was not, unfortunately, copied for many centuries in the West. The surprise, ladies and gentlemen, is the extent to which Islam has been a part of Europe for so long, first in Spain, then in the Balkans, and the extent to which it has contributed so much towards the civilisation which we all too often think of, wrongly, as entirely Western. Islam is part of our past and our present, in all fields of human endeavour. It has helped to create modern Europe. It is part of our own inheritance, not a thing apart.”

Early Muslim Scholars

Early Islamic philosophy or classical Islamic philosophy is a period of intense philosophical development beginning in the 2nd century AH of the Islamic calendar (early 9th century CE) and lasting until the 6th century AH (late 12th century CE). The period is known as the Islamic Golden Age, and the achievements of this period had a crucial influence in the development of modern philosophy and science. This period starts with al-Kindi in the 9th century and ends with Averroes (Ibn Rushd) at the end of 12th century. The death of Averroes effectively marks the end of a particular discipline of Islamic philosophy usually called the Peripatetic Arabic School, and philosophical activity declined significantly in Western Islamic countries, namely in Islamic Spain and North Africa, though it persisted for much longer in the Eastern countries, in particular Persia and India where several schools of philosophy continued to flourish: Avicennism, Illuminationist philosophy, Mystical philosophy, and Transcendent theosophy.

Some of the significant achievements of early Muslim philosophers included the development of a strict science of citation, the isnad or "backing"; the development of a method of open inquiry to disprove claims, the ijtihad, which could be generally applied to many types of questions (although which to apply it to is an ethical question); the willingness to both accept and challenge authority within the same process; recognition that science and philosophy are both subordinate to morality, and that moral choices are prior to any investigation or concern with either; the separation of theology (kalam) and law (shariah) during the early Abbasid period, a precursor to secularism;[1] the distinction between religion and philosophy, marking the beginning of secular thought; the beginning of a peer review process; early ideas on evolution; the beginnings of the scientific method, an important contribution to the philosophy of science; the first forms of non-Aristotelian logic and the introduction of temporal modal logic and inductive logic; the beginning of social philosophy, including the formulation of theories on social cohesion and social conflict; the beginning of the philosophy of history; the development of the philosophical novel and the concepts of empiricism and tabula rasa; and distinguishing between essence and existence.

Thomas Aquinas knew of at least some of the Mutazilite work, particularly Avicennism and Averroism, and the Renaissance and the use of empirical methods were inspired at least in part by Arabic works translated into Latin during the Renaissance of the 12th century, and taken during the Reconquista in 1492.
[Wikipedia]

Al-Ghazali

One of the greatest figures in Islamic philosophy is held to be al-Ghazali [1058-1111], who was a jurist, theologian, philosopher and mystic. In philosophy, Ghazali upheld the approach of mathematics and Ghazali wrote many books including Tuhafut al-Falasifa (The Incoherence of the Philosophers) and Ihya al-Ulum al-Islamia (The Revival of the Islamic Sciences). Ghazali's influence was deep. His theological doctrines penetrated Europe and influenced Jewish and Christian Scholasticism and Thomas Aquinas.

Ibn Rushd

Another great philosopher was Ibn Rushd [1126-1198], a jurist, and interpreter of the Shari'ah. Ibn Rushd was a rationalist and wrote about religion and philosophy. He wrote commentaries on Aristotle, to such an extent that in the West he was known as "The Commentator" contributing thereby to the rediscovery of the ‘Master', after centuries of near-total oblivion in Western Europe. That discovery was instrumental in launching Latin Scholasticism and, in due course, the European Renaissance of the fifteenth century. Ibn Rushd's influence on Medieval and Renaissance European history is found to be greater than that of his influence on the Islamic world. A common theme throughout his writings is that there is no incompatibility between religion and philosophy when both are properly understood.

Ibn Khaldun

Ibn Khaldun's (1332-1395) main contribution as another leading Muslim scholar lies in the philosophy of history and sociology. The Muqaddimah, his monumental work identified psychological, economic, environmental and social facts that contributed to the advancement of human civilizations and the currents of history as opposed to just the political context of earlier writers. He analyzed the dynamics of group relationships and showed how group feelings, al-'Asabiyya, give rise to the ascent of a new civilization and political power and how, later on, its diffusion into a more general civilization invited the beginning of a still new 'Asabiyya in its pure form. He identified an almost rhythmic repetition of rise and fall in human civilization and analysed factors contributing to it. His contribution to history is marked by the fact that, unlike most earlier writers who interpreted history through the political context, he emphasised environmental, sociological, psychological and economic factors governing the apparent events. This revolutionised the science of history and also laid the foundation of Umraniyat (Sociology).

The Islamic Financial System

While elimination of "Riba" or interest in all its forms is an important feature of the Islamic financial system, Islamic banking is much more. At the heart of Islam is a sense of cooperation, to help one another according to principles of goodness and piety (but not to cooperate in evil or malice). In essence, it aims to eliminate exploitation and to establish a just society by the application of the Shari'ah or Islamic rulings to the operations of banks and other financial institutions. To ensure compliance to the Shari'ah, Islamic banks use the services of religious boards comprised of Shari'ah scholars.

Islamic finance may be viewed as a form of ethical investing, or ethical lending, except that no loans are possible unless they are interest-free. Among the ethical restrictions is the prohibition on alcohol and gambling and the consumption of pork. Islamic funds would never knowingly invest in companies involved in gambling, alcoholic beverages, or porcine food products

Its practitioners and clients need not be Muslim, but they must accept the ethical restrictions underscored by Islamic values.

The Concepts

Islamic economic principles offers a balance between extreme capitalism and communism. It offers the individual the freedom to produce and create wealth, while surrounding the individual with an environment controlled, not by human rulers, but by Divine Guidance, which sets moral rules and norms of behaviour that must require the utmost sincerity of intention. When these rules and norms are internalised and acted upon by people, peace and prosperity result for the wider society.

The Qur'an (2:30) says that man was created as the representative of God on earth. This concept has a considerable effect on Islamic business, since the lack of a sense of absolute ownership promotes a sense working for society, especially the needy.

This is not some philosophical concept, removed from the daily life of the society. It manifests itself in all the different aspects of lives. What makes the trader, banker, agriculturist or research and development scientist perform his job to the best of his ability? In capitalist economies, it is the notion of competition. This involves the necessity to constantly produce more new things for profit to keep up with others and this makes for wastage and often generates unbridled greed. But in an economy based on Islamic principles, the idea of man representing God on earth gives businessmen a feeling of co-operating with others for the good of society as a whole, including himself. Thus Quranic guidance enables man to conserve and use prudently all the resources of the earth that God has given mankind.

The Essentials

Divine Guidance for the economy, as enshrined in the Qur'an and the Sunnah (the living example of Prophet Muhammad), can be summarised as follows:

1. Trusteeship

The Qur'an (57:7) emphasises that all the resources of the earth belong to God, the Creator, who has made human beings a trustee for them. Humans are therefore accountable to God for the uses they make of these resources. The idea of trusteeship distinguishes the Islamic approach to economics from materialistic approaches such as extreme capitalism and socialism. It introduces a moral and spiritual element into business life and has been made practicable by creating rules to govern individual behaviour and public policy.

2. Care For Others

Care for others tempers self-interest, which is ingrained in human nature. It goes naturally with trusteeship, since, in caring for others, one also serves God, who created all humans. No one can have fulfilment or happiness in his life without interacting with others. Thus individual happiness and collective interests go hand in hand.

We gain through giving, since it would be impossible for everyone to acquire while giving nothing. The Qur'an states this in 30:39 and 2:276. It follows that Islam discourages indulgence in luxuries. One is expected to consider what is available to others before acquiring good things for oneself. Moderation in consumption is mentioned in the Qur'an 7:31.

People who believe that they can increase their wealth through charging others interest and by reducing charitable giving are under an illusion. The wealth and integrity of a society can only increase when the rich give part of their wealth to the needy for no other motivation than to please God. Those who have faith and a vision of their future life understand this.

To think only of how to gain profit for oneself leads to using others as mere instruments. In societies where unbridled self-interest is allowed to dominate unchecked, there is no protection for the weak against the strong. Thus exclusive pursuit of self-interest, when not tempered by charity, is self- defeating.

3. Productive Effort as a Means of Serving God

Islam emphasises the duty of every individual to work for his living. Productive enterprise is looked upon as a means of serving God (2:195).

Islam requires wealth to be spent in the cause of God. This realisation moves Muslims to greater efforts in their economic activities. The fourteenth-century thinker Abu Ishaq Shatibi, writing of the companions of the Prophet, said,

"They were expert in business enterprise, keen and persistent in a variety of economic pursuits. They did not do so to amass wealth or save it for themselves; rather their aim was to spend their earnings in good causes.” (Shatibi, Al-Muwafiqaat fi Usul al-Shari'ah, Vol. 2, p188, Cairo, Maktaba al Tijarah al-Kubra.)

In the west, it is now considered enough to merely to ‘enjoy life', work being an unfortunate necessity. But in Islam, it is seen that working for a living gives man a sense of worthiness in his society. To support a family and contribute to others with any surplus enables one to take one's part in consultations on practical, social matters, so that all can benefit.

4. Application of the Shari'ah Rulings to Business

The aim of the Shari'ah rulings is to make the transfer of goods safe and easy and to facilitate economic transactions by eliminating vagueness or misunderstanding in all types of contracts. It prohibits the charging of interest on loans as a form of injustice. The goal is to remove the causes of social tension or litigation and to promote a climate of peace and goodwill. Islam strongly recommends that the terms of financial agreements be put in writing.

5. Mutual Consultation

Men are free to make private economic decisions, but decisions concerning the public welfare must be based on consultation. The Qur'an describes Muslims as a people "whose rule (in all matters of common concern) is by consultation among themselves.” (42:39). Mutual consultation avoids society or local communities coming under the rule of a dictator and makes sure that reasonable decisions acceptable to all are made.

6. Treating Wealth as a Means and not an End

Islam regards economic well being as a means to peace, freedom from hunger and freedom from fear of others, except God. Beyond the satisfaction of basic needs, the ultimate objectives of earning and spending money are moral and spiritual. It is against Islamic rationality to hoard money (9:34, 35).

It follows that savings must be put to good use. One who cannot go into business himself can do so in partnership with others, or can supply funds on a profit-sharing basis. People can also borrow and lend, but it is forbidden for the lender to claim interest from the borrower as this is unjust (2:275). Islam prohibits gambling, cheating, exploitation, coercion, etc., but freedom to make financial arrangements is constrained only by these few prohibitions and by the Islamic tendency to treat money as a means to the good life.

Proper Functioning of the Market

Islam prohibits dishonesty, fraud and deception, coercive practices, gambling and usurious and injurious dealings. Hoarding, speculation and collusion among producers and traders against the interest of consumers, and such monopolies as are injurious to the socio-economic health of society are all ruled out. The basic principles regulating market operations in an Islamic state are:

a) A person should be free to buy, sell or dispose of his possessions and money within the framework of the Shari'ah.

b) There is no restriction on the percentage of profit which a trader may make. It is left to him and depends on the business environment and the nature of the goods. However, moderation, contentment and leniency must be taken into consideration.

c) The Shari'ah emphasises avoiding illicit acts detrimental to the wellbeing of society or the individual.

d) The State should not fix prices except where there are artificial factors in the market which may lead to excessive price increases or decreases or fraud. If there are such, the State should intervene to remove these factors.

7. Protection of Consumers

The State should insure that producers, manufacturers and traders do not exploit each other or the buyers. It should curb adulteration, under-weighing, encroachment of thoroughfares, unhealthy trades and unlawful professions and maintain good, firm employee relationships.

8. Monopolies and Cartels

Industrialists in a free and competitive economy can form cartels and monopolies and exploit people and a firm law is needed to control them. No unjust, oppressive or cheating business can be allowed to continue in an Islamic economy.

9. Zakat or Zakah

Zakat is a levy on certain categories of wealth. It can be collected and distributed by the government and is obligatory only on Muslims. It is applicable to income and savings, agricultural harvests, commercial goods, gold and silver over certain amounts, some categories of livestock, excavated treasures, mined wealth, etc.

In accordance with the Qur'an (9:60), the proceeds from zakat are paid to the poor, the sick and destitute and to travellers, especially those seeking education or going on pilgrimage.

The Islamic view of distributive justice is contained in the three points: a guarantee of the fulfilment of basic needs; equality of opportunity; and elimination of glaring inequalities in personal income and wealth. Zakat also acts as an excellent form of social insurance.

10. Qard Hasan

Qard hasan is a Quranic term meaning an interest-free loan. It was the primary source of financing introduced by the Prophet after entering Medina and was used primarily for productive economic purposes, such as setting up qualified, but poor, people in trade and agriculture.

What is Islamic Banking?

Islamic banking refers to a system of banking or banking activity that is consistent with the principles of the Shari'ah (Islamic rulings) and its practical application through the development of Islamic economics. The principles which emphasise moral and ethical values in all dealings have wide universal appeal. Shari'ah prohibits the payment or acceptance of interest charges (riba) for the lending and accepting of money, as well as carrying out trade and other activities that provide goods or services considered contrary to its principles. While these principles were used as the basis for a flourishing economy in earlier times, it is only in the late 20th century that a number of Islamic banks were formed to provide an alternative basis to Muslims although Islamic banking is not restricted to Muslims.

Islamic banking has the same purpose as conventional banking except that it operates in accordance with the rules of Shari’ah, known as Fiqh al-Muamalat (Islamic rules on transactions). Islamic banking activities must be practiced consistent with the Shari’ah and its practical application through the development of Islamic economics. Many of these principles upon which Islamic banking is based are commonly accepted all over the world, for centuries rather than decades. These principles are not new but arguably, their original state has been altered over the centuries.

The principle source of the Shari’ah is The Qur’an followed by the recorded sayings and actions of Prophet Muhammad (pbuh) – the Hadith. Where solutions to problems cannot be found in these two sources, rulings are made based on the consensus of a community leaned scholars, independent reasoning of an Islamic scholar and custom, so long as such rulings to not deviate from the fundamental teachings in The Qur’an.

It is evident that Islamic finance was practiced predominantly in the Muslim world throughout the Middle Ages, fostering trade and business activities. In Spain and the Mediterranean and Baltic States, Islamic merchants became indispensable middlemen for trading activities. It is claimed that many concepts, techniques, and instruments of Islamic finance were later adopted by European financiers and businessmen.

The revival of Islamic banking coincided with the world-wide celebration of the advent of the 15th Century of Islamic calendar (Hijra) in 1976. At the same time financial resources of Muslims particularly those of the oil producing countries, received a boost due to rationalisation of the oil prices, which had hitherto been under the control of foreign oil Corporations. These events led Muslims' to strive to model their lives in accordance with the ethics and principles of Islam.

Disenchantment with the value neutral capitalist and socialist financial systems led not only Muslims but also others to look for ethical values in their financial dealings and in the West some financial organisations have opted for ethical operations.

Origin

The origin of the modern Islamic bank can be traced back to the very birth of Islam when the Prophet himself acted as an agent for his wife's trading operations. Islamic partnerships (mudarabah) dominated the business world for centuries and the concept of interest found very little application in day-to-day transactions.

Such partnerships performed an important economic function. They combined the three most important factors of production, namely: capital, labour and entrepreneurship, the latter two functions usually combined in one person. The capital-owner contributed the money and the partner managed the business. Each shared in a pre-determined share of the profits. If there was a loss, the capital-provider lost his money and the manager lost his time and labour.

Commercial Banks in Muslim Lands:

Western commercial banks date from about two and a quarter centuries ago, when the western world was dispensing with moral and ethical considerations in economics. When the Muslim world came into contact with the west, Muslims had two choices:

a) To accept commercial banking, arguing that the interest charged by them did not contain the element of riba prohibited in the Qur'an; or,

b) To accept that interest charged was riba and try to develop an alternative system of banking.

But ancient Muslim institutions, such as the Shari'ah courts, had been made ineffective by the colonial powers. Muslims had no alternative but to work with the colonial institutions, including commercial banking.

Nevertheless, during the 19th century, several religious scholars argued that the term riba referred to loans for consumption, which people found it difficult to repay, and not to commercial banking loans, where the debtor can repay from the profits.

But the Qur'an makes no distinction between loans for consumption and loans for productive purposes. So their views were rejected. As a consequence, modern commercial banking did not make much headway in Muslim countries and to this day the presents of the conventional framework still dominates the national financial system.

Early Western PLS Proposals

Equity-participation systems had been proposed at various times of economic crises in the United States and Latin America. The most ardent proponent of these was American Economist, Henry Simons (1899 – 1946), who, in the 1930s, argued that the traditional fractional reserve banking system was inherently unstable and should be replaced by two separate financial institutions:

Deposit banks, which would maintain 100% reserves. They could not fail the depositors and could not create or destroy effective money. They would simply accept deposits.
Investment trusts, which would perform the lending functions of existing banks. Such companies would obtain funds for lending by selling their own stock.

Simons' call for a distinction between the payments and portfolio functions of banks, and for 100% reserve requirement in the former, was rejected at the time, but interest in Simons' ideas has remained.

Many reasons have been advanced for the possible instability of the traditional banking system. Simons suggested that the basic flaw was that as a crisis develops and earnings fall, banks make loans to increase reserves. However, each bank can do so only at the expense of other banks and thus some banks become insolvent.

The bank failures in the U.S. during the 1980s revived interest in equity-based proposals and the separation of the payment of deposits from the portfolio activities of banks. The proposals made were strikingly similar to the Islamic systems now being implemented, at least on the deposit side. But the Islamic system goes further, requiring that loans made by banks should also be equity-based.

Islamic Banks in the 20th Century

When, in the1960s, Muslim thinkers began to explore ways and means of organising commercial banking on an interest-free basis, economists dismissed their work as wishful thinking.

But, in 1963, in Mit Ghamr, in Egypt, the first Islamic interest-free bank came into being. Mt Ghamr was a rural area and the people were religious. They did not place their savings in any bank, knowing that interest was forbidden in Islam. In these circumstances, the task was not only to respect Islamic values concerning interest, but also to educate the people about the use of banking.

The following types of accounts were accepted:

a) Savings accounts
b) Investment accounts
c) Zakat accounts

No interest was paid on savings accounts, but withdrawals could be made on demand. Small, short-term, interest-free loans for productive purposes could be made. Funds in investment accounts were subject to restricted withdrawals and invested on the basis of profit- sharing. The zakat account attracted the official amount of zakat.

The Mit Ghamr project was successful, as deposits increased from 1963 to 1966. The bank was cautious, rejecting about 60% of loan applications and the default ratio was zero in economically good times. But project was eventually abandoned for political reasons. Nevertheless, it had shown that commercial banking could be organised on a non-interest basis.

Islamic Banking Principles

The Shari’ah prohibits the payment of charges for the renting of money (riba, which in the definition of Islamic scholars covers any excess in financial dealings, usury or interest) for specific terms, as well as investing in businesses that provide goods or services considered contrary to its principles (Haram, forbidden). While these principles were used as the basis for a flourishing economy in earlier times, it is only in the late 20th century that a number of Islamic banks were formed to apply these principles to private or semi-private commercial institutions within the Muslim community.

"While a basic tenant of Islamic banking - the outlawing of riba, a term that encompasses not only the concept of usury, but also that of interest - has seldom been recognised as applicable beyond the Islamic world, many of its guiding principles have. The majority of these principles are based on simple morality and common sense, which form the bases of many religions, including Islam.

"The universal nature of these principles is immediately apparent even at a cursory glance of non-Muslim literature. Usury was prohibited in both the Old and New Testaments of the Bible, while Shakespeare and many other writers, particularly those writing in the 19th century, have attacked the barbarity of the practice. Much of the morality championed by Victorian writers such as Dickens - ranging from the equitable distribution of wealth through to man's fundamental right to work - is clearly present in modern Islamic society.

"Although the western media frequently suggest that Islamic banking in its present form is a recent phenomenon, in fact, the basic practices and principles date back to the early part of the seventh century." (Islamic Finance: A Euromoney Publication, 1997)

Theoretical Basis for Islamic Banking

A popular belief persists that Islamic banking is simply an interest-free financial structure. But, in fact, Islamic economics is a complete system of social and economic justice. It deals with property rights, the incentive system, the allocation of resources, economic freedom and decision-making and the proper role of government.

Western bankers have said that savings and investments would soon dry up if interest were not paid. But this is due to identifying "rate of interest" and "rate of return". The Qur'an says: "God has permitted trade, but forbidden riba (interest)” (2:275). Therefore it is only the fixed, or predetermined, return on savings or transactions that is forbidden, not an uncertain rate of return, such as the making of profit.

Modern Justifications for Interest

Modern economists have developed many arguments to justify interest.

One argument is that interest is the reward for saving; a compensation that the creditor pays the debtor for the latter's temporary loss of the use of capital.

Another is that interest is the payment for the loss in value of money due to inflation. The goods the saver wants will cost more in the future, so he is justified in charging a rent for the use of his loan.

John Maynard Keynes (1883-1946) argued that money is the most liquid of assets, that is to say, it is the asset most readily exchangeable for other forms of assets and that interest is the price paid for loss of liquidity.

The theory that interest protects savings from inflation neither explains why the rate of interest is, nevertheless, always above the rate of inflation, nor does it question the proposition that inflation is the cause of interest. Nor do these theories answer the question as to why interest should be the market regulator for the supply and demand of money. Why should interest be paid for one's postponement of enjoyment of present goods, or paid for abstaining from diminishing one's present capital, which would otherwise be diminished by the ravages of time and consumption?

Basis of Islamic Banking

In order to be Islamic, the banking system has to avoid interest. Consequently, much of the literature on the theory of Islamic banking has grown out of a concern as to how the monetary and banking system would function if interest were abolished by law.

Another Islamic principle is that there should be no reward without risk-bearing. This principle is applicable to both labour and capital. As no payment is allowed to labour unless it is applied to work, so no reward for capital should be allowed unless it is exposed to business risks.

Consider two persons, one of whom has capital but no special skills in business, while the other has managerial skills but possesses no capital. They can co-operate in either of two ways:

Debt-financing (the western loan system). The businessman borrows the capital from the capital-owner and invests it in his trade. The capital-owner is to get back his principal and an additional amount on the basis of a fixed rate, called the interest rate, as his compensation for parting with liquidity for a fixed period. The claim of the lender for repayment of the principal plus the payment of the interest becomes viable only after the expiry of this period. This payment is due irrespective of whether the businessman has made a profit using the borrowed money. In the event of a loss, the borrower has to repay the principal amount of the loan, as well as the accrued interest, from his own resources, while the capital-owner loses nothing. Islam views this as an unjust transaction.
Mudarabah (the Islamic way, or PLS). The two persons co-operate with each other on the basis of partnership, where the capital-owner provides the capital and the other party puts his management skills into the business. The capital-owner is not involved in the actual day-to-day operation of the business, but is free to stipulate certain conditions that he may deem necessary to ensure the best use of his funds. After the expiry of the period, which may be the termination of the contract or such time that returns are obtained from the business, the capital-owner gets back his principal amount together with a pre-agreed share of the profit.

The ratio in which the total profits of the enterprise are distributed between the capital-owner and the manager of the enterprise is determined and mutually agreed at the time of entering the contract, before the beginning of the project. In the event of loss, the capital-owner bears all the loss and the principal is reduced by the amount of the loss. It is the risk of loss that entitles the capital-owner to a share in the profits. The manager bears no financial loss, because he has lost his time and his work has been wasted. This is, in essence, the principle of mudarabah.

There are at least three reasons for considering the mudarabah relationship to be more just than the creditor-debtor relationship:

(i) Both parties agree on the ratio in which profits will be shared between them.

(ii) The treatment of both parties is uniform in the event of loss, since if the provider of the capital suffers a reduction of his principal, the manager is deprived of a reward for his labour, time and effort.

(iii) Both parties are treated equally if there is any violation of the agreement. If the manager violates anyone of the stipulated conditions, or if he does not work, or is instrumental in causing loss to the business by negligence or bad management, he will have to bear the responsibility for the safe return of the whole amount in question. If, on the other hand, the provider of the capital violates any of the stipulated conditions, for example, by withdrawing his funds before the stipulated time, or by not providing part or full funds at the promised time, etc., he will have to pay the manager a reward equivalent to what he would have earned in similar work.

Mudarabah is the basis of modern Islamic banking on a two-tier basis.

1st tier: The depositors put their money into the bank's investment account and agree to share profits with it. In this case, the depositors are the providers of the capital and the bank functions as the manager of funds.

2nd tier: Entrepreneurs seek finance from the bank for their businesses on the condition that profits accruing from their business will be shared between them and the bank in a mutually agreed proportion, but that any loss will be borne by the bank only. In this case, the bank functions as the provider of capital and the entrepreneur functions as the manager.

Islam argues that there is no justifiable reason why a person should enjoy an increase in wealth from the use of his money by another, unless he is prepared to expose his wealth to the risk of loss also. Islam views true profit as a return for entrepreneurial effort and objects to money being placed on a pedestal above labour, the other factor in production. As long as the owner of money is willing to become a shareholder in the enterprise and expose his money to the risk of loss, he is entitled to receive a just proportion of the profits and not merely a merely nominal share based on the prevailing interest rate.

Thus, under an Islamic banking system, the cost of capital is not analogous to a zero interest rate, as some people wrongly assume it to be. The only difference between Islamic banking and interest-based banking in this respect is that the cost of capital in interest-based banking is a predetermined fixed rate, while in Islamic banking; it is expressed as a ratio of profit.

The records of banks that have been involved in PLS show that they have usually provided higher returns to their depositors than those who have used such transitory instruments as cost-plus and leasing. PLS is thus the real goal of Islamic banking.

Rules of Permissibility

Muslims believe that all things have been provided by God, and the benefits derived from them, are essentially for man’s use, and so are permissible except what is expressly prohibited in The Qur’an or Hadith. When guidance is not clearly given in he Qur’an there are several other sources of law. For example, guidance can be sought from Fiqh, which means ‘understanding’ and is the science of jurisprudence: the science of human intelligence, debate and discussion

Prohitbition of Interest

Riba best translated today as the charging of any interest, meaning money earned on the lending out of money itself. The prohibition on paying or receiving fixed interest is based on the Islamic tenet that money is only a medium of exchange, a way of defining the value of a thing; it has no value in itself, and therefore should not be allowed to give rise to more money, via fixed interest payments, simply by being put in a bank or lent to someone else. The human effort, initiative, and risk involved in a productive venture are more important than the money used to finance it.

Money in Islam is not regarded as an asset from which it is ethically permissible to earn a direct return. Money tends to be viewed purely as a medium of exchange. Interest can leads to injustice and exploitation in society; The Qur’an (2:279) characterises it as unfair, as implied by the word zulm (oppression, exploitation, opposite of adl i.e. justice)

There is no real 'lending' in Islam since all 'lenders' obtain ownership interests in the assets that they finance, or earn a profit-share or purely fee-based remuneration. In order for an Islamic bank to earn a return on money lent, it is necessary to obtain an equity, or ownership, interest in a non-monetary asset. This requires the lender to also participate in the sharing of risk.

Individuals and the world as a whole probably know too well the burden of interest and misery and suffering that irresponsible lenders have inflicted on individuals and societies. It has become so completely institutionalised and accepted in modern economies that it is almost impossible to conceive that there are some who completely oppose it and refuse to enter into any transactions that involve interest.
Islam's prohibition of interest and usury was not unprecedented. The early Jewish and Christian traditions also forbade riba. Even the renowned Greek philosopher, Aristotle, condemned acquiring of wealth by the practice of charging interest on money.

“Very much disliked also is the practice of charging interest: and the dislike is fully justified for interest is a yield arising out of money itself, not a product of that for which money was provided. Money was intended to be a means of exchange; interest represents an increase in the money itself. Hence of all ways of getting wealth, this is the most contrary to nature." Aristotle, The Politics, tr. Sinclair, pg. 46, Penguin

“Do not charge your brother interest, whether on money or food or anything else that may earn interest.” (Deuteronomy 23:19)

“If you lend money to My people, to the poor among you, you are not to act as a creditor to him; you shall not charge him interest.” The Holy Bible (American Standard Bible)

[Jesus said], “If you have money, do not lend it at interest, but give [it] to one from whom you will not get it back.” Gospel St Thomas, V95.

Other Key Prohibitions

Islam not only prohibits dealing in interest and investment in unlawful activities that Islam deems harmful to society, but also transactions involving excessive uncertainty (gharar) and all forms of gambling (maysir).

Islamic Economics Order

Islamic banking is an instrument for the development of an Islamic economic order. Some of the salient features of this order may be summed up as:

While permitting the individual the right to seek economic well-being, Islam makes a clear distinction between what is halal (lawful) and what is haram (forbidden or unlawful) in pursuit of such economic activity. In broad terms, Islam forbids all forms of economic activity, which are morally or socially injurious.
While acknowledging the individual's right to ownership of wealth legitimately acquired, Islam makes it obligatory on the individual to spend his wealth judiciously and not to hoard it, keep it idle or to squander it.
While allowing an individual to retain any surplus wealth, Islam seeks to reduce the margin of the surplus for the well-being of the community as a whole, in particular the destitute and deprived sections of society by participation in the process of Zakat (a tax on wealth that is distributed to the needy).
While making allowance for the ways of human nature and yet not yielding to the consequences of its worst propensities, Islam seeks to prevent the accumulation of wealth in a few hands to the detriment of society as a whole, by its laws of inheritance.
Viewed as a whole, the economic system envisaged by Islam aims at social justice without inhibiting individual enterprise beyond the point where it becomes not only collectively injurious but also individually self-destructive.

Wealth and Islam

Islam has a unique dispensation on the theme of wealth, its ownership, distribution and social relationship. Islam enjoins wealth creation not for its own sake.

The theme of Islamic dispensation of wealth is treated as a deeply moral study of self and society. The true nature of wealth in Islam requires social preferences and market exchange mechanisms that are ethicised by human consciousness of the Moral Law. Islam gives precise moral injunctions as to what are, and are not acceptable kinds of wealth. They point out how individual preferences on wealth formation ought to be utilised within the social meaning.

According to Shaikh Yusuf Talal DeLorenzo, well-known and respected Shari’ah advisor and Islamic scholar as well as also author of the three volume “Compendium of Legal Opinions on the Operations of Islamic Banks” the first English reference on the fatwa (religious ruling) issued and published by the Institute, business, in the Qur'anic sense of "profitable trade" or tijarat'un rabihah is business that brings blessings to those who conduct it. Obviously, profits are important as ends, but the means by which those profits are earned are even more important. Indeed, the reason for the emphasis in the Shari’ah on proper transacting is that Islam accords great importance to the economic welfare of society.

Profit-and-Loss Sharing

While Islam employs various practices that do not involve charging or paying interest, the Islamic financial system promotes the concept of participation in a transaction backed by real assets, utilising the funds at risk on a profit-and- loss-sharing basis. Such participatory modes used by Islamic banks are known as Musharakah and Mudarabah. This by no means implies that investments with financial institutions are necessarily speculative. This can be excluded by careful investment policy, diversification of risk and prudent management by Islamic financial institutions.

The concept of profit-and-loss sharing in an enterprise, as a basis of financial transactions is a progressive one as it distinguishes good performance from the bad and the mediocre. This concept therefore encourages better resource management. The Islamic sukuk system is similar to bonds of capitalist system, but in sukuk, money is invested concrete projects and profit share is distributed to clients instead of interest earned.

Financing Modes of Islamic Banks

Islamic financing in its first stages used only the partnership modes of musharakah and mudarabah. Later it was realised that, to avoid moral hazards, yet compete successfully with conventional banks, it was necessary to use all permissible Islamic modes and so trade-based and leasing techniques were developed.

The general rule is that all financial arrangements that the contracting parties agree to use are lawful, as long as they do not include an element of interest. Equity-holding and commodity and asset-trading are an integral part of Islamic financing.

The two basic categories of financing are: 1) profit-and-loss-sharing (PLS), also called participatory modes, i.e., musharakah and mudarabah and 2) purchase and hire of goods or assets and services on a fixed-return basis, i.e., murabaha, istisna'a, salam and leasing.

Legitimate modes include financing trade, industry or budget deficits through domestic or foreign sources. Islamic banks may design diversified investment portfolios and instruments that generate profit with the required liquidity. To maximise its profits, a bank needs to look for investments that yield the highest return, minimize risks and provide adequate liquidity. At the same time, it is necessary for the bank's liabilities and assets to be matched.

A pyramid of financial assets can be built based on liquidity and profitability, which are the criteria of prudent banking. At the top would be high-risk and less-liquid assets, such as long-term investments out of its own equity or from deposits of its risk-accepting account-holders. At the bottom of the pyramid would be the least risky and most highly liquid assets, based on murabaha (leasing) or short-term (even overnight) Mudarabah Certificates (PLS).

Musharakah and mudarabah can be used for short, medium and long-term project-financing, import-financing, export financing, working capital financing and financing of single transactions. Diminishing musharakah can be used for large fixed assets such as houses, transport, machinery, etc. Murabaha can be used for purchases of goods needed by the bank's clients. Salam is useful for financing farmers, trading commodities for the public and private sectors and other purchases of measurable and countable things. But it must be kept in mind that buyback and rollover modes may not be used, because they are seen as a back door to interest.

With Islamic financing, the need to assess clients' acceptability is more important than it is for conventional banks. The bank needs to be vigilant and prudent by concentrating on the client's integrity as well as his status regarding property and particularly his willingness to comply with Shari'ah-compliant contracts.

Islamic banks, while functioning within the Shari'ah, can perform the crucial task of resource mobilization and efficient allocation on the basis of both PLS and non-PLS modes. Sharing modes can be used for short, medium and long-term financing, import financing, pre-shipment export financing, working capital financing and financing of single transactions. To ensure the maximum use of Islamic finance in the development of the economy, it is necessary to create an environment that can induce financiers to earmark more funds for musharakah- or mudarabah-based financing of productive units, particularly those of small enterprises.

The non-PLS modes acceptable to the Shari'ah not only complement the PLS modes, but also provide flexibility of choice to meet the needs of different sectors and economic agents in the society. Trade-based modes, such as murabaha, having less risk and better liquidity options, have several advantages over other techniques, but may not be as fruitful in reducing income inequalities and generation of capital goods as participatory techniques are.

Ijarah-based financing, that requires Islamic banks to purchase and maintain the assets and afterwards dispose of them according to Shari'ah rules, requires the banks to engage in activities beyond financial intermediation and are very much conducive to the formation of fixed assets and medium- and long-term investments.

On the basis of the above, it can be said that supply and demand of capital in an interest-free environment have the additional benefit of providing a greater supply of risk-based capital. There is also a more efficient allocation of resources and an active role for banks and financial institutions to play, as required in the asset-based Islamic theory of finance.

Islamic banks can not only survive without interest, but are also helpful in achieving the objective of distributive justice by increasing the supply of risk capital in the economy and facilitating capital formation and the growth of fixed assets and real-sector business activities.

Salam (forward purchase with prepayment of price) has a vast potential to finance productive activities in crucial sectors, particularly agriculture, agro-based industries and the rural economy as a whole. It also provides an incentive to enhance production, as the seller will spare no effort to produce at least the quantity needed for settlement of the loan taken by him as the advance price of the goods.

Salam can also lead to creating a stable commodities market, especially of seasonal commodities, and therefore to stability of their prices. It enables savers to direct their savings to investment outlets, without waiting, for instance, until the harvesting time of agricultural products or the time when they actually need industrial goods and without being forced to spend their savings on consumption.

Banks might engage in fund and portfolio management through a number of asset-managing and leasing and trading companies. Such companies can exist on their own or can be an integral part of some big companies or subsidiaries, as in the case of Universal Banking in Europe. They would manage Investors Schemes to mobilize resources on a mudarabah basis, and to some extent on an agency basis, and use the funds so collected on a murabaha, leasing or equity-participation basis. Subsidiaries can be created for specific sectors or operations and would enter into genuine trade and leasing transactions. Low-risk funds based on short-term murabaha and leasing operations of the banks, in both local and foreign currencies, would be best suited to risk-averse savers who cannot afford the possible losses of PLS-based investments.

Under equity-based funds, banks can offer a type of equity exposure through specified investment accounts where they identify possible investment opportunities from existing or new business clients and invite account-holders to subscribe. Instead of sharing in the bank's profits, the investors share in the profit of the enterprise in which the funds are placed and the bank takes a management fee for its work. Banks can also offer open-ended multiple-equity funds to be invested in stocks.

The small and medium enterprises (SME) sector has a great potential for expanding production capacity and self-employment opportunities in developing countries. Islamic banks may introduce SME-financing funds for various places. Enhancing the role of the financial sector in the development of the SME sub-sector can mitigate the serious problems of unemployment and the low level of exports of such countries.

Pricing Transactions Linked to Interest rate Benchmark

There are continuing debates on whether the spirit of Shari`ah is being violated by the practice of "benchmarking" linked interest rate benchmark such as London Interbank Offered rate (LIBOR) plus an agreed mark-up in also pricing returns on Islamic finance transactions . At a very fundamental level, the reason for the debates is the lack of understanding to clearly discern the difference between the use of LIBOR as a benchmark for pricing and the use of non-Shari’ah compliant assets as a determinant for returns.

However, benchmarking touches upon the integrity of Islamic Finance as a whole, and the concept of Shari’ah-compliance vs Shari’ah-based approach in particular. There are practical challenges delaying a switch to participation-based structures, such as Musharakah and Mudarabah, that require financiers to participate in the underlying asset in a financing transaction.

Islam's Approach to Ethical Investment

Given that many ethical funds have similar characteristics as Islamic funds, it is important for ethical investors attracted by the appeal of Islamic principles as well as the performance of Islamic investments to understand that there are additional prohibitions that must be applied on the products offered. These restrictions which are essentially self-imposed based on belief and conviction act a moral compass; the monitoring of the prohibitions by a Religious (Shari’ah) Supervisory Board may have prevented Islamic financial institutions to deviate from a faith-based system and absorb the shocks within the conventional financial system.

The important principles for Islamic financial instruments for participation and investments that require strict adherence, while providing good returns, are:

Investments must be free of interest, speculation and gambling, all are considered as forms of exploitation
Investments are made in permissible activities
Investments must be separately approved by an independent Shari’ah supervisory board to ensure Shari’ah principles are strictly adhered to and deviations and wayward business practice penalised, for example in Islamic finance requires penalties to be paid to charity

"The ethical principles on which Islamic finance is based may bring banks closer to their clients and to the true spirit which should mark every financial service," the Vatican's official newspaper Osservatore Romano said in an article its latest March 2009 issue.

Shariah Authenticity

Shaikh Yusuf Talal DeLorenzo, Islamic scholar, position is that unless a financial product or service can be certified as Shari’ah compliant by a competent Shari’ah supervisory board, that product's authenticity is dubious. At that point, it will be the responsibility of the individual investor or consumer to determine on his or her own that the product complies with the principles and precepts of the Shari’ah.

Shari'ah Supervisory Board [Religious Board]

Islamic financial institutions must adhere to the best practices of corporate governance however they have one extra layer of supervision in the form of religious boards. The religious boards have both supervisory and consultative functions. Since the Shari’h scholars on the religious boards carry great responsibility, it is important that only high calibre scholars are appointed to the religious boards.

An Islamic financial institution is required to establish operating procedures to ensure that no form of investment or business activity is undertaken that has not been approved in advance by the religious board. The management is also required to periodically report and certify to the religious board that the actual investments and business activities undertaken by the institution conform to forms previously approved by the religious board.

Islamic financial institutions that offer products and services conforming to Islamic principles must, therefore, be governed by a religious board that act as an independent Shari’ah Supervisory Board comprising of at least three Shari’ah scholars with specialised knowledge of the Islamic laws for transacting, fiqh al mu`amalat, in addition to knowledge of modern business, finance and economics.

They are responsible primarily to give approval that banking and other financial products and services offered comply with the Shari’ah and subsequent verification that of the operations and activities of the financial institutions have complied with the Shari’ah principles (a form of post Shari’ah audit). The Shari’ah Supervisory Board is required to issue independently a certificate of Shari’ah compliance.

The day-to-day application of Shari’ah by the Shari’ah Supervisory Boards is two-fold. First, in the increasingly complex and sophisticated world of modern finance they endeavours to answer the question on whether or not proposals for new transactions or products conform to the Shari’ah. Second, they act to a large extent in an investigatory role in reviewing the operations of the financial institution to ensure that they comply with the Shari’ah.

The concept of collective decision-making, in other words, decisions made by more than one scholar, is especially important. Shari’ah Supervisory Boards function is to ensure that decisions are not unilateral, and that difficult issues of finance receive adequate consideration by a number of qualified people.

It is the role of the Supervisory Boards to supervise the activities of Islamic banks. To this end, several of them have drafted out model agreements for the modes of financing mentioned above and the banks concerned are bound to follow these forms in all their transactions.

Whenever a case arises where there are difficulties in applying any of these forms, the management of the bank is expected to bring the problem to the notice of its Supervisory Board, who will look into it, come to a decision and issue a decree (fatwa), which the management must obey. A large number of these decrees now exist, covering many of the current practical problems of Islamic banks.

Because today's problems do not appear in the original sources of classical Islamic financial law, dealing with problems has required innovative thinking by Supervisory Boards. This sometimes leads to differences of opinion, since the members of the boards specialise in different areas of Islamic learning. These differences are settled by discussion or, if necessary, further research may be undertaken. This process leads to valuable additions being made to the body of the law.

The Importance of Religion in Islamic Banking

Islam is a total way of life. Its system of laws permeates social, economic, political and cultural life. Islamic banks are thus one of the direct consequences of the resurgence of interest in Islam.

The primary source of all Islamic jurisprudence, the body of which is known as the Shari'ah, is the Qur'an and Sunnah. Thus it is the Quranic scholars to whom the leaders of Islamic economics and banking turn for guidance in setting up their internal compliance systems and processes.

Conformity to the Shari'ah

The Advisory Board (also known as the Religious Board) of an Islamic bank looks into the day-to-day running of the bank to check its conformity to the Shari'ah and also decides whether proposals for new varieties of transactions conform to the Shari'ah. It offers constructive advice as to how to address the integration of an Islamic bank's operations into today's world of financial information and technology.

Bringing uniformity to the practices of all Islamic banks would contribute much to the progress of interest-free banking in the world.

Preferably, members of Shari'ah boards should also have some knowledge about the law system within which their Islamic bank operates.

The Religious Board both protects the interests of investors in ensuring that their profits are legitimate according to the Shari'ah and helps the management to adapt its operations to today's financial world. The latter role, which is either to issue fatwas (decrees) on specific investment proposals or give precautionary advice, makes it an unwavering foundation supporting the very nature of the Group.

To some it may seem that the role of Supervisory Boards is solely prohibitive in that it proscribes certain forms of activity, yet the part played by them is really one of assistance and contribution. Just as the Shari'ah does not confine itself to what a Muslim may not do, the Advisory Boards of Islamic banks do not limit their role to prohibiting certain transactions, but play a large part in innovation, while still respecting all aspects of Islam itself.

The Innovative Role of the Supervisory Board

It was the ability of religious scholars and Islamic jurors to use the Shari'ah adaptability to develop an alternative to interest-oriented financial transactions that laid the foundation for the first Islamic banks. Islamic scholars and intellectuals from the world of Islamic law worked closely with entrepreneurs, businessmen, prominent Muslims and others and ultimately created a mechanism of finance which was completely different from the West's interest-based one.

Since the beginning of this alternative financing mechanism, development and refinement have never ceased. The methods and instruments of Islamic finance, being based upon risk and profit-sharing, require an ever-evolving adaptation within the pattern of economic relationships which are defined by the Shari'ah.

The present forms of financial transactions used by Islamic banks, such as mudarabah, musharakah, murabaha, ijarah and ijarah wa iqtina are concepts born of the past thinking of religious scholars and jurists.

So while the definition of the Islamic framework of economics does not change, the types of financial instruments required for the survival of Islamic banks necessitates the constant involvement of religious scholars.

The ideal way for Islamic banks and financiers to operate is to set up partnerships with entrepreneurs on a profit-and-loss-sharing (PLS) basis. This avoids the injustice of interest-based transactions, since, by this system, the profits are divided by agreement between the bank, the entrepreneur and the depositor.

For Islamic banks to be able to operate fully according to the Shari'ah, it is necessary for the interest-free Islamic economic system to be recognised by the state. Meanwhile, the Shari'ah Supervisory Boards have allowed the use of two instruments by which Islamic banks can exist in the present conventional banking environment without charging or receiving interest.

These two instruments are cost-plus sales (where the bank buys an asset required by the customer and sells it to him for a profit, by instalments) and leasing, which, although not the best Islamic means, are at least acceptable in that they are devoid of interest.

First, cost-plus and leasing can only serve their true purpose if the requirements of the Shari'ah are strictly observed. It must not be merely a matter of new names for conventional transactions. With cost-plus transactions, there must be a definite period during which the financier is the legal owner, bearing all the risks, liabilities and benefits of that position. He is then the genuine seller of the commodity to the buyer and is entitled to make a profit on the sale.

Second, these two types of transactions are not to be thought of as ideal Islamic modes. On the contrary, the goal of Islamic banks is to move towards PLS modes, that is, musharakah and mudarabah partnerships.

These two instruments have been criticised as being so similar to the interest-based instruments of conventional banks that they have not brought much real change to the banking system and this is true, as far as it goes. Yet their use does carry an element of risk for the financier and it is this element which makes them acceptable to the Shari'ah, for the Qur'an says that "God has permitted trade and forbidden usury" (2:275), and both cost-plus sales and leasing are forms of trade.

It is the risk in trading which makes it an acceptable way of making profit. Fixed interest, on the other hand, carries no risk for the bank and is therefore against Islamic principles as a way of making money, since it is the entrepreneur who takes all the risk of loss, while still having to pay back his loan.

Status of Islamic Banking

Islamic banking is no longer a novel experiment. When the concept of Islamic banking with its ethical values was propagated, financial circles the world over treated it as a utopian dream. Having lived for centuries under the ‘valueless’ capitalist economic system, they asked what ethics had to do with finance?

Besides their range of equity, trade-financing and lending operations, Islamic banks also offer a full spectrum of fee-paid retail services that do not involve interest payments, including checking accounts, spot foreign exchange transactions, fund transfers, letters of credit, travellers' checks, safe-deposit boxes, securities safekeeping investment management and advice, and other normal services of modern banking. Islamic banking because of its value-orientated ethos enables it to draw finances from both Muslims and non-Muslims alike.

Islamic banks are evolving financial and investment instruments that are not only profitable but are also ethically motivated. The ever-increasing application and innovation of the methodologies associated with derivative instruments that revolutionised the global financial industry have also led to a global financial crisis because of the excess greed for profit and the immense uncertainty and risk associated with these types of transactions. There are doubts associated with the permissibility of derivative instruments under Islamic finance generally.

Addressing issues to resolve the global financial crisis world leaders called for a set up on the basis of capitalism of entrepreneurship where banks finance economic development in the real economy, as opposed to the set up on the basis of capitalism of speculation whereby banks derive excessive profit from speculative transactions that do not make any contribution to the real economy.

Integrity in Islamic Banking

Islamic banks need to give special care to their integrity and credibility. Some critics are disappointed that Islamic banks have deviated, to a great extent, from the philosophic and idealistic basis that inspired their originators in the 1970s.

Islamic banks come in all shapes and forms: banks and non-banks, large and small, specialized and diversified, traditional and innovative, national and multi-national, successful and unsuccessful, prudent and reckless, strictly regulated and free-wheeling, etc. Some, particularly the “Islamic windows” of conventional banks, are virtually identical to their conventional counterparts, while others are markedly different. Some are driven by real religious considerations, while others use religion only as a way of attracting customers.

There are considerable disagreements among scholars as to which institutions and instruments are religiously acceptable. For some, their legal structure does not allow them to carry out real Islamic business such as trading, leasing or construction activities and hence they end up doing only conventional financial operations with slight changes to appear Islamic.

There is a risk that Islamic banking ideals may get diluted with conventional banking unless Islamic banks do something to establish their distinctness as “Islamic banks”. Non-sharing Islamic modes such as murabaha, salam, istisna'a and ijarah also provide a link between financial transactions and real economic activities, such as trading in tangible assets. But there have to be some underlying goods and services to be the objects of such modes of financing.

Innovation and Research

An important area is development of products for meeting statutory liquidity requirements. A related, but more complicated, issue is that of products for Government financing. For the Islamic financial system to be adopted at national levels, the role of Islamic banks and financial institutions in monetary management and government financing, whether it is to cover budget deficit, refinancing or financing the activities of utilities, needs to be enhanced.

The lack of involvement of Islamic finance in government financing is due to lack of research and development (R&D) and differences in Shari'ah-compliance criteria between different countries. Problems arise and are not attended to owing to a lack of active jurists or their differences with regard to innovations. Different Shari'ah Boards interpret contracts differently.

R & D should therefore be attended to by Shari'ah experts under the guidance of the Organisation of Islamic Conferences (OIC) Fiqh Academy (Islamic jurisprudence) and AAOIFI (Accounting and Auditing Organisations of Islamic Financial Institutions). It is also imperative to find ways to block avenues of wilful default and delays by clients.

The institution of discussion (ijtihad) in this perspective is vitally important, because the Shari'ah has the flexibility to respond to changes and diversity. But it is not open to changing from Divine to manmade law. The concepts of custom, the general good, utility or necessity are taken into consideration, but they are relevant only when the clear texts of the Qur'an and Sunnah are taken as a basis for analogies. This still leaves a great deal of room for acceptable inferences to be made in regard to business and finance transactions.

Much research needs to be done on the securitization of assets and strengthening of the recovery/payment systems. In particular, there is a lack of alternatives for public debts and tools of monetary management. Well-defined products, standards and risk management tools to hedge against high volatility in markets are urgently needed.

Besides developing instruments and the framework, Islamic countries have to redesign their plans and priorities. The establishment of a permanent trade fair and an Islamic free market may facilitate the achievement of the objective by promoting intra-OIC trade. This can be achieved by increasing links and establishing an Islamic Monetary Fund by expanding the scope of the International Islamic Financial Market (IIFM) and Liquidity Managed Centre (LMC). The proposed Islamic Monetary Fund (IMF) can have a wider scope to tap excess liquidity with some of the Islamic banks through a mechanism which would encourage both governments and institutional subscribers to the fund to make efforts to promote Islamic finance.

In order to encourage international participation in the Fund, an adjustment mechanism through a coordinating institution such as the Islamic Financial Services Board (IFSB) will have to be introduced to provide a guarantee against exchange rate fluctuations which can cause a loss of principal invested by nationals in the international Islamic capital market.

Some Important Essays

The Role of Central Banks in Islamic Banking

Dr. Iraj Toutounchian

Prof. C. G. Harcourt

"...ideologies…affect the topics discussed, the manner of discussion, the factors included or left out or inadequately stressed in arguments, comments, and models and attitudes shown, sympathetic or hostile,…to past and contemporary economists' works and views. "

Based upon above statement it can be argued that there are a lot of differences between Islamic and conventional banking systems both at micro and macro levels. These differences are in approach, in concepts, and in the resulting behaviour.

My presentation is based upon the following primary and secondary assertions, which are the result of 27 papers and 3 books. The last book: "Comparative Money and Banking in Capitalistic and Islamic Systems", in 856 pages, has been recognized in February 2002 in Iran as "The Economic Book of The Year". These assertions and the final conclusion may seem rather unorthodox, but they are the product of their own logical reasoning. The essence of my paper is thus nothing but one of the logical consequences, among others, of the following assertions everybody is able to derive.
Primary assertions are those, which can directly be used to reach the final conclusion of this paper. Secondary assertions are key issues to be used, one way or another, to lead one to the problems in implementing Islamic Banking. These two types of assertions, however, constitute separable sets.

Based upon the fact that the primary function of banks is to deal with "money", one cannot speak about " banking" without referring to money. Hence, it seems a "must" to understand money first. Otherwise many Miss-interpretations may arise as the result.

Interest and profit, although being clear concepts, have been subjected to many misunderstandings. To be sure, let me make them clear at the outset. Interest and profit are rewards to money and capital investment, respectively. In other words, capital investment produces profits and money produces interest. Furthermore, it has constantly and mistakenly written and quoted by some writers that the price of money is 1 (unity). One is the exchange rate of money with itself; but the price of money is interest (rate).

Some of my findings about the nature and role of profits closely correspond to those of Prof. Adrian Wood in his seminal book " A Theory of Profits ". With the abolishment of interest (as it has in Islamic school of economic thought), the LM curve loses its total validity and becomes redundant and useless.

All in all, interest is a normative concept (basically discussed in schools of economic thoughts), which can neither be proved nor refuted by use of scientific tools of analysis. It is a value judgement. In evaluating an economic system, economists are supposed to take it for granted.

Assertions:

1. In economics we are basically dealing with two inter-related concepts; one is legal (or conventional) concept and the other is real concept. To distinguish one from another, one does not need to focus on the physical features of each one. All contractual agreements like marriage, ownership, organizational hierarchy, money, interest, and the like fall into the first category; while human beings, commodities, buildings, amenity, and the like are included in the second category. Each one of these two concepts is able to produce the other or be transformed into itself. Let us call these two properties " Completeness" and " Reflexivity", respectively. Hence, money itself being a legal concept is capable to producing another legal concept (actually its derivative) called "interest" or to produce real concept like capital equipment.

2. Money as a potential capital is a legal (conventional) concept capable of being transformed into actual capital. A simple example would be Mudarabah contract, among others, in which as soon as one person's money is legally combined with another person's labour force, the nature and the function of money is changed into capital. Given that in an Islamic framework there is no reward to money lending (i.e. interest being zero) yet capital (i.e. money's transformed version) is eligible for part of the profit earned.

3. Various modes of contract available to Islamic banks are the major source of transforming money deposits of individuals and firms into capital (or asset). Any type of financing under any modes of contract by these banks will essentially increase the value of the asset of the economy. However, some modes of contract like Musharakah and instalment sales (originated by firms) increase the productive capacity of the economy. Any positive change in the firm's asset values (rather than their capital values which is by itself a vague concept responsible for some obscurities) can be called " investment". Following this practice it is easy to calculate, rather than to estimate, the amount of investment, which has taken place in an economy during one specific year with relatively high precision. This can be done by reading the asset values off the current balance sheets, firms submit to tax authorities. By putting asset values, instead of capital, into the production function, not only it becomes more precise, but also meaningful. Firms' rate of profit is, hence, logically defined as the ratio of profit to their assets. Since the value of firms' assets is normally greater than their value of capital, therefore, the rate of profit defined as the ratio of profit to the value of capital, underestimates the true rate of profit.

4. Based upon J. M. Keynes' criticism on the classical economists inability to recognize speculative demand for money in the presence of interest (rate), it can easily be shown that interest is both necessary and sufficient condition for speculation. In other words, there is a two-way relationship between interest and speculation. It is probably for this reason that he has also recognized commodities rates of interest in addition to money rate of interest that he was much concerned about. That is, whenever a commodity is speculated upon a specific rate of interest would emerge. With the abolishment of interest, speculative motive of the demand for money, logically derived from interest, would disappear. Speculation, which necessarily entails artificial risk in any market, be it in money, bond, gold, commodities and the like, is not permissible in an Islamic setting. All of these can safely be taken under the heading of "gambling".

A corollary to the above assertion is that with the disappearance of bond market stocks are expected to be exchanged in an Islamic stock market based upon their book values. In terms of Tobin's Q this quotient is supposed to be close to unity (one). It is because in a world with perfect markets, economic value (EV) and replacement cost (RC), will coincide. This brings the quotient to unity. An implication of this is that in a world with perfect markets valuing the firm would be easy; i.e. we could read the economic value of the firm off the current balance sheet. Risk is essentially interwoven with investment. It can be considered "natural" and hence permissible in Islam. However, impermissibility of artificial risk may be grounded upon the fact that any income received by speculator will eventually bring about excess demand for goods and services (without the speculator having any share in productive activities). This excess demand, in turn, becomes the main source of inflation.

Let me conclude discussing about this assertion by citing two statements correctly made by Prof. Gardner Ackley:

a) "Speculation - if mistaken - tends ultimately to be self -correcting in any commodity market. "

b) " ...the real cause of unemployment is speculative demand for money".

5. The natural consequence of elimination of interest, as said earlier, is the elimination of money market. Hence, the major motive to use money is for transaction purposes, which underlies the structure of ordinary demand and supply schedules for goods and services. Furthermore, based upon the logical statement that "the speculative motive is derived from money's use as an asset, as a store of value", money can no longer possess the "store of value function" in an Islamic framework.

In the absence of interest, money market and speculation, and all monetary policy tools used in conventional banking, would lose their validity in Islamic banking. Let us call the policy followed in this new setting "Financial Policy". The unique and powerful tool of financial policy is to determine the share of profit relative to that of capital for all investment projects submitted to Islamic banks. This is probably the most important role a central bank can play in an Islamic banking. There are many factors underlying the determination of this share, especially in the face of natural risk.

This share if effectively used would make bank's sources of finance properly channelled into asset building processes without worrying about money whirlpool to emerge. To determine equilibrium in this market the relative profit rate of the Islamic bank (call it financier) to that of the investor (call it the financee) can be constructed. This rate is especially useful in cases where different risks are involved. To prepare a list of different risks involved in various investment projects is another important task of a central bank.

6. Western economists have always and justifiably been worried about unnecessary expansion of money supply the volume of which is hard to control by central banks. This is due to the fact that considerable portion of it (very difficult to determine if not impossible due to uncertainties involved in interest rates) goes to money whirlpool. This is probably the reason Prof. Milton Friedman in his paper addressing the problem of stabilization policy has advocated the Required Reserve Ratio (RRR) to be raised to one hundred percent. It is clear that such a banking, if possible, would lose its own entity and merely becomes safe-deposit office. If Islamic banks are prohibited to lend on interest nonetheless different modes of contract, as mentioned earlier, are available to them to finance specific needs of both firms and individuals upon their proper requests. If constant and effective supervision is conducted on a random basis by the central bank the chances are very slim a money market, which could be outlawed, to be developed. So the kernel of Islamic banking is Profit and Loss Sharing (PLS). By preparing accurate information and making them available to the general public, central bank in Islamic banking system would be able to provide symmetric information and prevent moral hazard, to a great extent.

7. Money's inability to be a tradable entity and its production and volume being closely watched by the central bank (which is apart of the public sector), seems appropriate to be classified as "Impure Public Good" in an Islamic state. For the sake of brevity some properties of (impure) public goods which also applies to money, in this setting, will be outlined as follows:

a) Non-existence of money market.

b) Elimination of speculation.

c) Demand for it can be constructed by vertical summation of individual demands.

d) Externality of money can be derived from its capability of becoming actual capital; hence, government's (i.e. central bank's) intervention. Furthermore, it benefits each person simultaneously and is thus equally available to each person. Simultaneous benefit is not a "must" for a "thing" to be public. A good example is highway. Highways do not generate simultaneous benefit to all individuals; they are equally available to all individuals. Non-exclusion principle also applies here. Additional individuals looking for money may be added at zero marginal cost.

e) Indivisibility of money refers to its purchasing power and not its physical character.

f) Its velocity is greater than unity implying that one is not supposed to "capture" it as opposed to the case of private good whose velocity is unity implying that it can be "captured".

A caveat is in order here. Money has two distinct attributes; one at micro and the other at a macro level. At the micro level, it is part of the asset of an individual possessing it. But at macro level it cannot be added to the assets of the economy. To count money as wealth (or asset) of a nation will lead one to commit both fallacy of composition and double counting problem. This property of money may be the only one that makes it distinct from other "public goods". This could probably be the consequence of money being the medium of exchange.

8. Removal of interest and all its derivatives (i.e. lending on interest, money market and speculation) from an economy will lead Islamic banks to finance investment projects through PLS. The criteria to be used by such banks are both profitability and feasibility of the projects. Hence, projects compete with each other on the bases of their Internal Rates of Return (IRR). However, the criterion used by a potential investor is IRR of a specific project. The role of the central bank in determining arrays of IRRs for different sectors and various activities is highly valuable in channelling resources into proper projects.

Ranking IRRs in descending order, an investor would first choose the project with the highest IRR. However, the rule, which seems appropriate in choosing the amount to be invested, is "cut-off rate". The maximum amount one investor is willing to invest in a project is determined by the IRR of the next project whose value is almost equivalent to the chosen project, without it being "the opportunity cost" of capital.

Cut-off rate, seems to me, has long been mistakenly interpreted as opportunity cost. In investment decision making most of the times we are ~ dealing with the cut-off rate concept (even in an interest based economic system) but very rarely with opportunity cost. In capitalistic system, rate of interest is justifiably used as the opportunity cost of capital. It is well justified that interest rate is essentially determined independently from the rate of return in the real sector of the economy. However in the absence of interest, projects compete with each other to obtain finance from Islamic bank on the basis of their IRR because there is no other alternative. Comparison among various IRRs brings about the role of cut-off rate without anyone of them becoming opportunity cost of another project. Cut-off rate functions as a signal to show an investor up to what point he should invest and where to stop and select another project. Interdependencies among various investment projects produce cut-off rate the special character and function of which differ from those of interest rate.

The reason, seems to the author, that we often fail to distinguish between these two concepts is the interdependence condition. Furthermore, choosing one, IRR of one project as the opportunity cost of another project in the same activity (on the basis of the principle of next best alternative) will lead one to a whole range of so-called opportunity cost list, none of which have possibly the same value. Hence, different cost calculations in the same activity. Whereas cut-off rates could be numerous for many producers in the same activity without making them run into any problem.

In the absence of interest rate there is nothing to compare IRR of an investment project with. Therefore, we can conclude that in an Islamic economy opportunity cost of capital is zero. The foregoing statements were justified on the basis of economic logic; accountants do not seem to have any reason to believe otherwise. One final remark can be added to above statements. Opportunity cost of capital can also be used as the cut-off rate but the reverse is not true.

After their feasibility and profitability have been confirmed by Islamic bank's qualified personnel, projects become eligible to obtain finance; furthermore, the projects themselves become collateral for finance. Central bank's role in providing guidelines about both of these two aspects will certainly be appreciated by Islamic banks.

As long as there are unemployed factors of production suitable to be utilized in investment, projects have to be financed by Islamic banks no matter how much money is required to finance them. This gives appropriate apparatus to materialize the assertion made by S. M. Bagher Sadr when he says; "Tools of production are treated servants in Islam and man the master". It is the right of labour, in Islam, not to be kept unemployed.

In the final analysis, every piece of bank note coming out of an Islamic bank in response to financing an investment project can be called Certificate of Asset Building (C.A.B.). These C.A.B.'s are appropriate both to production and household sectors.

9. In dealing with various modes of contract, Islamic banks finance profitable and appropriate projects. Appropriateness of projects are expected to be determined by the central bank; however, to determine which projects are more profitable to finance is the task of each individual Islamic bank. Central bank's task is to instruct Islamic banks to give priority to those projects, which are more compatible with the country's economic plan (be it either explicit and written or unwritten and implicit).

Islamic modes of contract can be classified into two broad categories:

1. Those with variable return and (2) with fixed return. Musharakah and Mudarabah contracts fall into the first classification and Instalment Sales, Hire-Purchase, Joalah, and the like into the second one. Musharakah (i.e., PLS) has well and rightly been recognized as the core of Islamic banking. In Mudarabah contract labour has no responsibility as to any loss that may occur provided that it had done its best. The second class of contracts may be defined as auxiliary contracts, which could be used in conjunction with and after the first category has been utilized. Risk is involved with the first type but the second is risk less which is more appealing to Islamic banks. To reduce or even to eliminate the burden of risk from the shoulders of investors it requires another paper, which IS beyond the scope of this presentation.

However, to make sure that the guideline controlling the complementarity of the second type contracts has properly been observed, the Islamic central bank is supposed to keep close eye on the contracts signed by each individual Islamic bank. I skip going into the mechanism of how the burden of risk can be lessened or even eliminated; to determine the degree of risk in different sectors and regions throughout the country. This is another crucial task of an Islamic central bank. This will facilitate the task of Islamic banks in determining the relative share of their own profit vis-à-vis that of the investor. This task not only is beyond the capabilities of an individual Islamic bank, but also provides a uniform procedure for all Islamic banks for various sectors, locating in different regions of the country.

10. Whether an Islamic bank uses the variable or fixed- rate-of-return contract, accountants are very keen about costs that are supposed to be deducted from, total revenue. Accountants who are responsible to approve and submit both balance sheets and profit and loss statements to tax authorities do not accept anything under the heading of cost from neither of the two types of contracts provided that they have been financed by Islamic banks. It is a fact that economists use these two valuable documents for economic analysis and their own interpretations without being able to adjust them on the basis of their own interpretation of cost. Nevertheless, neither of the two professions (accounting and economics) can deny that the Islamic banks' share of profit paid by investors (i.e. financees) is in fact sort of dividend which is essentially determined after all costs have been subtracted from revenue and hence can no longer be considered cost.

To sum up the role of a central bank in an Islamic state, we come up with six different crucial functions to be performed at different levels of rigorousness:

a) Active participation in the process of preparing economic development plan.

b) Informing individual Islamic banks about the priorities of investment projects as outlined in the country's economic development plan at different regions and various sectors.

c) Calculating and submitting to Islamic banks the profit shares of banks relative to those of capital for different projects at various regions and sectors.

d) Calculating and submitting to Islamic banks the value of risk involved in different projects, different regions, and various sectors of the country.

e) Constant inspection and supervision to make sure that projects have properly been financed relative to the priorities and the value of risks.

Note: To do all above functions effectively an Islamic central bank is supposed to be well equipped with highly qualified personnel in portfolio and risk management and project appraisal. This is also a must for each individual Islamic bank.

f) After making sure that Islamic banks have concisely followed the central bank's instructions they can safely be allowed to gradually reduce RRR down to zero.

Let me admit that monitoring cost in Islamic banking compared to the conventional banking is relatively high. However, potential benefits as to its effects on reducing unemployment and keeping prices constant over-shadow the cost. Most important, distribution of income and wealth is expected to be more equitable than otherwise. Such a scheme of distribution guarantees sustained economic development. The role of an Islamic central bank in a uniform distribution of information and prevention of moral hazard cannot be overstated.
Whether it is the Islamic banking or the realization of Keynes' expectation to reach full employment, it is yet to be seen. In closing my presentation, I would like to cite what Keynes has to say about this whole issue: "If I am right in supposing it to be comparatively easy to make capital goods so abundant that the marginal efficiency of capital is zero, this may be the most sensible way of gradually getting rid of many of the objectionable features of capitalism."
Nonetheless it seems that these two models, in the final analysis, converge. He, in this respect, admits that "...it is to our best advantage to reduce the rate of interest to that point relatively to the schedule of the marginal efficiency of the capital at which there is full employment."

Islamic Banking: True Modes of Financing

Dr. Shahid Hasan Siddiqui

Eminent Pakistani Banker & Economist

Introduction

Prohibition of interest is ordained in Islam in all forms and intent. This Prohibition is strict, absolute and unambiguous. The Holy Qur'an in verse 278 of Surah Al-Baqarah states:

"O ye who believe!fear Allah and give up what remains of your demand for riba, if ye are indeed believers." and verse 2: 279 says "If you do it not, take notice of war from Allah and His Messenger. But if ye turn back, ye shall have your capital sums. Deal not unjustly and you shall not be dealt with unjustly."

It therefore, follows that interest is prohibited as it leads to injustices (zulm) and Islam is against all forms of injustices and exploitations and pleads an economic system, which aims at securing extensive socio-economic justice. The Islamic law of prohibition of riba, which includes interest, was originally not based on economic theory but on Divine Authority which considers the charging of interest as an act of injustice.

There could be no denying of the fact that under the interest-based system of banking or in a system not strictly based on the principles and spirit of Shariah, depositors as well as borrowers are exploited in one form or the other. It is however, significant to note that, as in the case of conventional banking, the depositors are being exploited most under the system and practices enforced by banks and financial institutions operating world-wide under the banner of Islamic banking.

Islamic banking made its debut over a quarter a century ago. At present 200 Islamic banks and financial institutions, operating in 27 Muslim and 16 non-Muslim countries, are managing a portfolio of about $200 billion. It is now the time to pose the following questions:

i) Whether banks operating under the banner of Islamic banking have succeeded in the elimination of injustices of the interest-based system as ordained by Holy Qur'an (2:279)?

ii) Whether banks operating under the banner of Islamic banking have contributed to the attainment of socio-economic justice in line with the objectives of Islamic economic system?

iii) Whether banks operating under the banner of Islamic banking are, for all practical purposes, not following the bench marks of interest-based system under Murabaha, Bai-Mu'ajjal or the like modes of financing?

iv) Whether the net result in modes referred to at (iii) above really differs much from the interest-based loaning?

v) Whether by adopting the modes referred to at (iii) above, banks assume any responsibility for the operational losses of the party availing finances from them?

vi) Whether sharing in the operational losses are not the essence of Islamic system of banking?

vi) Whether large scale financing on a perpetual basis, on modes approved for "Sale transactions", can continue to be made for an indefinite period by Islamic banks which are not trading houses but are financial institutions?

While attempting to firm up views in respect of above questions, it must be kept in view that Islamisation of banking system is a part of overall Islamic value system and is not merely refraining from interest-based transactions. The objective of Islamic banking system is to make a positive contribution to the fulfilment of socio-economic objectives of the society in all spheres, including trade, industry & agriculture etc.

True Modes of Financing

An Islamic bank is a financial institution which identifies itself with the spirit of Shariah, as laid down by the Holy Qur'an and Sunnah, as regards its objectives, principles, practices and operations. An Islamic bank does not normally lend money except interest-free loans which are termed as Qard Hasanah (Benevolent Loans) while loans on service charge, not exceeding the actual administrative cost of such loans, have also been permitted by Muslim Scholars.

To replace interest, the ideal mode of financing under the Islamic banking system is "Financing on Profit & Loss Sharing" (PLS) basis. Qard Hasanah are for the benefit of the individuals and the society at large. To safe-guard the interest of depositors/investors, these type of loans, as a matter of policy, do not constitute a significant source of financing by Islamic banks. However, if in any country, the Islamic System of Zakat is established and the Islamic State treasury starts functioning, the requirements of Qard Hasanah would primarily be met by the treasury.

The bulk of financing by Islamic banks has to be equity oriented. In this mode of financing, the losses are shared by the financier along with the entrepreneur in the ratio of their respective capitals. The profits are, however, shared in an agreed ratio. The rates of returns are thus replaced by ratios.

While designing an alternate to interest-based system, it was realised that large scale resorting to PLS system of Islamic banking could pose serious risks and hazards to Islamic banks due to wide-spread tendency to adopt un-ethical accounting practices to conceal true profits, high rate of illiteracy and host of other reasons.

It was therefore, considered necessary to devise various other modes of financing in addition to Mudaraba & Musharka based on PLS system and of course, Qard-Hasan. These modes being the second line fixed return techniques include the following:

i) Murabaha (Cost-plus sale).

ii) Bay Mu'ajjal (Deferred payment sale).

iii) Bay' Salam (Purchase with deferred delivery).

iv) Bay' Istis'na (Made to order).

v) Ijara (Leasing).

vi) Ju'ala (Loans with a service charge).

It may be mentioned that the above mentioned six modes cannot be expected either to remove the injustices of the interest-based system or to contribute to the achievement of socio-economic objectives which Islam seeks to achieve. The fact however, remains that these modes bear pre-determined fixed rates wherein neither the operational losses are shared by the banks nor the returns charged are dependent on the operational result of the entrepreneur.

It is important to note that Islam wants that in case the entrepreneurs earn profit from the finances provided to them by banks, these must be shared with the banks. The banks, on the other hand, must share their profit with their depositors / investors. A large number of depositors would thus hopefully be able to get significantly higher rates of return from the banks leading to over-all prosperity. It will be only then that justice would be ensured between the parties and the banks would start moving towards the path of making a positive contribution towards the achievement of socio-economic objectives.

Islamic banking is now over 25 years old. It is however, observed that, despite all the good intentions, Islamic banks world-wide have generally sheltered themselves in comfort zone by persisting with the second line fixed return techniques for bulk of their financing operations and that too within the bench-marks of interest-based system.

As the single largest mode of financing adopted by Islamic banks is on the basis of Murahaba, it is now proposed to briefly examine this mode.

Murabaha

Murabaha in ancient Islamic connotations referred to a particular kind of simple sale and had no relevance whatsoever with a transaction of financing. In view of the difficulties and risks visualised in adopting PLS system of Islamic banking on a large scale, in recent times, the Murabaha, for all practical purposes was transformed from the sale transaction to a mode of financing.

In this mode, the bank, at the request of its client, purchases the specified goods from a third party against payment. Immediately on the transfer of ownership of the goods as also obtaining its physical or, in most cases, the constructive possession, the bank sells these goods to the client at cost plus an agreed fixed profit margin. The client then takes physical possession of the goods and undertakes to pay the price to the bank either in instalments or in lump sum, at an agreed later date.

The instances are not lacking where customers of the bank and the seller of the goods are sister concerns. In yet many other cases, the customers of the bank purchase the commodities themselves as agents of the bank and then they repurchase the same commodity from the bank for a cost plus profit to be paid at a mutually agreed later date. In many cases of Murabaha, there is therefore, only a change of name.

It is however, felt that there would be no objection if an Islamic bank, in addition to its normal banking business, separately establishes a Merchant Banking Division wherein various types of goods are purchased and then offered for sale to other prospective buyers at a profit. There are however, serious reservations to the wide spread use of murabaha technique as a mode of finance where the bank purchases the commodity only after the customer has agreed in principle to purchase it from the bank at a profit - mark-up. It must therefore, be appreciated that under Murabaha, a trading transaction is being transformed into a mode of finance just to meet the Shariah requirements.

While referring to alternate modes of financing based on Murabaha and Ijara (Leasing) etc., Justice Taqi Usmani observes that if designed to fulfill the Shariah requirements, these modes can be adopted as transitory measure. He however, cautions that " ....there should be a gap between purchasing the commodity and selling it to the customer and the risk of owning the commodity during the period should be borne with all its basic components and all its essential consequences."

In actual practice, practically there is no gap as in many cases, the bank makes the payment almost simultaneously or even after the goods are delivered at the premises of the client. The bank thus does not in fact assume any risk including even the risk of the goods, during the short period, the bank is supposed to own and possess these goods. The bank however, gets a return at a pre-determined fixed rate, which is not dependent on the operational results of the entrepreneur. This in any case, does not appear to be in conformity with the requirements of Shariah.

Taqi rightly observes: -

a) Islamic banks are using the instrument of Murabaha and Ijarah within the framework of the conventional benchmarks like Libor etc. where the net result does not differ much from interest-based transactions.

b) By not even gradually enhancing the financing on PLS basis, the basic philosophy of Islamic banking seems to be totally neglected by the Islamic banks.

c) The Shariah Scholars have allowed the use of fixed return financing techniques i.e. Murabaha & leasing etc only in those spheres where Musharaka can not work.

d) When the common people realise that the net result in the transaction of the Islamic banks is the same as was in the transactions of conventional banks, they become sceptical towards the function of Islamic banks. It therefore, becomes very difficult to argue for the case of Islamic banking before the common people, especially before the non- Muslims who feel that it is nothing but a matter of twisting documents only.

Nijatullah Siddiqui says: -

"The payment obligations of the firms operating with murabaha - financed goods and services are independent of the profitability of the enterprise, unlike Profit - Sharing, thus exposing it to the charge of being inequitable, as in the case of debt financing".

While commenting on "Mark-up" system he opines: -

"I would prefer that Bai' Mu'ajjal is removed from the list of permissible methods altogether. Even if we concede its permissibility in legal form, we have the overriding legal maxim that anything leading to something prohibited stands prohibited. It will be advisable to apply this maxim to Bai'Mu'ajjal in order to save interest-free banking from being sabotaged from within."

At this point it is important to mention that Maududi observes: -

"Islam says in clear terms that the lender is not justified in earning a fixed rate of profit, irrespective of the operational results of the business."
It therefore, appears that, in most cases, the fixed returns charged by banks on transactions which are financial in nature are not permissible simply by providing them a cover of Murabaha or the like modes which are in fact transactions of sale.
It was over two decades ago that The Council of Islamic Ideology, Pakistan observed: -
" ... ideally the real alternatives to interest under an Islamic economic system are profit / loss-sharing and Qard-Hasan."

While referring to other modes of financing such as Bai-Mu'ajjal, Hire Purchase & Leasing etc. the Council observed: -

"It is, therefore, imperative that the use of these methods should be kept to the minimum extent that may be unavoidably necessary under the given conditions and that their use as general techniques of financing must never be allowed."

The Council in this report cautioned:

"It would not be advisable to use it widely or indiscriminately in view of the danger attached to it of opening a back door for dealing on the basis of interest."

"The basis of this technique, though not prohibited according to Hanafi and Hanabali Schools of Fiqh and that too in exceptional circumstances, its wide spread use is not permissible as mark-up does not differ in essence from the interest system."

The Council however, observed: "It is unfortunate that this warning was disregarded and the mark up system was made the pivot of the new arrangements."

The Federal Shariat Court, Pakistan in its Judgement dated November 14, 1991 also referred to the following observations of the Council: -

" The fact of the matter is that "mark-up" is a crude trading practice which has been permitted by certain religious scholars under specified conditions. Its permissibility is questioned by other scholars. In any case, it is a device, which is relevant in the contract of transactions between a seller and buyer of goods. Banks are not trading organizations. They are essentially financial institutions which mobilise funds from the general public and make them available to productive undertakings."

Hasanuzzaman says:

" ..... the ghost of interest is haunting banks to calculate a fixed rate percent per annum in many modes of financing including Murahaba (Bai-Mu'ajjal , Mark-up) etc. The spirit behind all these contracts seems to make a sure earning comparable with prevalent rate of interest and as far as possible, avoid losses which otherwise could occur."

He adds that "they (Second line techniques), have failed to do away with undesirable aspects of interest thereby they have retained what an Islamic bank should eliminate."

The Supreme Court of Pakistan (2000) in its' historic judgement delivered on December 23 1999 i.e. after about sixteen years of the observations, of The Council of Islamic Ideology, referred to above, inter-alia gave the following verdict: -

a) "The major condition for the permissibility of a mark-up transaction is that it should not be charged on lending or advancing money. It must be based on the genuine sale of a commodity with all its substantive consequences."

b) " ...... murabaha or Bia Mu'ajjal is a transaction of sale effected on the basis of deferred payment."

c) "We are conscious of the fact that the transaction of a sale of murabaha based on mark-up, even after fulfilling its necessary conditions is not an ideal mode for the extensive use of Islamic banks, Still, the banks will have to resort to this transaction in certain cases, especially in the initial phase of transformation."

Looking at the Murabaha from yet another angle, it is important to note that Almighty Allah has condemned riba in harshest possible terms perhaps only second to "Shirk". It does not appeal to the mind that by simply assuming some risks by banks in financing through murabaha and the like during "shifting of stocks" from the godown of the seller to the entrepreneur (party availing finance from the bank) which can also be practically avoided and ensuring a fixed return on financing while not sharing in the operational losses of the entrepreneur, which is the essence of Islamic banking, the objectives of the Shariah are met.

It is obvious that the wide spread and persistent use of the second line techniques has neither contributed in removing the injustices of the interest-based system as ordained by Holy Qur'an (2:279) nor in securing the socio-economic justice in the society. If Islamic banks persist with these modes for bulk of their operations, the cause of Islamic banking would never be fulfilled.

It was only in the initial stages of transformation of the conventional banking system into Islamic banking system that the second line fixed return techniques could have been adopted by Islamic banks with a proviso that gradual shift to PLS system will take place. With the passage of time, the second line techniques should have been adopted only where PLS is not possible or feasible including say leasing of machinery or vehicle etc. which are not trading items of the enterprise availing funds from the banks. Unfortunately these modes have been allowed to be perpetuated by Islamic banks. This is injurious to the cause of Islamic banking.

During the last few years, a number of Western bankers, economists and journalists have posed to this writer a rather cynical question about what the real difference between the interest-based system and it's Islamic counterpart, as being practised by Islamic banks actually is. However, even they concede that the PLS system of Islamic banking, if practised in earnest, could ensure socio-economic justice across the globe.

It is therefore, seriously apprehended that if the present sad state of affairs is allowed to continue, even many innocent Muslims may develop doubts about the feasibility, practicability and usefulness of the "Islamic system of banking" notwithstanding that the fault lies with us and not with the system.

The large scale financing by banks on second line techniques is some times advocated on the ground that the size of Islamic banks is too small. The combined assets of 200 Islamic banks and financial institutions are almost 1/3 of the quantum of individual assets of some of the largest conventional banks. Since Islamic banks have to compete with these banks, they generally tend to avoid indulging in risky financing based on PLS. To make the situation worse, some of the Islamic banks find it more feasible to divert part of their funds received from Muslims to multinationals and large corporations of the West.

The Arab world including GCC countries and rich citizens of many others Muslim countries are reported to be maintaining huge deposits with conventional banks operating in the West. The quantum of these deposits is estimated to be more than the total external debt of Muslim countries.

The placement of these funds by Muslims is enabling the imperialistic powers to exploit the Islamic world by simply providing them loans and credits out of these deposits. The placement of funds in this manner by Muslims is clearly not in conformity with the directives of Qur'an and Sunnah.

The Ummah must keep in mind that according to the injunctions of Islam, surplus wealth of Muslims can no be utilised for strengthening the Capitalistic System or for the benefit of non-believers or enemies of Islam. This wealth should therefore, be profitability invested for the common benefit of Ummah, initially in their own country / region. The need of the hour is that a 'Fatwa' is issued on the subject immediately.

If only a portion of these funds is brought back to the respective Islamic countries, the size of many Islamic banks would become large enough to enable them to diversify their financing portfolio including more and more financing on PLS basis with greater sense of confidence.

Financing on PLS Basis

The real alternate to interest on loans in an Islamic framework is financing on PLS basis- a shift from debt based transaction to investment based funding. It is believed that the financing on PLS system of Islamic banking in a conducive environment would not only ensure a healthier financing portfolio and of course higher rates of return to depositors but would also lead to optimum allocation of resources for over-all economic growth and welfare of the society, individually and collectively.

It is however, accepted that the banks allowing financing on PLS basis are exposed to risk of losses as even a profitable company may sustain genuine loss due to various factors even beyond their control. The assuming of this risk is the essence of PLS mode of financing as all business transactions have an inseparable risk factor. It should not therefore, deter banks from making funds available on PLS basis to sound entities in feasible projects in the normal course of business.

In actual practice however, we find that traders and industrialists etc. generally earn substantial profit with the funds of a large number of depositors but they do not share these profits with the banks for onward passing on the share to the depositors. This injustice can be avoided if banks accept deposit on PLS basis according to its true spirit and also allow bulk of financing on the same basis. This will bring prosperity in the society, as a large number of depositors will be receiving higher rates of return on their deposits.

In the Islamic banking system, the concept is that of ratios in which profits and losses are shared instead of fixed, pre-determined interest and mark-up / profit rates. The issue of possible injustice due to inflation and recession, in money lending transactions, was settled by Islam over 1400 years ago, as PLS system absorbs the impact of inflation as regards the sharing of operational results are concerned. A glaring example is that of partnership where there is no dispute between partners due to high inflation or other-wise.

A comparison of the salient features of the financing on PLS Basis and the second line fixed return techniques is given below:-

Financing: PLS Vs Second Line Fixed Return Techniques

S. NO. Financing On PLS Basis Financing On Second Line Techniques

1. Unanimously held as an ideal mode of financing in an Islamic framework. A sale transaction which has ecently been transformed as a second line mode of financing and that too for transitory period. Reservations are expressed by many scholars about these mode.

2. Inequitable distribution of income and wealth will be significantly removed. Inequitable distribution of income and wealth continues like interest-based system.

3. Depositors are likely to get higher returns leading to prosperity. Returns are practically based on the bench marks of the interest based system. Depositors continue to be exploited.

4. Justice between the parties is ensured as the return to the bank on finance is dependent on the operational results of the entrepreneur. Injustice of interest-based system continues as bank is guaranteed a fixed return irrespective of the loss sustained by the entrepreneur. The return to bank is positive and pre-determined in the shape of agreed price.

5. Inflation is likely to be controlled to some extent. Same as under the interest-based system.

6. Progress towards Self-reliance will hopefully be made through enhanced
rate of savings. Same as under the interest-based system.

7. May lead to more efficient and optimum allocation of resources as compared to interest-based system. Same as under the interest-based system.

It is now about the time that the performance of Islamic banks worldwide should be judged from the contribution it is making in achieving the objectives of Shariah in the real sense and not merely by the number of Islamic banks or the quantum of their deposits portfolio.

MODEL ISLAMIC BANK

It is important to appreciate that the requisites for total implementation and success of Islamic banking in a country, include re-shaping the society, re-structuring of the economic system and re-framing of the laws according to the dictates of Islam. The most important and difficult task however, is the reformation of society which has to be undertaken as an on-going process.

We therefore, need to change our priorities and at least as much emphasis should be laid on improving the ethics, honesty and values of the society as is being done for expansion of " riba-free banking". This will then create a conducive environment for more and more financing under profit and loss sharing system of Islamic banking.

Mirakhor observes, "Perhaps the most challenging issue facing the implementation of an Islamic financial system is the development of risk-bearing instruments that can provide the investors with a sufficient degree of liquidity, security and profitability to encourage their holding". Islamic banks also face a challenge of developing innovative services and products for utilising these funds effectively and efficiently for financing under PLS system.

In view of the position explained here-in-above and considering the real difficulties in presently adopting the PLS system of Islamic banking for bulk of the financing for trade, industry and agriculture, it is felt that the need of the hour is to establish Model Islamic banks in all GCC countries as also in other Islamic countries where a large number of interest-free banks have been operating for a number of years.

The Proposed Model Bank would be a commercial bank. While the objective of the Bank would be to earn profit, it would identify itself with the Shariah as regards objectives, principles, practices and operations. The Proposed Bank would undertake all normal banking business as is done by interest-based banks but the Provisions of Shariah would be kept in view at all times.

The proposed Model Bank would accept deposits/investments on PLS basis (other than demand deposits) and would also allow financing only on this basis. The operations of the Bank will be supervised from Shariah point of view by a board of religious scholars.

The proposed Bank would develop risk-bearing but competitive products for deposits / investments wherein depositors / investors are given reasonable assurance of higher returns as also of safety of their funds. This Bank would also develop innovative but competitive products for financing which are not only compatible with Shariah but also cater to the needs of traders and industrialists etc., in the modern complex world which is ever - changing.

The sponsor directors of the Proposed Model Bank should be Muslim Scholars, Jurists, chartered accountants, economists, bankers and investors. All these persons should be men of integrity and of highest reputation. They should also have unshakeable faith and commitment in the Islamic banking system and should have good knowledge of it's principles, products and procedures.

These persons would take up the challenging assignment for the pleasure of Allah and for proving that Islamic banking in its totality is not only workable but would In sha Allah also pay rich dividends in material terms to all those who deal with or work for the Bank.

It is sincerely believed that the proposal of Model Islamic Bank is not only feasible but is the need of the hour. The successful operational results of this Bank would also motivate the existing Islamic banks to enhance their share of financing on PLS basis.

Conclusion

The first full-fledged Islamic Bank was established in Dubai in 1975. In 1995, GCC countries accounted for 15 percent of the paid up capital, 27 percent of the assets, 34 percent of the deposits and 28.8 percent of the net profit of the Islamic banks world-wide. The Islamic banks in GCC countries are therefore, in an ideal position to take a lead to shift the bulk of financing operations to PLS system of Islamic banking.

It is now time that Islamic banks and financial institutions resolve to gradually enhance their share of financing on PLS basis and reduce the share of financing on the basis of Murabaha, Bai Mu'ajjal and the like modes of financing.

If Islamic banks succeed in demonstrating a practical example of socio-economic justice by gradually enhancing their financing on PLS basis and also achieve further satisfactory operational results, there is no reason why more cooperation would not be extended to them by the European, American and other interest-based banks. Some of these conventional banks may even be tempted to adopt PLS system of financing in their subsidiaries & affiliates operating under the banner of Islamic banking.

The dawn of an era of justice can, therefore, be visualised where the fruits of the Islamic system would be available to a large number of people leading to over-all social and economic prosperity.

Adequacy of Disclosure in Islamic Financial Institutions

By Muhammad Shabbir

Bank Analyst, Capital Intelligence, Cyprus

Introduction

Public disclosure through the publication of financial statements has long been the source of information on business performance of financial institutions. In recent years, however, financial institutions, under pressure from market forces, have started focusing on the disclosure of a wide range of information, including management policies, risk exposures and risk management practices. Given that disclosure disciplines management of financial institutions and helps to enhance the efficiency and transparency of the markets, it has acquired great significance in promoting the stability of financial systems.

Moreover, its importance in enabling investors and parties to assess risks and returns of investing in, or dealing with, a particular institution has grown due to the increasing number of risks that financial institutions now take. The expansion in the role of disclosure also encouraged regulatory authorities in various jurisdictions to make it legally binding on financial institutions to follow a set of certain minimum disclosures in their annual reports.

Like conventional banks/financial institutions, Islamic Financial Institutions (IFIs) are engaged in the business of dealing in money (collection of deposits and lending and investing). However, the fact, which distinguishes them, is that their dealings with depositors are based on profit and loss sharing rather than a fixed pre-determined interest. This signifies an IFI's fiduciary role where it is considered to be dealing in trust money. Thus depositors' / investment account holders' trust in an IFI's ability to achieve investment goals (to record profit) and make a fair distribution of the revenues between itself and the investment account holders (according to the Mudaraba agreement) become paramount in the continuity of the IFIs business.

Given this importance, IFIs are obliged to be transparent by making adequate disclosures to their investment account holders, not only with regard to their own financial condition as is the case with conventional banks but also in respect of the management of trust money. This is the area, going beyond disclosure, where topics such as participation of stakeholders in the corporate governance of IFIs and developing effective control and accountability mechanisms to enhance fiduciary relationships in IFIs become relevant.

In order to discuss the adequacy of disclosure in IFI's financial statements we take a brief look at AAOIFI's1 standards2, discuss the role played by these standards in improving the disclosure of information by Islamic financial institutions. We will then move on to review disclosure adequacy with regard to credit, investment and liquidity risks citing examples wherever appropriate.

Before elaborating on disclosure of information desirable in the IFIs financial statements, AAOIFI has set out Objectives and Concepts of Financial Accounting for Islamic Banks and Financial Institutions as a prelude to its financial accounting standards so that varying accounting policies can be harmonised. These statements are in addition to the 12 accounting, 3 auditing and 3 governance standards, which has been published till June 1999. The topics covered by the respective standards are as follows:

Financial Accounting Standards (FAS):

FAS 1 relates to general presentation and disclosure in the financial statements of IFIs. FAS 2-4 relate to different modes of financing (Murabaha, Mudaraba, and Musharaka). FAS 5 discusses disclosure of bases for profit allocation between owners' equity and investment account holders. FAS 6 covers equity of investment account holders and their equivalent. FAS 7 & 8 are about Salam and Ijarah (leasing) transactions, respectively. FAS 9 is about Zakah, FAS 10 relates to Istisna'a. FAS 11 is on provisions and reserves and FAS 12 relate to general presentation and disclosure in the financial statement of Islamic Insurance Companies. Auditing Standards for IFIs cover areas such as objective and principles of auditing, the auditor's report, and terms of audit engagement. AAOIFI's Governance Standards relate to Shari'a Supervisory Board (appointment, composition and Report), Shari'a Review, and Internal Shari'a Review.

A major achievement in the area of establishing concepts of financial accounting for Islamic banks & financial institutions, which improved disclosure, is the clarification of the position of investment account holders (depositors). Not a long ago, third party investment accounts were treated by IFIs either as deposits (similar to conventional bank deposits) or as funds under management, reported off balance sheet with no or little disclosure.

AAOIFI upholds that unrestricted investment accounts3, the largest funding source for the IFIs, are part of the financial position (balance sheet) of an IFI to be classified between a liability and equity capital. It is maintained that these investment accounts are not a liability for an IFI because an IFI is not obligated in case of loss to return the original amount of funds received from the account holders unless the loss is due to negligence or breach of contract. This fact alone has a substantial impact on the risk profile of IFIs. As investment deposits are not treated equivalent to conventional bank deposits, where banks are obligated to return principal amount of the deposit to the deposit holders, the risk to the IFI, as an institution, is considerably reduced. Consequently, shareholders' capital has now to absorb only that part of losses which arise as the share of IFI's own funds in lending and investing. At the same time, however, unrestricted investment accounts, despite being a partner in profit and loss sharing with the IFI, are not treated similarly to the shareholders of the IFI. This is because holders of investment accounts do not enjoy the same ownership rights (voting rights and entitlement to an IFI's profits in the form of dividends). The standards only recognise current accounts and other non-investment accounts as guaranteed by an IFI's owners' equity.

Funds provided by restricted investment accounts4 holders are not reflected as part of an IFI's financial position. The relevant information about such accounts is provided in the statement of changes in restricted investments and their equivalent or as a footnote to the statement of financial position (balance sheet), a treatment similar to that for funds under management.

AAOIFI has also clarified concepts and provided guidance for accounting policies to be followed with regard to different financing and investment modes (Murabaha and Murabaha to the Purchase Orderer, Mudaraba Financing, Musharaka Financing, Salam and Parallel Salam, Ijarah and Ijarah Muntahia Bittamleek, Istisna's and Parralel Istisna'a). While examining the standards related to these aspects, we confine ourselves to the assessment of disclosures with regard to credit, market and liquidity risks.

Disclosure of Credit Risk

With regard to credit risk, information on concentrations of financing assets by sectors/industries, geographical distribution, maturity and currency profile of the financing portfolio together with break up of financing facilities by collectability is considered important. General disclosure in the financial statements of IFIs, as required by AAOIFI standard FAS 1, cover concentration of assets risks (economic sectors, geographical areas), distribution of assets in accordance with their respective period to maturity or expected periods to cash conversion, disclosure of related party transactions.

However, the standard is ambiguous on the most critical information from collectability point of view, which helps the reader of financial statements to determine the extent of doubtful (non-performing) financing assets (sales receivables). The related disclosure that FAS 1 requires is that accounting policies adopted by the IFI's management for the recognition and determination of doubtful receivables and policies of writing off debts be disclosed. There is no definition of doubtful receivables given by AAOIFI.

In practice, however, some IFIs avoid making any mention of non-performing financing assets or the basis on which they make provision for doubtful receivables, particularly the specific provision. This is in contrast to the growing practice among conventional banks to give a break up of their overdue/non-performing loans so that to help the reader in analysing the relative level of credit risk.

To illustrate further, a large Islamic bank (Shamil Bank, former Faysal Islamic Bank) did not provide information on overdue or non-performing facilities in their 1999 financial statements (prepared according to AAOIFI standards) whereas the same has been provided in 1998 accounts (prepared in accordance with the IAS5). However, another IFI (Bahrain Islamic Bank) has provided information on non-performing financing facilities in its accounts for the years 2000 and 1999 as it follows both AAOIFI standards and IAS. Given that the information on non-performing/overdue facilities is a key indicator of the credit risk profile of a financial institution, CI believes that this disclosure inadequacy needs to be covered.

Under AAOIFI standards, disclosure regarding Murabaha sales receivables, the major type of financing conducted by IFIs, is largely focused on two factors. One, on the separation between financing jointly financed by the IFI's and unrestricted investment account holders' funds and financing exclusively financed by the IFI's own funds. The purpose of this disclosure requirement is to separate an IFI's own assets from the assets managed for others (investment account holders) and thereby helping in the assessment of fiduciary risk, to some extent. Second, on the maturity profile of assets and liabilities, to help in the estimation of liquidity risk taken by the IFI by identifying maturity mismatches.

Disclosure of Investment / Market Risk

The assessment of risk that arises from investments in equities or other investments (e.g., property) is as important as financing or credit risk due to the high proportion of such assets in the financial position of IFIs. This is because these investments are considered more Shari'a compliant than Murabaha financing which differs from conventional lending only in semantics. AAOIFI's standard on such items (FAS 1: general presentation and disclosure in the financial statements of IFIs) limit itself to the statement that 'disclosure should be made of the net realisable value of an asset if such value is less than the asset's recorded amount. However, all expected losses should be recognised when reasonably measurable'.

If we look at the financial statements of IFIs which have adopted AAOIFI standards, we observe that investment in shares/securities has been classified into marketable securities, related/associated companies investments, investment in funds portfolios and short term/long term Mudaraba investments. From a risk assessment point of view, the market value of marketable securities has been provided together with movement in provisions for securities. However, it is observed that IFIs do not disclose NAV of their investment in mutual funds (either their own or managed by third parties) or fair value information about their Mudaraba investments (a partnership in profit between the IFI and business owners where funds are provided by the IFI). Both these investments are substantial in the case of some IFIs and therefore limited disclosure in the financial statements force users of financial statements to make subjective assessments of the riskiness of such investments. IFIs should be encouraged to provide adequate disclosure in this regard.

In the case of Mudaraba, this disclosure may include an explanation of the reason for not giving fair value, principal characteristics of the investment, information about the market for such investment as is required under IAS 32. This can assist users to make their own judgements about the possible differences between the carrying amount of these investments and their estimated fair value. As regards investment in real estate, the current market value of real estate is disclosed in the notes to the financial statements of IFIs, a disclosure that appears adequate.

Disclosure with regard to Liquidity Risk

Liquidity of IFIs is generally good because of the concentration of their financing operations in self-liquidating short-term Murabaha financing and commodity backed placements with banks. However, there are serious concerns regarding their macro level liquidity - ability of these institutions to generate funds from other banks (including central banks) in the event of financial distress. The fears arise principally because of IFI's rejection of interest as a cost for the use of money. Although, by practice, majority IFIs does have arrangements to keep compensating balances6 with other financial institutions and even with central banks, to meet or provide for the urgent liquidity needs of the respective counterparties, these balances are not disclosed in the financial statements.

AAOIFI's disclosure requirements (FAS 1) demand that disclosure be made of any amount an IFI is obligated to deposit with others as compensating balances. However, we observed that financial statements of IFIs that follow AAOIFI standards never state anything to this regard. A good example of adequate disclosure in this regard is Kuwait Finance House which discloses such compensating balances as 'balances with banks and financial institutions - exchange of deposits, both on the assets and liabilities sides of the balance sheet. CI believes that such presentation of compensating balances alleviates the fears of other counterparties regarding the inability of IFI's in obtaining funds from the inter-bank market due to the non-payment of interest. This necessitates the need for making such disclosure mandatory by the regulators of IFIs in their respective jurisdictions.

Hopes for the Future of Islamic Finance

Dr. Abbas Mirakhor
Eminent Islamic Scholar and Executive Director
International Monetary Fund (IMF)

Introduction

I am grateful to Allah SWT, to brother Muazzam Ali and to organizers of this Conference: the Institute of Islamic Banking and Insurance and the Islamic Development Bank for the opportunity of being here tonight. I am especially pleased to see our dear brother Muazzam Ali, the Dean of Islamic banking and finance. I have the pleasure of knowing him since the late 1970s. He indeed counts among the very early pioneers in this field and has greatly contributed to the growth and development of Islamic banking. We owe him an enormous debt of gratitude.

Past Successes

The topic of my talk is challenges to and for Islamic finance: a look into the past, present, and our hopes for the future. For someone like me, it is astonishing to realize how far and fast Islamic finance has come and how well it has managed to meet the challenges it faced in just two decades. It is astonishing because when I started my own research in this field in mid-1970s, there was virtually no analytic works on Islamic banking and finance that could explain in modern economic and financial analytic language what Islam expects of a financial system in a modern economy. And, of course, virtually no major Islamic banks existed at the time.

Based on what was known then, and in the absence of an analytic framework recognizable by modern economic and financial theory, most western observers and commentators began to refer to Islamic banking and financial system as a "zero-interest" system, by which they meant "no return to capital". I recall when the Islamic Revolution of Iran succeeded and its leaders and economists declared they wished to eliminate Riba from their economic system, western media, including the BBC and the Wall Street Journal, commented on the impossibility of such a system referring to the thinking behind it as " voodoo economics".

By 1983-84, when Iran, Pakistan, and Sudan declared that they would adopt a system-wide Islamic banking and finance, the challenge was to show that such a system was first theoretically and analytically a viable financial system; second, it had to be shown that such a system was empirically workable as a whole and financially viable for each of its parts, meaning Islamic banks and financial institutions.

The challenge came from western analysts who suggested the folly of adopting such a system. Here, I summarize their arguments in six propositions:

that zero interest meant infinite demand for loanable funds and zero supply;
such a system would be incapable of equilibrating demand for and supply of loanable funds;
with zero interest rate there would be no savings;
this meant no investment and no growth;
in this system, there could be no monetary policy since no instruments of liquidity management could exist without a fixed predetermined rate of interest; and, finally,
this all meant that in countries adopting such a system there would be one way capital flight.

By 1988, this challenge was met when research, using modern analytic financial and economic theory, showed that:

A modern financial system can be designed without the need for an ex ante determined positive nominal fixed interest rate. [In fact, it had been shown by western researchers that there was no satisfactory theory that could explain the existence of a positive nominal ex ante interest rate];
Moreover, it was shown that not assuming a nominal fixed ex ante positive interest rate, i.e., no debt contract, did not necessarily mean that there would have to be zero return to capital;
The basic proposition of Islamic finance was that the return to capital would be determined ex post, and that the magnitude of return to capital was determined on the basis of the return to the economic activity in which the funds were employed;
It was that expected return which determined investment;
It was also the expected rate of return, and income, which determined savings. Therefore, there is no justification for assuming that in such a system there would be no savings and investment;
It was shown that in such a system there would be positive growth;
That monetary policy in such a system would function as in the conventional system, its efficiency depending on the availability of instruments which could be designed to manage liquidity;
Finally, it was shown that, in an open-economy macroeconomic model without an ex ante fixed interest, but with returns to investment determined ex post, there was no justification to assume that there would be a one-way capital flight.

Therefore, the system which prohibited a fixed ex ante interest rate and allowed the rate of return to capital to be determined ex post, based on the returns to the economic activity in which the funds were employed, was theoretically viable.

In the process of demonstrating the analytic viability of such a system, research also clearly differentiated it from the conventional system. In the conventional system, based on debt contracts, risks and rewards were shared asymmetrically with the debtor carrying the greatest part of the risk, and with governments enforcing the contract. Such a system had a built-in incentive structure that promoted moral hazard and asymmetric information requiring close monitoring whose costs could be managed if monitoring could be delegated to an institution which could act on behalf of the collectivity of depositor/investor; hence the reason for existence of banking institutions.

In the late 1970s - early 1980s, it was shown, mostly by Minsky, that such a system was inherently prone to instability because there would always be maturity mismatch between liabilities (short-term deposits) and assets (investment-long-term). Because the nominal values of liabilities were guaranteed, but not the nominal value of assets, when the maturity mismatch became a problem, the banks would go into a liability management mode by offering higher interest rates to attract more deposits. There was always the possibility that this process could not be sustained resulting in erosion in confidence and bank runs. Such a system, therefore, needed a lender of last resort and bankruptcy procedures, restructuring processes, and debt workout procedures to mitigate contagion.

During 1950s - 60s, Lloyd Metzler of the University of Chicago had proposed an alternative system in which contracts were based on equity rather than debt, and in which there was no guarantee of nominal values of liability since these were tied to the nominal values of assets. Metzler showed that such a system did not have the instability characteristics of the conventional banking system. In 1985, in his now classic article in the IMF staff papers, Mohsin Khan, showed the affinity of Metzler's model to Islamic finance. Using Metzler's basic model, Mohsin Khan demonstrated that this system produces a saddle point and is, therefore, more stable than the conventional system.

By early 1990s, it was clear that an Islamic financial system was not only theoretically viable, but had desirable characteristics that rendered it superior to a debt-based conventional system. The phenomenon growth of Islamic finance during the decade of 1990s, demonstrated the empirical and practical viability of the system.

Hopes for the future

The crises we have been witnessing in the international financial system since 1997 have set the stage for Islamic finance to demonstrate its viability as potentially a genuine alternative global financial system. The present international system is deficient in many ways of which the two most important are:

A debt-based system needs an effective lender of last resort, and the present international financial system does not have one and it is not likely that one will emerge anytime soon; and

A debt-based system needs bankruptcy proceedings, debt restructuring, and workout mechanisms and processes which the present international financial system lacks. There are preliminary discussions underway for an international sovereign debt restructuring mechanism to be established, but there are many complications. While such a mechanism, if and when it comes into being, will help reduce the risk of moral hazard and lead to better distribution of risk, it will not address the inherent fundamental fragility of a system largely based on debt contracts.

In the mean time, there are no guarantees that the international financial system has witnessed its last crises with their huge domestic costs that, at times, have threatened the very foundation and fabric of societies. The example of Indonesia is a heartbreaker; it took this country 25 years to reduce poverty by 50 percent, but it took a year of severe financial crisis to wipe out most of this gain. Countries with an otherwise viable economic system have paid dearly for crises generated by a debt structure whose nominal values and maturities were out of line, with the ability of the economic structure to service them.

There are many analyses of financial crises and a long list of their causes, but surprisingly little is said about the one underlying common denominator to all of them: debt contracts that are by nature out of sync, and unrelated to, the income flows that the underlying productive and capital assets of these countries can generate to serve them. The jury is still out as to the reasons why Malaysia did not suffer from contagion as much as other crises countries. While capital controls may have played a role, some analysts believe its liability structure and its general reliance on non-debt-creating flows made Malaysia less vulnerable to crisis.

While the financial innovations of the 1990s in the conventional system have led to mobilization of financial resources in astronomical proportions, they have also led to the equally impressive growth of debt contracts and instruments. According to the latest reports, there are now US$32 trillion of sovereign and corporate bonds alone. Compare this (plus all other forms of debt, including consumer debt in industrial countries) to the production and capital base of the global economy and one observes an inverted pyramid of huge debt piled up on a narrow production base that is supposed to generate the income flows that are to serve this debt. In short, this growth in debt has nearly severed the relationship between finance and production. Analysts are now worried about a "debt bubble". For each dollar worth of production there are thousands of dollars of debt claims. An Islamic financial system has the potential to redress this serious threat to global financial stability because of its fundamental operating principle of a close link between financial and productive flows and because of its requirement of risk sharing.

It is now a serious advice of the IMF to developing countries that they should:

Avoid debt-creating flows;
Rely mostly on FDI;
If they have to borrow, they should ensure that their debt obligations are not bunched toward the short end of maturities;
If they have to borrow, they should ensure that their economy is producing enough primary surplus to meet their debt obligations;
Ensure that their sovereign bonds incorporate clauses (majority action clause, engagement clause, initiation clause) that make debt workout and restructuring easier. That is, to make sure that there exists better risk sharing mechanisms to avoid moral hazard; and finally,
They should put in place an efficient debt management structure.

In these circumstances, Islamic finance can provide a viable financial system on a global scale, but there are challenges that have to be met to make it so. Islamic finance has to adopt the best standards of accountability, transparency and efficiency. Fortunately, an architecture of Islamic finance on a global scale is emerging with the establishment of supporting institutions such as:

The Accounting and Auditing Organization for Islamic Financial Institutions through the efforts of Professor Rifaat Abdel Karim
The International Islamic Rating Agency
The Islamic Financial Services Board
The International Islamic Financial Market, and
The Liquidity Management Center

As this architecture emerges, Islamic finance has to develop its own genuinely Islamic financial instruments. So far, we have been free riding on financial theories and instruments developed within the context of the conventional debt and interest-based system. Unless Islamic finance develops its own genuinely Islamic financial instruments, it cannot achieve the dynamism of a system that provides security, liquidity, and diversity needed for a globally accepted financial system which would be a genuine alternative to the present debt-interest-based international financial system.

Unfortunately, there are, at the present, nothing in the Muslim world close to resembling large endowment institutions, such as the National Science Foundation, the Ford Foundation, the Rockefeller Foundation, and the like to support research in Islamic banking, finance and economics. There is, therefore, an urgent need for scholarly foundations, institutions, colleges, and universities that can train Islamic financial engineers who are well trained in economic and financial theory and methods, on the one hand, and Islamic Shariah, on the other. My generation was fortunate to have people like Dr. Anas Azzarqa and Dr. Kazem Sadr who are equally at ease with Islamic "Fiqh" as with economic theory and method. Trained by their fathers (Sheikh Mustafa Azzarqa and Ayatullah Reza Sadr, ???? ???? ??????) in "Fiqh" and having earned doctorate degrees in economics from reputable universities in the U.S.A., they were able to help the rest of us in understanding the intricacies of Islamic "Fiqh" as it related to finance. There is now a need to systematize the process of training financial engineers, experts in modern finance who are well versed in the Shariah, to expand the horizon and the menu of available Islamic financial instruments.

Islamic finance possesses the basic instruments that can be spanned into a wide, varied, and variegated menu of financial instruments. There is a theory developed in the 1980s referred to as the spanning theory which asserts that if there is one basic financial instrument it can be spanned into an infinite number of instruments. Islamic finance has at least 14 basic instruments and financial experts can span these into a much larger menu to provide greater security, liquidity, and diversity to meet the demand of investors on a global scale. Let me say once again that there is an urgent need for rich endowments to be established solely for the purpose of financially supporting institutions that can train the kind of research scholars and experts mentioned.

Let me conclude by mentioning a very important function of Islamic finance that is seldom noted: that is the ability of Islamic finance to provide the vehicle for financial and economic empowerment. Before I do so, let me recommend the works of the Peruvian economist Hernando de Soto. De Soto's long-time research has been summarized in a recent book titled: "The Mystery of Capital". His basic thesis is that much of the poor in developing countries are in possession of what he calls dead capital. He estimates that the developing and former communist countries possess US$9.3 trillion worth of dead capital. These are physical resources and capital that are not used for any purpose other than to provide physical service to their owners. He suggests that the ability of documenting and using this capital as a productive asset is what distinguishes the rich from the poor. How can Islamic finance help to empower financially those who are in possession of dead capital? Let me give some rudimentary examples:

Agricultural Development Bank of Iran through Mazarah partnerships with farmers helps them to convert their physical possession into assets that can generate additional capital. Also through the Islamic law of Arz Amwat Aiya of dead capital is converted into productive asset. A second example is that of the Housing Bank of Iran which through Musharakah and lease purchase agreements helps people without homes to own one. These

homes can then be used to generate additional capital for the owners to undertake other productive activities. Similarly, Islamic finance can be used in other Muslim and developing countries to convert dead capital into income generating assets to financially and economically empower the poor.

Shariah Requirements for conventional banks

By Sheikh Nizam Yaquby
Shariah Scholar
Bahrain

Many conventional banks and financial institutions are increasingly becoming interested in Islamic finance and investment. How can these conventional banks and institutions enter this market? Is it possible or not? This paper is an initial attempt to lay down the conditions necessary for conventional institutions to comply with and implement when doing so. The most important of these required conditions are: complete segregation of funds; the existence of a Sharia supervisory board; management committed to Islamic financial concepts; safeguarding Muslim investors' funds from negligence, trespass, and fraud; and compliance with the standards of the Accounting and Auditing Organization for
Islamic Financial Institutions (AAOIFI).

Introduction

This write up is a modest contributory note that sets out the most important conditions to be fulfilled when conventional banks and financial institutions, their Articles of Association of which do not comply with the tenets of Islamic law (the sharia), set up any Islamic bank, window, or fund. The importance of this issue cannot be overstated, particularly in view of the wide spread of this trend, over the past few years, and the oft-repeated claims by many parties that their transactions and dealings fully comply with the provisions of the sharia when subjected to scrutiny and examination, this proves otherwise. Little or no research appears to have been conducted on this matter, and therefore this note is a beginning toward this end. It is hoped that specialist research and studies by scholars and academics will follow.

Forms of collaboration and their permissibility

Before delving into the details of these requirements, we have to note that cooperation and overlap between Islamic and conventional financial institutions in managing investments has taken several forms. These include the following:

1) An Islamic financial institution (IFI) offers an investment portfolio, backed by its sharia expertise, but vests management of this portfolio in an external investment manager who undertakes to comply with the IFI's conditions and applies the criteria and standards laid down by the IFI when managing investment.

This is permissible under the sharia if the investment manager complies with the Islamic conditions and his or her success has been proven in more than one instance.

2) A conventional financial institution or bank sells and markets an Islamic product, introduced and planned by an IFI through its sharia expertise. This is also sanctioned by the sharia if it has been proved successful in more than one practical example.

3) Alternatively, a conventional financial institution or bank opens an "Islamic window" on its premises, introduces an investment product marketed as "Islamic," such as a fund, or sets up a private Islamic bank or company. This is the subject of the present discussion.

Some scholars believe that this is not permissible, because conventional financial institutions do not comply, in the first place, with the sharia in terms of their incorporation and statutes. If they do not comply with Islamic law in their basic charters, how can they claim to comply with it in their funds, branches, or windows?

In addition, the funds of these conventional financial institutions are drawn from prohibited earnings, so how can they invest unlawful funds in Islamic products? The rationale cited by scholars is that these financial institutions or banks are only intent on exploiting practicing Muslim investors and in so doing unfairly compete with Islamic financial institutions.

On the other hand, there is a group of contemporary scholars who permit this type of investment product as long as the sharia conditions laid down for them are satisfied. They argue that dealing, in compliance with the teachings of the sharia, in transactions and their Islamically sound contracts is not confined to a certain group of people. In this view, it is permissible-indeed incumbent-upon whomever can conduct dealings in accordance with the provisions of the sharia to do so. If it is impossible to do so in all contracts, at least one should start with those that are possible. In response to the argument that the source of these funds is unlawful earnings, one may reply that there is nothing to prevent such funds from being purified, cleansed, and subsequently directed to lawful and permissible channels. Jurists say that it is permissible to deal with commingled (mixed) funds-funds that are not purely lawful funds, but rather are mixed, containing both lawful and unlawful money. This is as stated by Ibn Taymiyyah, in his Collection of Fatawa, and by other eminent scholars.

Moreover, the claim that traditional financial institutions desire to unfairly compete with Islamic financial institutions can be refuted by saying that competition is always in favour of the most suitable, efficient, and fittest. This kind of competition may prompt Islamic financial institutions to exercise more diligence and care to introduce better quality products and conduct their activities more efficiently. This is in fact evident in many nations in which competition exists.

On the other hand, conventional financial institutions may gradually convert into full-fledged IFIs if they find this viable and if they have acquired adequate practical experience and sharia practices in this field. There are practical examples to substantiate this argument.

Among scholars and jurists who hold this view are Yusuf AI Qaradawi, Abdul-Sattar Abu Ghuddah, M. Taqi Usmani, Nazih Hammad, Abdullah Al Muslih, and Abdullah bin Sulaiman Al Manea. Economists who also espouse this view include M. Ali Elgari and Monzer Kahf. They all concur that the required conditions, outlined below, necessitate strict compliance.

Required conditions

The most important of these required conditions are: complete segregation of funds; existence of a sharia supervisory board; management that is committed to Islamic financial concepts; safeguarding of Muslim investors' funds from negligence, trespass, and fraud; and compliance with the standards of the Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI).

a) Complete Segregation of Funds

The funds of the Islamic investment product and those of the financial institution in which sharia provisions are not observed must be completely segregated. The funds of investors who are very diligent and anxious to earn lawful income should not be commingled with those of conventional investors who are not observant of the sharia. Therefore, there should be separate accounts, books, and computer programs evidencing this complete segregation of funds. This matter is not difficult or problematic in view of the availability of modern computer systems, assuming that intentions are sincere and the required expertise is available. This compliance should be enshrined and expressly stated in the statutes or the prospectus.

b) Sharia Supervisory Board

There should be a sharia supervisory board for any institutional Islamic investment body, and that Board should consist of trustworthy scholars who are highly qualified to issue fatawa (religious rulings) on financial transactions. In addition, they ought to have considerable experience with knowledge of modern dealings and transactions. The Articles of Association, prospectuses, or statutes (depending on the type of activity) should provide for the existence of a sharia board, whose fatawa and resolutions should be binding upon the financial institution's management. It should be independent and free to give opinions on proposed contracts and transactions. The role of the sharia supervisory board should be concurrent with that of the financial institution itself in the sense that it should be formed from the moment the financial institution is incorporated, and that it should provide continued supervision and permanent checking of contracts, transactions, and procedures. This should be expressly provided for in the Articles of Association or the prospectus.

c) Managerial Commitment

The financial institution's management, which is undertaking such business activities, should be fully convinced of the concept and fully committed and dedicated to it. It should be anxious to implement it and comply with the teachings governing it. Unless the entire management is committed and convinced, the business activities and the enterprise will not be foul free or will not escape irregularities and deviation. Regardless of how strict and stringent fatawa and contracts are, this will not ensure sound practices if there is no one sufficiently sincere and committed to implement the principles. However, there is no harm in starting first with the executive senior management, which implement resolutions and subsequently trains the other members of the administrative team. The general manager himself should act as a springboard and set a good example for all in this respect.

d) Safeguarding Muslim Investors' Funds

It is an established principle in Islamic law that the mudarib does not guarantee the mudaraba capital for the capital provider. Hence, investment accounts in Islamic financial institutions are not guaranteed by the mudarib. However, this does not prevent the laying down of a stipulation requiring that the parent conventional financial institution (the original company) guarantee Muslim investors' funds against trespass, negligence, and fraud. Major financial institutions may sometimes shirk their responsibility in this connection by claiming that their Islamic windows, branches, or sections are privately incorporated, among other reasons and excuses. This is wholly unacceptable. Precautions should be taken to guard against this, and a similar policy should be expressly stated in the Articles of Association or the prospectus of the financial institution.

e) Compliance with AAOIFI Standards

The Accounting and Auditing Organization for Islamic Financial Institutions has issued and published a number of accounting and auditing standards that all Islamic financial institutions should comply with and implement. The AAOIFI's activities are considered a fundamental groundwork that underpins Islamic banking activities by keeping them away from individual, personal reasoning. The collective personal reasoning (ijtihad) of the AAOIFI is highly important in this vital aspect of Islamic economic life. Therefore, these standards deserve strict adherence. A number of government authorities and central banks in certain countries have circulated these standards and obliged other financial institutions to comply with them. That is why any party wishing to incorporate or set up an Islamic financial institution should be required to conform to these standards in order to avoid confusion, misunderstanding, and ambiguity, and to seek clarity and sound business activities.

Conclusion

Islamic investment, with its governing sharia rulings and provisions, is an open area for all those wishing to give it a try, provided that they approach it from its front door. They ought to comply with its provisions and honestly deal with people in their communications and transactions. For those who are intent on fraud, cheating, and misleading, all that can be said is that "he who cheats us is not one from us."

Riba, Its Economic Rationale and Implications

By Dr. Abdel-Rahman Yousri Ahmad
Director General
Institute of Islamic University
Pakistan

Introduction

The word "Riba", in Arabic language, literally means an "increment' or addition". In Islamic Fiqh the term riba has a special meaning. Riba is an unjustified increment in borrowing or lending money, paid in kind or in money above the amount of loan, as a condition imposed by the lender or voluntarily by the borrower. Riba defined in this way is called in Fiqh riba al-duyun (debt usury). Riba also is an unjustified increment gained by the seller or the buyer if they exchanged goods of the same kind in different quantities. This is called "riba al-fadl" or "riba-al-buyu" (trade usury).

The Prophet (p.b.u.h.) exposed to his companions, also, this form of riba known as "riba al-buyu". He warned them that barter exchange of commodities of the same kind will be leading to riba. He (p.b.u.h.) advised all traders to use money for the exchange of such goods to avoid riba. In Islamic literature this kind of riba is also described as riba al-khafi, i.e. disguised or implicit riba, in contrast to "riba al-duyun" which is considered "Jali" i.e., explicit or clear.
Riba prohibition in Quran is mentioned in three distinct passages. To consider the chronological order of the Quranic revelation, Allah, firstly, gave a warning (Sura 30:39) that riba earnings will be wiped out while persons giving charity will be rewarded more than they have spent. Secondly, believers have been ordered, and warned never to take riba at compound rates (Sura 3:130). Thirdly riba in all forms was utterly condemned, and those cared not for its prohibition were threatened a holy war to be waged against them by Allah and his Messenger (Sura 2:275-279). It was made clear that riba transaction is different than trade and that it is the Will of Allah to prohibit riba irrespective of any reasons which may be given for its support. Prohibition of riba in Quran is undoubtedly quite strict and decisive. Sunna explains different forms of riba and puts more emphasis on its prohibition. The Prophet (p.b.u.h.) in his hadith warned that riba is more sinful than committing adultery repeatedly.

The "riba" system was formally introduced in Islamic countries during the 19th and 20th Centuries through two channels; (i) secular legislations which have endorsed the Western definition of usury, (ii) the modern banking system whose activities are interest based. These two channels were opened during the era of Western colonial rule to the Islamic world. Besides, the riba system has increasingly gained strength in the Islamic world because of the serious economic dependence on the Western world on one hand and secular education which neglected the teachings of Islam.

Arguments "justifying" interest

Affected by the changes, some Muslim scholars and jurists from the Islamic world volunteered to defend the interest system, by distinguishing interest from riba. The same controversy of ancient times and mid centuries has been repeated in the modern Islamic world. M. Dwaleeby (1950) thought that interest charged on consumption loans is definitely "usury", but that on loans taken to finance trade or production is not. Much earlier A. Jewish (1908) insisted that prohibited riba is only that which is accumulating at a compound rate. Thus simple interest is not riba.

A. Sanhory (1956) an eminent Professor of Law and Fiqh emphasized the prohibition of all kinds of interest, whether simple or compound, charged on consumption loans or on production loans. Yet he recognized that the economic system prevailing in contemporary Islamic countries is not confirming with Shariah rules and Islamic ethics. Thus business finance on loss and profit sharing basis, as Islam requires, has become rare. Under such conditions it has become "most urgent" for business people to seek finance on interest basis.

Sanhory emphasized that debt finance involving interest has become a matter of great urgency that it justifies a resort to "Darura" (necessity) rule in Shariah. Sanhory emphatically asserted that "Darura" to interest is not similar to "Darura" which permits eating pork or dead animals' meat. Yet the capitalist system adopted by Islamic countries, or imposed upon them from outside, and its interest-based financial institutions has created emergency conditions calling for relaxation of riba prohibition rule. Hence, he concluded that simple, but not compound, interest may be allowed till the economic system can be changed and becomes Islamic.

Sharing in civil and commercial law drafting in Egypt and in other Arab countries, Sanhory accepted that interest can be charged at simple rates in the range of 4% -8%. Exactly as happened before in 16th Century Europe, "exceptions" or relaxation of usury prohibition rule led to more exceptions and further relaxations. Besides, the capitalist system and the interest-based institution have continued and become well established.

Another attempt to separate interest from riba has been made by some economists in the Islamic countries who believe that interest rates are frequently less than or equal to inflationary rates. Therefore, under such conditions, interest payments may be considered as a compensation to the loss in real value of money, and not riba. This argument to the disappointment of its exponents could not defend interest if the general price level decreased, remained constant, or increased at a rate lower than the interest rate.

In all these cases, which are quite possible in practice, interest will be riba according to the inflation/interest argument. This attempt to justify interest, as claimed by its exponents, relied upon Ta'weed (compensation) principle set in Fiqh by Abu Yusuf (Saheb Imam Abu Hanifa) in the 8th Century (2nd Century- Hijri Calender) in the case of fulus (cheap metal money) whose real value against gold or silver money was subject to considerable deterioration at times of "Ghala" (inflation). Yet, Abu Yusuf and his followers had never thought of inflation as a permanent case, a monetary system entirely dependent on fiat money, or that their suggested compensatory system may be used for justification of the interest system. Many Islamic economists have already recognized that the problem of entrenched inflation in many Islamic countries is severely affecting the real value of money particularly over the long run and that it calls for a solution on Shariah basis. Compensation of loss in real money value may be accepted on Shari'ah basis through an acceptable form of indexation, but never through the interest system. In fact, the real solution of the problem, as many Islamic economists suggest is to take positive steps towards a just monetary system in which interest has no place and inflation can be cured effectively.

All attempts to separate interest from riba have supported the interest system which the contemporary Islamic countries came to accept under external forces a century or two ago. Yet these attempts have entirely failed to convince true Muslims all over the world. Besides, Al-Azhar' Islamic Research Academy in Egypt, The Council of Islamic Ideology (Pakistan), The Islamic Fiqh Academy of the Organization of the Islamic Conference, other Fiqh academies in the Islamic world have refused and refuted all attempts to justify interest or separate it from riba.

Fiqh rules on prohibition of riba

To emphasize interest or riba prohibition, reference should be made to three Fiqh rules:

a) A benefit gained from a loan is riba. A rule which is based on the ethics of Qard Al-Hassan (Benevolent or good loan) in Quran and on Hadith of the Prophet (p.b.u.h.) "the only reward for a loan is the thanks giving and the repayment".

b) Which means that the capital owner has to choose either a "return" on his capital by sharing with its user in profit, or a "guarantee" to repay his capital intact. A "return" and "guarantee" on capital can not be combined together in one deal.

c) Which means that the capital owner will be entitled to "Profit" only if he is ready to accept "loss" if this happened. These rules are the basis of all profit and loss sharing financing methods in Islam, and they leave no doubt that interest paid to bank depositors above their money, or interest paid by borrowers from banks for the use of banks' money is riba.

The nature of the Islamic Economic Rationale

Before tackling the economic rationale of riba prohibition a few remarks ought to be made. Firstly a necessary distinction should be established between an economic rationale from an Islamic point of view and a secular one. The latter depends on secular theory and empirical test. An Islamic economic rationale would not deny the importance of the secular theory if its basic assumptions or postulates confirm with Islamic Shari'ah rules and ethics. Otherwise, because the Islamic economic theory is still in its formative stage, dependence is heavily placed on theoretical arguments and hypotheses within the boundary of Islamic rules and ethics. Yet, these theoretical arguments and hypotheses cannot be tested as long as contemporary Islamic economic experience is limited. Available experience can be cited to support theoretical arguments.
The second remark concerns our approach in exposing the Islamic economic rationale of riba prohibition. Interest is not the only form of riba, but it is the most popular one. Thus arguments showing the inefficiency of the interest system in fulfilling economic targets and inability to achieve socio-economic justice will be reviewed. In contrast, the expected advantages of the interest-free financing will be presented.

Thirdly it should be made clear in advance that all arguments concerning the economic rationale of interest prohibition should not on Shari'ah basis be taken 'reasons' for riba prohibition. Arguments and theories may be accepted or rejected but riba will remain prohibited and condemned in Islam. Any argument, in this respect, should be viewed therefore as an attempt on our part to understand and explain the "wisdom" rather than the "reason" of riba prohibition.

Economic Rationale of Riba Prohibition and Implications

1st Argument

The interest system is inherently incapable of allocating available liquid funds among firms and activities in the society according to considerations of efficiency, productivity and growth. An Islamic system based on profit/loss sharing financing methods would offer, in principle, an efficient substitute.

Secular economic theory claims that the interest mechanism guarantees an efficient allocation of available funds. According to the Keynesian theory every businessman would estimate the marginal efficiency of investment (MEI) while the interest rate (i) is determined by money demand and supply. If (MEI) is equal or greater than (i) it will be rewarding to borrow and finance the investment project. Otherwise the project will not be undertaken. Accordingly, available money for lending will be allocated efficiently among firms and activities.

This argument cannot be theoretically or empirically defended. Let us assume for sake of simplicity and discussion that (i) measures accurately the opportunity cost of money available for lending in the credit market, and that a uniform interest rate (i) is applied by banks (lenders) in all cases of borrowing. Hence investment projects for which (MEI) below (i) will be excluded. On the other hand all projects fulfilling the condition (MEI> i) will find excess to loanable funds without any preference given by banks (lenders) to projects with relatively higher (MEI). In a free market economy we can not claim that loanable funds would be optimally or best allocated in this way. Theoretically speaking an Islamic free-interest financial system would offer a much better substitute for allocating available funds among firms and activities. Assuming that interest-free financial institutions would aim at maximizing their "halal" (i.e. legal on shari'ah basis) revenues, a preference will be given to projects with higher (MEI) over other projects with relatively lower (MEI). Under these circumstances deviation from an optimum (or the best) pattern of funds allocation in the economy may occur because of some other factors, such as failure to estimate accurately (MEI) on the part of enterprises or lack of experience on the part of the financial institutions' managers. Yet such inefficiencies are likely to exist in a traditional interest-based financial system as well.

Let us, now investigate the simple assumptions which have been made above.

a) Current or market rate of interest can not simply be taken to measure the opportunity cost of available units of money capital. The rate is not determined in practice as the theories claim by loanable funds or by money supply and demand. It is rather determined by monetary authorities which take into consideration, besides loanable funds or money supply and demand, several macroeconomic policy requirements and variables such as income and price stability, unemployment rate, public debt, and balance of payments position. Determined in this way the interest mechanism will not necessarily help in allocating loanable funds efficiently among firms or between different economic activities.

Research studies, years ago, showed that (MEI) tends to increase considerably at boom and fall sharply at depression, whereas the rate of interest, due to macroeconomic policy requirements, would not be changed at all in the same manner. Hence allocation of loanable funds according to the interest mechanism would further be driven away from the optimum pattern. On the contrary in an Islamic financial system, under the same circumstances, available funds will always be distributed efficiently among investors since financiers share with them expected profit, high or low. Assuming that financiers would raise their profit share margin proportionally with expected higher future returns at boom and that they would be reluctant to extend their finance at depression because they would share in loss which is quite expected profit and loss sharing mechanism would also help in bringing about stability at the macro level.

b) Investors with projects satisfying the (MEI) condition and seeking interest-based finance are not treated equally by banks (lenders) as we have simply assumed. Large corporations are given priority and better borrowing terms, irrespective of how funds will be used by them. In fact banks (lenders) are concerned, above anything else, with borrowers solvency. Hence, preferential treatments and financing priorities are set by banks on credit-worthiness basis. It should be noticed that today's bankers are not, in this respect, different from olden days or mid-centuries' usurers. Their main concern is identical, namely to take utmost precaution for loan repayment plus interest. Consequently small enterprises are either neglected or given least attention by bankers, even if their investment projects are expecting highest returns.

The problem of small enterprises with the interest-based financial institutions is quite serious in the developing world, though it may be of minor importance only in developed countries. "Surveys indicate that less than I% of small firms in developing countries obtain credit at controlled rates from financial institutions; the remainder rely on the informal sector. The combined net effect is to raise their capital costs and reduce their ability to compete against large firms", according to W.B (I987). In fact failure of small businesses to obtain finance from banks have forced them quite frequently, in the absence of equity finance, to borrow from money lenders in the informal market at very high rates of interest. So they have jumped from the frying pan to the fire.

A study concerning the informal credit market in Peru mentioned that interest rate in that market was as high as 800% - I000% per annum sometimes in the mid 1980s. Todaro, M., states that "commercial banking system of many LDCs restricts its activities almost exclusively to rationing scarce loan able funds to "credit-worthy" medium-and large-scale enterprises in the modern manufacturing sector. Small farmers and indigenous small scale entrepreneurs and traders in both the formal and informal manufacturing and service sectors must normally seek finance elsewhere sometimes from family members and relatives, but more typically from local moneylenders and loan sharks who charge exorbitant rates of interest.

In addition, a brief note should be given on interest rate control policies because these, it may be claimed, have always exerted favourable economic effects, which is not true. In the developing world, to which Islamic countries belong, experience showed that interest rate and selective credit policies have reduced the efficiency of investment on the whole. "This is particularly true when controls on interest rates make them negative in real terms. As well as promoting investment in low return projects, interest rate controls encourage firms to build up their inventories. Furthermore, faced with the need to ration credit, banks lend to the borrowers they know well - large scale enterprises and parastatals - or even to the industrial groups that own them. In Colombia, interest rate controls reduced the funds available for smaller-scale industrial enterprises; the efficiency of investment fell as a result. Interest rate controls also keep credit cheap in relation to labour for those firms with unrestricted access to loans from the formal financial sector and thus encourage capital intensive investments in some parts of industry. These distortions ultimately affect growth."

All the facts mentioned above are quite relevant to Islamic countries which are classified, without exceptions, within the LDC category. The interest system now in application in Islamic countries (with minor exceptions, i.e. Pakistan, Iran and Sudan) against Shariah is not helping in allocating their scarce funds efficiently, among firms or between economic activities. The system is also discriminating unfavourably against small-scale firms, farmers and traders irrespective of efficiency or productivity considerations.

The riba system is full of contradictions and attempts to regulate it through interest rate controls have either failed or accentuated its imperfections. On the whole, therefore, the system which is prohibited by Shariah, is adversely affecting economic development in the Islamic countries. On the contrary a financial system based on profit and loss sharing offers a much better alternative to Islamic countries since it is expected to be free of all the imperfections of the riba system.

2nd Argument

The interest system brings about and effectively maintains a pattern of income distribution which is biased towards wealthy people and large businesses, irrespective of rational economic considerations. An Islamic interest-free financial system supports a just income distribution pattern fairly correlated to economic efficiency, productivity and actual factors contributions to the total value added.

This argument is directly dependent on preferential treatment given by interest-based financial institutions, mainly commercial banks, to wealthy persons and large enterprises because they are credit-worthy. Medium-scale enterprises are not deprived of finance from banks but they may not obtain all their requirements always while they are usually charged with relatively higher interest rates. Small-scale economic activities in all economic sectors are discriminated against, as mentioned previously. In quite a few number of developing countries, however, governments provide for special arrangements to cover a higher portion of small activities financial requirements through banks. Yet even then, credit ceilings are usually imposed strictly upon the small share of finance allotted to small activities, whereas cumbersome formalities and heavy guarantees are demanded from their owners. Thus the interest system will effectively help large enterprises to grow larger and rich entrepreneurs to grow richer irrespective of their economic efficiency or productivity.

On the other hand small entrepreneurs even with bright new ideas, carefully studied projects with prospects of high returns and possible positive contribution to the total value added will be deprived of finance or may obtain much less than their requirements. Hence they have much less chance to grow their activities and their incomes. It should be noticed that this problem is particularly serious in most developing countries, where small-scale activities employ the largest portion of the total labour force, while its share in GDP is much less than medium and large-scale businesses.

An Islamic interest-free financial system would not cause the same disturbances. "Mudaraba", first and foremost in Islamic finance, is based on personal confidence of the capital owner in his partner, the agent manager; in his efficiency, dedication to work and honest character. Thus economic and managerial considerations are taken into account where as trust-worthiness replaces credit-worthiness. Profit, when realised, will be divided between the capital owner and his partner, the agent manager according to a mutually agreed proportions while all loss, if happened, is born by the capital owner. It should be noticed that the agent manager also suffers, in the last case, from the loss of all his efforts, as these will be rewarded nothing.

Musharaka, another principal financing method, flexibly allows for large and small capital owners to come together in various forms of companies. Partners will divide realised profits among them according to agreed proportions, fixed in advance in the company's contract. Fiqh rules allow small partners to obtain the same percentage share in realised profits as large partners, or even more, according to efficiency, experience or managerial efforts considerations. On the other hand loss, if happened, will be born by all partners according to their shares in the company's total capital. Economic justice is carefully protected and maintained between partners in Musharaka. All other Islamic financing methods are of the same nature, i.e., based on partnership and profit/loss sharing principles. Some of these methods namely Istisnaa Muazrah and Murabaha can be used effectively to solve the financial problems faced by small-scale entrepreneurs, farmers and traders in particular.

To conclude, the Islamic financing methods would undoubtedly help in supporting a just income distribution pattern. These methods endorse partnership and profit/loss sharing principles, they do not discriminate against partners who do not share in finance or contribute only with a small share, and they facilitate the extension of finance to small-scale activities, on the basis of confidence in their efficiency and expected returns. However, it should be expected that the application of the Islamic financing methods will be faced with many problems at the beginning as actually has happened.

3rd Argument

The interest system encourages passive behaviour to develop among people having liquid funds by helping them to relinquish responsibilities and risks in investment activities. In contrast sharing in responsibilities and risks is inherent in the profit/loss sharing methods of finance.

No doubt that the interest system relieves money capital owners from holding any responsibilities and risks related to the execution or to the final outcome of the investment activities financed by them. It is claimed by the interest system's exponents that this is one of its merits since easy and risk less income is guaranteed to the capital owners periodically. It is also claimed that entrepreneurs within this system are willingly accepting its terms and satisfied that the financiers do not intervene in their business. Interest paid by the entrepreneurs is included in costs and thus transferred to purchasers through sales, while net profit once realised is totally their own.

Yet, such system is viewed quite differently on ethical and social grounds. Money capital owners are encouraged to develop a passive behaviour in the production sector. On the other hand entrepreneurs financed by loans and paying interest are not really doing this with comfort whether at boom when interest rates are relatively high and the uncalculated risk is greater than normal or at recession when interest rates are relatively low but loss expectations are greater than normal. If profits are not actualised they, along, will face the consequences and may be subject to bankruptcy. Ethically, this is a kind of gambling rather than risk-taking based on rational calculations. Therefore, within the interest system, options of self finance, equity or a mixture of equity and debt finance may be preferred by enterprises than purely debt finance.

The growth of the interest-based finance in any society whether through the banking system or by selling bonds in capital markets will directly be reflected in growth of passive behaviour among society members. Individuals who receive guaranteed interest paid to them periodically without bearing any responsibilities or risk can not be considered but inactive society members. As well as, their passive behaviour is emphasised by the full option, given by the banking system, to restore their funds at any time. Those inactive individuals are considered sleeping partners in secular literature and it is estimated that the growth of their members in any society would endanger economic growth.

It goes without saying that partnership based on profit/loss sharing mechanism would help in getting rid of passive individualistic behaviour. The Islamic modes of finance help directly in promoting responsibility and risk-taking morals and motivations, which are quite essential for economic growth. The economic rational of the interest-free finance is quite clear here, i.e. providers and users of finance will be sharing together in all the responsibilities and risks involved in the investment activities from A to Z. All partners are actually active in the Islamic system. Islamic ethics motivate people to exchange opinions, advice, share positively in production. All these ethics are basic for rational behaviour and good deeds. At the same time the sharing ethics will always provide a support for brotherhood and co-operation among members of the Islamic society.

4th Argument

Prohibition of interest would not affect savings, as well as it would not affect their mobilisation provided that Islamic ethics are prevailing, and the application of various interest-free financing methods is conducted successfully by specialised Islamic institutions.

Classical and Neo-classical economists have held that national saving is positively related to the rate of interest (S=f(i)). The Keynesian theory refuted this proposition and showed that saving is a function of income. Practical evidences confirm the Keynesian proposition to a great extent. High income groups, in comparison to low or middle income, are more capable of saving in any society. High income economies, in comparison to low and middle income at the world level, save higher proportions of their incomes. However attempts to defend "interest' as a prime mover of saving continued but on new basis. "Real" rather than "nominal" interest is given much attention by secular economists in this respect.

Literature concerning these attempts for developed and developing countries can not be surveyed here. Yet since Islamic countries belong to the developing world our attention will be given to empirical studies testing the responsiveness of savings to real interest within this scope. G. Arrieta (1988) reviewing several empirical research studies showed that saving responsiveness to real interest could not be confirmed in five out of nine studies and still requires further enquiries. The results of secular empirical researchers should be treated with care by Islamic economists. Conclusions which are unfavourable to the interest system would strengthen the economic argument against it but they should not intervene with "belief' concerning riba prohibition in Islam. Also there are cases in developing countries where empirical studies indicate that real interest rates played a positive role in mobilising saving resources. These studies would strengthen the secular view which is supporting the interest system, but they are irrelevant to the Islamic economic rationale concerning riba prohibition. In fact the interest mechanism may play a significant role in mobilising saving resources if its prerequisites are well satisfied. These prerequisites are mainly; favourable secular laws and values to interest, active interest-based financial institutions, and savers' willingness to obtain guaranteed and regular returns on their funds.

Concerning the Islamic countries we have to be careful, therefore, before drawing any conclusion with respect to the responsiveness of savings to interest rates (nominal or real). Secular laws prevailing at present in these countries are favourable to the interest system, with exceptions in three cases only. Commercial banks were established in most of the Islamic countries during the Western colonial rule and succeeded in developing their financial activities gradually. A portion of the Muslim population have become accustomed to deposit savings in commercial banks in return for guaranteed regular interest (income). Most of those who developed these anti- Islamic behaviour have been affected by the western life-style and secular values. Some of them would assert that they deposit their savings in commercial banks only because they have no other alternative to "protect" their funds or to "invest" them. Besides, governments, large and medium scale businesses in the modern manufacturing, trade and services sectors deposit their savings in commercial banks.

On the other hand a large section of population in the Islamic countries is still against interest transactions. It is important to note that this section has not been affected by modern attempts to justify interest. And that it is consisting mainly of low and middle income households, small-scale farmers, traders and manufacturers. Yet, the petite savings of all those are not given any, of proper, attention by commercial banks.

Conclusion

Under all these circumstances it will not be unexpected that interest-based financial policies would be in some cases, successful in savings mobilisation. However many of the above mentioned factors are bound to change once 'efficient' Islamic interest-free financial institutions are established. Not only petite savings will be mobilised by these Islamic institutions but also the savings of all those who say that they have no alternative to commercial banks at present.

In fact, a revival of Islamic Shariah and ethics would settle the matter decisively against the interest-based system and its ability to mobilise Muslims, savings. But before realising this precious target, it is very important that the ability of any new Islamic financial institution to effectively mobilise saving resources would mainly depend on efficient practice of interest-free financing methods, success in achieving highest possible "halal" returns and thus gaining the confidence of the savers to invest their funds through them.

The adverse effects of interest on society

Justice Muhammad Taqi Usmani
Justice of the Supreme Court of Pakistan

The Nature of money and the effects of interest charged by banks and whether it comes within the purview of injustice, are some of the issues discussed by Justice Taqi Usmani, in the course of his judgement on the Historic Judgment on Interest in the Supreme Court of Pakistan, which was considering the Islamisation of the Country's financial system.

Introduction

The Holy Qur'an has itself decided what is injustice in a transaction of loan, and it is not necessary that everybody finds out all the elements of injustice in a riba transaction, yet the evil consequences of interest were never so evident in the past than they are today. Injustice in a personal consumption loan was restricted to a debtor only, while the injustice brought by the modern interest affects the economy as a whole. A detailed account of the rationale of the prohibition of riba would, in fact, require a seperative volume, but for the purpose brevity we would concentrate on three aspects of the issue:

i. The logic of the prohibition on theoretical ground
ii.The evil effects of interest on production
iii.The evil effects of interest on distribution.

On a purely theoretical ground, two basic issues will be focused on; firstly on the nature of money and secondly on the nature of a loan transaction.

Nature of Money:

One of the wrong presumptions on which all theories of interest are based is that money has been treated as a commodity. It is, therefore, argued that just as a merchant can sell his commodity for a higher price than his cost, he can also sell his money for a higher price than its face value, or just as he can lease his property and can charge a rent against it, he can also lend his money and can claim interest thereupon.

Islamic principles, however, do not subscribe to this presumption. Money and commodity have different characteristics and therefore they are treated differently. The basic points of difference between money and commodity are as follows:

(a) Money has no intrinsic utility. It cannot be utilized in direct fulfilment of human needs. It can only be used for acquiring some goods or services. A commodity, on the other hand, has intrinsic utility and can be utilized directly without exchanging it for some other thing.

(b) The commodities can be of different qualities while money has no quality except that it is a measure of value or a medium of exchange. Therefore, all the units of money of the same denomination, are hundred per cent equal to each other. An old and dirty note of RS1000/= has the same value as a brand new note of Rs.I000/=.

(c) In commodities, the transactions of sale and purchase are effected on an identified particular commodity .If A has purchased a particular car by pinpointing it, and seller has agreed, he deserves to receive the same car. The seller cannot compel him to take the delivery of another car, though of the same type or quality. Money, on the contrary, cannot be pin-pointed in a transaction of exchange. If A has purchased a commodity from B by showing him a particular note of Rs.l000/- he can still pay him another note of the same denomination.

Based on these basic differences, Islamic Shariah has treated money differently from commodities, especially on two scores:

Firstly, money (of the same denomination) is not held to be the subject matter of trade, like other commodities. Its use has been restricted to its basic purpose i.e. to act as a medium of exchange and a measure of value.

Secondly, if for exceptional reasons, money has to be exchanged for money or it is borrowed, the payment on both sides must be equal, so that it is not used for the purpose it is not meant for i.e. trade in money itself.

Imam Al-Ghazzali view on the Nature of Money

Imam Al-Ghazzali (d.505 A.H.) the renowned jurist and philosopher of Islamic history discussed the nature of money in an early period when the Western theories of money were not existent, at all. He stated:

"The creation of dirhams and dinars (money) is one of the blessings of Allah. They are stones having no intrinsic usufruct or utility, but all human beings need them, because every body needs a large number of commodities for his eating, wearing etc, and often he does not have what he needs and does have what he needs not... therefore, the transactions of exchange are inevitable. But there must be a measure on the basis of which price can be determined, because the exchanged commodities are neither of the same type, nor of the same measure which can determine how much quantity of one commodity is a just price for another.

Therefore, all these commodities need a mediator to judge their exact value Allah Almighty has, therefore, created dirhams and dinars (money) as judges and mediators between all commodities so that all objects of wealth are measured through them... and their being the measure of the value of all commodities is based on the fact that they are not an objective in themselves. Had they been an objective in themselves, one could have a specific purpose for keeping them, which might have given them more importance according to his intention while the one who had no such purpose would have not given them such importance and thus the whole system would have been disturbed. That is why Allah has created them, so that they may be circulated between hands and act as a fair judge between different commodities and work as a medium to acquire other things. So, the one who owns them is as he owns every thing, unlike the one who owns a cloth, because he owns only a cloth, therefore, if he needs food, the owner of the food may not be interested in exchanging his food for cloth, because he may need an animal for example. Therefore, there was needed a thing which in its appearance is nothing, but in its essence is everything. The thing which has no particular form may have different forms in relation to other things like a mirror, which has no colour, but it reflects every colour. The same is the case of money. It is not an objective in itself, but it is an instrument to lead to all objectives.

Hence the one who is using money in a manner contrary to its basic purpose is, in fact, disregarding the blessings of Allah. Consequently, whoever hoards money is doing injustice to it and is defeating their actual purpose. He is like the one who detains a ruler in a prison. And whoever effects the transactions of interest on money is, in fact, discarding the blessing of Allah and is committing injustice, because money is created for some other things, not for itself. So, the one who has started trading in money itself has made it an objective contrary to the original wisdom behind its creation, because it is injustice to use money for a purpose other than it was created for ... If it is allowed for him to trade in money itself, money will become his ultimate goal and will remain detained with him like hoarded money. And imprisoning a ruler or restricting a postman from conveying messages is nothing but injustice."

This brief, yet comprehensive, analysis of the nature of money, undertaken by Imam Al-Ghazzali about nine hundred years ago, is admitted to be true by the economists who came centuries after him. That money is only a medium of exchange and a measure of value is universally accepted by almost all the economists of the world, but unfortunately a large number of these economists failed to recognize the logical outcome of this concept, so clearly elaborated by Imam Al-Ghazzali: that money should not be treated as a commodity meant for being traded in. After holding that money is a commodity, the modern economists have plunged into a dilemma that was never resolved satisfactorily.

The commodities are classified into the commodities of first order which are normally termed as 'consumption goods' and the commodities of the higher order which are called 'productive goods'. Since money, having no intrinsic utility, could not be included in 'consumption goods' most of the economists had no option but to put it under the category of 'Production goods', but it was hardly proved by sound logical arguments that money is a 'production good'. Ludwig Yon Mises, the well-known economist of the present century has dealt with the subject in detail. He says:

"of course, if we regard the twofold division of economic goods as exhaustive, we shall have to rest content with putting money in one group or the other. This has been the position of most economists; and since it has seemed altogether impossible to call money a consumption good, there has been no alternative but to call it a production good... It is true that the majority of economists reckon money among production goods. Nevertheless, arguments from authority are invalid; the proof of a theory is in its reasoning, not in its sponsorship; and with all due respect for the masters, it must be said that they have not justified their position very thoroughly in the matter."

He then concludes: "Regarded from this point of view, those goods that are employed as money are indeed what Adam Smith called them, "dead stock, which... produces nothing."

The author has then expressed his inclination to the Kien's theory that money is neither consumption good nor a production good; it is a media of exchange.

The logical result of this finding would have been that money should not be taken as an instrument that gives birth to more money on a daily basis, nor should it have been taken as a tradable commodity, when it is exchanged for another money of the same denomination, because once it is accepted that money is neither consumption good nor production good, and that it is merely a medium of exchange, then there remains no room for making itself an object of profitable trade, for it will be like a mediator himself has been made a party. But, perhaps due to the overwhelming domination of interest-based monetarily system, many economists did not proceed any further to this direction.

Imam Al-Ghazzali, on the other hand, has taken the concept of 'medium of exchange' to its logical end. He has concluded that when money is exchanged for money of the same denomination, it should never be made an instrument generating profit by such exchange.

This approach of Imam Al-Ghazzali, fully backed, the clear directives of the holy Qur'an and Sunnah, has never been admitted to be true by some realistic scholars, even in societies dominated by interest. Many of them after facing the severe consequences of their financial system based on trade in money have admitted that their economic plight was caused, inter alia, by the fact that money was not restricted to be used for its primary function as a medium of exchange.

During the horrible depression of 1930s, an "Economic Crisis Committee" was formed by Southampton Chamber of Commerce in January 1933. The Committee consisted of ten members headed by Mr. Dennis Mundy. In its report the committee had discussed the root causes of the calamitous depression in national and international trade and had suggested different measures to overcome the problem. After discussing the pitfalls of the existing financial system, one of the committee's recommendations was that "In order to ensure that money performs its true function of operating as a means of exchange and distribution, it is desirable that it should be traded as a commodity."

This real nature of money which should have been appreciated as a fundamental principle of the financial system remained neglected for centuries, but it is now increasingly recognized by the modern economists. Prof. John Gray, of Oxford University, in his recent work 'False Dawn' has remarked as follows:

"Most significantly, perhaps transactions on foreign exchange markets have now reached the astonishing sum of around $1.2 trillion a day, over fifty times the level of the world trade. Around 95 percent of these transactions are speculative in nature, many using complex new derivative's financial instruments based on futures and options. According to Michael Albert, the daily volume of transactions on the foreign exchange markets of the world holds some $900 billions -equal to France's annual GDP and some $200 million more than the total foreign currency reserves of the world central banks. This virtual financial economy has a terrible potential for disrupting the underlying real economy as seen in the collapse in 1995 of Barings, Britain's oldest bank.

The size of derivatives mentioned by John Gray was, by the way, of their daily transactions. The size of their total worth, however, is much greater. It is mentioned by Richard Thomson in his "Apocalypse Roulette" in the following words: "Financial derivatives have grown, more or less from standing starting in the early 1970s, to a $64 trillion industry by 1996. How do you imagine a number that big? You could say that if you laid all those dollar bills end to end, they would stretch from here to the sun sixty-six times, or to the moon 25 900 times"'

James Robertson observes in his latest work, 'Transforming Economic Life' in the following words:

"Today's money and finance system is unfair, ecologically destructive and economically inefficient, the money-must-grow imperative derives production (and thus consumption) to higher than necessary levels. It skews economic effort towards money out of money, and against providing real services and goods. It also results in a massive world-wide diversion of effort away from providing useful goods and services, into making money out of money. At least 95% of the billions of dollars transferred daily around the world are for purely financial transactions, unlinked to transactions in the real economy."

This is exactly what Imam Al-Ghazzali had pointed out nine hundred years ago. The evil results of such an unnatural trade have been further explained by him as follows:

"Riba (interest), is prohibited because it prevents people from undertaking real economic activities. This is because when a person having money is allowed to earn more money on the basis of interest, either in spot or in deferred transactions, it becomes easy for him to earn without bothering himself to take pains in real economic activities. This leads to hampering the real interests of the humanity, because the interests of the humanity cannot be safeguarded without real trade skills, industry, and construction."

It seems that Imam- Al-Ghazzali has, in that early age, pointed out to the phenomenon of monetary factors prevailing on production, creating a wide gap between the supply of money and the supply of real goods which has emerged in the later days as the major cause of inflation, almost the same 'terrible potential' of trading in money as explained by John Gray and James Robertson in their above extracts. We will examine this aspect a little later, but what is important at this point is the fact that money, being a medium of exchange and a measure of value cannot be taken as a "production good" which yields profit on daily basis, as is presumed by the theories of interest. This is a mediator and it should be left to play this exclusive role. To make it an object of profitable trade disturbs the whole monetary system and brings a plethora of economic and moral hazards to the whole society.

The Nature of Loan

Another major difference between the secular capitalist system and the Islamic principles is that under the former system, loans are purely commercial transactions meant to yield a fixed income to the lenders. Islam, on the other hand, does not recognize loans as income-generating transactions. They are meant only for those lenders who do not intend to earn a worldly return through them. They, instead, lend their money either on humanitarian grounds to achieve a reward in the Hereafter, or merely to save their money through a safer hand. So far as investment is concerned, there are several other modes of investment like partnership etc which may be used for that purpose. The transactions of loan are not meant for earning income.

The basic philosophy underlying this scheme is that one who offers his money to another person has to decide whether:

(a)he is lending money to him as a sympathetic act; or
(b) he is lending money to the borrower, so that his principal may be saved; or
(c) he is advancing his money to share the profits of the borrower.

In the former two cases (a) and (b) he is not entitled to claim any additional amount over and above the principal, because in the case (a) he has offered financial assistance to the borrower on humanitarian grounds or any other sympathetic considerations, and in the case (b) his sole purpose is to save his money and not to earn any extra income.

However, if his intention is to share the profits of the borrower, as in the case (c), he shall have to share his loss also, if he suffers a loss. In this case, his objective cannot be served by a transaction of loan. He will have to undertake a joint venture with the opposite party, whereby both of them will have a joint stake in the business and will share: its outcome on fair basis. Conversely, if the intent of sharing the profit of the borrower is designed on the basis of an interest-based loan, it will mean that the financier wants to ensure his own profit, while he leaves the profit of the borrower at the mercy of the actual outcome of the business. There may be a situation where the business of the borrower totally fails. In this situation he will not only bear the whole loss of the business, but he will have also to pay interest to the lender, meaning thereby that the profit or interest of the financier is guaranteed at the price of the destructive loss of the borrower, which is obviously a glaring injustice.

On the other hand, if the business of the borrower earns huge profits, the financier should have shared him in the profit in reasonable proportion, but in an interest-based system, the profit of the financier is restricted to a fixed rate of return which is governed by the forces of supply and demand of money and not on the actual profits produced on the ground. This rate of interest may be much less than the reasonable proportion a financier might have deserved, had it been a joint venture. In this case the major part of the profit is secured by the borrower, while the financier gets much less than deserved by his input in the business, which is another form of injustice.

Thus, financing a business on the basis of interest creates an unbalanced atmosphere, which has the potential of bringing injustice to either of the two parties in different situations. That is the wisdom for which the Shariah does not approve an interest-based loan as a form of financing.

Once interest is banned, the role of 'loans' in commercial activities becomes very limited, and the whole financing structure turns out to be equity-based and backed by real assets. In order to limit the use of loans, the Shariah has permitted to borrow money only in cases of dire need, and has discouraged the practice of incurring debts for living beyond one's means or to grow one's wealth. The well-known event that the Holy Prophet refused to offer the funeral prayer (salat-ul janazah) of a person who died indebted was, in fact, to establish the principle that incurring debt should not be taken as a natural or ordinary phenomenon of life. It should be the last thing to be resorted to in the course of economic activities. This is one of the reasons for which interest has been prohibited, because, given the prohibition of interest, no one will be agreeable to advance a loan without a return for unnecessary expenses of the borrower or for his profitable projects. It will leave no room for unnecessary expenses incurred through loans. The profitable ventures, on the other hand, will be designed on the basis of equitable participation and thus the scope of loans will remain restricted to a narrow circle.

Conversely, once interest is allowed, and advancing loans, in itself, becomes a form of profitable trade, the whole economy turns into a debt-oriented economy which not only dominates over the real economic activities and disturbs its natural functions by creating frequent shocks; but also puts mankind under the slavery of debt. It is no secret that all the nations of the world, including the developed countries, are drowned in national and foreign debts to the extent that the amount of payable debts in a large number of countries exceeds their total income. Just to take one example of UK, the household debt in 1963 was less than 30% of total annual income. In 1997, however, the percentage of household debt rose up to more than 100% of the total income. It means that the household debt throughout the country, embracing rich and poor alike, represents more than the entire gross annual incomes of the country. Consumers have borrowed, and made purchases against their future earnings, equivalent to more than the entirety of their annual incomes.

Peter Warburton, one of the UK's most respected financial commentators and a past winner of economic forecasting awards, has commented on this situation as follows:

"The credit and capital markets have grown too rapidly, with too little transparency and accountability. Prepare for an explosion that will rock the western financial system to its foundation."

Overall Effects of Interest

Interest-based loans have a persistent tendency in favor of the rich and against the interests of the common people. It carries adverse effects on production and allocation of resources as well as on distribution of wealth. Some of these effects are the following:

(a) Evil effects on allocation of Resources

Loans in the present banking system are advanced mainly to those who, on the strength of their wealth, can offer satisfactory collateral. Dr. M. Umar Chapra (Senior Economic Advisor to Saudi Arabian Monetary Agency) who appeared in this case as a juris-consult has summarized the effects of this practice in the following words:

"Credit, therefore, tends to go to those who, according to Lester Thurow, are 'lucky rather than smart or meritocratic. The banking system thus tends to reinforce the unequal distribution of capital. Even Morgan Guarantee Trust Company, sixth largest bank in the U.S has admitted that the banking system has failed to 'finance either maturing smaller companies or venture capitalist' and 'though awash with funds, is not encouraged to deliver competitively priced funding to any but the largest, most cash-rich companies. Hence, while deposits come from a broader cross-section of the population, their benefit goes mainly to the rich."

The veracity of this statement can be confirmed by the fact that according to the statistics issued by the State Bank of Pakistan in September 1999, 9269 account holders out of 2,184,417 (only 0.4243% of total account holders) have utilized Rs.438.67 billion which is 64.5% of total advances as of end December 1998.

(b) Evil effects on production

Since in an interest-based system funds are provided on the basis of strong collateral and the end-use of the funds does not constitute the main criterion for financing, it encourages people to live beyond their means. The rich people do not borrow for productive projects only, but also for conspicuous consumption.

Similarly, governments borrow money not only for genuine development programs, but also for their lavish expenditure and for projects motivated by their political ambitions rather than being based on sound economic assessment. Non-project-related borrowings, which were possible only in an interest-based system have thus helped in nothing but increasing the size of our debts to a horrible extent. According to the budget of 1998/99 in our country 46 percent of the total government spending is devoted to debt-servicing, while only 18% is allocated for development which includes education, health and infrastructure.

(c) Evil effects on distribution

We have already pointed out that when business is financed on the basis of interest, it may bring injustice either to the borrower if he suffers a loss, or to the financier if the debtor earns huge profits. Although both situations are equally possible in an interest-based system, and there are many examples where the payment of interest has brought total ruin to the small traders, yet in our present banking system, the injustice brought to the financier is more pronounced and much more disturbing to the equitable distribution of wealth.

In the context of modern capitalist system, it is the banks that advance depositors' money to the industrialists and traders. Almost all the giant business ventures are mostly financed by the banks and financial institutions. In numerous cases the funds deployed by the big entrepreneurs from their own pocket are much less than the funds borrowed by them from the common people through banks and financial institutions. If the entrepreneurs having only ten million of their own, acquire 90 million from the banks and embark on a huge profitable enterprise, it means that 90% of the projects is created by the money of the depositors while only 10% was generated by their own capital.

If these huge projects bring enormous profits, only a small proportion (of interest which normally ranges between 2% to 10% in different countries) will go to the depositors whose input in the projects was 90% while all the rest will be secured by the big entrepreneurs whose real contribution to the projects was not more than 10%. Even this small proportion given to the depositors is taken back by these big entrepreneurs, because all the interest paid by them is included in the cost of their production and comes back to them through the increased prices. The net result in this case is that all the profits of the big enterprises is earned by the persons whose own financial input does not exceed 10% of the total investment, while the people whose financial contribution was as high as 90% get nothing in real terms, because the amount of interest given to them is often repaid by them through the increased prices of the products, and therefore, in a number of cases the return received by them becomes negative in real terms.

While this phenomenon is coupled with the fact, already mentioned, that 64.5% of total advances went only to 0.4243% of total account holders, it means that the profits generated mostly by the money of millions of people went almost exclusively to 9,269 borrowers. One can imagine how far the interest-based borrowings have contributed to the horrible inequalities found in our system of distribution, and how great is the injustice brought by the modern commercial interest to the whole society as compared to the interest charged on the old consumption loans that affected only some individuals.

How the present interest-based system works to favour the rich and kill the poor is succinctly explained by James Robertson in the following words:

"The pervasive role of interest in the economic system results in the systematic transfer of money from those who have less to those who have more. Again, this transfer of resources from poor to rich has been made shockingly clear by the Third World debt crisis. But it applies universally. It is partly because those who have more money to lend, get more in interest than those who have less; it is partly because those who have less, often have to borrow more; and it is partly because the cost of interest repayments now forms a substantial element in the cost of all goods and services, and the necessary goods and services looms much larger in the finances of the rich . When we look at the money system that way and when we begin to think about how it should be redesigned to carry out its functions fairly and efficiently as part of an enabling and conserving economy, the arguments for an interest-free inflation-free money system for the twenty-first century seems to be very strong."

The same author in another book comments as follows:

"The transfer of revenue from poor people to rich people, from poor places to rich places, and from poor countries to rich countries by the money and finance system is systematic One cause of the transfer of wealth from poor to rich is the way interest payments and receipts work through the economy.

(d) Expansion of artificial money and inflation

Since interest-bearing loans have no specific relation with actual production, and the financier, after securing a strong collateral, normally has no concern how the funds are used by the borrower, the money supply effected through banks and financial institutions has no nexus with the goods and services actually produced on the ground. It creates a serious mismatch between the supply of money and the production of goods and services. This is obviously one of the basic factors that create or fuel inflation.

This phenomenon is aggravated to a horrible extent by the well-known characteristic of the modern banks normally termed as 'money creation'. Even the primary books of economics usually explain, often with complacence, how the banks create money. This apparently miraculous function of the banks is sometimes taken to be one of the factors that boost production and bring prosperity. But the illusion underlying this concept is seldom unveiled by the champions of modern banking.

The history of money creation' refers back to the famous story of the goldsmiths in medieval England. The people used to deposit their gold coins with them in trust, and they used to issue a receipt to the depositors. In order to simplify the process, the goldsmiths started issuing 'bearer' receipts which gradually took the place of gold coins and the people started using them in settlement of their liabilities. When these receipts gained wide acceptability in the market, only a small fraction of the depositors or bearers ever came to the goldsmiths to demand actual gold. At this point the goldsmiths began lending out some of the deposited gold secretly and thus started earning interest on these loans. After some time they discovered that they could print more money (i.e. paper gold deposit certificates) than actually deposited with them and that they could loan out this extra money on interest. They acted accordingly and this was the birth of 'money creation' or 'fractional reserve lending' which means to loan out more money than one has as a reserve for deposits. In this way these goldsmiths, after becoming more confident, started decreasing the reserve requirement and increasing the percentage of their self-created credit, and used to loan out four, five, even ten times more gold certificates than they had in their safe rooms.

Initially, it was abuse of trust and a sheer fraud on the part of the goldsmiths not warranted by any norm of equity, justice and honesty. It was a form of forgery and usurpation of the power of the sovereign authority to issue money. But overtime, this fraudulent practice turned into the fashionable standard practice of the modern banks under the 'fractional reserve' system.

How the money changers and bankers have succeeded in legalizing the creation of money by the private banks, in spite of the strong opposition from several rulers in England and USA, and how the Rothchilds acquired financial mastery over the whole of Europe and the Rockfeller over the whole of America is a long story, now lost in the mist of numerous theories developed to support the concept of money-creation by the private banks. But the net result is that the modern banks are creating money out of nothing. They are allowed to advance loans in the amounts ten times more than their deposits. The coins and notes issued by the government as a genuine and debt-free money have now a very insignificant proportion in the total money in circulation, most of which is artificial money created by advances made by the banks.

The proportion of real money issued by the governments has been constantly declining in most of the countries, while the proportion of the artificial money created by the banks out of nothing is ever-increasing. The spiral of loans built upon loans is now the major part of the money supply. Taking the example of UK according to the statistics of 1997 the total money stock in the country was 680 billion pounds, out of which only 25 billion pounds were issued by the government in the form of coins and notes. All the rest i.e. 655 billion pounds were created by the banks. It means that the original debt-free money remained only 3.6% of the whole money supply while 96.4% is nothing but a bubble created by the banks. The way this bubble is growing annually can be seen from the following table that details the quantum of money supply in UK during twenty years.

Year	Total coins and notes issued by the Govt. MO S. Pound billion	Total money stock M4 S. Pound bln	Percentage of real debt free money to the money supply
1977	8.1	65	12%
1979	1.5	87	12%
1981	12.1	116	10.5%
1983	12.8	161	7.9%
1985	14.1	205	6.8%
1987	15.5	269	5.8%
1989	17.2	372	4.6%
1991	18.6	485	3.8%
1993	20.0	525	3.8%
1995	22.4	585	3.8%
1997	25.0	680	3.6%

This table shows that money created by the banks has been growing with speed throughout the last two decades until it reached 680 billion pounds in 1997. The last column of the table shows the yearly declining percentage of the real money to the total money supply, which fell from 12% in 1977 to 3.6% in 1997. This phenomenon unveils two realities. Firstly, it shows that 96.4% of the total money supply is debt-ridden money and only 3.6% is debt free. Secondly, it means that 96.4% of the aggregate money circulated in the country is nothing but numbers created by computers having no real thing behind them.

The position in the USA is almost the same as that in the UK. Patrick S.J Carmack and Bill Still, observe as follows:

"Why are we over our heads in debt? Because we are labouring under a debt money system, in which all our money is created in parallel with an equivalent quantity of debt, that is designed and controlled by private bankers for their benefit. They create and loan money at interest and we get the debt.

So although the banks do not create currency, they do create cheque-book money, or deposits, by making new loans. They even invest some of this created money. In fact, over one trillion dollars of this privately created money has been used to purchase US bonds on the open market, which provides the banks with roughly 50 depositors. In this was though fractional reserve lending, banks create far in excess of 90% of the money and therefore cause over 90% of our inflation."

Conclusion

All this appalling situation faced by the whole world today is the logical outcome of giving the interest based financial system an unbridled power to reign the economy. Can one still insist that the universal horrors brought about by the commercial interest are byt far greater than the individual usurious loans that used to affect only some individuals.

Issues and Relevance of Islamic finance in Britain

By Iqbal Khan, Managing Director Head of Global Islamic Finance, HSBC Amanah Finance, UK

Introduction

Philosophical Foundation and Core Concepts

Islamic finance is an ethical, indigenous and equitable mode of finance, which derives its principles from the Quran (The revealed book of Muslims) and tradition of the Prophet Muhammad (pbuh). Shariah law (Islamic law), which is based on the Quran and Sunnah, governs Islamic finance.

It is a trend which is broadening the ownership base, creating more stakeholders and thereby bringing the hope of stability to more than 1.3 billion Muslims spread across the world.

Islamic Finance as a concept is based on themes of Community Banking, Ethical and Socially Responsible Investments and Affinity Marketing. These themes themselves are based on core ideas, which include individual responsibility, reliance on market mechanism, commitment to economic and social justice and mandatory care for the environment. These guidelines also include prohibitions from investing in areas such as Defence and Armaments, Casinos, Breweries - areas which are considered to be value destroyers.

In Islamic Finance Scholars say that everything is allowed except that which has been specifically forbidden. In essence the believing Muslims view of economics is based on Man's obligation to organise his affairs in accordance to the will of God as his representative and vice regent on Earth. The goal is not equality but an avoidance of gross inequality along with an injunction that wealth should not become "a commodity between the rich among you". Islamic Finance is firmly embedded in the commercial, real, value-producing economy.

Early Beginning

The desire of enlightened Muslims to seek the moral equivalent of Modern Capitalism goes back to Egypt in the early 1960s. The pioneering effort, in Egypt, took the form of a savings bank based on profit-sharing in the town of Mit Ghamr. The Islamic Development Bank (IDB) was established in l975 by the Organisation of Islamic Conference (OIC), but it was primarily an intergovernmental bank aimed at providing funds for development projects in member countries. The IDB now also extends to private sector corporates for project and trade finance facilities.

In the mid-seventies, Islamic banks came into existence in Saudi Arabia and the United Arab Emirates. Since then, Islamic financial institutions have emerged in a large number of Muslim countries including Kuwait, Bahrain, Qatar, Turkey, Pakistan, Indonesia and a belt of other IDB member countries. These institutions have taken the form of commercial banks, investment banks, investment and finance companies, insurance companies, etc.

Market sizing

Islamic banking today is an industry that is still evolving. The industry manages approximately $180 Billion dollars today, growing at approximately 15% per annum. The growth of Islamic banking is a result of economic growth in the Islamic world, fuelled primarily by oil wealth. This growth created a growing middle-wealth segment and hence made banking a necessary service to the larger segment of the population rather than a service for the few, as had been the case some 10 to 15 years earlier.

Evolution of Islamic Finance

In the 1970s and 1980s, Islamic banking was characterised by a large number of commercial banks serving retail Muslim customers in their respective countries. However, since the late 1980s a shift towards investment banking has taken place. No where is this better witnessed than in Bahrain, which has the largest number of offshore Islamic investment banks in the Muslim world.

In the early years, investments and products used by most Islamic financial institutions were driven by the concept of Mudaraba (referred to as Trust Financing) and focused on short-term investments. During this period, Murabaha (cost-plus finance) emerged as the most widely used instruments by Islamic banks, accounting for over 80 per cent of a portfolio of an Islamic bank.

During the 1990s Islamic financial institutions have become increasingly more innovative, developing more complex instruments and structures to meet the demands of modern day business. The use of instruments such as leasing and construction finance have become far more widespread. Islamic finance tranches have also been structured into big-ticket syndication.

Equities have only recently opened up as an asset class to Islamic investors, following approval from the Islamic Fiqh (Islamic jurisprudence) Academy in Jeddah, one of the major legal bodies in the Muslim world. Islamic investors are now able to invest in equities subject to certain criteria. Over 100 Islamic equity funds have now been launched since 1995 with Assets under management in excess of $7 billion. Some of these funds are being sold in UK and it would be useful to make their ISA compatible.

The Markets and the Players

More than 2/3rd's of Islamic finance business is currently originated in the Middle East. The GCC countries, with the exception of Oman, are all major markets for Islamic finance. Bahrain is regarded as the hub for Islamic finance. Other major non-GCC markets for Islamic finance include Egypt, Malaysia, Turkey, Indonesia, and Pakistan.

Malaysia operates a dual banking system promoted by the government. This allows conventional financial institutions, investment banks, commercial banks and finance companies to launch separate Islamic banking divisions, competing alongside two Islamic banks, Bank Islam Malaysia and Bank Muamalat Malaysia. Bank Negara Malaysia (the central bank) has its own Shariah Advisory Board, which sets the rules for the entire Islamic banking sector, ensuring uniformity of products and services.

Over 150 Islamic financial institutions now operate in over 40 countries around the world, from commercial banks, investment banks, investment companies to leasing, and insurance companies.

The Products and Structures

Islamic banks around the world have devised many financial products based on the risk-sharing, profit-sharing principles of Islamic banking. For day to day banking activities, a number of financial instruments have been developed that satisfy the Islamic doctrine and provide acceptable financial returns for investors. Broadly speaking, the areas in which Islamic banks are most active are in trade and commodity finance, property and leasing. Almost every Islamic bank has a committee of religious advisers whose opinion is sought on the acceptability of new instruments and services and who have to provide a religious opinion of the bank's activities for year-end accounts.

Britain and Islamic finance

Community Banking

Muslims in Britain and throughout the world aspire to carry out their financial matters in accordance with the principles of Islamic law. Muslims are forbidden from obtaining the various conventional banking and insurance products and services in the forms currently offered due to their incompatibility with the principles of Islamic law.

It is estimated by various surveys that over 2 million Muslims are permanently residing in the UK. The community is predominantly composed of people from the Indian sub continent who have settled in Britain during the 1950s. Beside them, there are also Muslims of Middle Eastern and North African origins. Additionally there is a growing population of indigenous Muslims.

The UK Muslim community has now reached the "Second-Generation" stage. The first wave of immigrants having settled down, the second-generation Muslims are now slowly penetrating the different strata of the British society. It is not uncommon to find successful Muslim lawyers, chartered accountants, bankers, businessmen and even Members of Parliament, both at the House of Lords and the House of Commons.

The third generation of Muslims are also emerging from the educational system and is projected to increase the Muslims' presence in all strata of British society, especially, the educated middle class.

The vast majority of Muslims either is living in rented houses or has taken conventional interest-based mortgages. The total number of Muslim households as estimated by the Muslim Council of Britain is around 500,000. Of the 500,000 households, it is estimated by various market researches that approximately 40,000 families seek financing for home purchases each year.

We have regularly received enquiries regarding the availability of Islamic finance products, in particular Islamically compatible finance to purchase both residential and commercial properties. It is believed that a large number of Muslims have abstained from taking the conventional mortgage because of its incompatibility with the Islamic principles. The needs of these Muslims need to be served immediately.

Beside the market represented by Muslims living in Britain, there is potential for overseas investors to be introduced by HSBC. We understand that a considerable number of Muslims living abroad (mainly in the Middle East) had expressed their desire to own properties in Britain (mainly as a holiday residence) but have been reluctant to embark into an interest bearing financing facility. For these investors an Islamic home financing scheme will offer the opportunity to own a property in Britain.

Islamic Home Financing

Structure

The potential customer, having identified the property, will approach the Bank to finance the purchase of the property. The transaction structure will be as follows:

The customer chooses the property for purchase and agrees the purchase price with the owner of the property ("Seller"). The bank buys the property from the Seller at the agreed price. The customer will be requested to provide a deposit against the purchase price, but the Bank will remain the sole registered owner.
The customer signs a lease agreement with the Bank. The lease will be for a period of up to 25 years with the lease rentals to be reviewed annually to reflect the capital repayment. The terms of the lease agreement will stipulate that in the event of a default the Bank will have the right to repossess and sell the property.
The customer/lessee will give an undertaking that in the event of a default under the lease agreement, the Bank/lessor will have the right to compel the customer to purchase the property for the purchase price (which shall equal the amount of principal outstanding).
There will also be an undertaking whereby the Bank/lessor promises to sell the property to the customer/lessee at the end of the agreed lease period (i.e., when the whole of the principal portion has been repaid). There will also be a provision for certain other specified instances including when the customer desires to sell the property.

The above structure would allow British Muslims to get access to home financing without forcing them to choose between their religion and home ownership. It allows British Muslims to purchase homes without violating Islamic prescriptions on borrowing money on which interest is charged. Further, this initiative will be consistent with the well-established public policy of encouraging home ownership and making Muslim stakeholders in Britain.

Islamic Home Financing: Current Impediments

1. Risk Weighting

A key element, which will impact the pricing, is the FSA's approach to risk weighting for this product. FSA has provisionally ruled that the product is to be 100% risk weighted. This is essentially because the transaction is equivalent to a lease and leases are weighted 100%. This assumes that the house remains the property of the Bank throughout the term of the transaction and is treated as a fixed asset on its balance sheet. If we are obliged to weigh at 100% then pricing will be significantly higher than the conventional mortgage rate. Good Muslims should not be penalised for being good Muslims. The Muslims in the United States have approached the Comptroller of the Currency Administration of National Banks ("OCC") to seek the approval for Islamic home finance based on the above leasing structure. The OCC had in 1997 approved the Islamic home financing based on the above leasing structure and ruled, inter alia, that the banks' risks under the Islamic leasing structure are similar to the risks on traditional mortgage loans (see OCC's Interpretive Letter #806). We hope that a similar approval would be granted in Britain.

2. Taxation

The transfer of ownership from vendor to bank at the commencement of the lease and from bank to customer at the end of the lease, may attract the payment of two sets of stamp duty. The second set would arise at the end of the term of the lease at the rate of stamp duty then applicable. The second set of stamp duty needs to be exempted because the true effect of the transfer is similar to the redemption of a conventional mortgage or charge: when the property finally vests with the customer without any encumbrance. If the second set of stamp duty is not exempted, the uncertain cost of the second stamp duty would make the Islamic home financing unattractive and cost prohibitive.

3. Legal Fees

Unlike the conventional mortgage the proposed product would require the appointment of two sets of Solicitors, thereby making the product more expensive. It is suggested that the Law Society should consider giving a general exemption as is done for the mortgage product.

For British Corporates

Britain has always been a major trading partner of the Muslim world. Trade volumes became increasing significant in some parts of the Muslim world in the 1970s following the oil driven economic boom.

The oil boom during this period brought about growth in the domestic economies of the oil producing countries. This brought opportunities for British firms to play a role in building the infrastructure of these countries. Surplus funds from the Muslim world found their way into the safe and stable environments in Britain to be managed by London-based banks.

Similarly, funds have also been channelled into direct investments. Good examples here are Kuwait Investment Office's acquisition of a 20% stake in BP stands out, the acquisition of Lotus the car manufacturers by Proton, the Malaysian car company and purchase of the Hartwell Group by a prominent trading family from Saudi Arabia.

The investment in the London property market by the investors from the Muslim world has historically been very important. Real estate analysts believe that in 1998 alone well over 20% of all such investments came from the Muslim world. In addition, a significant number of Muslim businesses in Britain are also seeking Islamically compatible finance to purchase commercial properties in Britain.

We are witnessing an increasing desire from Muslim investors that these funds be managed and corporate acquisitions be structured under Islamic financial principles. Here UK regulators can play an important role in facilitating the flows of funds and investments into Britain from the Muslim world through the introduction of "Islamic finance friendly" regulation.

UK corporates too, trading with their counterparties in the Muslim world need to be cognisant of the growth of this indigenous and ethical mode of financing and be aware of the characteristics, qualities and benefits of Islamic finance.

For British Exporters

Many of the Muslim countries throughout the world would be classified as developing markets. Consequently, cross-border funding for these countries from western financial markets may be either restricted or limited, thus hindering trade and investment flows between the UK and the Muslim world. Here Islamic financial institutions, who have a greater knowledge and understanding of these markets and consequently the risks, can play key role by providing financing in instances where western commercial financiers would be unwilling to lend.

British exporters and British export credit agencies would benefit tremendously by using this indigenous form of finance to gain access to precious cross-border lines in the 54 Islamic Development Bank Member Countries, These cross-border lines could become a tremendous source of competitive advantage for British exporters.

Today Islamic finance is a trend, which is broadening the ownership base, and creating more stakeholders. It offers a viable financial alternative that may run parallel to conventional finance. Regulators, bankers, asset managers and users of capital in Britain may capitalise on the opportunities afforded by this market and play a proactive role.

London already supports this form of finance by offering products and services through its financial institutions and through leading law firms. The regulatory authorities should come out proactively to introduce regulations which will allow these instruments to be established as an ethical alternative to other instruments which are available in the London financial markets, meeting the needs of Islamic fund providers.

This will require an understanding and appreciation of the roles which these ethical indigenous instruments play in keeping the commercial economy as close as possible to the financial economy. British exporters to the Muslim countries would be in a very favourable position if they could provide not only the exports but also export financing that meets the importers' religious requirements. HSBC is working together with the Export Credits Guarantee Department and other Export Credit Agencies in the EEC to provide Islamically compatible financing and guarantee for exports to Muslim countries. The proactive role of the ECGD is providing Islamically acceptable financing is essential to ensure that British exporters to the Muslim countries have an edge over others. This would lead to more trades between Britain and the Muslim countries, which could lead to a positive contribution to the British economy.

Conclusion

Islamic Finance has mainstream relevance for British Muslims, British Business and British Exporters. It is therefore important that relevant Government Institutions such as ECGD, FSA and DTI should pay attention to this corporate and social responsibility movement, which is becoming increasingly important for both Muslims in Britain and abroad.

Perhaps more important is the demonstration effect which such an effort may have for all of humanity.

Dr. Martin Luther King Jr. described the challenge, which we face:

"Through our scientific genius we have made the world a neighbourhood, now through our moral and spiritual genius we must make of it a brotherhood."

It is in this domain and in bringing the financial economy close to the commercial economy that Islamic Finance can make a real and lasting difference. Britain with its history and culture of trade, commence and community banking is well positioned to benefit from this growing trend of Islamic Finance.

Islamic Investment Products Available In The United Kingdom

Professor Rodney Wilson
University of Durham, United Kingdom

Introduction

London has become the largest international centre for Islamic finance outside the Muslim World, largely as a result of the City's role as a centre for Middle Eastern and Asian banking. Treasury management facilities are provided on behalf of Islamic banks in the Gulf, and Islamic fund management and promotion is becoming more significant. Possibilities for Islamic electronic financial services are opening up, and London is the major centre for information gathering and dissemination on the Islamic banking industry.

London's role in serving the British Muslim community has been disappointing and despite almost two decades of experience of Islamic financing, there are few retail products available. The aim of this article is to ask why this continues to be the case, to review the limited range of products on offer, and to see if there are any more hopeful signs for the future.

Islamic financial services in the UK

The Muslim community in the United Kingdom numbers more than 1.5 million British citizens and permanent residents, with up to another 500,000 temporary residents including students and visitors. The community is ethnically and linguistically diverse however, and geographically scattered, that makes marketing aimed at attracting the attention of the community a major challenge. The community is increasingly affluent, and comprises a growing number of professionals such as doctors, as well as a substantial small business component.

Although casual evidence suggests there is a greater propensity to use cash for transactions than with the population generally, the demand for banking and financial products is not markedly different from the national picture. Some devout Muslims avoid using conventional interest based banks, and others donate interest earnings to charity in an attempt to purify their income. The majority use conventional financing services, largely because they have little alternative, and tend, like the rest of the population, to have greater trust in large retail financial institutions with established brand names. For Islamic financial institutions to gain acceptance within the community there would need to be a substantial educational and marketing promotion.

HSBC Islamic Financing

In many respects the HSBC is the best placed British retail bank to potentially offer Islamic financial services to the local Muslim community, but so far it has been reluctant to take on the promotional and marketing risks. HSBC's advantage is that it already has an Islamic finance unit and extensive experience through its global operations in this type of business. It has a significant presence in many Muslim countries, including Malaysia, Pakistan and Bangladesh, and has become a major force in Middle Eastern banking since its acquisition of the British Bank of the Middle East. Its network includes six branches in Bahrain, six in Lebanon, fifteen in the United Arab Emirates, nine in Egypt, and five in Oman. HSBC also owns a minority stake in the Saudi British Bank that has 80 branches in the kingdom. These networks give the bank unparalleled business knowledge of different Muslim societies.

In the United Kingdom HSBC is the only high street bank to have a dedicated network of branches to serve the South Asian community with staff who speak Urdu and are themselves part of the community. It has teams of specialist business banking managers who profess to understand the needs of small Asian businesses. Its South Asian network has 11 branches in Blackburn, Glasgow, Harrow, Leeds, Leicester, London (2), Manchester, Preston, Walsall and Uxbridge. Islamic products could potentially be offered through all these branches.

It is however easier for HSBC, like other British retail banks, to offer conventional loans and savings products rather than to introduce differentiated products for a potential market of Muslim clients who do business with the bank in any case. The gains from cross selling Islamic products to existing clients are not thought to be great, and the potential to attract new clients limited due to the inertia of most retail account holders. HSBC therefore has concentrated on serving foreign Muslim clients of high net worth through its international operations, and in serving Islamic banks through wholesale business, rather than the domestic market. The HSBC's Amanah Global Equity Fund is marketed to foreign investors, for example, rather than the British Muslim community.

United Bank of Kuwait's Islamic Investment Banking Unit's Manzil Scheme
The most significant Islamic financial product to be launched for the Muslim community in the United Kingdom was the Manzil home purchase plan. Manzil can be translated as home, or in spiritual terms as the house or dwelling of the soul. The original scheme, which was introduced in 1997, provides for murabaha financing through a trading mark-up contract. The Islamic Investment Banking Unit that runs the scheme is a part of the United Bank of Kuwait, which was established in London in 1966 to serve Kuwaiti overseas financial and commercial interests. In August 2000 it was taken over by the Al-Ahli Commercial Bank, which formed a new institution, the Ahli United Bank. This has been registered as an offshore banking unit in Bahrain with its shares listed on the stock exchange in Manama.

Once the client has chosen a suitable property and agreed a price he approaches the bank for Manzil financing. An application form is completed together with a direct debit mandate for the monthly payments if the request for financing is approved by the bank's credit committee. The client must pay 0.1 percent of the purchase price of the property, or a minimum of £176.25 including VAT, so that the bank can commission an independent valuation of the property. The IIBU will also seek references regarding the client's financial position, usually from an employer or accountant and current bank. The client's solicitor will be expected to liase with the IIBU's solicitor who will seek assurances regarding the legal title of the property, which may involve legal searches.

For murabaha to be legitimate under Islamic law, the bank, as financier of the property, must be the first owner. It is therefore the bank, and not the client, who contracts with the vendor and pays the deposit required when contracts are exchanged. The sale price from the IIBU to the client has to allow for administrative expenses, a return to the bank's investors and a profit margin. The client pays the purchase price through fixed monthly payments over a period of up to 15 years.

The Manzil Ijara Home Hire Purchase Plan

The Manzil ijara scheme, which was introduced in March 1999, has proved much more popular than original murabaha house purchase plans. It is the flexibility that seems to appeal to clients, who can repay larger amounts as and when they can afford to do so to reduce their rental payments. They have the right to purchase the entire property from the bank at any time, but few are likely to choose to do so in the first few years, largely because they lack the funds. Those with the necessary funds to purchase a property outright would not have sought a Manzil home purchase arrangement in the first place.

Under the Manzil ijara scheme the property is registered in the bank's name, not just initially, but throughout the period of the lease that may extend to 25 years. The tenant or lessee agrees at the outset to eventually purchase the entire property, but at the original price that the bank paid without any mark-up. The monthly payments by the client comprise three elements. The first represents the repayments of the funds that the bank has used to purchase the property. The second is the rent on the property, which is the source of the bank's profit. The rent is reassessed annually to ensure the bank is making a reasonable return and adjusted downward to reflect payments already made. The third element of the monthly payment, referred to as insurance rent, is to recover the cost of the insurance that the bank has to pay on the property. Over time the monthly payments may increase or reduce or both, depending on the size of the first repayments element that the client decides he can afford. Early repayment could be potentially unprofitable for the bank, unless it can obtain a higher return by reinvesting the funds.

The Success of the Manzil Scheme

Although there has only been limited marketing effort put into the Manzil schemes there are between 50 and 80 potential clients a week who phone to enquire about Manzil house purchase and a further 40 who respond by email to the Web pages. This translated into around 20 applications per week for Manzil house purchases. The majority of applications are for housing purchase in the South East of England, but there is also a steady stream of enquiries from the Midlands and the North. Because of the different conveyancing system under Scottish law, Manzil financing is not available for house purchases north of the border. A down payment of 20 percent of the value of the property is required for all Manzil financing, which is higher than for conventional mortgages, but ensures that the client has a significant equity stake in the property from the outset. The minimum value of the property purchased is £50,000, which is a very modest sum in relation to property values in the South East, but which has applied to some of the inner city properties acquired in the Midlands and the North.

Under the Manzil ijara scheme clients can convert existing interest based mortgages. The banks shariah board's members, Justices Shaikh Muhammed Taqi Usmani and Shaikh Nizam Yaquby, have approved a conversion plan whereby the IIBU purchases the property from a client for a sum sufficient to repay the current loan plus certain costs and expenses, with the bank's payment being repaid over a period of years by the client. The bank's profit is derived from the rent the client pays over under the ijara wa-Iqtina hire purchase scheme.

Fund Management Possibilities

London is the major European centre for fund management, both for funds listed onshore and offshore funds listed in the Channel Islands, Dublin, Luxembourg and other centres. There are seven Islamic funds that are promoted in the Muslim world but managed from London and four that are both promoted and managed from London. All of these are designed for clients in Saudi Arabia and the Gulf, with the prices denominated in dollars and the funds administered from offshore tax havens. The HSBC Amanah Global Equity Fund is typical of these offerings, being listed in Luxembourg and managed to provide exposure to leading companies worldwide with a particular focus on major multinationals whose primary listing is in New York.

There have been mixed fortunes for Islamic funds managed from London with Kleinwort Bensons' Islamic Fund, the first to be established in 1986, being wound up in 1989 because of poor subscriptions. Flemings Oasis Fund was launched with great promise back in 1996, but was liquidated in 2000 following the take-over by Chase of Flemings. The Institutional Investor of Kuwait, which managed the Ibn Majeed Fund that was listed in Dublin, decided to close its London office in 2000 and focus its operations in the Gulf.

The only sterling denominated fund was the Halal Mutual, also listed in Dublin, and managed by the Gulf based Al Tadamon Group. It was designed to provide income from commodity trading rather than equity investment, the price being fixed at £250, but with the income dependent on trading profits, which in practice was always around 3.6 to 3.8 percent gross, a very modest return.

None of these funds is of much interest to the British Muslim community, who as United Kingdom residents have potential tax liabilities on both income and capital gains, and therefore cannot take advantage of offshore funds. For local Muslims what is required is an Islamic fund that can qualify for tax exemptions under the Individual Savings Account (ISA) scheme. This provides for exemption from capital gains and income tax for up to £7,000 invested in any tax year for qualifying funds in a maxi ISA. This has proved popular with ethical and ecological investors, with funds such as the Friends Provident Stewardship and the Jupiter Merlin Ecology qualifying for this status. Similar on-shore funds that complied with the Sharia law could potentially appeal to British Muslim investors if a major fund management group was willing to take the initiative.

Conclusion

Although London has emerged as the major western centre for Islamic finance so far it has failed to serve the United Kingdom Muslim community. The major retail banks and fund management institutions seem reluctant to take the initiative by promoting shariah compliant products for the local market. Whether the new on-line financial services groups such as ii-online.com or ihilal.com break into this market remains to be seen, but this may be one way forward.

Q - Why is interest banned in Islam?

A.C. Company
Pakistan

A - The holy Qur'an, (the book of Allah) makes it expressly clear in many verses that interest in any form is forbidden by Islam. In one of the Hadiths of the Holy Prophet (SAW) he holds any person who receives it, gives it, witnesses it and records it accountable.

In fact the Qur'an gives a warning that those who refuse this divine decree will face a severe punishment on Judgement Day.

Allah says in Surah al-baqarah (2), verse 275:

"Those who devour usury will not stand except as stands one whom the Evil one by his touch has driven to madness. That is because they say: 'Trade is like usury'. But Allah hath permitted trade and forbidden usury".

Surat al-nisa (4), verse 161:

"That they took usury, though they were forbidden, and they devoured men's subsistence wrongfully; We have prepared for those among them who reject faith a grievous punishment."

With regard to loans for consumption purposes, in times of need, ethical considerations demand that people should help each other without charging interest, because to charge interest amounts to taking advantage of a person's weaker economic position, which is against the Islamic spirit of justice and equity. Today, credit is mostly given for production purposes rather than consumption.

There are at least five reasons why interest is undesirable:

1) Transactions based on interest violate the equity of a business. In business the outcome of any enterprise is always uncertain. Yet the borrower is obliged to pay the agreed rate of interest, even if he makes a loss on his enterprise. Even if he makes a profit, the interest he has to pay may amount to more than the profit and this clearly militates against the Islamic norm of justice.

2) The inflexibility of an interest-based system leads to a number of bankruptcies and this results in loss of productive potential for the whole society as well as unemployment for many people.

3) A bank's commitment to keeping its depositors' money safe as well as paying them a fixed amount of interest makes banks anxious to recover their principal as well as the interest. Thus more loans are provided for those who are already successful, while potential entrepreneurs are prevented from starting up.

4) The interest-based system discourages innovation by small businesses. Big businesses can risk trying out new techniques and products because they have reserves of funds to fall back on if the new idea does not succeed. Small businesses cannot try new things because they would need to borrow money on

interest from banks to do so and if their ideas failed, they would have no way of paying back the loan or the interest and would be bankrupt.

5) With the interest system, banks have no interest in a venture except in so far as there are possibilities of recovering their capital and earning interest. Any business plan put to them is judged only on this criterion.

Q - Please inform us if it is lawful to seek payment before the delivery of a leased object?

A - Firstly, It is essential to consider the contract for the purchase of items separate from the lease contract owing to differences in the requirements and the rules particular to each contract.

The initiation of a contract to import items that stems from an understanding of the presence of a lessee for those items and his/her determination to lease them must be limited to the motivation or the reason (for the same) which happens to be that mutual promise. This, however, should not lead to confusion with regard to the duties of each party or to ambiguity with regard to their responsibilities.

The contract to purchase items is between the bank and the importer. Everything connected to the contract, like responsibilities, payment, and results becomes the responsibility of those two parties. The contract to lease is between the client and the bank. Likewise, the responsibility of the lessee to make payments stems from his taking possession of the item(s) leased to him, which constitutes the subject of the lease contract. The responsibility does not stem from payment of the amount financed either in advance or later on. Rather, that is a matter that concerns the bank, and the bank is to bear it on its own. So, before delivery of the items (in part or entirely) there is nothing to justify the right to receive payments. This is because the lease contract is the contract that is subject to time, and no rent will be due merely because of the contract, but rather as a result of the subject of the lease being made available. Even so, rent payment may be made in advance when availability is ensured for the entire period of the lease, even before the lease usufruct is exhausted. Still, the important thing is that the rent be countered by the usufruct, and this is not possible before delivery of the leased item.

Secondly, the rent payment must be known exactly, with regard to the amount and the due date. An indication of the same, by saying that it should represent so much profit, is not acceptable. This may be no more than an indication of how the rent is to be calculated, and there is nothing wrong with that. Even so, it is essential that the rent be specified in the contract itself, far removed from any mention of profit.

Q - What is the Shariah position in regard to an Islamic Bank making deposits in foreign banks, and then using the interest that accrues from such deposits for purposes like training or research and development?

A - Muslim may not deposit in a foreign bank. However, if necessity leaves no other recourse, or if circumstances otherwise compel him/her to do so, and then the deposits earn interest, the interest may not be benefited from by the individual Muslim, or by the Islamic Bank (if the bank makes the deposits). Nor may such earnings, if spent in charity, reduce Zakat liability. Nor may they be used to settle debts. At the same time, however, the earnings should not be left at the disposal of the foreign banks so that these may grow stronger in opposition to Islam and Muslims. Rather, such earnings should be withdrawn and then spent on the general welfare of the Muslims. Such earnings may not, however, be spent on the construction of mosques because only pure and lawful earnings may be used for that purpose. The reason for this is that leaving those earnings to the bank may become a factor in strengthening the enemies of Islam. At the same time, it is unlawful to destroy the earnings because the destruction of wealth is unlawful.

Regarding the proposal to use the earnings for a research and training institute, that may certainly be considered to be in the interest of the general Muslim public, and is therefore a lawful recipient of those earnings. This is certainly better than leaving the money to the foreign bank, or destroying it.

Q - Does the Islamic Development Bank offer any type of financing?

A.I
USA

A - The Islamic Development Bank (IDB) does offer financing with a view to promoting intra trade among the Islamic countries.

The IDB and some Islamic banks and financial institutions have established an "Islamic Banks' Portfolio to achieve these objectives, besides serving as the nucleus of an Islamic financial market.

This Portfolio's main objective is to promote and co-finance intra-trade and instalment sale. It is also an invitation to participate in the promotion of trade links and exchange of benefits among Muslim countries.

The (IDB) manages the operations of the Portfolio as a "Mudarib" according to the Regulations of the Portfolio and decisions of the "Participants' Committee", by making use of its own facilities and human resources and the outside assistance of experts in Islamic Shariah, the Securities Market and other relevant technical fields, if necessary.

The assets and liabilities of the Portfolio are completely separate from those of the IDB. Its accounts are independent from the Bank's ordinary, accounts and are audited every quarter of the Hijra year by two external auditors. Net profits are distributed annually to participants. The resources of the Portfolio are mainly oriented to exporters and importers within the private sector, besides the possibility of financing operations of the public and government sectors.

The different types of financing the Portfolio are involved in are:

Direct Financing - This type of financing is provided only from the Portfolio's resources and within the beneficiary country's ceiling. There is a financing contract between IDB as Portfolio Manager and the beneficiary.

Joint/Parallel Financing - The Financing takes place upon joint agreement among the donor institutions, but there are separate agreements between each party and the beneficiary due to differences in mark-ups, repayment periods or any other terms and conditions.

Syndication - This takes place under the management of the Bank/Portfolio, which invites the co-financing banks and financial institutions.

There are two agreements: (a) a "Mudaraba agreement between the Bank/Portfolio and the Financiers; and (b) a financing agreement between the Bank/Portfolio, as Mudarib, and the beneficiary.

Modes of financing

To finance operations submitted to it, the Portfolio adopts Shariah-compatible modes of financing like:

Murabaha: It is a sale contract at a price considered as the capital, i.e. cost price plus a specific profit based on the fact that the party making the purchase order is getting ready to purchase the item he ordered. The first contract which proves the ownership, has to become effective before the second contract can enter into force and by virtue of which ownership of the sold item is transferred to the party making the purchase order. The maximum period for this mode of financing is 18 months according to the type of commodities, which are mostly intermediate and consumer goods.

Salam: This represents a purchase or sale contract of goods or products to be delivered in the future with advance payment of the price according to Shariah Rules, which stipulate that the price and maturity period should be known, and the quantity as well as quality of the sold item should be defined. The maximum financing period here is 18 months, according to the type of commodities which are mostly intermediate and consumer goods.

ljar (Leasing): Under this mode, any asset owned by the Portfolio is leased upon the order of the lessee who finally owns the item after he settles the final instalment of its price. The maximum period for this mode of financing is 7 years, according to the type of commodities which are mostly machinery, equipment and capital goods.

Instalment Sale: This involves the purchase of a commodity upon the request of a beneficiary and re-sale of the item to him, with payment of the sale price in quarterly or half-yearly instalments. Ownership of the asset is transferred to the purchaser upon its arrival at the port of the beneficiary country. The maximum period of financing under this mode is two years and the commodities are mostly intermediate or capital goods.

Equity: The Portfolio may have equity participation in the capital of Islamic financial institutions as well as industrial, commercial and agricultural corporations.

Q - My question relates to the Islamic unit trust fund, what is its concept and what investments are utilised by the trust?

N.M
Malasysia

A - A unit trust is an investment vehicle which normally suits all categories of investors in the medium and long term periods. In the short term and specialist categories, market volatility is more relective. It is certainly one of the most efficient and cost effective ways of participating in the market. What makes it compliant with the Shariah is that the risks and rewards are shared by the investors who employ the expertise of the professional managers.

There are three important factors which are involved in Islamic unit trusts, western investrment expertise, islamic finance expertise and Shariah guidelines provided by Islamic religious scholars. This way individual Muslim investors, Islamic corporate bodies and financial institutions can participate in the international financial markets. Islamic unit trusts focus mainly on equity investments in Islamic banks and financial institutions, stock markets of Muslim countries and companies managed under the Islamic system.

Investments used by Islamic unit trusts include: Mudarabah in which all the capital of a business is provided by the unit trust and the business expertise and management is the responsibility of the third party. Profits are divided between the third party and the Trust in accordance to the terms of the contract.

Murabahah in which the third party wishing to purchase equipment or goods requests the Trust to purchase the goods at cost and add a reasonable profit, which will accrue to the Trust.

Musharaka, which is a joint venture agreement by which the Trust advances funds, which added to a third party's funds produces a participation in the equity of the venture. Profits and losses are shared by the parties in direct proportion to their contributions.

Ijara and Ijara Wa Iktina which is a contract under which the Trust finances equipment, a building or entire project for a third party against an agreed rental, together with an undertaking from the third party to make payments to the Trust which will eventually permit the purchase by the third party of the equipment or project. The difference in value between the cost of the original finance and the total payments made by the third party would be for the benefit of the Trust.

Q - Is it ok to invest in the stock market (not options) by actually buying and selling stocks for companies that are NOT involved in haram deallings? And under what conditions?

M.A
Pakistan

A - Modern scholars of Islamic law have determined that, when certain conditions are met, it is lawful to invest in the stock market, and that the earnings which result, if any, will be halal. In fact, when you purchase shares in a company you actually acquire an equity interest, which means that you, as a shareholder, are actually a partner in the business. Then, as a partner, your equity is exposed to risk so that you actually share in either profits or losses. All of this equates to the Islamic concept of musharakah and is clearly halal.

Even so, there are several conditions that must be satisfied before one may invest in stocks. To begin with, one must be sure that the business of the corporation offering the stock must be halal. This means that the corporation must not be involved in any of the "sin" industries like entertainment, alcohol, pork, conventional finance, and so on. Of course, this is a vast subject with many details. In general, however, the broad guidelines are self-evident.

Scholars have developed another set of criteria for stocks, and these have to do with the capital structure of the corporation. These criteria are three, and their purpose is to determine the extent to which a corporation is involved in riba. In other words, these criteria represent tolerance levels for eligibility; companies that stay within the prescribed criteria, or screens, may be invested in by Muslim investors. On the other hand, if a company's capital structure is such that it goes beyond the tolerance levels, or falls outside of them, then it will not be lawful to invest in that company. Again, without going into details, the three financial screens are:

1. total debt divided by total assets must be less than 33%

2. accounts receivable divided by total assets is equal to or greater than 47% (where receivables = current + long term receivables)

3. non-operating interest income must be less than 10%

Of course, these criteria are the results of modern fiqh scholarship and should be understood to represent the current state of thinking on the subject. As such then, they represent interim tolerance parameters and not the last word on the subject. In recognition of the sensitivity of the subject, it is recommended that Muslim investors place their money in Islamic mutual funds that are professionally managed and have the added guarantee of a qualified Shari`ah Supervisory Board.

In fact, the importance of such a Board cannot be underestimated. Obviously, there is the matter of determining which stocks qualify on the basis of the criteria outlined above; and such decisions will best be made by a Shari`ah Board. Oftentimes, Shari`ah Suprevisory Boards will work hand in hand with money managers on issues related to these criteria. But beyond that there are several other areas of importance for Muslim investors. Perhaps most importantly, there is the matter of purification. From the balance sheets of corporations, if it is determined that the company has non-operating interest income (though less than 10%), then this must purified. The Shari`ah Supervisory Board will ensure that this is being done; it will also advise management as to what should be done with the funds collected through the purification process. Likewise, the Shari`ah Supervisory Board will ensure that the management of the fund will manage cash reserves in a manner that complies with Shari`ah teachings, and that the strategies of the fund, and its policies as well, are Shari`ah compliant. For example, many funds have defensive strategies which require that when the stock market is underperforming, or volatile, holdings there will be liquidated in favor of more stable instruments like treasury bills, or commercial paper, or bonds, or the like. A Shari`ah Board will see to it that such steps are avoided, and that only halal alternatives are chosen.

In short, if a Muslim investor is comtemplating a substantial investment in the stock market, s/he must be careful to do so prudently; both in terms of profitability and in terms of Shari`ah compliance. To ensure profitability, particularly in the long run, prudence dictates that the investor seeks out a reliable and established Islamic mutual fund. And to ensure Shari`ah compliance, the investor should be sure that the fund is supervised by a reputable board of Islamic scholars, i.e., scholars who combine knowledge of the Shari`ah sciences with a practical understanding of modern finance. Al hamdu lillah, the number of such funds is on the increase; and with the tawfiq granted by Allah, it is hoped that a variety of Shari`ah-compliant alternatives will soon be available to Muslims in need of financial services, including banking, insurance, and investments.

Q - This question relates to debtors defaulting on an Islamic finance based transaction. Specifically, most non-Muslims are concerned about the debtor defaulting in their payment. In the conventional system, defaults in payment of loans is punished by the imposition of interest for the time extension. However, under the Shariah, this is not allowed as it constitutes riba al-nasiah. Moreover, Islam encourages the creditor to give time extension when the debtor fails to pay the debt. How does the creditor discourage the debtor from defaulting? Can a penalty be imposed on the debtor for defaulting? What factors do you consider when deciding whether an extension of time should be given?

M.S
Pakistan

A - It is necessary to bear in mind that there are basically two categories of financing, loans and investments. Under loans there is basically one type that is provided for by the Shariah which is Qard Al Hasan - a loan granted on compassionate grounds free of interest or service charge. Only certain categories of people qualify. The other category includes mudaraba, murabaha, ijarah, musharakah etc.

Islam makes a distinction between two categories of defaulting debtors. One type is he who defaults by necessity, i.e. a person whose financial situation is such that with the best of intentions he simply lacks the means of paying. The Qur'an is explicit that this is the debtor who deserves compassion and to be given a grace period. It is required that the defaulter be given respite until he is able to pay. The Holy Qur'an expressly states:

"And if the debtor is in difficulty, grant a delay until a time of ease. But if ye remit it (the debt) by way of charity, that is best for you if ye only knew. (2:280)

This verse suggests that creditors should readily grant pressed debtors additional time to pay. Islam does not encourage a creditor to give an extension to every debtor who defaults. The extension is for debtors in genuinely dire straits.

As for the second type, the debtor who refuses to pay even though he has the

means, he is a perpetrator of injustice (zulm) who, far from deserving alms, exposes himself to possible punishment.

The Holy Prophet SAW condemns the person who delays the payment of his dues without a valid cause. He said in a hadith "The well off person who delays the payment of his debt subjects himself to punishment and disgrace".

The fulfilment of one's obligation under all contracts is a religious duty for every Muslim. Allah says:

"O ye who believe! Fulfil (all) your undertakings." (5:1) And He says:"...and keep the covenant. Lo! of the covenant it will be asked." (17:34)

So he who defaults deliberately contravenes Allah's law. The Prophet S.A.W. for this reason said in a hadith: " the defaulting (matl) of a man of means (ghaniyy) is wickedness (zulm)."

With regards to enforcement of the debt, the contract entered into between the Islamic financial institution and its client is legal and valid and in the event of default the Islamic financial institution can exercise its right in court to enforce the contract based on a creditor and debtor relationship.Some Islamic jurists hold that that which is compulsory in religion is enforceable in law. Also there is a majority view that anything prohibited in the Shari'ah if committed can be punished under what is called ta'zeer, where the punishment is not specified.

On the penalty to be imposed on the defaulter, the Judge exercises his discretion depending on the nature of default. He can admonish, threaten, disgrace or even jail the defaulter and if necessary dispose of his asset to pay the debt. However, it is generally agreed by Islamic jurists that a monetary fine is not one of the options open to the Judge in this case as this would amount to a monetary penalty for delayed payment, which is riba or interest.

Some contemporary views suggest that such a fine is permissible if it is applied to charity as a deterrent, but this seems to some as, at best, doubtful in its validity.

On what measures an Islamic bank can take to protect itself from defaulting clients, firstly, Islamic banks operating in a non-Islamic environment will need to ensure that the laws of the land punish defaulters on commercial contracts or have deterrents as a fall-back. Secondly, and perhaps more importantly the onus is higher in an Islamic bank for establishing the character of the borrower, by obtaining a character reference, possibly a credit check of the client's past borrowings. The primary assumption is that this situation should not arise as every true Muslim should pay his debts when due as a religious obligation.

And Allah knows best

Q - If a buyer is unable to pay for goods he/she has ordered, is it lawful for the bank to purchase the goods from him/her by making the payments that remain? And may it then enter into a new contract with the client for a lease, purchase, or murabahah sale of the goods, on condition that the client repays the bank within a fixed period of time?

F.L
Malaysia

A. The Shariah Advisory Board's opinion on this matter is that if the new contract is concluded with the client for an amount greater than the previous one, the bank will have entered into an unlawful transaction. The Board further clarified that if the amount in the new contract is the same as the previous one, the bank will derive no benefit from the transaction, and there will therefore be no reason to enter into a new agreement, unless its purpose is nothing more than to help its client.

Q - I wonder if you have any information about Islamic banking and derivative instruments. This involves a foreign exchange deal with a client. The issue that arises is whether the client would be better suited to using currency options rather than simply fixing the exchange rate forward by using a forward contract. Is it allowed under Islamic banking law to use such an instrument? Are currency options in dealings allowed under the Shariah?

G.N
Dubai

A - Contemporary Muslim jurists are divided on the matter of forward currency contracts. They are generally agreed, however, on the impermissability of currency options. The general practice among Islamic banks is that they will agree in advance on the sale and purchase of foreign currency at a certain rate, with the understanding that the transacting will take place at a later date. Islamic law treats this arrangement as a promise, and several of the classical jurists held a promise to be binding. The caveat here is that if the promise is linked to anything that suggests a contract, such as a down payment, the deal will take on aspects of a sale of debt for debt, which is clearly prohibited by the Shariah

Q - I would like to get some clarification on an investment strategy (market neutral) that I wish to employ in a new Islamic hedge fund. The hedge fund will take a long position in one stock (buying) and taking an offsetting short position in another stock (selling) to neutralise the inherent risk. The short selling is not for the purpose of speculating but solely for hedging purposes and risk control purposes.

I am looking for some comments that have been made by Islamic scholars on the matter or if you can guide me as to whether such a strategy would be permissible under Islamic law to someone who can make qualifying remarks.

A.M
U.K

A - Short selling is based on an educated guess that stocks will go either up or down in value in the near future. Such a guess may be characterized as speculation, and there is nothing wrong from a Shari`ah perspective with speculation unless it involves ambiguity in the essentials of the contract (in which case it becomes gharar and will lead to the invalidation of the contract). Likewise, the strategy for managing risk by taking offsetting positions is one that is consistent with Islamic principles. But the problem in the strategy that you outline in your question is in the details of short selling.

Generally speaking, short selling involves the borrowing of stock and then their sale in anticipation of later repurchase at a lower price. The strategy is completed thereafter when the borrowed stocks are returned to their owner. Selling long is essentially the reverse of this process. The problem for Islamic investors is that if they are to profit from the sale of stock, they must own the stock. Under those circumstances, the advantages of short selling, the limited capital exposure and the capital gains leverage, are nullified. Even so, the strategy of taking offsetting positions is a valid one.

Q - In the recent past many conventional banking institutions have opened Islamic banking divisions within the same bank to extend Islamic products to their customers to attract this line of business which had proved profitable. In addition they also established banking relationships with other Islamic banks operating under the strict guide lines of the Sharia. The balance sheets of such banks reflect both conventional and Islamic banking products. Is it permissible for conventional banking institutions to intermingle in Islamic products to their advantage and whether the return on investments received by customers based on Islamic products through such conventional banking institutions are halal and permissible under Sharia.

M.C
Saudi Arabia

A - Before answering this question, a short introduction may be in order.

A number of conventional banks have begun to offer Islamic products. Some of these banks are Muslim owned and managed, and some are not. Contemporary scholars have cooperated with the Muslim-owned banks for two reasons; firstly, because the services and products they offer are halal, and secondly because they hope that if the Islamic operations of these banks are successful, then perhaps they will convert all of their operations to Shari`ah -compliancy. The cooperation of scholars with non-Muslim owned and managed financial institutions is based on their understanding that Muslims are presently in need of the experience and influence that these institutions possess. Thus, even though there is little likelihood that such institutions will ever convert all of their operations to comply with Shari`ah principles, the purpose they serve at the present time is to offer stability in serving the financial needs of Muslims individuals and organizations. Likewise, their presence in the Islamic investment sector lends the sector an important degree of credibility. Finally, these institutions are ideal vehicles for the training and education of a new generation of Muslim financial professionals.

Now, with regard to the question of whether or not the profits earned by the Islamic products offered by these banks are halal, the short answer is yes, the profits are usually halal. In other words, if the ways in which these profits are earned are known to be Shari`ah-compliant, then the profits will be halal. But investors should be careful. Conventional institutions have been known to take advantage of the religious sentiments of Muslims by marketing products that are Islamic in name only. The only guarantee against this sort of abuse is the presence of a reputable Shari`ah Supervisory Board. Some conventional banks have even attempted to abuse the institution of Shari`ah Supervisory Boards bymarginalizing their participation and limiting their access to the bank's dealings. As a general rule, however, the presence of reputable scholars on a Board will ensure that the products it offers are indeed Shari`ah compliant.

Q - I have a money market account in a bank in the USA. Is this a lawful account from the Islamic point of view? I would also appreciate some information about what type of investments the money market is using?

Dr M.O
USA

A - In a traditional interest based system such as the one you are investing in, the money market becomes a means by which financial institutions can adjust their balance sheet and finance positions in these markets. Short-run cash positions, which exist as a result of imperfect synchronisation in the payment period become essential raw material for the presence of money markets. A money market in this case becomes a source of temporary financing and an abode of excess liquidity in which transactions are mainly portfolio adjustments and no planned or recently achieved savings need be involved.

Within the Islamic financial system money markets can be operative, provided they have assets which are eligible for this market. The existence of broad, deep and resilient markets in which financial intermediary assets or liabilities can be negotiated is a necessary ingredient. The basic raw material for the money market is the existence of pools of excess liquidity.

Further in an Islamic financial system, the liabilities that an economic unit emits are by necessity closely geared to the characteristics of its investments. The liabilities that financial intermediaries emit are expected to have nearly the same distribution of possible values as the assets they acquire. Also they must be flexible enough to handle cash shortage periods for individual banks based on some form of profit sharing. Thus given that debt instruments cannot exist, money market activities will have characteristics different from the traditional system.

Investments in the Islamic money market system include instruments that satisfy the liquidity, security and profitability needs of the markets while at the same time ensuring compliance with the rules of the Sharia, i.e, the provision of uncertain and viable rates of return on instruments with corresponding real asset backing. One principal activity of money markets in this system are arrangements by which the surplus funds of one financial institution can be channelled into the profit-sharing projects of another.

Q - What is the Shariah ruling in a case where an exporter sends goods to the bank, offering them for sale either to the bank directly, or through the bank to another by means of agency?

M.A
Bahrain

A - There is nothing to prevent the bank from buying the goods for itself, or from selling them to another by acting as the exporters agent. When the bank buys the goods for itself it will have the right to sell them to any of its clients by means of murabaha or musawamah (a sale of bargaining), for cash or credit. The source of this ruling is the verse in the Quran that says: Allah has made sales lawful, but has prohibited riba (2:275).

Q - What is the Shariah ruling in regard to the following transaction?

A company enters into a transaction with the bank to install equipment that the company owns for an agreed price; and then, in a separate transaction, the bank contracts with a contractor for the installation of the equipment for a certain price.

S.H
Egypt

A - From a Shariah perspective, the bank's undertaking such business is lawful as long as the two transactions remain separate.

Q - Certain reservations arise with regards to companies whose shares are sold on credit, such as the company not being careful about lending with interest and borrowing from interest based banks. And that the company's holding is cash either in deposits in banks or in funds. The question for consideration, then, is whether or not it will be lawful to deal in the shares of such a company for either cash or credit?

O.A.M
Kuwait

A - There is no legal impediment to dealing in the shares of such a company on credit when the price is greater than the cash holdings of the company so that there will be something to match the cash holdings and the rest will be matched by the other assets. In answer lo the second part of the question, regarding the lending and borrowing on interest, if the majority of the company's transactions are of the nature of lending and borrowing on interest, then it will not be lawful to deal in its shares. However, if these transactions are only undertaken occasionally and do not constitute the focus of its activities, then it will be lawful to deal in the company's shares. The rationale for this ruling is that such dealings are sometimes unavoidable, and may therefore be overlooked.

Q - A customer approached our company to buy merchandise and promised to buy it on a deferred payment basis. We made arrangements for the merchandise to be shipped. Before the arrival of the merchandise, we received information that the customer had financial problems and was indebted to his creditors, to the extent that he was under investigation by the courts. Our dilemma is, do we carry out our promise to him and deliver the merchandise (as agreed) thereby becoming a part of the court investigation? Or do we cancel delivery in order to protect our rights?

J.K
Indonesia

A - A promise, according to the entire community of jurists, is not legally binding. It is essential, moreover, to protect the wealth of the shareholders and depositors by not delivering the goods to a wanted person. In the event that a contract has been completed, and knowledge of the buyer's situation before delivery of the merchandise is revealed, no delivery should be made. This is because the seller is more rightfully entitled to the goods than the rest of the person's creditors, as the goods that were sold to him might well be confiscated and never recovered owing to the buyers bankruptcy.

Q - May an Islamic institution lawfully finance a project to construct a residential building on land owned by its employees, and then sell the building to them for the cost of construction plus an agreed upon profit?

M.H
Saudi Arabia

A - Such an arrangement is unlawful for the reason that it represents a loan with profit and not a sale. This is because the project involves no profit that accrues lo either of the parties lo it even if it is called murabahah.

Q - Are fees charged by a bank or finance house in return for services provided to patrons at the time of purchase, cancellation and changing possession (of cars), in accordance with the principles of the Shariah?

I.S
Pakistan

A - It is not lawful to take an amount in return for cancelling a sale because the business done by the bank or finance house in cancelling a sale, and all that follows, is in fact what the bank or finance house is supposed to do in its capacity as a party to the cancellation.

Q - If a company sells merchandise for a delayed payment and seeks to retain possession of the goods as security until the buyer has paid in full, is this lawful?

M.A.I
Malaysia

A - Such an arrangement will be lawful only if both parties agree to it. In doing so, the buyer will be foregoing his right to take immediate possession of the merchandise, in return for the deferred payment. The goods may be considered security for the purchase price. If the goods are destroyed, it will be the responsibility of the seller, who is the pledgee, and who will pay either its value or its price, whichever is lowest.

The reason for this is because the hand of the pledgee on the security is the hand of the guarantee, because he was satisfied with the possession of the goods, as a guarantee that what he was owed would be paid. This opinion is based on the Hanafi school.

Q - Is it permissible for a bank or finance house to open letters of credit for the importation of women's clothing, which may not be modest?

M.D
USA

A - Such clothing is not in itself prohibited. Rather, the prohibition is for its use in ways that do not accord with the Sharia, for example lewdness, or in the display of beauty to those for whom that display is not permitted. Since it is not possible to say with authority that the clothing will be used in ways that are not pleasing to the Almighty, it will therefore be lawful to open such letters of credit.

Q - As a bank executive, my work takes me to different parts of the world, what is the lawfulness of consuming foods such as beef, chicken and other foods prepared with their by products in non-Islamic countries?

M.U
Ukraine

A - The general principle with regards to food products particularly in Jewish and Christian countries is that they are lawful unless there is reason to believe that they have been tainted by pork or anything else that is unlawful for consumption by Muslims. In Communist and atheist countries, however, the general principle is that it is unlawful to consume food products unless there is reason to believe that they are halal and have been slaughtered in accordance with Sharia teachings.

Q - What is the Sharia ruling in regard to an advance received from a client in return for his/her binding agreement to buy goods from the bank and to be consistent in repaying his instalments. Further also that the amount advanced will be kept in a current account until such time as all responsibilities in regard to the shipment of the goods have been met.

Y.S
Germany

A - Such an advance given to the client is what is called `urbun, and is actually a price paid by the buyer in order that he may have the option for a certain period of time to either continue with the deal or pull out.

Where the buyer decides to continue with the deal, the advance becomes a part of the price. In the event the buyer decides not to go through with the deal, the advance becomes the right of the seller, and is forfeited by the buyer. Before the contract of sale is completed, or in cases of a pledge to purchase (such as Murabaha), the advance given by the purchaser is not called `urbun, nor does it have the same legal properties.

Rather it is an amount given by the purchase pledger so that if he fails to live up to his end of the contract, the amount advanced may serve to recompense the bank for its expenses. If there is a remainder, after the bank is recompensed, it will be returned to the client. If the advance is insufficient as recompense, the purchase pledger should pay the rest.

Q - Is a transaction lawful, where a person wants to buy a new car from a Finance House by selling his used car to a third party who will then take possession of the used car and pay its price to the Finance House. Further, the applicant will then pay the difference and take possession of a new car from the Finance House, or the amount will be an advance. Finally, is it permissible if the applicant agrees to buy a car from the Finance House in return for the purchase of his used car by a third party?

L.U
United Kingdom

A - In the opinion of the Board, the first part of the question describes a situation similar to selling the used car to another company. Then the company pays its price to the seller of the car, or authorizes its transfer to whomever the seller wishes, like the Finance House for example. Then the patron agrees with the Finance House to pay the remainder in return for his taking possession of the new car. This form of transaction is permitted by the Shari'ah I and there is nothing wrong with it. In the second part of the question, the patron's agreeing to buy a car from the Finance House in return for the purchase of his used car by a third party, the patron's agreeing (lit. obliging himself) is not lawful. Rather, what is lawful is if the applicant buys a car from the Finance House and its price includes both the used car and an amount in cash, regardless of whether the sale takes place all at once or at a later time; but without specifying any price for the used car, or referring to it in the contract.

Q - What is the Shari'ah ruling in regard to the issuance of certification for a client that states that he has a balance in his account for a specific amount when, in fact, he does not possess that balance?

A.S
Saudi Arabia

A - Certificates granted concerning account balances must be in keeping with the truth. If the patron has no balance in his account, he may be loaned a sum for his account and given a certificate to that effect.

Islamic Mortgages

Q. I have a problem, my husband does not want to buy a house here in USA because of mortgages (interest) but we are paying 1800 US$ dollars every month. So could you please send me the lists of those Islamic banks that do interest free banking. Thanks

S. S
USA

A. Thank you very much for your e-mail. Regarding Islamic financial institutions that offer Shariah compliant mortgages in the US, please contact:

1) United Bank of Kuwait
(Al Manzil Islamic Finance)
New York 10022
Tel 1 212 9068500
Fax: 1 212 3194762
2) Ameen Housing Co operative
800 San Antonio Road, Suite 1
Palo Alto, san Francisco CA 94303
Tel: 415 8560440

Q. I am a Muslim resident of NY, USA, a US citizen. Our family has been living in the US for about 15 years now. We are in the process of looking for a suitable house for our family. I would like to know if you offer interest free loans, even if they cost us more than interest loans in the long run, anything not to involve ourselves in riba.
Please get back to me with your answer.

R. K
USA

A. Thank you very much for your enquiry. Unfortunately we are not a financial institution, hence do not provide any Islamic financial services. Our institute is dedicated to the promotion of Islamic Banking, we are involved in publications and offer training and research programs. There are financial institutions in the US that do offer Islamic housing financing.

Q.I wonder if you can send me details of the banks that are offering Islamic mortgages in the UK preferably on a flexible payment scheme etc.

L. M.
UK

A. Please contact the Islamic Investment banking Unit of the United Bank of Kuwait, London, they offer Islamic mortgages. Contact details: 0207 487 6626.

Q - A person who owns property in a European country and pays (real estate) taxes on it, subsequently has the money earning interest in a European bank. Is it lawful for this person to take interest and use it to pay the property taxes?

A - It is an established rule that interest earned from deposits in riba-based banks must be disposed off by charitable means, other than the construction of mosques or the printing of the Qur'an. No obligation may be discharged with the interest; so it may not be used to pay taxes or debts.

Q - People in western countries buy homes by means of mortgages. My question concerns the lawfulness of buying a home in cash (no mortagage) from an owner who originally bought the home with a mortgage, and for which there is still an outstanding amount owed to the bank? Once the home is sold, the previous owner will pay off the mortgage with the proceeds of the sale and keep the rest. Secondly, if I own a home, can I sell it to a person who will finance his/her purchase of the home by means of a mortgage? Should I care where the money I receive as payment for the home is coming from?

M.F
U.S.A

A - This question brings up some important issues. To begin with, it is clear that conventional home financing in most western countries is based on the idea of mortgaging which, in turn, is based on riba and thus repellent in the extreme to all Muslims. Even so, a number of reputable Muslim scholars have written fatwas which allow, on the basis of legal necessity (darurah), the purchase of homes in the west through mortgages. These fatwas are based on the assumption, however, that no Shari`ah-compliant alternative is available. Should such alternatives become available, however, the legal necessity will no longer exist, and the fatwas will no longer be valid. Allah willing, in the near future, Shari`ah-compliant alternatives to mortgages will become available to Muslims worldwide. None of this, however, changes the question above.

The first part (a) of the question asks whether or not it is lawful to purchase, for cash, a home financed by the seller through a mortgage which, at the time of sale, has not matured (i.e., the seller has not finished paying off the mortgage and plans to use the cash from the sale to do so). Thus, the concern of the questioner in this instance would appear to be in regard to hadith prohibiting one's direct and indirect participation in riba. In the case mentioned in the question, a part of the cash payment advanced by the questioner would undoubtedly be used by the seller to pay off a mortgage. In this manner it would appear that the buyer is indirectly involved in the payment of riba.

The second part (b) of the question is similarly concerned with indirect involvement in riba, but from another perspective.

In fact, there is no involvement in either case, neither direct nor indirect. The most that can be said is that there is an appearance of involvement, but appearance and reality are two different matters.

In the first part of the question, the transaction of sale is compliant in every aspect with the teachings of the Shari`ah. It takes place between two compentent parties, there is an offer and its acceptance, the object of the sale (a home) is itself halal, and the purchase price is paid by halal means, or cash. The subsequent uses to which the seller may put that cash is of no legal consequence to the sale. The seller may give it to the poor, or he may spend it on sin. In either case, the sale of the house is valid, and the buyer may rest assured that s/he has done nothing wrong. The same is true in regard to the second part of the question because there, again, the sale is completely Shari`ah-compliant. Even though the buyer has financed his end of the deal by means of a mortgage, the bank with which he has contracted, or the mortgage company, will pay cash to the seller. In this manner, then, the transaction described in the second part of the question will be perfectly halal.

While the caution on the part of the questioner is to be admired, it must be understood that a Muslim is responsible for ensuring that his or her transactions are halal. Beyond that, money will pass through the hands of all manner of people, honest and dishonest, just and unjust, and for all manners of purposes, halal and haram. In his work entitled The Book of the Halal and the Haram, Imam Abu Hamid al Ghazali wrote:

One who knows for a certainty that the wealth of the world has definitely had the Haram intermixed with it need not abstain from buying and selling, or from eating, because that would be an undue burden. And Islam is not a burden. This is attested to by the fact that in the time of the Prophet of Allah, Allah bless him and grant him peace, when a shield was stolen, and when an abba was misappropriated from among the spoils of war, no one refrained from buying shields or abbas. The same applies to anything stolen. Likewise, it was known at that time that certain people were making usurious transactions in dinars and dirhams, yet neither the Prophet of God, upon him be peace, nor his Companions refrained from dealing with dinars and dirhams. Essentially, then, the world will be free of the Haram only when people stop doing wrong, and that is impossible.

Q Muslims in the UK are greatly interested in purchasing homes through Islamic financing. What procedure does this entail and how does it function?

A. A Islamic banks can participate in home financing on the basis of diminishing Musharakah.

This concept requires the financier and the client to participate in the joint ownership of a property. The share of the financier is further divided into a number of units.

The client is then able to purchase those units one by one periodically, thus increasing his own share till all the units of the financier are purchased making the client the sole owner of the property.

Transactions involved in Diminishing Musharaka

The proposed arrangement is based on the following transactions:

The first step is to create a joint ownership in the property. There is no objection from Islamic scholars against structuring this transaction.

The second part of the arrangement is that the financier leases his share in the house to the client and charges rent to him.

Islamic scholars also permit this transaction, however where the undivided share is leased out to a third party, its permissibility has been a point of contention between Muslim jurists.

Imam Abu Hanifa and Imam Zufar are of the view that the undivided share cannot be leased out to a third party, while Imam Malik and Imam ShafiT, Abu Yusuf and Muhammad Ibn Hassan hold that the undivided share can be leased out to any person.

But so far as the property is leased to the partner himself, all of them are unanimous on the validity of this Tjarah leasing transaction that eventually results in full ownership.

The third step in the arrangement is that the client purchases different units of the undivided share of the financier. If the undivided share relates to both land and building, the sale of both is allowed according to all the Islamic schools.

Similarly if the intention is to sell the undivided share of the building to the partner, all the Muslim Jurists also, unanimously, permit it. Again, there is a difference of opinion if it is to be sold to a third party.

It is clear from the previous three points that each of the transactions mentioned above are allowed per se, but the question is whether this transaction maybe combined in a single arrangement.

The answer is that if these transactions have been combined by making each one of them a condition to the other, then the Shariah does not permit this.

It is a well-established rule of the Islamic legal system that one transaction cannot be made a pre-condition for another.

However, the proposed scheme suggests that instead of making two transactions conditional to each other, there should be an undertaking from the client.

Firstly, to take the share of the financier on lease and pay the agreed rent, and secondly, to purchase the units of the share of the financier of the house at different stages.

This leads to the fourth transaction, which is the enforce-ability of such an undertaking or promise. It is generally believed that an undertaking or promise to do something creates only a moral obligation on that person, which cannot be enforced through courts of law.

However there are a number of Muslim Jurists who hold the view that promises are enforceable, and the court of law can compel people to fulfill their promise, especially, in the context of commercial activities.

Some Maliki and Hanafi jurists have declared that an undertaking or promise can be enforced through courts of law in cases of need. The Hanafi Jurists have adopted this view with regards to a particular sale called bai-bilwafa.

Bai-bilwafa is a special arrangement for the sale of a house where a buyer promises the seller that whenever the seller repays him/her the price of the house, he/she will resell the house hack to the original seller.

Hanafi jurists, on the other hand, have argued that if the resale of the house to the original seller is made a condition for the initial sale, it is not permitted.

However, if the first sale is effected without any condition, but alter effecting the sale, the buyer promises to resell the house whenever the seller offers him the same price. Then this promise is acceptable and it creates not only a moral obligation, but also an enforceable right of the original seller.

The Muslim jurists allowing this arrangement have based their view on the principle that "the promise can be made enforceable at the time of need".

One may raise an objection that if the promise of resale has been taken before entering into an actual sale, it practically amounts to putting a condition on the sale itself, because the promise is understood to have been entered into between the parties at the time of sale.

Therefore, even if the sale is without an express condition, it should he taken as conditional because a promise in an express term has preceded it.

This objection can be answered by saying that there is a big difference between putting a condition in the sale and making a separate promise without making it a condition. If the condition is expressly mentioned at the time of sale, it means that the sale will be valid only il' the condition is fulfilled, meaning that if the condition is not fulfilled in future, the present sale will become void.

This makes the transaction of sale contingent upon a future event that may or may not occur. It leads to uncertainty (Gharar) in the transaction, which is totally prohibited in Shariah. Conversely, if the sale is without any condition, but one of the two parties has promised to do something separately, then the sale cannot be held to be contingent or conditional upon fulfilment of the promise made.

It will take effect irrespective of whether or not the promise is fulfilled. Even if the promise is backed out of, the sale will remain effective. The most that the person whom the promise has been made to can do is to compel those undertaking the promise, through the courts of law, to fulfil that promise.

A claim for actual damages suffered resulting from a default can consequently be made. This makes it clear that a separate and independent promise to purchase does not render the original contract conditional or contingent. Therefore it can be enforced.

Conditions of Diminishing Musharaka

On the basis of the above analysis, diminishing Musharakah may be used for House Financing subject to the following conditions: The agreement of joint purchase, leasing and selling different units of the share of the financier should not be tied up together in one single contract.

However, the joint purchase and the contract of lease may be joined in one document whereby the financier agrees to lease his share, after joint purchase, to the client. This is permitted because Ijara can be effected for a future date.

At the same time the client may sign a one-sided promise to purchase different units of the share of the financier periodically and the financier may undertake that when the client purchases a unit of his share, the rent of the remaining units will be reduced accordingly.

At the time of the purchase of each unit, sale must be effected by the exchange of an offer and acceptance at that particular date.

It is preferable that the purchase of different units by the client be effected on the basis of the market value of the house as prevalent on the date of purchase of that unit.

It is also permissible that a particular price is agreed in the promise of purchase signed by the client.

Q - Is it lawful for the Finance House to purchase real estate owned jointly between partners (four brothers, each with their own share) and then to sell it to one of them at his request? Secondly is it legitimate for the Finance House to purchase the share of one of two partners who jointly own real estate, and thereafter to sell the share to the other partner?

A.K
India

A - With regards to the first question, if the Finance House buys the shares of the other heirs, and not the share of the person who came to it, and then sells the shares of the house it bought to that person, there is nothing to prohibit it legally from doing so, as such a deal is lawful and without reproach. On the second question, if the Finance House buys the entire house from the heirs, and then sells it to one of them, that will be lawful from a Shari'ah perspective so long as the purchase by the Finance House is not made conditional upon its selling the house to one of the heirs.

Takaful on Shari'ah Ruling

Q - Is it lawful to pay a part of the surplus from the Takaful fund at the end of each year into a reserve kept for the purpose of meeting the demands of takaful, when this is done voluntarily by the subscribers to the takaful?

Also will it be lawful if the shares of all those who withdraw (either by notice or owing to non-payment of premiums) from the mudarabah (established for the takaful) during the period of subscription are returned to such a reserve, and the shares of participants to whom takaful payments in excess of their own contributions have been made?

A.N
Saudi Arabia

A - Yes, it is lawful to pay a part of the surplus from the takaful fund at the end of each year into a reserve kept for the purpose of meeting the demands of takaful, when this is done voluntarily by the subscribers to the takaful fund. Also when their consent to the same is obtained in writing on the application form (for the takaful). It will also be lawful if the shares of all those who withdraw (either by notice or owing to non-payment of premiums) from the mudarabah (established for the takaful) during the period of subscription are returned to the reserve, and likewise the shares of participants to whom takaful payments in excess of their own contributions have been made.

Mudarabah on Shari'ah Ruling

Q. What is Mudarabah?

1. Mudarabah:

The term refers to a form of business contract in which one party brings capital and the other personal effort. The proportionate share in profit is determined by mutual agreement. But the loss, if any, is borne only by the owner of the capital, in which case the entrepreneur gets nothing for his labour. The financier is known as ‘rabal-maal’ and the entrepreneur as ‘mudarib’. As a financing technique adopted by Islamic banks, it is a contract in which all the capital is provided by the Islamic bank while the business is managed by the other party. The profit is shared in pre-agreed ratios, and loss, if any, unless caused by negligence or violation of terms of the contract by the ‘mudarib’ is borne by the Islamic bank. The bank passes on this loss to the depositors.

2. Mudarabah:

We may act as managing trustee (‘Modareb’) while you are the beneficial owner (Rab El-Maal). It is our responsibility to invest the funds that you provide. Alternatively, our roles may be reversed, when you, as managing trustee, are responsible for investing our funds. In each case, we shall agree on our relative share of any profits.

3. Mudarabah:

In the theoretical model of Islamic banking Mudaraba has been suggested a technique which shall provide the basis for the Islamic re-organisation of commercial banking sector. In actual practice of Islamic banking, Mudaraba has not made much progress on t he asset side of the balance sheet, although on the liability side the Islamic banks on Mudaraba accept the funds in investment accounts. Mudaraba is mostly translated in English as profit and loss sharing.

There is no loss sharing in a Mudaraba contract. Profit and loss sharing is more accurate description of the Musharaka contract. The Mudaraba contract may better be represented by the expression profit sharing Mudaraba is an Islamic contract in which one party supplies the money and the other provides management in order to do a specific trade. The party supplying the capital is called owner of the capital. The other party is referred to as worker or agent who actually runs the business. In the Islamic Jurisprudence, different duties and responsibilities have been assigned to each of these two.

As a matter of principle the owner of the capital does not have a right to interfere in to the management of the business enterprise which is the sole responsibility of the Agent x. However, he has every right to specify such conditions that would ensure better management of his money. That is why sometime Mudaraba is referred as sleeping partnership. An important characteristic of Mudaraba is the arrangement of profit sharing. The profits in a Mudaraba agreement may be shared in any proportion agreed between the parties before hand. However, the loss is to be completely borne by the owner of the capital. In case of loss, the capital owner shall bear the monetary loss and agent shall lose the reward of his effort. Mudaraba could be individual or joint.

Islamic banks practice Mudaraba in its both forms. In case of individual Mudaraba an Islamic bank provides finance to a commercial venture run by a person or a company on the basis of profit sharing. The joint Mudaraba may be between the investors and the bank on a continuing basis. The investors keep their funds in a special fund and share the profits without even the liquidation of those financing operations that have not reached the stage of final settlement. Many Islamic Investment Funds operate on the basis of joint Mudaraba.

4. Mudarabah:

This is an agreement made between two parties: one which provides ‘100 percent of the capital’ for the project and another party known as a ‘Mudarib’ who using his entrepreneurial skills, manages the project. Profits arising from the project are distributed according to a predetermined ratio. Any losses accruing are borne by the provider of capital. The provider of capital has no control over the management of the project.

Q - Is it lawful for the investor to seek from the contractor (agent-manager) payment of a specific percentage of the contract (for the deal the agent-manager is to undertake as his/her part of the mudarabah operation) in addition to (the agreed upon return from) the capital invested? Regardless of the amount financed, and regardless of whether the operation is profitable or not?

W.Q
Saudi Arabia

A - Such a contract will not be valid because it includes the agent-manager's liability for the capital investment; when the agent-manager is no more than a trustee of the capital and cannot be made liable for it unless he/she has been negligent or incompetent in its use. Secondly, the investor's stipulating that the agent-manager pay a certain amount; when such a condition invalidates the contract because it means that the two partners will not share in the profits.

Q - Where an Islamic Bank owing to its position in the international banking community, undertakes mudarabah operations in partnership with several other banks and financial institutions, some of which are Islamic and some of which are not. And that the bank serves as agent-manager for the group, using the funds they invest to purchase goods and then sells them by means of murabahah, such that the bank authorizes an international firm, as its agent, to purchase goods on behalf of the bank by means of a murabahah sales contract with that company. Is this permitted under the Shariah?

H.Y
Geneva

A - The jurists of all the major legal schools are agreed on the legitimacy of mudarabah transactions. In this regard they cite texts from the Qur'an and the Sunnah. In the Qur'an, the root for the word mudarabah, d-r-b, is used in a verse that clearly indicates the lawfulness of trade: And others who go forth in the earth, seeking the bounty of the Almighty (73:20). In the Sunnah, it is related that Ibn 'Abbas said, "Our tribal leader, al 'Abbas ibn 'Abd al Muttalib, whenever he paid money out in mudarabah, would stipulate to his partner that he must not cross over water with his money, or make camp in a dry riverbed, or buy a fractious mount with it. If his partner did any of those things, he would be held personally responsible. When news of these conditions reached the Prophet of Allah, upon him be peace, he endorsed them."

Given the lawfulness of mudarabah from a Shari'ah perspective, the Board sees no impediment to the bank's purchasing goods on the international market with funds gathered from other Islamic banks and financial institutions in partnership, and then its assuming the responsibility of managing the operation (as agent-manager) as a mudarabah in which it also participates as an investor, regardless of whether its dealings are undertaken on a short or a long-term basis, or take the form of either a sale of trust, such as murabahah, or an ordinary bargained sale.

Q - Is it lawful for the bank to charge its client for consultative services ordered by the bank for the study of a project's feasibility before investing in it with, or for, its client by means of mudarabah?

M.A
Jordan

A - There is no legal impediment to taking payment from a client in return for actual consultation presented to the bank in regard to the study and evaluation of projects for mudarabah, musharakah, ijarah, etc. Services performed after a contract has been signed, however, will be shared equally by the client and the bank; except in regard to interest-free loans in which case all fees will be paid by the client alone after the contract has been signed.

Q - What is the Shari'ah ruling in regard to the bank's paying zakah on the profits earned by investors in mudarabah operations?

P.Z
Egypt

A - There is no legal impediment to the bank's paying zakah from the accounts of its investors so long as it does so with the approval of investors who have authorized it in writing to deduct their zakah portions from their investment accounts; either from their profits or, if no profits are realized, then from the capital investment itself.

Q - It is a well-established fact in international economics that the greater the amount of capital invested, the greater the profits that may be expected. Will it be lawful, therefore, to combine the capital from two or more mudarabah operations in a single investment vehicle, especially when the mudarabah operations are managed by a single firm?

A.M
Cayman Islands

A - The Board sees no legal impediment to combining the capital from two or more mudarabah operations in a single account that is maintained in accordance with the Shari'ah of Islam, so long as the profits and losses are distributed in proportion to the percentage of each shareholder's investment in the mudarabah.

Q - To what extent will it be lawful to include the following condition in a contract for an investment savings account: The minimum daily balance acceptable for participation in investment schemes will be one hundred Dinars. If the balance falls below that amount, the account will become a regular current account, and will no longer be subject to the rules for a mudarabah investment.

R.H
France

A - There is no legal impediment to placing a minimum on the daily balance in the conditions of the contract. If the balance falls below one hundred, the account will be treated like an ordinary current account because a musharakah may be dissolved by means of such a condition.

Q - Is it lawful to transfer mudarabah contracts from one agent manager to another, when there is an express or implicit approval for the same, and/or the transfer is agreed to either, individually or collectively by the investing partners in their capacity as the benefiting owners.

M.J
India

A - It is lawful to transfer mudarabah contracts in the light of the legal principle which states that the agent-partner in mudarabah transactions may be engaged under the following conditions:

a) The investors will not have to pay for the second agent-partner brought in by the first. Rather the two will share in the percentage of the profit specified for the first agent-partner and agreed to by the investor(s).

b) Since the mudarabah contract is not legally binding, it may be dissolved at will by either of the contracting parties.

Q - Is it lawful for the bank in a mudharabah sale transaction, to invest in one of its accounts, a deposit (representing 5% of the value of the sale transaction) paid in by the purchase pledger as a guarantee of payment.

M.S
USA

A - Such an investment is not lawful, regardless of whether the deposit is kept in a current account or in an investment account. This is because the deposit is a (the client's) guarantee against payment and, if it is to be invested, it should be invested to the benefit of the client.

Q - Is the practice of the bank lawful, in coming to an agreement with its clients on an amount that will serve as a ceiling for their transactions over a specified period of time. And within the framework of that agreement, dealings are undertaken with the client by means of murabahah in which the amount of profit is specified in advance of purchases, and on a deal to deal basis. Is this practice in accordance with the Shariah?

S.A.O
Switzerland

A - There is no legal impediment of setting limits on the extent the bank is willing to Finance a client in their original agreement, or to specify the percentages of profit for each and every murabahah deal when the bank receives the client's order, in the understanding that the order represents the clients pledge to purchase. A pledge to buy, however, is not the same as a sale, but rather a binding agreement to but at the time the sale is ready to be completed.

Q - Will it be lawful to distribute monthly or periodical profits to investors in long- term mudarabah operations that will not yield returns until after the passing of several years?

I.M
U.K

A - There is no legal impediment to an agent-manager's distribution of profits from long term mudarabah operations to investors, by periodically paying investors in the for of interest free loans guaranteed by their capital investments. The periods for such payments may be determined by the agent manager. Furthermore the loans will be debited at the final accounting of the profits.

Q - How is the share of profits for each of the parties in a mudarabah operation to be determined?

I.A
Sharjah, UAE

A - It is legally required that whatever is specified as profit for both the bank (the agent-manager) and the investor (the bank's client) be for-mulaled precisely from the joint share, that it be known to both parties, and that it remain intact throughout the mudarabah operation period. Such a determination, moreover, must be included in the mudarabah contract either at the time it is entered into or when it is renewed. If the profit percentage is to be changed in the future, prior notification of such a change must be made, and a period of time must be set, the passing of which will be taken to indicate the investors agreement to the change if he/she has not objected (to it by that lime).

Q - Is it lawful for the working partner in a mudharabah operation to sell the possessions of the financing partner without seeking the permission of the partner?

I.N
India

A - It is not lawful for the working partner in mudarabah to sell his own possessions in exchange for mudarabah money (that he is administering), regardless of whether those possessions are lar removed from the wealth of the (mudarabah financed) company (operation), or actually considered a part of it. It is likewise unlawful for the partner to buy merchandise from the mudarabah operation for himself. In both cases, however, if the financing partner gives special permission, the sale will be lawful.

Murabaha on Shari'ah Ruling

Q. What is Murabaha?

1. Murabaha: (Cost-Plus Financing)

Sale on profit. Technically a contract of sale in which the seller declares his cost and profit. This has been adopted as a mode of financing by a number of Islamic banks. As a financing technique, it involves a request by the client to the bank to purchase a certain item for him. The bank does that for a definite profit over the cost which is settled in advance. Some people have questioned the legality of this financing technique because of its similarity to riba or interest.

2. Murabaha:

A contract of sale between the bank and its client for the sale of goods at a price plus an agreed profit margin for the bank. The contract involves the purchase of goods by the bank which then sells them to the client at an agreed mark-up. Repayment is usually in instalments.

3. Murabaha:

Used if you wish to purchase equipment or goods. We will purchase these items, and then sell them to you at cost - plus a reasonable profit.

4. Murabaha:

Murabaha is the most popular and most common mode of Islamic inancing. It is also known as Mark up or Cost plus financing. The word Murabaha is derived from the Arabic word Ribh that means profit. Originally, Murabaha was a contract of sale in which a ommodity is sold on profit. The seller is obliged to tell the buyer his ost price and the profit he is making. This contract has been modified a little for application in the financial sectoIn its modern form Murabaha has become the single most popular technique of financing amongst the Islamic banks all over the world. It has been estimated that 80 to 90 percent of financial operations of some Islamic banks belong to this category. The Murabaha mode of finance operates in the following way: The client approaches an Islamic bank to get finance in order to purchase a specific commodity. An interest-based bank would lend the money on interest to this customer. The customer would go and buy the required commodity from the market. This option is not available to the Islamic bank, as it does not operate on the basis of interest. It can not lend the money on interest. It can not lend money with zero interest rate, as it has to make some money to stay in the business.

Some portion of total finance may be offered as an interest free loan, however, the banking institutions have to make profit in order to stay in business. Hence, what course of action is open to the bank? The Murabaha model offers a solution. The bank purchases the commodity on cash and sells it to the customer on a profit. Since the client has no money, he buys the commodity on deferred payment basis. Thus, the client got the commodity for which he wanted the finance and the Islamic bank made some profit on the amount it had spent in acquiring the commodity.

There are a number of requirements f or this transaction to be a real transaction to meet the Islamic standards of a legal sale. The whole of Murabaha transaction is to be completed in two stages. In the first stage, the client requests the bank to undertake a Murabaha transaction and promises to buy the commodity specified by him, if the bank acquires the same commodity. Of course, the promise is not a legal binding. The client may go back on his promise and the bank risks the loss of the amount it has spent. In the second stage, the client purchases the good acquired by the bank on a deferred payments basis and agrees to a payment schedule. Another important requirement of Murabaha sale is that two sale contracts, one through which the bank acquires the commodity and the other through which it sells it to the client should be separate and real transactions.

The Murabaha form of financing is being widely used by the Islamic banks to satisfy various kinds of financing requirements. It is used to provide finance in various and diverse sectors e. g. in consumer finance for purchase of consumer durable such as cars and household appliances, in real estate to provide housing finance, in the production sector to finance the purchase of machinery, equipment and raw material etc. However, probably the most common and the most popular application of Murabaha is in financing the short-term trade for which it is eminently suitable. Murabaha contracts are also used to issue letters of credit and to provide financing to import trade.

5. Murabaha:

(Cost-plus financing) This is a contract sale between the bank and its client for the sale of goods at a price which includes a profit margin agreed by both parties. As a financing technique, it involves the purchase of goods by the bank as requested by its client. The goods are sold to the client with a mark-up. Repayment, usually in instalments is specified in the contract.

Q - I have observed that certain banks operating in Saudi Arabia have incorporated clauses in their Murabaha agreement that "In the event of default of payment, the customer will be black-listed and his name circulated to all other banks operating in Saudi Arabia. In accordance with the blacklisting rules the names will appear in the blacklist for a certain period of time even if the customer arranges settlement at a later date".

I feel that this will impose an unnecessary burden on the customers even though they agree to the inclusion of the clause in the Murabaha Agreement at the time of the execution. It is said the terms and conditions should be just and fair relating to transaction under the Shariah. I would like to know whether such conditions imposed in Murabaha Agreement is permissible under the Shariah.

M.M.U
Saudi Arabia

A - The problem of default in Islamic banks has become very serious. In the interest-based loan system if the debtor defaults the interest keeps on increasing automatically which serves as a deterrent against default. But in the case of Islamic bank no extra charge can be imposed after the due date. It is, therefore, suggested by some circles that the defaulters should be blacklisted so that the apprehension of being blacklisted may serve as a deterrent against wilful default. This is an arrangement made on the basis of expedience which is not impermissible in Shariah. Even if this arrangement is not expressly mentioned in the agreement of Murabahah the government may act according to it. However, this should be done only in cases of wilful defaults, but if the debtor has faced a genuine hardship because of which he could not pay on time he must be given respite as expressly mentioned by the Holy Quran. Moreover, this penalization should not be exercised in cases where the debtor has paid shortly after the due date. It is therefore advisable that blacklisting is resorted to after a considerable time subsequent to the due date so that it may be ascertained whether the default was wilful and without a genuine reason.

Q - What is the Shariah ruling with regards to the purchase of a certain service and then its resale to a client? For example, if the bank were to pay a contractor to finish a building, and then sell the service to its client by means of murabaha payable in installments?

A.M.A
Kuwait

A - The sale of services by means of murabahah as envisioned in the question is not lawful. Rather, what is lawful is for the bank to complete the transaction as a contractor itself, or by entering into a contract of manufacture (istisna)

Q - May the bank enter into a murabahah transaction with a client who wishes to order the purchase of music cassettes, such as those used by children in their play?

R.A
UK

A - Aside from the differing opinions on the question of the status of music in Islam, the Board's opinion is that bank should not engage in such transactions in accordance with the legal principle that legitimate means may be obstructed if it is feared that they may lead to illegitimate ends.

Q - What is the Shari'ah viewpoint concerning the purchase of tickets for travel and their resale, on a murabahah basis, to clients, by means of a special arrangement between the bank and the national (or any other) airline?

R.M
Malaysia

A - It is lawful for the bank to purchase tickets from an airline, and then to sell them on the basis of murabahah to its clients, provided that the agreement between the bank and the airline, and the details of how the transaction is to be carried out, are scrutinized beforehand by the Fatwa Council of the bank before the plan is implemented.

Q - What is the Shariah ruling in regard to the opening of a letter of credit for the import of cigarettes, or for its financing their purchase and sale through murabahah?

K.D
Malaysia

A - In view of the differences of opinion in regard to the ruling on smoking, and its prohibition, we will advise the bank to refrain from all such equivocal transactions. The Prophet, upon him be peace, said, "The lawful is self-evident, and the unlawful is self-evident; but between the two lie matters of ambiguity not readily understood by many people. Thus, those who avoid such matters will preserve their religion and reputations. But those who become involved with the ambiguous will (eventually) become involved with the unlawful." It should therefore be clear that the bank should have nothing to do with the likes of these dubious ventures.

Q - Is it lawful for the Islamic bank to invest surplus funds in operations with other banks (sometimes called investment accounts for banking operations) as a part of an initial agreement over the expected profits, as determined by the market prices and the profit margin agreed upon for murabahah sales, with the understanding that the deal will be completed when the portfolio is finally evaluated.

A.M
Bahrain

A. If the intent of the question is that an agreement will be made over expected profits, i.e., as yet unrealised, and that later on the matter will be settled on the basis of actual profits (when the portfolio is evaluated), then this will not be lawful. This is because jurists have resolved that profits will not appear until they are ready to be divided after the initial capital investment is recovered.

Q - May an Islamic bank finance the purchase of shares of stock in a land investment company, or any other sort of company that deals in lawful trade, by means of murabahah?

R.K
Nepal

A - There seems to be no legal impediment to the bank's purchasing shares and then selling them to a third party by means of murabahah, if the company's cash assets are not in excess of its material value, and on condition that the company's business is in no way involved in the unlawful, such as usury, or intoxicants, or pork, or the like.

Q - Is it lawful for the bank, when it sells equipment to a company on the basis of murabahah, to add the costs of installation to the selling price?

H.I
Saudi Arabia

A - It is lawful for the bank to conclude such a deal, provided that the price mentioned in the contract is clearly described as the price of the equipment plus the costs of installation.

Q - Some people have raised questions concerning the lawfulness of murabahah sales on credit for a term because these involve issues that resemble interest. They further question the lawfulness of a credit sale to the buyer, on the basis of the following:

a) Such a transaction implies the sale of something that is not in the possession of the seller;

b) There is a delay in exchange;

c) The transaction involves sales of like for like, dollar for dollar, when the actual

sale is delayed; i.e., there is a mutual exchange of identical currencies;

d) According to the Maliki school, it is unlawful to stipulate the fulfilment of a promise in a contract of sale;

e) Such a sale involves a degree of exaggeration, which is unlawful.

M.O.
UAE

A - Murabahah sales are well known in the Shariah and are lawful by consensus, whether they are conducted for cash or credit. Moreover, the misgiving that murabahah involves interest, as a sale on credit, is without basis, and the same is true of misgivings concerning credit sales on terms.

The Committee affirms the resolution of the Second Conference on Islamic Banking held in Kuwait in regard to the murabahah sales and reservations about compulsion. The text of the resolution follows:

"The conference resolves that a mutually agreed upon promise to transact a murabahah sale to a buyer, following purchase and possession of goods (by a bank) for a specified amount of profit in accordance with a prior agreement is lawful, on condition that the bank will be responsible for loss or damage before delivery, and what accrues from the return of the merchandise if a return becomes necessary.

The promise and its binding nature (to both the buyer and the bank) safeguard the transaction and brings it stability, and therefore serves the interests of both. Thus, it is lawful for the Bank to insist on such a promise, and every bank has the right to follow the advice of its own Shariah board or supervisory body.

In response to those who harbour doubts concerning the validity of murabahah sales to buyers, we will point out the following:

1. This agreement does not involve or imply a sale of something that one does not possess, because the agreement made with the buyer is concluded after actual possession. In addition, there is no agreement on the sale of what is not possessed.

2. Ownership of the commodity takes place immediately upon either a cash or credit payment. Thus, there is no question of a delay of exchange between the parties.

3. A usurious transaction of exchange in a loan on interest takes place when like commodities are exchanged. A lender, for example, will loan a hundred dollars for a certain period of time and will receive in exchange a hundred and ten dollars. In a murabahah sale on credit, however, the exchange is between unlike commodities, like goods and cash. Therefore, how can a murabahah sale be compared to a usurious transaction? It should further be noted that in a murabahah sale, even though the profit is fixed, the seller may still suffer a loss if market prices rise; and if market prices go down, the buyer may suffer a loss. All of this is a function of supply and demand in regard to the commodity, rather than the supply of and demand on cash.

4. The stipulation prohibited by the Maliki school hinges on two points, and neither are present in the murabahah sale described here:

(i) The person who provides the commodity must be an owner of the capital sum;

(ii) The person requiring the commodity must intend to benefit from its price rather than from the commodity itself.

Q - This question relates to a murabahah transaction, where the bank opens a letter of credit in favour of the exporter but before shipment of the goods and payment. And the exporter accepts the bank's offer, i.e indicating its (exporters) agreement to the bank's opening a letter of credit and of the conditions (if any) accompanying it. May such a letter of agreement be considered acceptance (qubul) on the part of the exporter? Such that the transaction is complete? And, if this is indeed the case, then will it be lawful for the bank to dispose of the commodity as it wishes, by selling it, for example, to a purchase pledger, and then sending it to him/her in his/her name directly? Or must the bank take possession of the commodity and then deliver it to the purchase pledger?

Y.I
Sudan

A - It is not recommended that the bank take part in transactions in which the bank does not have a major role to play. Rather, in order to avoid any detriment to itself, and in order to avoid giving the impression that the bank's only role is as a bank roller, the bank should work through an agent in matters of buying and selling. The written agreement on (he part of the exporter to the offer and terms of the bank may be considered express acceptance (qubul). Then when both the offer and acceptance lake place, the transaction will be complete. The bank has no right to sell the commodity to the purchase pledger or anyone else before it receives payment from him/her or his/her agent. The commodity may not be shipped to the purchase pledger or to any other before (he bank enters into a contractual agreement with them.

Q - What is the Shariah ruling with regards to a bank seeking Kafalah (surety) from a purchase orderer in murabahah sales, guaranteeing the safe arrival of goods in working and acceptable condition?

Z.H
UK

A - Kafalah (surety) is lawful from a Shariah perspective because it is a voluntary sort of contract, and may be entered into before any right is established. In this case, the surety given will be as a guarantee against loss.

Q - Is it lawful for the bank to purchase goods from a seller, a third party for the purpose of selling those goods to the bank's client, the second party, by means of murabahah, and then have the bank authorise the second party to take delivery of the goods from the third party directly?

A.Z
U.K

A - It is lawful for the bank to purchase goods from a third party in order to resell the same lo its client by means of a muabahah sale. After the goods have been sold lo the client, the second party, the bank may authorise its client to take delivery of the goods from the third party, but only after the goods have been sold to the bank and the hank has taken legal possession of them such that the goods have become the bank's responsibility. If however such legal possession has not taken place, and the bank has not become liable for the goods, it will not be lawful. This is because the Prophet of Allah, upon him be peace, prohibited one from prohibiting from that for which one is not liable.

Q - What is the Shariah ruling in regard to the Murabaha project for gold mining?

U.M
Kuwait

A - This project is unacceptable because it includes the sale of gold on credit, and in addition does not specify a dale of delivery. Under the circumstances, other alternatives should be studied by the bank; including the establishment of a joint stock company with shares representing material assets, thereby allowing shareholders to earn profits from the mining of gold.

Q - Charitable organisations generally present charitable projects to those desirous of assisting them and of establishing charitable trusts for Muslims. Examples of such projects are the digging of wells in African villages, or building mosques, or the printing and free distribution of books or the Qur'an, and the like. Is it lawful for a company to purchase these charitable services, and then sell them, through Murabahah sales, to persons who want to buy them, the main aim being to make a profit?

A.B
Bahrain

A - What may lawfully be possessed may lawfully be bought or sold; as the possessions of an individual or a group of individuals may be disposed of by the owner or owners as he or they please; like the digging of a well, and the like. Moreover, what may not lawfully be possessed may not lawfully be bought or sold, like a mosque, or land bequeathed as a religious endowment, or a similarly bequeathed well, or anything else that may not be bought or sold.

Q - What is the Shari'ah ruling in regard to tawarruq? What is our responsibility in regard to a person who deals with the Finance House in short term credit and murabahah sales in the trade in which he normally deals, like furniture. This patron came to the Finance House and evinced his desire to make a murabahah purchase of a quantity of cement owing to the rapidity with which it can be resold, as he desired to sell it (quickly) and then make use of the cash for his other mercantile needs.

U.M
Dubai

A - In the terminology of fiqh, tawarruq is a stratagem for generating cash, when goods are purchased on a deferred payment, and then sold for less than the agreed price. Thus, the buyer goes into the deal knowing that he will lose, but accounting the cash worth the loss. Among the classical schools of fiqh, the only one to approve of such a transaction was the Hanbali school. There is no legal bar to this form of sale, though certain scholars have disliked it, particularly if someone habituates this sort of transaction.

Q - What would be the ruling where a bank was offered a deal to purchase a brick factory, including what was owed to the factory and what it owed. The purpose of this procedure was that the Bank would later sell the factory in a Murabahah sale.

All the conditions in the transaction that were required to protect our rights were fulfilled.But the one difficulty that remained in the process was that the factory was being held as security for a debt, and that it would remain as such until the bank took possession of it. What would be the Shariah boards decision in this case?

M.N
Kuwait

A - From a Shari'ah perspective, you are not permitted to buy other than what is actually present in the factory. Its financial responsibilities do not enter into the deal. If the physical plant, however, is pledged as security, the sale is permitted and the pledge will continue in the interests of the pledgee.

Q - In regard to murabahah sales, documents will be handed over to the purchaser so as to enable him to take delivery of the merchandise. At times, there will be demurrage charges on the merchandise, or a fine that is to be paid to customs owing to a delay in clearing the merchandise. My question is, who is to pay the fine? The purchaser, or the Finance House?

U.B
Bahrain

A - If the fine was brought about owing to a shortcoming on the part of the seller, the Finance House, then it will be responsible for paying the demurrage. If it was brought about by the buyer, however, he will be responsible.

Musharakah on shari'ah Ruling

Q. What is Musharakah?

1. Musharakah:

The term refers to a financing technique adopted by Islamic banks. It is an agreement under which the Islamic bank provides funds which are mingled with the funds of the business enterprise and others. All providers of capital are entitled to participate in the management but not necessarily required to do so. The profit is distributed among the partners in predetermined ratios, while the loss is borne by each partner in proportion to his contribution.

2. Musharaka (Partnership Financing):

This is a classical partnership agreement. All parties involved contribute to towards the financing of a venture. The parties share profits on a pre-agreed ratio while losses are shared according to each parties equity participation. Here again the reason is because in Islam, one cannot loose what they did not contribute. Management of the venture is carried out by all, some, or just one party member.

3. Musharaka (Joint Venture)

We add our funds to your funds, and participate in the equity of the project. We share profits and losses in direct proportion to our contributions.

4. Musharaka:

Musharaka is another popular techniques of financing used by Islamic banks. It could roughly be translated as partnership. In this technique two or more financiers provide finance for a project. All partners are entitled to a share in the profits resulting from the project in a ratio which is mutually agreed upon. However, the losses, if any, are to be shared exactly in the proportion of capital proportion. All partners have a right to participate in the management of the project. However, the partners also have a rig ht to waive the right of participation in favour of any specific partner or person.

5. Permanent Musharaka:

In this form of Musharaka an Islamic bank participates in the equity of a project and receives a share of profit on a pro rata basis. The period of contract is not specified. So it can continue so long as the parties concerned wish it to continue. This technique is suitable for financing projects of a longer life where funds are committed over a long period and gestation period of the project may also be long.

6. Diminishing Musharaka:

Diminishing Musharaka allows equity participation and sharing of profit on a pro rata basis but also provides a method through which the equity of the bank keeps on reducing its equity in the project and ultimately transfers the ownership of the asset on of the participants. The contract provides for a payment over and above the bank share in the profit for the equity of the project held by the bank. That is the bank gets a dividend on its equity. At the same time the entrepreneur purchases some of its equity. Thus, the equity held by the bank is progressively reduced. After a certain time the equity held b y the bank shall come to zero and it shall cease to be a partner. Musharaka form of financing is being increasingly used by the Islamic banks to finance domestic trade, imports and to issue letters of credit. It could also be applied in agriculture and Industry.

7. Musharaka (Venture Capital):

This Islamic financing technique refers to a partnership between two parties, who both provide capital towards the financing of a project. Both parties share profits on a pre- agreed ratio, but losses are shared on the basis of equity participation. Management of the project is carried out by both the parties.

Q - Will it be lawful for a company lo enter into a musharakah for a business enterprise with an interest-based bank when there is an understanding that business will be conducted in a manner that conforms to the principles of the Shariah?

H.A
London, U.K

A - There is no legal impediment into entering into a musharakah with an interest-based bank for the purpose of conducting lawful business. The evidence for the legitimacy of this opinion is that the Prophet of Allah himself, upon him peace be peace, is known lo have done business with the Jews, and they dealt with interest. Except that the Prophets dealings with them were confined only lo lawful transactions in which interest was not involved. After him, his Companions did the same.

Q - When a bank agrees to enter into a musharakah with one of its clients for the purchase and sale of goods, will it be necessary for the bank to deposit a cash amount as its share of the capital investment at the time the contract is signed? Or will it be lawful for it to deposit the capital as the need arises?

S.U
Bahrain

A - When the agreement is made between the bank and its client to enter into a musharakah for the purchase and sale of goods, and the amount of capital to be invested (by both parties) is determined, this will be the same as a mutual promise to enter into a partnership. A partnership, however, will not be legal until both parties have actually paid their shares of the capital. Thereafter, all accounting for profits and losses will be based on the percentage of the amounts actually invested by each of the partners.

Q - Will it be lawful for the bank to present letters of surety in return for its receiving a percentage of profits? The letter of surety will be issued for the musharakah accounts, and may be considered a part of the bank's share in the capital investments. Will all of this be lawful?

S.J
Turkey

A - The bank may not lawfully present letters of surety and then consider its doing so a part of its share of the capital investment in a musharakah. This is because surety indicates a readiness to lend, and a loan may not be used for the capital invested in a musharakah because a loan is a debt. So a readiness to lend is even less acceptable. Moreover, if an exporter seeks a letter of surety for a share of profits from a musharakah, he will be taking a fee for the surety. Whereas the Jurists have said, and this has become a legal principle, that it is not lawful to take a fee for a letter of surety. Therefore, it will not be lawful to consider a letter of surety an instrument of the banks financing a musharakah.

Q - Is it possible to securitise a musharakah transaction?

J.O
Saudi Arabia

A - Musharakah is a mode of financing which can be securitized easily, especially, in the case of big projects where huge amounts are required which a limited number of people cannot afford to subscribe. Every subscriber can be given a musharakah certificate which represents his proportionate ownership in the assets of the musharakah, and after the project is started by acquiring substantial non-liquid assets, these musharakah certificates can be treated as negotiable instruments and can be bought and sold in the secondary market.

However, trading in these certificates is not allowed when all the assets of the musharakah are still in liquid form (i.e. in the shape of cash or receivables or advances due from others). It must be noted that subscribing to a musharakah is different from advancing a loan. A bond issued to evidence a loan has nothing to do with the actual business undertaken with the borrowed money. The bond stands for a loan repayable to the holder in any case, and mostly with interest. The musharakah certificate, on the contrary, represents the direct pro rata ownership of the holder in the assets of the project. If all the assets of the joint project are in liquid form, the certificate will represent a certain proportion of money owned by the project.

OMAR KHALED RUMI

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