iSLAMIC BANKING

VIVEK COLLEGE OF COMMERCE
Chapter 1
INTRODUCTION TO ISLAMIC BANKING.
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1.1 INTRODUCTION
Islamic banking a financial institution and its products designed to comply with the central tenets of Sharia (or Islamic law) is one of the most rapidly growing segments of the global finance industry. Starting with the Dubai Islamic Bank in 1975 (and operations in the United Arab Emirates, Egypt, the Cayman Islands, Sudan, Lebanon, the Bahamas, Bosnia, Bahrain and Pakistan), the number of Islamic financial institutions worldwide now exceeds over three hundred, with operations in seventy-five countries and assets in excess of US$400 billion.
Though initially concentrated in the Middle East (especially Bahrain) and South-East Asia (particularly Malaysia), Islamic finance principles are now increasingly found elsewhere. This includes developing economies where the financial sector is almost entirely Islamic (such as Iran and Sudan) or where Islamic and conventional financial systems coexist (including Indonesia, Malaysia, Pakistan and the United Arab Emirates). It also includes developed economies where a small number of Islamic financial institutions have been established and where large conventional banks have opened Islamic financing windows (such as in Europe and the United States).
The global proliferation of Islamic financial institutions has been accompanied by parallel developments in Islamic financial products. Starting with simple prohibitions on usury, investment in tobacco, alcohol, gambling and armaments and a requirement that all financial transactions be based on real economic activity, Islamic financial products now cover a broad range of financial services, including funds management, asset allocation, payment and exchange settlement services, insurance and reinsurance, and risk management.
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For almost all conventional financial products there is nearly always an analogous Islamic finance product.
1.2 THE HISTORY OF ISLAMIC BANKING

Although Islamic Banking can be traced back to 7th Century in Muslim countries, modern Islamic Banking started in Egypt in 1963 by Ahmad EL Najjar. The history of Islamic Banking can be divided into two parts- Ancient and Modern. Ancient Islamic Banking. (From 7th century until 19th century)
I.
The development process of Islamic finance commenced at the beginning of the 7th Century when Muhammad is professed to have received revelations directly from Allah (the God of Islam). The actual date was 613AD when Prophet Muhammad (pbuh) was about forty years old. At that time, the doctrine of financial operations during Muhammads era was derived directly from the Holy Quran and the Sunna (traditions) of Muhammad. Since then, while Islamic Sharia (Quran and Sunna) has ostensibly coordinated all financial transactions between Islamic persons, there has been a continuing process of mutual adjustment between Sharia and the actual financial practices of Muslim societies. In Muhammads lifetime, Islamic methods of finance often drew upon examples from the Prophets experiences. For example, it was pointed out that Muhammad (pbuh) was the first to use the Mudarabah (silent partnership) in trade with rich women named Khadijah (who later became his wife). At that time, Muslims used to practice Musharakah (full partnership) when operating large commercial enterprises under a profit/loss sharing principle. In addition,
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Muhammad made it permissible for people to use sale on credit (bai salam) which was to finance consumption or production without usury and he encouraged Muslims to provide benevolent loans (Quard Hassan). The ongoing Islamisation of Arabic countries meant that Sharia rapidly spread to both Muslims and non- Muslims at this time.
After the death of Muhammad in 632AD, a great expansion of Islam occurred throughout the Arabic states and in large parts of the non-Arab world. The Islamic state in this golden age was dominant in three continents, Asia, Africa and Europe. The Islamisation of economic systems during the four centuries following Muhammads death reached Morocco and Spain to the west, India and China to the east, central Asia to the north and Africa to the south. The extension of Islamic tools of finance is also indicated by historical records of contracts registered between businessmen at the time, including Mudarabah and Musharakah. Islamic finance practices continued largely unchanged until the beginning of the 19th Century. Modern Islamic Banking.(From 19th century till date)
II.
From the nineteenth century, nearly all Muslim countries fell under the control of the Western colonial powers (France in North Africa, Britain and France in the Middle East, Britain in the Indian sub-continent and Britain and The Netherlands in South-East Asia), effectively dividing the Islamic world into many small states. By the mid nineteenth century almost all Muslim-controlled areas fell to the Western colonial powers and thus the existing financial scheme which complied with Sharia was effectively replaced by the capitalist system. From then until the second half of the twentieth century, most Muslim economies were dominated by the economic traditions and systems of Western Europe. However, while commercial banks, insurance companies and other
types of intermediary firms employed conventional methods of finance (mostly as braches or agents of institutions in the colonizing country), Islamic methods of finance were still often practiced between individual Muslims.
With the independence of the Arabic countries from the colonial powers by the second half of the twentieth century, many Islamic economies also became more independent. As a result, Muslim economists started reconsidering the application of Islamic finance into a formal banking industry.
The modern Islamic banking is further divided into two parts. First when it still remained an idea. Second when it became reality by private initiative in some countries and by law in some others a. Islamic Banking as an Idea (20th century) The scholar of the recent past in early fifties started writings for Islamic Banking in place of Interest Free Banking. In the next two decades Islamic Banking attracted more attention. Early seventies saw the institutional involvement. Conference of the Finance Ministers of the Islamic countries was held. The involvement of institution and Government led to the application of theory to practice and resulted in the establishment of the Islamic Banks. In this process the Islamic Development Bank IDB was established in 1975.
b. The coming into being of Islamic Banks The first private Islamic Bank, the Dubai Islamic Bank was also set up in 1975 by a group of Muslim business men from several countries. Two more private banks were founded in 1977 under the name of Faisal Islamic Bank in Egypt and Sudan. In the same year the Kuwaiti Government se t up the Kuwait Finance House.
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In the ten years since the establishment of the first private commercial bank in Dubai, more than 50 Islamic Banks have come into being. Though nearly all of them are in Muslim countries, there are some in Western Europe as well: in Denmark, Luxembourg, Switzerland and the U.K.
In most countries the establishment of Islamic banking had been by private initiative and was confined to that bank. In Iran and Pakistan, however, it was by government initiative and covered all banks in the country. The Government in both these countries took steps in 1981 to introduce Islamic Banking.
1.3 MEANING and DEFINITIONS

Islamic banking is defined as banking system which is in consonance with the spirit, ethos and value system of Islam and governed by the principles laid down by Islamic Shariah. Interest free banking is a narrow concept denoting a number of banking instruments or operations which avoid interest. Islamic banking, the more general term, is based not only to avoid interestbased transactions prohibited in Islamic Shariah but also to avoid unethical and un-social practices. In practical sense, Islamic Banking is the transformation of conventional money lending into transactions based on tangible assets and real services. The model of Islamic banking system leads towards the achievement of a system which helps achieve economic prosperity.
Islamic Banking is defined as a system of banking that is consistent with Islamic law (Sharia) known as Fiqh al-Muamalat (Islamic rules on transaction), and is guided by Islamic economics. Islamic law prohibits usury, which is the collection and payment of interest, commonly called as Riba. Islamic banking
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also prohibits in investing in business that are considered unlawful or Haram (such as alcohol, gossip columns or pornography). The organization of Islamic Conference defined an Islamic Bank as, a financial institution whose statutes, rules and procedures expressly state its commitment to the principles of Islamic Shariah and to the banning of the receipt and payment of interest on any of its operations.
From the explanation about Definition of Islamic Banking, Islamic Banking has the following characteristics: In Islamic banking, there is a contractual relationship (contract) between the customer and bank that work together to be productive and the profits are divided equally. Thus, it can avoid the exploitative relationship between the bank and the client or vice versa between customers and banks. Islamic banks are financial institutions which collect and invest money in a way that is in harmony with the rulings of the Islamic Shari`ah. All transactions and goals of Islamic banks are in harmony with the disciplines and rules of Islamic Shari`ah. Islamic banks depend on lawful money which is exposed to profit and loss. Islamic banks neither use percentage nor interest rate, whereas they take only a fixed share of unknown profit. The Islamic financial institutions does not involve in activities that are not productive to the society and upheld the morale of the citizen.
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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. In the book, the Future of Money by Bernard Lietar, he expertly highlights the intrinsic dangers of interest and then mentions how Islam has admirably represented the last bastion of resistance. He illustrates how interest is a direct cause of inflation, wealth imbalance contributing to the rich getting richer and the poor getting poorer.
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1.4 BASIC CONCEPT

Islamic economic principle 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 behavior that must require the utmost sincerity of intention. When these rules and norms are internalized 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.
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1.5 PHILOSOPHY OF ISLAMIC BANKING AND FINANCE

Islamic Shariah prohibits interest but it does not prohibit all gains on capital. It is only the increase stipulated or sought over the principal of a loan or debt that is prohibited. Islamic principles simply require that performance of capital should also be considered while rewarding the capital. The prohibition of a risk free return and permission of trading, as enshrined in the Verse 2:275 of the Holy Quran, makes the financial activities in an Islamic set-up real assetbacked with ability to cause value addition.
Islamic banking system is based on risk-sharing, owning and handling of physical goods, involvement in the process of trading, leasing and construction contracts using various Islamic modes of finance. As such, Islamic banks deal with asset management for the purpose of income generation. They will have to prudently handle the unique risks involved in management of assets by adherence to best practices of corporate governance. Once the banks have stable stream of Halal income, depositors will also receive stable and Halal income.
The forms of businesses allowed by Islam at the time the Holy Quran was revealed included joint ventures based on sharing of risks & profits and provision of services through trading, both cash and credit, and leasing activities. In the Verse II:275, Allah the Almighty did not deny the apparent similarity between trade profit in credit sale and Riba in loaning, but resolutely informed that Allah has permitted trade and prohibited Riba. Profit has been recognized as reward for (use of) capital and Islam permits gainful deployment of surplus resources for enhancement of their value. However, along with the entitlement of profit, the liability of risk of loss on capital rests with the capital itself; no other factor can be made to bear the burden of the risk of loss.
Financial transactions, in order to be permissible, should be associated with goods, services or benefits. At macro level, this feature of Islamic finance can be helpful in creating better discipline in conduct of fiscal and monetary policies.
Besides trading, Islam allows leasing of assets and getting rentals against the usufruct taken by the lessee. All such things/assets corpus of which is not consumed with their use can be leased out against fixed rentals. The ownership in leased assets remains with the lesser that assumes risks and gets rewards of his ownership.
1.6 OBJECTIVE OF THE STUDY

From a situation nearly 30 years ago when it was virtually unknown, Islamic banking has expanded to become a distinctive and fast growing segment of the international banking and capital markets. There are well over 200 Islamic banks operating in over 70 countries comprising most of the Muslim world and many Western countries. Not included in these figures are the 50 Islamic insurance (takaful) companies operating in 22 countries, Islamic investment houses, mutual funds, leasing companies and commodity trading companies. Also excluded are the very largest Islamic banks engaged at a multilateral level. To these numbers must be added the many hundreds of small Islamic financial institutions such as rural and urban cooperative credit societies, Islamic welfare societies and financial associations operating at a local level and dealing with rural entities, small business firms and individual households.
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Many people are interested in the phenomenon of Islamic banking and in the question of how it differs from conventional banking, yet, despite the expansion over the last 30 years, Islamic banking remains poorly understood in many parts of the Muslim world and continues to be a mystery in much of the West.
Unfortunately, this rapid development and the substantial cultural and language barriers that exist have acted against a fuller and more widely held understanding of Islamic finance. This is problematic in a number of respects. Concomitantly, there is ongoing debate over the fact that Islamic banks do not separate fund management and investment activities from commercial banking. This may cause technical difficulties for supervisors and regulators. Likewise, the risk sharing nature of liability contracts has raised concerns on the definition of capital and capital adequacy ratios: some have argued that the appropriate regulatory framework for Islamic banking must place a greater emphasis on operational risk management and information disclosure than is normally the case with conventional banks. Moreover, many developing economies are grappling with the design of optimal supervisory and regulatory regimes for systems including Islamic institutions and products, and whether these should treat Islamic finance identically, uniquely or with slight modification to conventional institutions and products. A better understanding of Islamic finance is called for in all respects.
At the same time, researchers in conventional finance have been restricted in their efforts to investigate these and other important issues by the strong interface between religion and finance and the social and cultural barriers that act against the acquisition of this knowledge. This necessarily impairs research into Islamic finance, its role and potential impacts. In a similar manner, practitioners in conventional finance firms may find it difficult to gain an
understanding of Islamic finance necessary for the design of compliant products and an awareness of the competitive position of Islamic finance firms and products.
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Chapter 2 ISLAMIC BANKING THEORITICAL VIEW
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2.1 ESSENTIALS OF ISLAMIC BANKING

Divine Guidance for the economy, as enshrined in the Qur'an and the Sunnah (the living example of Prophet Muhammad), can be summarized as follows:
I). Trusteeship
The Qur'an (57:7) emphasizes 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 behavior and public policy.
II). 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 fulfillment 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. Thinking 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 selfinterest, when not tempered by charity, is self- defeating.
III). Productive Effort as a Means of Serving God
Islam emphasizes 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 realization 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 alShari'ah, Vol. 2, p188, Cairo, Maktaba al Tijarah al-Kubra.)
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In the west, it is now considered enough to merely 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.
IV). 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.
V). 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.
VI). 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
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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.
VII). 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 emphasizes avoiding illicit acts detrimental to the wellbeing of society or the individual.
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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.
VIII). 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.
IX). 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.
X). 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.
XI). 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.
2.2 PRINCIPILES OF ISLAMIC BANKING
Contrary to positive (value-free) economics, Islamic economics are clearly normative. The Islamic values are reflected in Islamic economic principles. For this article, I selected seven of the most important of these economic principles. From these abstract principles concrete Islamic economic rules will be derived. Finally, based on these rules, various "contracts" will be discussed which can be used by Islamic banks to attract funds and provide financing in a truly Islamic way. Beginning with the seven principles, moving on to the rules, and ending with the contracts, we move from abstract theory to daily practice. But let us start off with the seven main Islamic economic principles:
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I). Justice, equality and solidarity
For many Muslims, these concepts are the essence of Islam. In the field of economics, they require that business should be conducted in an honest way. This precludes, for example, monopolization, or abusing the ignorance of an inexperienced partner. Solidarity is encouraged by promoting almsgiving as a noble deed, and it is the duty of each Muslim to pay zakat, a tax on wealth (usually about 2.5% of personal wealth).
II). Forbidden objects and creatures
Islam classifies certain objects or creatures as unclean (for example, pigs) or even forbidden (e.g. fortune telling books based on astrology). Such things cannot be the object of a legal transaction. Furthermore, certain objects are clean but not tradable, such as the soil of holy places. The number of prohibitions is extensive and unsystematic.
III). Acquisition of property rights
Property may be acquired in the following three ways: a) New rights can only be legally created by combining ones labor (including spiritual labor) with natural resources. Old rights can be transferred, either b) In exchange for a counter value of the same worth; or c) As a voluntary gift/inheritance.
Interest is not a legal form of property, because it is not acquired in one of the three legal ways: Islam does not consider lending or postponement of
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consumption as labor. Furthermore, interest is neither exchanged for a counter value of the same worth, nor given voluntarily.
IV). Property (wealth) should be used in a rational but fair way.
Islam rejects unproductive hoarding as wasting money. Wealth is a blessing of God, but not an end. It should be spent, but always in a responsible way. Property rights should not be used contrary to the interests of the community.
V). No gain without either effort or liability. Receiving a monetary advantage without giving a counter value is forbidden. Islam is not opposed to profit or financial gain, as long as: a) an effort is performed, or (partial) liability is accepted for the financial result of a venture (in the case of a financier); and b) the effort or venture was productive, i.e. it led to an increase of value; and c) the profit was made in an honest manner, in line with the Sharia.
According to Islam, money is sterile, as long as it is not combined with (spiritual) labor, "property does not breed property". Therefore, the mere postponement of consumption (saving) is no justification for compensation (interest).
Without investment, saving does not produce any additional value. If someone borrows money and consumes it, according to Islam it would be unfair to reward the lender, because no value was added with the money.
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If, however, the money is used for productive ventures, it can yield financial gain. Because this gain would have been impossible without the investor, it is logical and just that the profit should be shared with him. If there had been only losses, his money would be at stake. This liability entitles him to a share in the ventures result that is not a fixed one, but a predetermined share of the financial result. Contrary to this, in the case of interest-based financing, a venture could be extremely profitable, and still yield only a small reward for the lenders. On the other hand it could generate high losses, but the lenders would still receive a reward. Islam considers this unfair, and that the reward of investors should be tied to the result of the investment. This idea is called profit and loss sharing.
VI). General conditions of credit a) Debtors in financial distress should be treated leniently. If the debtor is not able to pay back the principal, he should be given a delay without a penalty. Even better, the debt could be remitted. b) There are diverging views about the lawfulness of different credit and spot prices. Opponents claim that the difference between credit and spot prices is nothing more than an implicit interest rate. Others claim that it is allowed for commodity transactions, but not in financing (when only money is involved).
VII). The duality of risk
Islam has a dual conception of risk. On the one hand, it considers the partial acceptance of liability (for risk) in a productive venture as a legitimation for a share in profit. On the other hand, risk should always be taken cautiously. Excessive, uncontrollable risks or uncontrollable obligations should be avoided.
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For example, the sale of an object which the seller does not yet possess is illegal. Furthermore, gambling or speculations are forbidden.
Finally, uncertainty in the obligations of contracting parties is forbidden. The object of a contract must be "known, ascertained and in existence" when the contract is concluded. The difference between legal and illegal risk is not always easy to determine, therefore, in concrete cases, an expert in Islamic law should be consulted. The essence of principles is that they are general, and not very concrete.
2.3 PROHIBITION OF RIBA-THE MOST IMPORTANT ASPECT OF ISLAMIC BANKING

2.3.1 MEANING AND DEFINITION
The word "Riba" means excess, increase or addition, which correctly interpreted according to Shariah terminology, implies any excess compensation without due consideration (consideration does not include time value of money).
The meaning of Riba has been clarified in the following verses of Quran: "O those who believe fear Allah and give up what still remains of the Riba if you are believers. But if you do not do so, then be warned of war from Allah and His Messenger. If you repent even now, you have the right of the return of your capital; neither will you do wrong nor will you be wronged." Al Baqarah 2:278-9
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2.3.2 TYPES OF RIBA There are two types of Riba: I. II. Riba-An-Nasiyah/Riba-Al-Quran Riba-Al-Fadl
I). Riba An Nasiyah/Riba Al-Quran: In the Holy Quran, Allah (SWT) says in Sura Al-Baqarah (2-279): And if you repent, yours is your principal It is reported by Harith ibne Abi Usamah in his Musnad that Sayyidna Ali Radi Allahu Anhu reportedly referred that the Holy Prophet said: "Every loan that derives a benefit (to the lender) is riba".
Example of Riba-al-Nasiyah/Interest: If Mr. A lends Rs.100 to Mr. B (a borrower) with a condition that Mr. B shall return him Rs.110 after one month. In this case, the extra amount of Rs. 10 is Riba or Interest.
II).Riba-al-Fadl: Abu Said al Khudri Radi-Allahu anhu narrated that Holy Prophet (Peace be upon him) said: "Gold for gold, silver for silver, wheat for wheat, barley for barley, dates for dates and salt for salt, like for like, payment made hand by hand. If anyone gives more or asks for more, he has dealt in riba. The receiver and giver are equally guilty"
Based on aforesaid definition, it may be noted that economically speaking it would be irrational to exchange one kilogram of wheat with one and a half kilogram of wheat in a spot exchange. Therefore, some fuqaha have pointed out that Riba-al-Fadl has been prohibited because if it was left un-prohibited it could be used as a subterfuge for getting Riba-al-Nasiyah. Of the six
commodities specified in the hadith, two (gold and silver) unmistakably represent commodity money used at that time. One of the basic characteristics of gold and silver is that they are monetary commodities. As a matter of fact, each of the six commodities mentioned in the hadith has been used as a medium of exchange at some time or the other.
During the dark ages, only the first form (Riba An Nasiyah) was considered to be Riba. However, the Holy Prophet (peace be upon him) also classified the second form (Riba-al-Fadl) also as Riba.
2.3.3 REVELATIONS/VERSES IN HOLY QURAN REGARDING PROHIBITION OF RIBA/INTEREST
There are four sets of revelations about Riba which were revealed on different occasions.
I). First Revelation: In Surah-Ar-Rum, verse 39, dealing in riba has been discouraged in the following words: "And whatever riba you give so that it may increase in the wealth of the people, it does not increase with Allah." [Surah Ar-Rum 30:39]
II). Second Revelation: Muslims have been informed about the practice of taking riba by Jews in Surah An-Nisaa: "And because of their charging riba while they were prohibited from it ." [Surah An- Nisaa 4-161]
III). Third Revelation: Riba/Interest has been abolished in the third verse of Surah Ali-Imran. The prohibition of riba is laid down in the following words:
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"O those who believe do not eat up riba doubled and redoubled." [Surah Al-e Imran 3- 130]
IV). Fourth Revelation: In the fourth revelation, Riba has categorically been prohibited in all its forms. The following set of verses is found in the Surah AlBaqarah, verse 275-281 in the following words: "Those who take interest will not stand but as stands whom the demon has driven crazy by his touch. That is because they have said: 'Trading is but like riba'. And Allah has permitted trading and prohibited riba. So, whoever receives an advice from his Lord and stops, he is allowed what has passed, and his matter is up to Allah. And the ones who revert back, those are the people of Fire. There they remain forever. Allah destroys riba and nourishes charities. And Allah does not like any sinful disbeliever. Surely those who believe and do good deeds, establish Salah and pay Zakah, have their reward with their Lord, and there is no fear for them, nor shall they grieve. O those who believe, fear Allah and give up what still remains of the riba if you are believers. But if you do not, then listen to the declaration of war from Allah and His Messenger. And if you repent, yours is your principal. Neither you wrong, nor be wronged. And if there be one in misery, then deferment till ease. And that you leave it as alms is far better for you, if you really know. And be fearful of a day when you shall be returned to Allah, then everybody shall be paid, in full, what he has earned. And they shall not be wronged." [Surah Al-Baqarah 2:275-281]
2.3.4 REASONS FOR PROHIBITION OF RIBA
I). Riba is a form of social corruption referred to by Arabic scholars as Fasad. Siddiqi (2004, p. 42) translates the following from the Holy Quran (30:38-41):
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That which you give in usury in order that it may increase in other peoples property has no increase with Allah; but that which yo u give in charity, seeking Allahs countenance, has increase manifold. Allah is He Who created you and then sustained you, then causes you to die, then gives life for you again. Is there any of your (so called) partners (of Allah) that does aught of that? Praised and exalted be He above what they associate with him. Corruption does appear on land and sea because of (the evil) which mens hands have done, that He may make them taste a part of that which they have done, in order that they may return. Here the giving or taking usury can be related to the appearance of corruption, which in a society results from mens wicked behaviours on earth.
II). Riba implies the wrongful appropriation of other peoples property without justification. In other words, usury or interest is a property right claimed outside the lawful framework of identified property rights that create a balance between rich and poor people. In Islam, people who affect the property rights of others will face punishment from Allah at the day of the judgment. The Holy Quran (4:161) supports this contention: And of their taking usury when they were forbidden it, and of their devouring peoples wealth by false pretences. We have prepared for those of them who disbelieve a painful doom.
III). Riba decreases the resources of states through a negative effect on the growth of economies. The Holy Quran (2: 276) states Allah has blighted usury and made almsgiving fruitful. Allah loves not the impious and guilty
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This verse suggests that the usury or interest creates unfairness. On the other hand, a better way to create positive growth in the economy is by giving to charities or providing interest-free loans.
IV). Riba demeans and diminishes the humanity of individuals. It means that those who receive or pay usury are affected by the touch of the Evil (2:275). Persons so affected become mad with greed because they need to obtain more and more interest and usury without stopping.
V). Riba leads to money being made from money. An unacceptable practice in Islamic finance. In Islam, money is an exchange instrument that has no value in itself. It is argued that those who place their money as a deposit in a bank or lend it to gain interest earn money without effort or risk. According to Sharia, people should be productive and useful, but only by investing their money in useful trade and economic enterprise.
Finally, the most essential reason for the prohibition of Riba is that it is unfair in that it affects borrowers and lenders alike. The borrower must pay interest and repay the capital, as well as bearing any losses from the use of these funds (a form of double charging: that is, charging for both the funds and the use of the funds). In addition, Riba is also regarded as being unjust to the lender. This is because the real rate of interest may become negative if, say, the rate of inflation is higher than rate of interest. Therefore, lenders who wish to earn a profit from lending money could make a loss. Once again the loss incurred would be unrelated to the actual use of the funds.
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2.4 ISLAMIC METHODS OF FINANCE As discussed in the previous section, Islamic finance is designed according to fundamental principles that comply with Sharia. This section focuses on the most common Islamic finance methods as practiced by Islamic banks and other financial institutions. The principal instruments take the following forms: (i) (ii) (iii) (iv) (v) (vi) (vii) Mudarabah, the provision of capital in a partialequity partnership; Musharakah, full equity partnerships, Murabaha, an instrument used for financing the purchase of goods; Bai muajjall, deferred payments on products; Bai Salam, advance sale contracts; Istisna, or manufacturing contracts; Ijarah, lease financing; and
(viii) Quard Hassan, a system of benevolent loans.
2.4.1 MUDARABAH (CAPITAL TRUSTS)
The Mudarabah (or capital trust) is a form of profit or loss (equity-based) sharing used by tradesmen in Mecca before Islam. The best evidence for its existence is Muhammad employed Mudarabah with a rich woman named
Khadijah about fifteen years prior to the establishment of Islam. Mudaraba, in jurisprudence, is a mode of financing through which the bank (the owner of the capital or rabb-al-mal) provides capital finance for a specific venture indicated by the customer (the entrepreneur or mudarib).
In other words, Mudarabah is a contract between two parties: an investor (individual or bank) who provides a second party, the entrepreneur, with financial resources to finance a particular enterprise. Profits are then shared between the two parties (rabb-al-mal and mudarib) according to some preISLAMIC BANKING Page 30
agreed ratio, but if there are losses the investor bears all financial losses and the entrepreneur the operating losses; principally the opportunity cost of their own efforts.
In an alternative form, the rabb-al-mal is a customer who deposits capital in a bank, representing the mudarib, to invest according to Mudarabah. In addition, Mudarabah deposits could be compounded in a public pool for investment, which is a permissible way for the manager (bank) to mix Mudarabah deposits with its own funds. In this case, profits would again be distributed according to an agreed formula, but losses once again remain the liability of the capital providers.
Although Mudarabah may be applied in various economic activities, the majority of Islamic jurists and scholars hold the view that Mudarabah contracts are only really suitable for commercial activities.
2.4.2 MUSHARAKAH (FULL PARTNERSHIPS) Musharakah (or full partnership) is an arrangement where two or more parties establish a joint commercial enterprise and all contribute capital as well as labour and management as a general rule. The profits and losses that flow from the Musharakah are again shared among the parties on a pre-agreed ratio. Generally, Musharakah is most suited for financing private or public companies and project financing. In the context of Islamic banking, Musharakah is described as a joint venture between an Islamic bank and a customer or business firm for certain operations. The Islamic bank can potentially act as the fund provider to finance industry, trade and almost all legal enterprises through either equity investment or direct participation.
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Musharakah contracts can be established in one of two ways. The first way of these is a permanent contract which ensures for its parties (the investor, bank and entrepreneur) an equitable share in the annual profit/loss on pre-agreed terms. This kind of permanent contract holds constant for a limited or unlimited period according to the original agreement. The second type of Musharakah is a diminishing contract preferred by bankers because it allows the bank to reduce its share of equity each year and receive periodic profits based on the reducing equity balance. In this form, the equity share of the customer in the capital of enterprise increases over time until he or she becomes the sole owner of the enterprise.
Musharakah has many advantages that provide equal benefits for all parties and there is a consensus among Islamic scholars of its validity under Sharia. However, most of the parties in Musharakah contracts usually require the help of legal experts to ensure that any potential Riba or Gharar is carefully avoided. ] 2.4.3 MURABAHA (MARK-UPS ON SALE)
Murabaha is an Islamic instrument for buying and reselling the purchase or import of capital goods and other commodities by institutions, including banks and firms. Under the Murabaha contract, the customer provides the bank with the specifications and prices of the goods to be purchased or imported. The Islamic bank studies the application and collects information about the specifications and prices of the goods, focusing especially on the price and conditions for payment. When the bank and its client agree on the terms of the deal, the bank purchases the goods or commodities and resells them to the customer. The profit that accrues to the bank is mutually agreed upon as a profit margin (mark-up) on the cost of purchase.
The fundamental principles attached to Murabaha can be summarised as follows: a. Goods must be classified, clearly identified according to commonly accepted standards and must exist at the time of sale; b. c. (goods for sale must be in the ownership of the bank at the time of sale The cost price must be known at the time of sale and this should be declared to the client. This is especially the case when the bank succeeds in obtaining a discount where the profit margin is calculated on the net purchase price (this means discounts also provide benefits to the client); d. The time of delivery of the goods and the time of payment must be specified.
In fact, the Murabaha contract is merely a two-party buying and selling contract between bank and customer involving no financial intermediation or financing. In other words, the bank offers this service to clients who should pay the cost of the goods plus a profit margin to the bank immediately following receipt. In addition, the client can pay for the goods and the banks profit margin by deferred instalments or a deferred lump sum without an increase over the original value. This type of contract is referred to as Bai muajjall-Murabbah or Bai bithaman ajjal .
2.4.4 BAI MUAJJALL (DEFERRED PAYMENTS)
The term Bai muajjall is a sale on a deferred payment basis that allows business or individuals to receive products now and pay for their value in the future. Credit sales could include Bai muajjall-Murabaha since all deferred payments are in instalments or a lump sum. However, there is a significant difference between Bai muajjall and Bai muajjall-Murabaha in that in any kind
of Murabaha the buyer must know the cost price of the commodity as a prerequisite to an acceptable contract. There is a consensus among Islamic jurists and scholars about the permissibility of credit sales (Bai muajjall) as a form of finance that includes no Riba. Islamic jurists have generally permitted sales where the price has increased with deferment, but have forbidden sales where the amount of the debt increased with deferment.
For example, in a credit sale both the buyer and seller agree to defer the sale price until payable in one month and increase the sale price to cover. This sort of agreement would be permissible. However, it is not permitted if they defer the lending that proceeds from the sale now for one month and increase the amount by interest. The first example is a trading transaction accepted by the Holy Quran and the Sunna, but the second example is a lending transaction involving Riba.
2.4.5 BAI SALAM (PREPAID PURCHASES) Bai salam is a form of advance payment or forward buying. Salam is a sale contract in which the price is paid in advance at the time of contracting against delivery of the purchased goods/services at a specified future date. Even though the sale and purchase of nonexistent goods are prohibited because of Gharar, the Bai salam is a permissible activity that is adopted by the Sunna to facilitate certain activities in agriculture and industry. As one example, following Hadith narrated on the authority of Ibn Abbas:
The Messenger of Allah came to Madinah and found its inhabitants entering salam contracts (with the price paid in advance) in fruits for one, two, and three years. He said: Whoever enters into a salam contract, let him specify a known volume or weight, and a known term of deferment.
In addition, the Messenger of Allah said: Whoever enters into Salaf, should stipulate a determined weight and measurement, and a determined date of delivery, the word (Salaf) of the Hadith has meaning of salam. The main legal requirements for Bai salam contracts to be permissible are: a. The commodities sold should not be available at the time of contracting b. c. The quality and quantity of goods must be known The date and place of delivery for these commodities should be defined. d. The purchase cost price should be paid completely at the time of the contract.
2.4.6 ISTISNA (MANUFACTURING CONTRACTS)
Istisna is a relatively new method in Islamic banking, defined as a manufacturing contract which allows one party to obtain industrial goods with either an upfront cash payment and deferred delivery or deferred payment and delivery. It has been translated as a commission to manufacture usually used to cover work progress in the manufacturing and building industries.This method has a significant advantage in that the cost price is prepaid or is deferred as installments to create a product at a lower price than the cost of buying the complete product or building.
In the context of Islamic banking, individuals or firms request their bank to facilitate a contract of production for a good, and the bank concludes an Istisna contract with a third party (the manufacturer) to produce and deliver the specific item under particular requirements. The permissibility of Istisna is adopted by the use of analogy (Qyas) among most Muslim jurists with the permissibility of Bai salam. However, Istisna differs in many ways from Bai
saslam. For example, the Istisnas subject is usually a commodity or item which demands manufacturing, the payment in Istisna could be a lump sum or instalments which can be deferred; and the time of delivery in an Istisna contract could be unknown.
2.4.7 IJARAH (LEASE FINANCING)
Ijarah is the reward or recompense that proceeds from a rental contract between two parties, where the lessor (the owner of the asset) leases capital asset to the lessee (the user of the asset). Ijarah literally means to give something on rent. The use of Ijarah was known before Islam and is evidenced by the Holy Quran and the Sunna.
For example, Said one of them: O father, hire him on wages, for truly the best to employ is a strong and trust worthy man. He said: I intend to wed one of my daughters to you, on condition that you work for me for eight years, and if you complete ten full years, that will be a grace from you.
It is also adopted in the following Hadith narrated by Ahmad Abu Dawud and Al-Nasai: The farmers during the time of the Prophet used to pay rent for the land in water and seeds. He forbade them from doing that, and ordered them to use gold and silver (money) to pay the rent.
In Islamic finance, one of the forms of leasing includes: Direct leasing finance (Ijarah), whereby the lessor (either an individual or a firm) allows the lessee to use capital assets owned by the lessor for a specified period of time ranging from a few days to years depending on the type of asset. In return, the lessee pays the rental fee monthly or annually. However, the ownership of the capital assets cannot transfer to the lessee in this type of
leasing (as in finance leases) and insurance on the capital assets remains the responsibility of the. In contemporary Islamic banking, Ijarah has been adapted to provide a form of hirepurchase (Ijarah wa-Iqtina), whereby an institution or individual customer requests the bank to purchase equipment with the intention of leasing it to the customer. In turn, the Islamic bank rents the asset to the client who pays a certain fixed rent and promises to purchase the asset within a specified period to transfer ownership from the bank to the customer. Furthermore, this could be transformed as a decreasing-value lease that allows the client to pay an installment of the value of the asset plus its rent each period to reduce the lessors share of ownership until the lessee becomes the owner.
2.4.8 QUARD HASSAN (BENEVOLENT LOANS)
The act of lending money is not forbidden in Sharia, only Riba is prohibited in the process of lending. Quard Hassan is a benevolent loan without interest to assist the needy in an attempt to alleviate hardship. Consequently, individuals and firms may lend money on an interest-free basis to any number of beneficiaries for many purposes, including expenses relating to education and marriage. The amount paid by the lender is considered an interest-free loan from the time of payment until the date of the settlement. The borrowers payment of any amount over and above the principal to the lender is permissible so long as it is at the borrowers discretion. It is also permissible for the lender to request assets as collateral and charge administrative expenses on the loan.
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Chapter 3
ISLAMIC BANKING- PRACTICAL VIEW
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In Chapter 2, a theoretical framework for Islamic banking was discussed. This section is concerned with the practical implementation of the theory. This will be done by discussing the implications for the main activities of a bank.
3.1.
COLLECTING DEPOSITS Since interest-bearing deposits cause Riba of debt, Islamic banks offer
two different kinds of deposit: current accounts and investment accounts.
I.
Current Account. Current accounts are similar to those offered by conventional banks.
The deposited capital is guaranteed and made available to the client at any moment. No reward is paid on deposits. They are mainly used for transaction and safety purposes.
II.
Investment Account. Investment deposits must remain with the bank for certain, previously
agreed, period. Customers open investment accounts to yield a financial return. Investment accounts are based on trust financing. The depositor is the financing partner, while the bank is the managing partner. The bank pools all investment deposits and searches for suitable investment opportunities. The return on investment (positive and negative) is then shared with the depositors, after the bank has deducted its own costs and a previously agreed fee for its efforts. The type of investment account and the terms of the deposit determine a depositors share in the investments return. A higher share of profit is paid for deposits with a longer maturity. In the event the investment is not profitable, the depositors share the loss. Their maximum liability is the deposited sum. Investment deposits can only be withdrawn prematurely by paying a certain fine.
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3.2
FINANCING Depending on the situation, Islamic banks can choose between PLS-
financing, trade financing or lending. With respect to PLS, a client will first of all present a detailed investment proposal to the bank. The bank will then decide to participate or not. If it does, it will usually do so on the basis of trust financing, assuming the role of financing partner so as not to be involved with the actual management of the venture. The contract between the bank and the client should clearly stipulate the partners responsibility and the profit sharing ratio. However, trust between both parties should prevail, so contracts should not be too restrictive and detailed. In practice, however, banks design extremely detailed contracts, thereby severely limiting the managing partners freedom to act. Banks try to minimize all chances for abuse of their funds. Furthermore, in practice, banks sometimes use their dominant position to renegotiate their profit share during the project, for example if profits, are disappointing. According to the Sharia, the conditions of the contract can only be altered with the consent of both parties. Some banks even try to avoid liability for losses, which is completely contrary to Sharia. The client should regularly report to the bank about the ventures progress, and should reveal all relevant information. In practice, however, entrepreneurs often inform the bank selectively, so as not to reveal sensitive information about their business. This illustrates that the ideal situation of mutual trust is seldom encountered. With respect to trade financing, besides mark-up financing, other popular methods are leasing (ijara) and lease-purchase (ijara wa iqtina). In section III.D.3, we saw that, in practice, banks involved with mark-up financing limit the freedom of the final buyer to refuse an ordered object by requesting him to sign a contract of promise. Furthermore, these contracts impose uncontrollable obligations. Both elements are forbidden by Sharia.
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Lending is possible in the form of overdrafts on current accounts or interest-free loans. In practice, not all banks allow overdrafts, and some charge a fee for overdrafts, contrary to principle no. 6 (debtors should be treated with leniency).
Regarding interest-free loans, there is no uniformity among Muslim scholars about the question of whether a bank is allowed to charge a fee to compensate for administrative costs and for bad loans, i.e. no profit is received for these loans, only a compensation for costs. Strictly orthodox scholars will, however, not agree with loans bearing a fee. In practice Islamic banks only provide costless loans for humanitarian and welfare purposes. After the agreed period, the debtor has to repay the loan, but in cases of financial distress, repayment may be postponed, in line with the Sharia. From the perspective of Sharia, PLS-financing is the most desirable possibility and secondly lending. Only in cases in which neither of these are suitable should banks resort to trade financing. In this respect, there is a great gap between theory and reality: in practice, 70% or more of all financing is provided through trade financing, whereas PLS never makes up more than 30%, and usually much .
3.3.
TRADING IN SECURITIES A bank may trade in securities for its client, and ask a fee for it. The legal
basis for this in the Sharia is the agency-contract. The fee, however, should be fixed and reflect the costs and efforts of the bank. Hence, it may not depend on the sum in transaction, unless the size of the transaction influences the banks effort. A number of securities are not acceptable according to the Sharia: consequently Islamic banks may not deal with them. I differentiate between
three types of securities: fixed income securities, stocks and derivatives. Fixedincome securities, such as certificates of deposit and zero-coupon bonds, are forbidden.
They contain either explicit or implicit forms of interest, i.e. Riba in debts. Stocks are a legal form of trust financing. As with trust financing, dividends are normally distributed according to the capital-contribution ratio. In general, Islam has a positive attitude towards shareholders hip and stockmarkets. This holds well, of course, only within the legal framework of the Sharia. Speculative trade in stocks, or shareholdership in forbidden sectors, such as breweries, is illegal. A majority of Islamic scholars also reject shareholder ship in firms that are in any way involved with interest-based financing. Preferred stocks form a special case: owners of preferred stocks are promised a fixed cash dividend periodically. This is similar to interest, and therefore illegal. A feasible Islamic solution would be to issue preferred stock with a preference dividend based on a pre-determined ratio of profit. There is still not much jurisprudence about the lawfulness of derivatives. For the purpose of this article, it would go too far to treat this topic in detail. I will confine myself therefore to briefly expressing my private view. Based on the principles of Islamic economics, I believe that commodity derivatives (commodity options, futures, etc.) are legal, as long as they are not used for speculation, and the Sharia is observed. Financial derivatives (swaps, currency futures, stock options, warrants, etc.) are illegal, as they involve Riba.
3.4.
OTHER BANKING SERVICES The fourth category of bank activities comprises services like payment
and clearing of cheques, money transfers, safeguarding of valuables, purchase and sale of foreign currency, and financial advice. The legal basis for these activities is the agency-contract. Clients benefit from these services, and the
bank has to incur costs to offer them. Hence, it is justified to ask a fee. When no extra effort is performed and no extra costs are incurred for repeated services, the bank cannot legally charge a fee. The fee must be proportionate to the effort and costs. It may not fluctuate with the size of the transaction, if size does not matter for cost and/or effort. Another important activity of banks is issuing letters of credit and guarantees. The legal basis for these transactions is the guarantee (kafala) contract. Earlier, we saw that liability (guarantee) is one of the justifications for a reward, so a fee may be asked.
3.5.
SOCIAL ACTIVITIES AND THE RELIGIOUS SUPERVISORY
BOARD Islamic banks have to incorporate both profit and morality into their objectives. Consequently, supporting social welfare programmes is a way of fulfilling their religious duty. Islamic banks finance social activities through the obligatory zakat (wealth) tax and through voluntary donations. In order to ensure that their operations conform to the Sharia, banks often need the advice of experienced religious scholars. Therefore, most banks employ a board of Islamic scholars. When confronted with a new problem, the bank should present a solution to the board, and seek its approval.
The religious board also administers the zakat-fund. Most boards have an orthodox approach, and try to apply the available Islamic jurisprudence as literally as possible. But where legal definitions are emphasised, too often legal tricks to evade the prohibitions of the Sharia are overlooked.
Fictitious sale transactions are an example. By manipulating parameters such as the pay-back period, the selling price, etc., a transaction that is completely equal to an interest-bearing loan can be modelled, whereas, in reality, no real transaction occurs at all. In the long run, such tricks may
undermine the authority of the Islamic banking movement. To avoid that, a solution must be found for the main problems of Islamic banking. These problems are the topic of the next section.
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Chapter 4
PROBLEMS FACED IN ISLAMIC BANKING
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4.1
PROBLEMS OF ISLAMIC BANKS
After a rapid expansion in the seventies and early eighties, Islamic banks experienced a setback. The exaggerated optimism of the early years made way for a more realistic view. Success was not only lacking in professional and financial matters. The ideological compromises that were made in practice worsened the picture. PLS-financing is only incorporated in the banks operations on a small scale. The stagnation is mainly caused by the following four problems:
I). PLS-financing is unpopular with both Islamic banks and clients. For the banks, there are too few attractive projects with an acceptable level of risk. Clients, on the other hand, are unwilling to share too much information and profit with the banks. As a result, PLS-financing attracts many high-risk/lowreward projects, and uncooperative, or even fraudulent, entrepreneurs.
II). PLS is not suitable for short-term financing or for the non-profit sector. Companies often need finance for short-term liquidity. The administrative procedure of PLS is too lengthy to answer such urgent needs. Furthermore, it is difficult to determine the return on financing liquidity. The same applies to financing the non-profit sector, what is the return of an investment in schools, or in a new highway?
III). There is a lack of developed Islamic financial products, institutions and markets. Owing to a lack of suitable financial instruments, Islamic banks still experience difficulties in optimising their risk, return and liquidity. Furthermore, the network of Islamic banks is still underdeveloped and too small.
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Finally, there are no developed Islamic money and capital markets. In cases of liquidity shortages, Islamic banks cannot call upon central banks, because they provide interest-based financing. Recently, Malaysia opened an Islamic inter-bank money market. Initiatives of this kind, more research, and new Islamic financial instruments may cure the childhood diseases of the system.
IV). Islamic banking in non-Islamic countries is still difficult. Western banking legislation requires banks to guarantee the capital of depositors, and ensure them a fixed return. This is directly opposed to the PLSprinciple. Furthermore, the valuation of Islamic banks investment is a difficult and cumbersome task, for which no adequate procedures have yet been developed. As a result, Islamic banks fail to satisfy central banks strict liquidity and capital adequacy requirements, and have great difficulty in obtaining full banking permission in the West. It is clear that the problems are mainly concentrated in the field of financing. With respect to deposits, Islamisation has succeeded. If the problem of financing could be overcome, Islamic banking should be able to make a decisive breakthrough.
4.2
FREQUENTLY ASKED QUESTION.
Q. If the Islamic banks do not lend money on interest then what modes of financing can be used for the following: A) Trade and industrial finance B) Financing the budget deficit C) Acquiring foreign loans
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A.
As a matter of principle, all the financial transactions between the parties
are lawful in the eyes of Islamic Shariah as long as they do not violate Islamic principles. Islamic Shariah provides several interest-free modes of finance that can be used to satisfy various business needs of the customer. These modes can be clubbed into two broad categories.
The first category may include modes of advancing funds on a profit-andloss-sharing basis. Examples of profit and loss sharing category are Mudarabah, Musharakah and participation in the equity capital of companies. The second category may include the modes of finance which are used for the purchase/hire of goods (including assets) and services on a fixed return basis. Examples of this type are Murabaha, Istisna, Salam and Ijarah.
Therefore the financial needs can easily be met through interest-free legitimate modes of finance. These can be used to finance the trade, industry or a budget deficit through domestic or foreign sources. The following would further elaborate in detail.
A) Modes for financing trade and industry: Murabaha, Musawama, Ijarah and salam are particularly suitable for trade while istisna is especially suitable for manufacturing or construction industry. Further, the trade and industry needs financing for the purchase of raw materials, inventories (stock in trade) and fixed assets as well as to meet some working capital requirements. Murabaha can be used for the financing of all purchases of raw materials and inventory. For the procurement of fixed assets including plant and machinery, buildings etc. either Diminishing Musharaka or Ijarah can be more feasible. Funds for continuing/recurrent expenses can be obtained by the advance sale of final products of the company using Salam or Istisna and even Musharika in appropriate circumstances.
B) Modes for financing a budget deficit: It is noted that in an Islamic state, all the efforts should be made to avoid the budget deficit. However, in case of unavoidable circumstances, the budget deficit may be kept to the possible minimum limit. Sometimes the budget deficits are seen as a result of either extravagant (and/or unproductive) expenditure or insufficient and/or inefficient effort to generate tax revenue due to political, economical reasons or otherwise. There is a need to win public confidence about these needs and to create transparency in government expenditure. There is also a need to prevent the leakage of revenue generating streams for the Government. This can serve better in keeping budget deficits to a minimum level. In case of unavoidable deficits, government owned enterprises can obtain finance by way of Mudarabah, Musharakah or Sukuk certificates, just like private companies do.
C) An alternative to foreign loans Seeking Islamic solution to foreign borrowing, arrangements could be made to attract foreign as well as domestic funds through the following two ways: I.) The issue of certificates Musharakah (partnership) or Ijara certificates can be issued to finance the projects of the Government. Such certificates can be denominated in foreign as well as domestic currencies and they would carry a predetermined basis for sharing the profits earned through the respective projects. The certificates issued can be restricted to a particular project or earmarked to a group of projects.
II.) The establishment of funds Funds can be created to finance the economic activities of public and private enterprises on equity, partnership, and Ijarah basis. These funds can
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attract funds through the issue of shares and certificates of various values and maturities and in domestic as well as foreign currencies.
These can be established either to finance a certain sector (for example agriculture, industry and infrastructure), a particular industry (for example textiles, household durables, etc.), or a conglomerate of projects.
Q. Is Islamic Banking Viable? A. Islamic banking is still in the stage of evolution. No one disputes that
there is a definite desire amongst Muslim savers to invest their savings in the venues which are permitted by the Shariah. Nevertheless, they must be provided with halal returns on their investments. Islamic scholars and practical bankers took up this challenge and have made commendable progress in the last few decades in providing a number of such instruments. However, the concepts of Islamic banking and finance are still in their early stages of development and Islamic banking is an evolving reality for continuously testing and refining those concepts.
Islamic banking and financial institutions have now spread across several Muslim countries as well as non-Muslim countries. Various components of the Islamic financial system are now available in different parts of the world in varying depth and quality. A detailed and integrated system of Islamic banking and finance is gradually evolving. Theoretical arguments and models developed by Islamic economists and the successful practice of hundreds of institutions in heterogeneous conditions both testify to the viability of Islamic banking as Islamic banking model provides a complete banking solution to all the business needs of the customers while remaining with the boundaries of Shariah. The average growth rate of assets in Islamic banks over the past twenty years has been around fifteen percent per annum. Islamic banking institutions have come
of age now and are realizing a high degree of success in respect of market penetration.
This is considered remarkable in view of the fact that the markets in which these Islamic banks were established have had highly developed and well-established commercial banks as their competitors.
Another manifestation of the success of Islamic banking is the fact that many conventional banks have also started using Islamic banking techniques in the conduct of their business, particularly in dealing either with Muslim clients or in predominant Muslim regions.
Q. How does Islamic banking fare vis--vis conventional banking? A: The approach of Islamic banking to satisfy the business needs of the
customers is entirely different from that of the approach adopted by conventional banking. Basically Islamic banking satisfies the business needs of the entrepreneurs by the following two modes: 1. Profit and Loss sharing modes 2. Debt creating modes (financing the purchase of commodities on credit with a mark-up)
On the other hand conventional banking satisfies the business needs of the entrepreneurs by charging fixed interest which raises several questions. Although the results of operations of an enterprise in which such loans are to be invested are by no means certain, yet, guaranteeing in advance, a fixed return on a loan without taking into consideration the actual results of the operations of the borrowing enterprise puts all business risks on the entrepreneur/borrower. The Islamic banking philosophy is not based on interest because according to Islam, interest is haram and a curse in society. Islamic banking focuses on the
common good, encourages highest ethics such as universal brotherhood, collective welfare and prosperity, social welfare and justice.
On the other hand, interest based system accumulates money around handful of people and it results inevitably in creating monopolies, opening doors for selfishness, greed, injustice and oppression.
Further, the allocation of financial resources on the basis of profit-andloss sharing gives maximum weight to the profitability of the investment whereas an interest based allocation gives it to credit worthiness. It is expected that the allocation made on the basis of profitability would be more efficient than that made on the basis of interest. Moreover, a system based on profit sharing would be more stable compared to the one based on a fixed interest rate on capital. In the latter, the bank is obliged to pay a fixed return on its obligations regardless of their fate, should the economic conditions deteriorate. In the former, the return paid on the bank's obligations depends directly on the returns of its portfolio of assets. Consequently, the cost of capital would adjust itself automatically to suit changes in production and in other business conditions.
Furthermore, any shock which might befall the obligations' side of the balance sheet would be automatically absorbed. This flexibility not only prevents the failure of the enterprises seeking funds but also ensures the existence of a necessary harmony between the firm's cash flow and its repayment obligations. This is the main element which enables the financial system to work smoothly. Since bank assets are created in response to investment opportunities in the real sector of the economy, the real factors related to the production of goods and services (in contrast with the financial factors) become the prime movers of the rates of return to the financial sector.
The transformation of an interest-based system into profit sharing system helps in the achievement of economic growth which results in increasing the supply of venture or risk capital and consequently encourages new project owners to enter the realm of production as a result of more participation in the risk-taking.
Q. How can Islamic banking institutions avoid money laundering and such kind of other illegal/illegitimate activities? A: In the post 9/11 global scenario anti money laundering measures by
regulatory authorities of banking and finance have gained extraordinary importance. It is pertinent to indicate in this regard that Islamic banks, by their nature, are less likely to engage in money laundering and other illegal activities. They cannot undertake activities which are detrimental to society, because to ensure the adherence of moral values, it has to go through an exhaustive test of Shariah compliance. Islamic banks are not allowed to invest in narcotics, casinos, nightclubs, breweries etc. This requires that the clients of Islamic banking must have business which should be socially beneficial for the society, creating real wealth and adding value to the economy rather than making paper transactions. Therefore, a more stringent Know Your Customer (KYC) policy is an in-built requirement for an Islamic bank.
Islamic modes of financing and deposit-taking discourage questionable or undisclosed means of wealth which form the basis of money-laundering operations. Islamic financing modes are used to finance specific physical assets like machinery, inventory and equipment etc. Further, the role of Islamic banks is not limited to a passive financier concerned only with timely interest payments and loan recovery. Islamic bank is a partner in trade and has to concern itself with the nature of business and profitability position of its clients. To avoid the loss and reputational risk, the Islamic banks have to be extra vigilant about their clientele. As such, Islamic banks are less likely to engage in
illegal activities such as money laundering and financing of terrorism than conventional banks.
However, the existence of rogue elements cannot be ruled out in any type of organization. Keeping this in view, Pakistan has adopted a strategy by adopting uniform international standards to ensure fair play by all kinds of banks and financial institutions including Islamic banks.
After reviewing its existing systems and procedures, it has developed a multiple-track strategy in its financial war on terrorism and money laundering. It has also put in place stringent regulations in order to effectively curb money laundering. The Know Your Customer (KYC) regulation has been sharpened to provide more detailed guidelines to banks/DFIs for due diligence in respect of customers. All banks are required to properly investigate transactions which are out of character with the normal operation of the account involving heavy deposits/withdrawals/transfers.
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Chapter 5
DISTRIBUTION OF PROFITS IN ISLAMIC BANKING. A CASE STUDY OF FAYSAL ISLAMIC BANK OF SUDAN (FIBS)
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ABSTRACT
The focus of this study is distribution of profits in Islamic banking, taking Faysal Islamic Bank of Sudan as a case study. The problem arises due to Islamic banks' commitment to share the actual profits resulting from investing depositors' money, with them. After describing the nature of deposits and the terms and condition of mudaraba, the study examines FIBS figures for two consecutive years to show how part of the profits accruing on the investment of current deposits, which actually belong to the shareholders, were diverted to boost the profit share of depositors into investment accounts.
5.1 INTRODUCTION.
This research deals with the distribution of profits in Faysal Islamic Bank of Sudan (FIBS) where all deposits are held in one pool and used for investment. This practice makes the determination of each party's share in investment, and hence in the profit, a difficult task. Since only a portion of each party's deposits is invested, the task is made even more difficult. The money used for investment consists of the bank's capital (from shareholders), and a certain percentage of the funds of current accounts, and funds in saving and investment accounts. Saving accounts and current accounts are not eligible for profit. So any profit accruing to these accounts goes to the bank (shareholders). A holder of an investment account is entitled to profit after the completion of an agreed period of time, and he has the right to withdraw his money or a part of it at any time.
The first problem we have to face concerning distribution of profit is, how can the bank determine the actual profit of every holder of an investment
account? The bank's money is invested in various projects. Some of these may be completed before the end of the financial year, and their profit known. However, some of them are not, so the bank cannot determine the profits from these uncompleted projects. The right of every holder of an investment account to withdraw part or all of his money at any time also makes it difficult for the bank to determine the actual profit for any financial year.
The second problem we face is that most Islamic banks cannot use all the money available for investment, either because the regulations do not allow them, or because funds available for investment are larger than the banks' investment portfolio. Thus it is difficult for the Islamic bank to determine how much of the invested money is its own, and how much belongs to the holders of investment accounts.
5.2 INVESTMENTS ACCOUNT IN ISLAMIC BANKING

FIBS accepts investment accounts (Mudarabah funds) and uses them in investment. The owners of these funds are entitled to profit according to the participation of their funds in the actual investment. The bank does not use all these funds in investment, but retains a part of them to meet withdrawals. Theoretically, these reserves, along with new deposits which are continually being made, enable the banks to meet all demands for withdrawals.
The Bank is entitled to a certain percentage of the profit on investment accounts as an agent (Mudarib). It is also entitled to profit as an owner ( Rub al Mal ) of the bank's funds participating in investment. These funds include a proportion of the bank's capital and of current and saving accounts whose repayment is guaranteed to their depositors.
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5.3 ACCOUNTING IN ISLAMIC BANKING.
Revenues in Islamic banking are the result of services rendered by these banks, and profits from participation (Musharakah, Mudarabah). The account books of Islamic banks contain a Mudarabah account, in which the balances from different Mudarabas (positive or negative) are shown. The resulting balance in this account is transferred to the profit and loss account. In the profit and loss account, all revenues and expenses are shown. The balance, positive or negative, is transferred to the balance sheet. If any profits are to be distributed, then they will be shown in the distribution account.
Financial statements in Islamic banking aim to measure the various activities of the bank in order to show the performance of the bank and the profit or loss of every activity. By aggregating the balances of all activities of the bank, an amount of net revenue is shown. These financial statements are prepared in accordance with accounting principles, rules and concepts, which, in the case of Islamic banking, should be in conformity with Islamic Law. This, however, needs a separate study. Here we shall briefly discuss accounting difficulties related to depositors' share in profit. Retaining of reserves poses a problem. Do depositors have to participate in them or not? If they have to participate then this should give them some rights in the reserves. However, it is believed that, because these deposits are of a short-term nature, it would be better to retain reserves after distribution of the depositors' share in profit. This will limit depositors' rights to those investments in which their money has actually participated. As stated before, interviews in Islamic banks revealed that some of them retain reserves after distribution of depositors' profit, while others retain them before such distribution.
The depositors' percentage of the profit should be prescribed in advance.
This will minimize the possibility of disputes.
The rights of depositors as participants also needs clarification. Are they
similar to shareholders in their rights and duties or they are different? The answer to this question, however, depends on the extent to which they participate in the reserves retained. If they receive their profit before reserves are retained, then they are participants of a different category than the shareholders.
Profits have to be computed on the basis of the volume of money that
participated in investment and on the duration of time for which the money was deposited. Expenses, disbursements, provisions and depreciation related to depositors' investment should be actual, and not exaggerated, in order to arrive at the depositors' actual profits.
It would be preferable, however, to consider depositors as a different group, and not to equate them with the shareholders. This is mainly because investment deposits are of a short-term nature. Reserves should be retained after distribution of depositors' profit. Projects in which these deposits are invested should be completed or liquidated before the depositors withdraw their investment. Failing that a fair valuation should be made to protect their rights. Placing depositors in a distinct category avoids many accounting difficulties and other complications.
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5.4 BANKS SHARE IN MUDARIBS PROFIT.
Islamic banking extends finance to entrepreneurs on the terms of Musharakah. Many difficulties arise in that Islamic banks monitor these projects to a minimal extent in order to minimize expenses. It would be helpful to prescribe the following in contracts between the banks and their clients
a. Clients combine their own money with that given by the banks on a
Musharakah basis. It is desirable to mention this clearly in the contract.
b. Another area which needs clarification in contracts is, which expenses

should be borne by the Mudarabah fund and which by the client himself?
c. The period of time during which the operation should be completed must
also be prescribed. However, the money realized from operations, in certain cases, should be transferred to the bank at once and not used by the client in private operations.
d. The clients share as an entrepreneur should be clearly stated in the

contract.
e. Situations whereby the client remains fully responsible for loss should
also be clearly defined and prescribed.
These points should be agreed and clearly stated in the contract, so that accounting can be established on that basis. Other banks' contracts related to
other activities such as Murabaha, Ijara etc. should also be carefully written, specifying each party's rights and duties. Hence each party would know his responsibilities, which would help to avoid disputes over the distribution of profit.
5.5 DISTRIBUTION OF PROFIT IN FIBS.
Faysal Islamic Bank of Sudan (FIBS) may reflect a good example for Islamic Banking where all deposits are held in one pool and used for investment. Net profit on investment deposits (Mudarabah deposits) in FIBS is calculated according to principles that have been suggested by the Shari'ah Supervisory Board. These principles can be summed up as follows:
I.
All investable deposits (90 percent of the total investment deposits) are to
be considered as actually invested. The remaining 10 percent are kept as reserves to meet withdrawals.
II.
With the exception of earnings from banking and other services,
investment depositors share in all income generated.
III.
Administrative expenses are to be borne exclusively by the banks'
shareholders.
IV.
Profits are to be distributed among the shareholders and the investment
deposit-holders, taking into consideration items II and III above.
V.
Investment depositors are not entitled to participate in profits from
current and savings deposits.

VI.
FIBS as an owner (Rab ul Mal) and an agent (Mudarib) is entitled to two
shares in the profit; firstly, a percentage of the profit as Mudarib and secondly, a share of the total profit proportionate to the bank's share in the Mudarabah's capital.
Table A shows the funds of different deposits actually invested in FIBS for the year 19X1(*).
The percentage of investment deposits ready for investment in the bank for this year was 100%, held at 90% as stated above. However, the funds available for investment were not fully invested. The actual investment is thus apportioned between the different sources. For example, the actual invested fund for current deposits in January, 19X1 is equal to:
Current deposits in column 3 total actual investment divided by total funds ready for investment.
The amount which is ready for investment is: 109,926 (i.e. 157,03770%).
The actual invested fund is: 75,540 calculated as follows: 109,926 176 ,539 256 ,900 75 ,540
The shareholders' share is represented by the capital plus reserves plus retained profits minus fixed assets and direct investment. This means that bank's capital minus (fixed assets + direct investment) is equal to the amount of the bank's capital which is used in investment.
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Table A Investment percentages for different deposits (LS '000')

Type of deposit Actual deposit 1 LS (000) January 19X1 Current deposits Invt. deposits Savings deposits Shareholders Total February 19X1 Current deposits Invt. deposits Savings deposits Shareholders Total March 19X1 Current deposits Invt. deposits Savings deposits Shareholders Total April 19X1 . . . . September 19X1 157,037 77,228 12,454 58,536 Investment percentage 2 % 70% 100% 90% 100% Funds for investment 12=3 LS (000) 109,926 77,228 11,209 58,537 256,900 112,839 76,007 11,805 55,951 256,602 114,487 76,151 12,240 54,266 257,144 Actual invested funds 4 LS (000) 75,540 53,070 7,703 40,226 176,539 74,433 50,137 7,787 36,908 169,265 76,563 50,926 8,185 36,291 171,965
161,198 76,007 13,117 55,951
70% 100% 90% 100%
163,553 76,151 13,600 54,266
70% 100% 90% 100%
Total actual invested funds as shown in column 4 determine individuals amount allocated for the purpose of distribution of profit. In other words total actual invested fund figure appears at the end of the Financial year first. After that each individual amount (deposit) is computed and determined accordingly.
Table B, shows the total investment for FIBS for the year 19X1. The information in this table is divided into three groups.
a) The monthly actual investment which represents the total sum in column No. 4, Table A.
b) The investment deposit funds which actually participated in the bank's investment. These funds are shown in column No. 4, Table A, against investment deposits.
c) Shareholders; the returns from shareholders + current and savings deposits will go to the bank (shareholders). Therefore, these three items are considered as one. This is shown in column No. 4, Table A. The total sum of money in this column is equal to (a)-(b) above (i.e., in January 19X1, it was LS 123,459,000.
Table B Participation of investment deposits in actual investment (LS '000') Total Amt. Invested.
January a. Credit facilities (Actual Investment.) b. Investment Deposits. c. Shareholders (Inc. current & saving deposits) 176,539 53,070 123,469
February 169,265 50,137 119,128
March
171,965 1,532,422 50,926 431,791
121,039 1,100,630
The term credit facilities, used by the bank, are more appropriately applied to the credit finance which is used in conventional banks. In the case of Islamic banking it may be preferable to use the term "investment" instead.
Investment deposits shown in the Table are the deposits which participated in the actual investment. Investment deposits which are ready to participate in investment are more than these sums, as shown in Table A, column No. 3.
The profit generated from investment in the financial year 19X1, was LS. 15,278,000, which consisted of two types of earnings: (LS '000') 1 - Earnings from investment activities: 2 - Earnings from foreign currency: Total 12,244 3,034 15,278
These profits do not include net revenues from banking services and other revenues generated from direct investment, such as, subsidiary companies.
a. The above profit is distributed between shareholders and investment

depositors in the ratio 72% and 28% respectively, calculated as follows:
i.
The percentage of shareholders' funds used in the actual investment is
equal to total of shareholders' funds divided by total annual investment, multiplied by 100, that is,
1,100,630 100 = 72% 1,532,422
ii.
The percentage of investment deposits used in the actual investment is
equal to total investment deposits divided by total annual investment multiplied by 100; that is, 431,791 100 1,532,422 = 28%
Share of shareholders in profit is (LS. 000') 72 15,278 100

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Share of investment depositors in profit is (LS. 000') 28 15,278 100 = 4,278

.
Therefore, total profit is equal to 11,000+4,278 = 15,278.
Table C, shows the investment deposits in foreign and local currency. These consist of two types; foreign currency deposits and local currency deposits. The investment depositors' share in profit would therefore be divided between foreign and local currency deposits.
Table C Investment in local and foreign currency (LS '000') 1 2 1+2=3 Total foreign currency in Total local currency in Total foreign and local branches(converted to branches currency LS) 373,716 291,404 665,120 The total foreign and local currency in branches is divided by 9 to obtain an average, though there is no need to do so, as the resulting amount (share of deposits in profit) will be the same in both cases. However, as the aim is to show the methods used by the bank, the research follows the same procedures as used by the bank. The profits are calculated for nine months only, because the bank has by agreement with its depositors, increased its profit ratio to 30%, as from the beginning of the tenth month of 19XI. The financial year also was changed to the Hijri calendar;
Therefore the average of foreign currency is (LS `000'). 373,716 = 41,524. 9

And the average of local currency is (LS `000'). 291,404 = 32,378. 9 Total : 41,524+32,378 = 73,902 or 665,120 = 73,920. 9
b. Distribution of profits between deposits in foreign and local currency.

As shown earlier, the share of depositors in profit is LS 4,278,000.
Share of foreign currency in profit =

Average deposits in foreign currency divided by average deposits in foreign and local currency multiplied by depositors' share in profit, in (LS '000') 41,524 4,278 = 2,403 73,902 .
Share of local currency in profit =

Average deposits in local currency divided by average deposits in foreign and local currency multiplied by depositors' share in profit, in (LS '000') 32,378 4,278 = 1,874 73,902
c. Share of depositors in profits after deducting the bank's share Share of investment deposits (foreign currency) =
Share of investment deposits in profit 75% (LS '000') = 2,403 75% = 1,802
Share of investment deposits (local currency) =

Share of investment deposits in profit 75% (LS '000') = 1,874 x 75% = 1,405
Total (LS '000') = 1,802 + 1,405 = 3,207

As shown above, the share of FIBS in the profit as an agent is 25%. However this ratio increased to 30% in the following years. The profits for the last three months of 19XI are calculated on this new ratio. For simplicity the discussion will ignore these three months' profits.
d. Distribution of the Investment Depositors Share in Profits between Branches (Foreign and Local Currency).
Table D, shows deposits (foreign and local) in each branch, and how profit is distributed among the different branches. Table D Share of local and foreign currency in profits (LS '000') Branches
Branch A Branch B Branch C Total Foreign currency (converted to local currency) 128,996 1,445 1,900 175,435
Share in profits
0.621 0.006 0.009 0.845
Local currency
110,072 3,459 1,360 186,654
Share in profits
0.530 0.167 0.006 0.900
Note: As stated above profit was distributed for only 9 months, thus foreign currency deposits (converted to local currency) and local currency deposits at the time of distributing profit were 175,435.00 and 186,654.000 respectively.
Share of investment deposits (foreign currency)=

Total of investment deposits (foreign currency) in branches divided by total of investment deposits for the financial year multiplied by the depositors' share in profits (foreign currency) in (LS '000').
175,435 1,802 = 0.845 (see b above) 373,716 (from Table C)

Total of investment deposits (local currency) in branches divided by total of investment deposits for the financial year multiplied by the local currency deposits share in profit (see 2 in b above) = (LS '000')
186,654 1,405 = 0.900 291,404 (from Table C)
Branch A's share in foreign deposits profit =

Total of investment deposits (foreign) in branch A divided by total for all branches in the financial year multiplied by all branches' share in profit, that is: (LS '000')
128,996 0.845 = 0.621 175,435 .
By using the same technique, the share in profits can be calculated for each branch.
5.6 DISTRIBUTION OF PROFITS IN FIBS IN 14X2(19X2).

The following review of the distribution of profits for the year 14X2 (19X2) permits a comparison between this year and the previous one. The first thing to observe is that, the financial year has been changed from the Gregorian calendar to Hijri. Table Al shows the various deposits which were mobilized for investment in FIBS in the financial year 14X2 (19X2).
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Table A1 Investment percentages for different deposits (LS 'm') for 14X2 (19X2).
Actual deposits 1 The 1st Month Investment deposits Shareholders Savings deposits Current deposits Total The 2nd Month Investment deposits Shareholders Savings deposits Current deposits Total . . . . The 12th Month Investment deposits Shareholders Savings deposits Current deposits Total 66.1 48.0 15.4 194.9 Investment % 2 90% 100% 90% 70% Deposits ready Actual invested for investment. funds 12=3 59.5 48.0 14.0 136.4 257.9 63.6 44.1 14.0 143.4 265.1 4 59.5 48.0 14.0 59.0 180.5 63.6 44.1 14.0 61.3 183.0
70.7 44.1 15.6 204.9
90% 100% 90% 70%
59.1 8.0 23.0 254.5
90% 100% 90% 70%
53.2 8.0 20.7 178.1 260.0
53.2 8.0 20.7 74.5 156.4
It is clear from Table Al that the part of current deposits which participated in actual investment is computed as a balancing figure, while it was computed as a proportion of total investment in 19X1. The reason for that was to favor investment deposits, as they are deposited with the primary aim of obtaining profit. In contrast, current deposits are not entitled to profit and the profit generated from them is transferred to the bank. The change was made according to a recommendation from the Shari'ah Supervisory Board. It is argued that investment deposits should be given the priority as far as distribution of profit is concerned.
For example, in January 19X1, the amount of investment deposits which actually participated in investment was LS 53,070,000, while the total amount available was LS 77,228,000. If the 19X2 method was used, then the investment deposits which should have participated in investment would have been 77,228,000 90% = LS 69,505,000.
Table B1 shows the annual actual investment and the share of investment deposits and shareholders' funds (including current and savings deposits) in the actual investment.
Table B1 Participation of investment deposits in actual investment (LS 'm') 14X2

Month Shareholders funds Investors deposits (used in investments) (used in investments) Actual Investments 1 The 1st Month The 2nd Month The 3rd Month The 4th Month The 5th Month The 12th Month Total 1,264.8 744.2 2,009.0 121.0 119.4 112.2 114.4 99.0 2 59.5 63.6 63.0 61.0 76.4 1+2=3 180.5 183.0 175.2 175.4 175.4
From Table B1 the following information is obtained:
a.
The total annual actual investment is LS 2,009 m.
b. The total annual investment deposits which participated in investment were LS 744.2 m.
c. The total annual shareholders' funds which participated in investment were LS 1,264.8 m.
The profit generated from investment in the financial year 14X2, was LS. 24.9 million which consisted of two types of earnings: (LS '000') 1 - Earnings from investment activities: 2 - Earnings from foreign currency: Total 24.8 4.1 24.9
a. Percentages of investment deposits and shareholders' funds in

investment i. The percentage of shareholders' funds used in the actual investment is equal to total of shareholders' funds divided by total annual investment, multiplied by 100, that is,
1,264.8 100 = 63% 2,009.0
ii. The percentage of investment deposits used in the actual investment is equal to total investment deposits divided by total annual investment multiplied by 100; that is, 744.2 100 2,009.0 = 37%
Share of shareholders in profit is (LS. m') 63 24.9 100 = 15.7
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Share of investment depositors in profit is (LS. 000') 37 24.9 100 = 9.2

.
Therefore, total profit is equal to 15.7+9.2 = 24.9 million.
Table C1 shows the investment deposits (local and foreign currency) in the branches of FIBS. The information in this Table is used to obtain the share of local and foreign currency deposits in the profits generated from the investment deposits, that is, 9.2 m; and hence to compute the share of the bank in the profits as an agent.
Branch Branch A Branch B Branch C Branch D TOTAL
Table C1 Investment in local and foreign currency (LS 'm') 1 2 1+2=3 Total foreign currency Total local Total foreign and in branches(converted currency in local currency to LS) branches 362.3 224.0 586.3 7.7 22.0 29.7 132.2 2.5 134.7 23.0 16.5 39.5 536.8 306.0 842.8
Local currency deposits = 306 m divided by 12 = 25.5 m. Foreign currency deposits 536.8 m divided by 12 = 44.7 m. Total (a + b) = 25.5 + 44.7 = 70.2 m. OR 842.8 = 70.2 12 m.
(Again it is not necessary to divided by 12. However, as the purpose is to illustrate the method as used by the bank, then the procedures used are shown).
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b. Distribution of profits between deposits in foreign and local currency.

As shown earlier, the share of depositors in profit is LS 9.2 m.
Share of foreign currency in profit =

Average deposits in foreign currency divided by average deposits in foreign and local currency multiplied by depositors' share in profit, in (LS '000') 44.7 9.2 = 5.9 m. 70.2 .
Share of local currency in profit =

Average deposits in local currency divided by average deposits in foreign and local currency multiplied by depositors' share in profit, in (LS '000') 25.5 9.2 = 3.3 m. 70.2
c. Share of depositors in profits after deducting the bank's share Share of investment deposits (foreign currency) =
Share of investment deposits in profit 70% (LS 'm') = 5.9 70% = 4.1

Share of investment deposits in profit 70% (LS 'm') = 3.3 x 70% = 2.3
Total (LS) = 4.1 + 2.3 = 6.4 m.
The bank ratio as an agent is 30%. The share of the bank in profit is: 9.2 30% or 9.2 - 6.4 = LS 2.8 m.
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d. Distribution of the Investment Depositors Share in Profits between Branches (Foreign and Local Currency).
Table Dl shows the share of each branch in profits (foreign & local currency deposits). The information in this Table is used to calculate each branch's share in the profits (column No. 2 and No. 4). Table D1 Share of local and foreign currency in profits (LS 'm') 14X2 Branches
Foreign currency (converted to local currency) 1 Branch A Branch B Branch C Branch D Total 362.4 7.7 132.2 23.0 536.8
Share in profits 2
2.8 0.06 1.0 0.2 4.1
Local currency 3
224.0 22.0 2.5 16.5 306.0
Share in profits 4
1.7 0.2 0.02 0.1 2.3
e. Share of branches in profits Branch A's share in profits =

Branch A total in foreign currency/total for all branches in foreign currency total share of all branches in profits, that is:
362.4 4.1 = LS 2.8 m. 536.8 . By using the same method, each branch's shares in profits can be computed.
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5.7 COMPARISON BETWEEN DISTRIBUTION OF PROFITS IN 19X1 & 14X2

In the year 19X1, the proportion of current deposits available for investment was 70%, the actual funds from the current deposits which participated in investment were a percentage of these deposits computed on the 70% basis. The average proportion was 45% of the total actual investment, that is: 695/1,532 100.
The proportion of investment deposits available for investment, for the same year, 19X1, was 100%. However, these funds were not wholly invested. The proportion actually invested was 67% of the total funds, that is: 430/645 100. These funds represented 28% of the total actual investment, that is 430/1,532 100.
In 14X2 (19X2) the current deposits were used to fill the gap between the amount of total actual investment and the amount of other deposits, that is, saving deposits, investment deposits and shareholders funds. However, the percentage of current deposits used in investment to the total actual investment was 794/2,009 100 = 40%. This percentage is 5% less than the percentage of current deposits used in investment in the previous year. This, however, shows that a large proportion of the generated profit is considered to be generated from current deposits. As mentioned before, the actual beneficiaries of such profit are the shareholders.
The proportion of investment deposits which participated in total actual investment in 14X2 (19X2) was 90%, as demonstrated previously (Table Al), a difference of 23% over the previous year. This means that the decrease of 5% of
current deposits used in investment in 19X1, was filled by investment deposits. This is the reason for the increase in the percentage of investment deposits by 23% in the year 14X2. This, in turn, increased the percentage of investment deposits in the total actual investment to 37% that is: 744/2,009 100, compared to 28% in 19X1
If we examine the shareholders' share in total investment we find that it consists of three elements: the shareholders fund, the current and the savings deposits. The shareholders fund percentage which participated in actual investment is very low compared to its share in profits, because the share of current and savings deposits goes to shareholders. For example, the shareholders fund in 19X1 was LS 330 m, while their share in total actual investment was LS 1,100 m. This means a sum of LS 770 m is pooled from current and savings deposits: about 233% of the shareholders fund. The current and savings deposits represented 50% of the total investment, that is 770/1.532 100, while the shareholders proportion was only 22%, that is: 330/1.532 100.
The position is similar for the year 14X2 (19X2). The shareholders fund was LS 275 m, while the share of shareholders in total actual investment was LS 1,265 m; almost LS 1,000 m is pooled from current and savings deposits, representing about 364% of the shareholders fund. The current and savings deposits represented 49% of the total investment, that is: 990/2,009 100, while the shareholders' percentage in total investment is only 14%, that is: 275/2,009 100.
It is acceptable from Shari'ah point of view for an Islamic bank to give the holders of current and savings deposits a part of the profits earned, though
without pre-agreement. By so doing, FIBS might encourage holders of these deposits to deposit more. At the same time, the practice will not harm the bank, because, as we have seen, these profits are mostly generated from the investment of current and savings deposits. The bank has to guarantee the principal of these funds, whether its investment results in profit or loss.
The share of investment deposits in profits for 19X1 was LS 3.2 m (for 9 months), a percentage of 4.3% (3.2/74 100), (table D), while their share in profits for 14X2 (19X2) was LS 6.4 m, 9.1% of the total investment, that is, 6.4/70.2 100 (table C1). Although the investment deposits ratio in profits decreased to 70%, compared with 75% in 19X1, their percentage in profits increased to 9.1% in 14X2 (19X2), as opposed to only 4.3% in the previous year. This is again because the share of investment deposits which participated in total investment increased at the expense of the shareholders' share, or to be more accurate, at the expense of current deposits.
A comparison between the investment deposits share in profits and the interest rates in conventional banks is not given, because it is assumed that investors in FIBS are more interested in interest-free banking than in a high return of profit. Recent studies show that almost all depositors in FIBS choose Islamic banking for religious reasons rather than other factors. Even though the depositors may make a comparison between rates of profits from one Islamic bank to another, it is believed that they are more interested in an efficient service and strict adherence to Islamic teachings than in high rates of profits. It can thus be concluded that the volume of investment deposits is a function of efficiency and strict conformity to Islamic teachings.
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Limited period mudarabah

From the above methods used by FIBS to distribute profits between the holders of investment deposits (Rub al Mal) and the bank 'shareholders' (Mudarib), it is observed that many difficulties arise, because different funds are held in a single pool. Some Islamic banks distinguish between investment of Mudarabah funds and that of other funds. An example of these banks is al Baraka Bank (Sudan).
In "Limited Period Mudarabah" every fund is separately invested, whereby an Islamic bank issues Mudarabah securities, or certificates. These are a special kind of promissory note, issued in LS 10 or other denominations. When such securities are issued, they represent a share in an investment project monitored by the bank that issues them. The relationship between the bank and the holders of these securities is based on the Mudarabah contract. The investment lasts for a specific period of time, predetermined according to the feasibility study. When the investment, which might be a project or a trade operation, is liquidated or completed, the profit will be distributed in the pre-determined ratio between the bank and the security-holders. If a loss occurs, the holders of Mudarabah securities would bear it, according to Mudarabah contract. The distribution of profit between security-holders themselves would be according to the number of securities held by each.
Mudarabah securities may thus be likened to 'common stocks' or ordinary shares. While the stockholder provides 'equity' and shares in profits and losses and, in theory, in the control of the business the Mudarabah securityholder shares in profits and bears losses, though he does not effectively share in the control of the business. This is a more risky venture.
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Ordinary shares aim to finance a specified project or trade operation, in other words a venture. A share in a company entitles its holder to the proportionate share in the assets and profits of that company. Hence the owner of a share in a company whose capital is represented by 100 such shares, owns one-hundredth of the assets of that company and is entitled to one-hundredth of the profits(2). However, the difference between the Mudarabah security-holder and an ordinary shareholder is that the former does not play any part in the management of the business, but shares in the profits and the risks.
This similarity between Mudarabah securities and shares does not mean that the consequences are the same - as, for instance, in selling, discounting or using these securities as a mortgage.
Shares can be offered for sale in the stock market, and the purchaser of the shares is entitled to all the rights appertaining to those shares. He will thus be entitled to vote in respect of his shares and will receive dividends.
Although Mudarabah securities are similar to shares, they represent capital for a short-term project, which will be liquidated in the near future, unlike shares, which represent a capital for an entity which will continue for an indefinite period of time. Another drawback to the supply of Mudarabah securities for sale is that their holders are liable to bear the whole loss in a project.
The value of Mudarabah securities depends on the feasibility of the project and the efficiency of its management, which makes it uncertain and not fit for discounting. Usually, a security which can be discounted is a security which forms a loan and a promise by the burrower to pay back that loan within a stated period of time. Such a bill can be sold or discounted before maturity.
However, discounting of bills or securities is not permitted according to Islamic Law as it involves interest.As far as mortgage is concerned, it is acceptable to use Mudarabah securities as guarantees.
However, limited period Mudarabah as a form of finance has many disadvantages. The main drawback is that financial institutions which use this method would not be efficient in mobilizing public savings, for they would mobilize only the savings of the high-income groups; within the high-income classes, only those with a low propensity to consume, are expected to acquire such an investment. Furthermore, liquidity-preference which depends on the transaction-motive and the precautionary-motive will be high. The public will tend to keep a relatively high percentage of their income in cash rather than channeling it into financial institutions for investment, because funds deposited for investment have to be kept in the bank and will not be immediately available to meet transaction and unforeseen needs.
It might be argued that such moneys can be pooled into current accounts, so that they participate, partially, in investment, yet are available and can be called at any time. However, the mobilization of money into the banking system will be more efficient if incentives are given to the public. We find that in the UK, most commercial banks have introduced a current account called "current plus", whereby all current accounts will start earning interest. The point to be emphasised is that incentives make mobilization of different kinds of money into the banking system more efficient, whereas limited period Mudarabah will increase the tendency towards keeping more cash with the public for transaction and precautionary purposes.
Another disadvantage of limited period Mudarabah is its impracticability for commercial banks. It is more orientated to investment banking than to
commercial banking, and it would be difficult and costly for a commercial bank to manage and follow up projects financed by this method.
The most important role played by limited period Mudarabab is that it provides a type of finance whereby the depositors' fund is segregated from the bank's money. Thus each party's share in profit is more easily distinguished and hence distributed. It also helps to put an end to the controversial point of "full liquidation". Full liquidation or realization of the goods of Mudarabah, that is, converting it to money (Tandeed) is required by jurists before profit can be distributed. The aim is to enable the financier (Rub al Mal) to recover his capital, in the first place, and then the profit accruing will be shared between him and the agent ( Mudarib) as agreed. Valuation of the inventory of the operation would not stand as an alternative to full liquidation, because the price of the goods may appreciate or depreciate.
To conclude, two techniques for mobilizing deposits in Islamic banking may be used to substitute interest based deposits; namely, (a) Mudarabah contract, where all funds are held in one pool for investment and (b) Limited Period Mudarabah contract, where each group of Mudarabah certificates is invested in one project and profit is distributed when the project is liquidated.
The first technique, though efficient in mobilizing different classes of savings, is problematic as regards determining each party's participation in investment and hence in profit. Moreover, the situation is more problematic when considering the right of depositors to withdraw and add to deposits. The second technique, (i.e. Limited Period Mudarabah), though not as efficient in mobilizing savings as the first has the advantage that each depositor's share in investment and in profit can be easily determined and distributed.
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Chapter 6
ISLAMIC BANKING IN INDIA
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In the straitjacket world of Indian banking, something as fascinating as Islamic banking is a distant dream. Nonetheless, countless advocates of Islamic banking have been trying their best over the years to propagate the concept. India has 18 percent Muslims population which is more than the Muslim population of Bangladesh, turkey, Egypt, Iran, Nigeria, Afghanistan, Sudan, Iraq, Saudi Arabia etc. But there is no/any full fledged Islamic bank currently working in this country. Reserve Bank of India and other legal institutions of India are not issuing license to banks to work as per the principles of Islamic banking. Necessary measures are, however, being taken by India Government for the same. The present study is taken to explain how Islamic banking is better for India while taking the SWOT analysis and Michael Porters five forces model. It also explains how Islamic bank can commence in India by suggesting necessary measure for the same.
6.1INTRODUCTION
Although Islamic banking is for all irrespective of religion, but particularly for Muslims interest is forbidden and that is why Islam has its own economic system which is based on social justice. But as far as Muslim population is concerned, then Islam is the world's second largest religion after Christianity with over 1.0-1.8 billion adherents, comprising 20-25% of the world population while most estimates figures that there are 1.5 billion Muslims worldwide. India is the second largest country in the world as far as population is concerned. Muslim population has been estimated to be 18.7 percent. Banking in India is totally base on interest and in this country 88 scheduled commercial banks (SCBs) - 27 public sector banks (that is with the Government of India holding a stake), 31 private banks (these do not have government stake;
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they may be publicly listed and traded on stock exchanges) and 38 foreign banks. They have a combined network of over 53,000 branches and 17,000 ATMs. According to a report by ICRA Limited, a rating agency, the public sector banks hold over 75 percent of total assets of the banking industry, with the private and foreign banks holding 18.2% and 6.5% respectively. But unfortunately there is not a single Islamic bank presently working in this country. Although some banks/institutions are working on the Islamic banking principles, but they are treated as Non Banking Financial Companies (NBFCs). NBFCs are doing functions akin to that of banks, however there are a few differences: (i) A NBFC cannot accept demand deposits (demand deposits are funds deposited at a depository institution that are payable on demand -- immediately or within a very short period -- like your current or savings accounts.) (ii) It is not a part of the payment and settlement system and as such cannot issue cheques to its customers; and (iii) Deposit insurance facility of DICGC is not available for NBFC depositors unlike in case of banks.
Taking
the
above
differences
into
consideration,
Islamic
banks/institutions are not becoming popular in India and that is why maximum population is unaware about the working of Islamic banks. Also these institutions/banks have not shown good performance compared to conventional banks may be due to Government and public support.
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6.2 INDIAN BANKING SCENARIO
Banks in India can be categorized into non-scheduled banks and scheduled banks. Scheduled banks constitute of commercial banks and cooperative banks. There are about 67,000 branches of Scheduled Banks spread across India. During the first phase of financial reforms, there was a nationalization of 14 major banks in 1969. This crucial step led to a shift from Class banking to Mass banking. Since then the growth of the banking industry in India has been a continuous process. As far as the present scenario is concerned the banking industry is in a transition phase. The Public Sector Banks (PSBs), which are the foundation of the Indian Banking system account for more than 78 per cent of total banking industry assets. Unfortunately they are burdened with excessive Non Performing assets (NPAs), massive manpower and lack of modern technology.
On the other hand the Private Sector Banks in India is witnessing immense progress. They are leaders in Internet banking, mobile banking, phone banking, ATMs. On the other hand the Public Sector Banks are still facing the problem of unhappy employees. There has been a decrease of 20 percent in the employee strength of the private sector in the wake of the Voluntary Retirement Schemes (VRS). As far as foreign banks are concerned they are likely to succeed in India. Indusland Bank was the first private bank to be set up in India. IDBI, ING Vyasa Bank, SBI Commercial and International Bank Ltd, Dhanalakshmi Bank Ltd, Karur Vysya Bank Ltd, Bank of Rajasthan Ltd etc are some Private Sector Banks. Banks from the Public Sector include Punjab National bank, Vijaya Bank, UCO Bank, Oriental Bank, Allahabad Bank, Andhra Bank etc. ANZ Grindlays Bank, ABN-AMRO Bank, American Express Bank Ltd; Citibank etc are some foreign banks operating in India.
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6.3 RECENT DEVELOPMENTS. The last decade has seen many positive developments in the Indian banking sector which is totally based on interest based banking. The policy makers, which comprise the Reserve Bank of India (RBI), Ministry of Finance and related government and financial sector regulatory entities, have made several notable efforts to improve regulation in the sector. The sector now compares favorably with banking sectors in the region on metrics like growth, profitability and non-performing assets (NPAs). A few banks have established an outstanding track record of innovation, growth and value creation. This is reflected in their market valuation. However, improved regulations, innovation, growth and value creation in the sector remain limited to a small part of it. The cost of banking intermediation in India is higher and bank penetration is far lower than in other markets. Indias banking industry must strengthen itself significantly if it has to support the modern and vibrant economy which India aspires to be. While the onus for this change lies mainly with bank managements, an enabling policy and regulatory framework will also be critical to their success. The failure to respond to changing market realities has stunted the development of the financial sector in many developing countries. A weak banking structure has been unable to fuel continued growth, which has harmed the long-term health of their economies. Indian banks which are based on conventional pattern have compared favorably on growth, asset quality and profitability with other regional banks over the last few years. The banking index has grown at a compounded annual rate of over 51 per cent since April 2001 as compared to a 27 per cent growth in the market index for the same period.
Policy makers have made some notable changes in policy and regulation to help strengthen the sector. These changes include strengthening prudential norms, enhancing the payments system and integrating regulations between commercial and co-operative banks. However, the cost of intermediation remains high and bank penetration is limited to only a few customer segments and geographies. While bank lending has been a significant driver of GDP growth and employment, periodic instances of the failure of some weak banks have often threatened the stability of the system. Structural weaknesses such as a fragmented industry structure, restrictions on capital availability and deployment, lack of institutional support infrastructure, restrictive labour laws, weak corporate governance and ineffective regulations beyond Scheduled Commercial Banks (SCBs).
Entry of New Banks in the private Sector:
As per the guidelines of licensing on new banks in the private sector issued in January 1993, based on review of experience gained on the functioning of new private sector banks, revised guidelines were issued in January 2001. The main provisions/ requirements are listed below: Initial minimum paid-up capital shall be Rs.200 crore; this will be raised to Rs. 300 crore within three years of commencement of business. Promoters contribution shall be minimum of 40 percent of the paid-up capital of the bank at any point of time; their contribution of 40 percent shall be locked in for 5 years from the date of licensing of the bank and excess stake above 40 percent shall be diluted after one year of banks operations.
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Initial capital other than promoters contribution could be raised through public issue or private placement. While augmenting capital to Rs. 300 crore within three years, promoters need to bring in at least 40 percent of the fresh capital, which will also be locked in for 5 years. The remaining portion of fresh capital could be raised through public issue or private placement. NRI participation in the primary capital of a new bank shall be to the maximum extent of 40 percent. In case of foreign banking company or finance company (including multilateral institutions) as a technical collaboration or a co-promoter, equity participation shall be limited to 20 percent within the 40 percent ceiling. Shortfall in NRI contribution to foreign equity can be met through contribution by designed multilateral institutions. No large industrial house can promote a new bank. Individual companies connected with large industrial houses can, however, contribute up to 10 percent of the equity of a new bank, which will maintain an arms length relationship with companies in the promoter group and the individual company/ies investing in equity. No credit facilities shall be extended to them. NBFCs (under which Islamic banks are covered in India) with good record can become banks. A minimum capital adequacy ratio of 10 percent shall be maintained on a continuous basis from commencement of operations. Priority sector lending target is 40 percent of the net bank credit, as in the case of other domestic banks; it is also necessary to open 25 percent of the branches in rural/semi-urban areas.
6.4 SWOT ANALYSIS OF ISLAMIC BANKING IN INDIA:

When SWOT analysis of Islamic banking is done as far as India is concerned, it shows a good that Islamic banking has high Strengths India compared to Weaknesses. The following is briefly a summary of the same.
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RBI and Islamic Banking In the straitjacket world of Indian banking, something as fascinating as Islamic banking is a distant dream. Nonetheless, countless advocates of Islamic banking have been trying their best over the years to propagate the concept. In furtherance of this propagation the Reserve Bank of India (RBI) constituted a committee in 2007 to examine the issue but viewed that Islamic banking cannot be offered by banks in India as well as the overseas branches of local banks under the present legal framework. Except a basic offering like current account, almost no other banking product in India can be modified to meet the conditions of Islamic banking. As a genre of financial services, Islamic banking shuns the very idea of interest rates, and rests on profit-sharing principles. Based on the Shariah law, it abhors the business of making money out of money, upholding the belief that wealth is generated through actual trade and investment. The RBI has not put the report in the public domain.
While the final form of the report is not known, from the newspaper reports it can be collected that the members had pointed out how Indian banking laws come in the way of various Islamic banking principles. These are as follows: Indian banking laws do not explicitly prohibit Islamic banking but there are provisions that make Islamic banking almost an unviable option. The financial institutions in India comprises of Banks and Non Banking Financial Institutions. Banks in India are governed through Banking Regulation Act 1949, Reserve Bank of India Act 1934, Negotiable Instruments Act 1881, and Co-operative Societies Act 1961.
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Certain provisions regarding this are mentioned below Section 5 (b) and 5 (c) of the Banking Regulation Act, 1949 prohibit the banks to invest on Profit Loss Sharing basis -the very basis of Islamic banking. Section 8 of the Banking Regulations Act (BR Act, 1949) reads, "No banking company shall directly or indirectly deal in buying or selling or bartering of goods" Section 9 of the Banking Regulations Act prohibits bank to use any sort of immovable property apart from private use this is against Ijarah for home finance Section 21 of the Banking Regulations Act requires payment of Interest which is against Sharia
As regards to partnership by Islamic banks in a firm, the bank has to make sure that the manager does not avoid his responsibilities or obtain other non-pecuniary benefits at the expense of non-participating partners and ensure the veracity of the profit statements. Monitoring of data about firms in which Islamic bank invests would involve exorbitant cost. However, Islamic banks need to set up monitoring cell to keep them informed of the internal function of their joint venture. The implication is that banks and entrepreneur have to function very closely.
Islamic banking needs to introduce corporate governance with transparent accounting standards. It needs to perform detailed evaluation before embarking Profit Loss Sharing Scheme, which demand a pool of highly trained professionals. The imparting of professional training is costly. Detailed principles are still to be laid down and techniques and procedures evolved to
carry them out. It is only after the satisfactory achievement of these that proper training can begin.
It is observed that inability to evaluate a projects' profitability has tended to act against investment financing. Some borrowers frustrate the banks appraisal efforts as they are reluctant to provide full disclosures of their business. These exercises are not limited to relatively few large loans but need to be carried out on nearly all the advances made by the bank. Yet, widely acceptable and reliable techniques are yet to be devised. Moreover, the borrowers do not observe business ethics which make it difficult to establish close bank-clientele relationship - a condition for successful Islamic banking. Adverse selection has been one of the major impediments in the world of Islamic banking.
Among the other disincentives from the borrower's point of view is the need to disclose his accounts to the bank if he were to borrow on the Profit Loss Sharing basis. However, many small-time businessmen do not keep any accounts, leave alone proper accounts. And large conglomerates do not like to disclose their real accounts to anybody. The widespread lack of business ethics among certain business community will be another major hurdle in the path of Islamic banking in India.
The practices in use by the Islamic banks have evoked questions of morality. Some critics view Sukuk (Islamic Bond) as unIslamic in nature. Others criticize that financing through the purchase of client's property with a buy-back
Agreement and sale of goods to clients on a mark-up, involved the least risk and are closest to the old interest-based operations. Bai' mu'ajjal (sale with
deferred payment) and Murabaha (cost-plus financing) are permitted in the Sharia under certain conditions. What is being done in many countries are fictitious deals which ensure a predetermined profit to the bank without actually dealing in goods or sharing any real risk. This is against the letter and spirit of Sharia.The BR Act even disallows an Indian bank from floating a subsidiary abroad to launch such products, or offering these through a special window. Thus, the upshot of the findings is that such banking experiment is impossible without a new law or multiple amendments to the BR Act.
Another important consideration is the tax procedures. While interest is a passive income, profit is defiantly an earned income which is treated differently. If principles of Islamic banking are incorporated then how does it comply with the tax procedure is the moot question. Further RBI cannot act as the lender to such banks because such accommodation by the monetary authority is also interest based. Islamic banks cannot interact with conventional banks based on principles of interest.
Michael Porter Five Forces Analysis The five forces model of Porter is an outside-in business unit strategy tool that is used to make an analysis of the attractiveness (value) of an industry structure. The competitive forces analysis is made by the identification of 5 fundamental forces: 1. Bargaining power of customers. How easy or difficult is it for new entrants to start competing, which barriers do exist. 2. Bargaining power of suppliers. How strong is the position of sellers? Do many potential suppliers exist or only few potential suppliers, monopoly? 3. Competitive rivalry among the existing players. Does a strong competition between the existing players exist? Is one player vary dominant or are all equal in strength and size.
4. Threat of substitute products. How easy can a product or service be substituted, especially made cheaper. 5. Threat of new entrants. How easy or difficult it is for new entrants to start competing, which barriers do exist. When applying Michal porters five forces model to Islamic banking, it shows the results like this.
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6.5 PRESENT STATUS

There are several Baitul Mals working in cities as well as in villages. Only 10 to 15 Islamic banks with deposits of about Rs 75 crore are operating all over the country in various states. They are actually non-banking finance companies (NBFCs) which work on profits/loss basis. Islamic banks by and large cater to the needs of local area except a few of them operating across districts or states. Their sources of funds are limited and as a result these banks have to operate on small scale missing the economies of scale. Islamic banks in India provide housing loan, on the basis of co-ownership, venture finance on mudarabah basis as well as on musharaka basis and consumers loans. Some banks finance transports also on the mark up basis via hire purchase. Education finance and skill development finance is also provided by them. Investments are made in government securities, small savings schemes or units of mutual funds. Investment in shares of companies is also made by some Islamic banks. Hire purchase and lease finance are other source of investments Islamic banks in India do not function under banking regulations.
They are licensed under Non Banking Finance Companies Reserve Bank Directives 1997 RBI (Amendment) Act 1997, and operate on profit and loss based on Islamic principles. RBI has introduced compulsory registration system. In the Monetary and Credit Policy for the year 1999-2000, it was proposed that in respect of new NBFCs, which seek registration with the RBI and commence the business on or after April 21, 1999, the requirement of minimum level of net owned funds (NOF) will be Rs 2 cr.
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Chapter 7
CONCLUSION & SUGGESTIONS
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7.1 CONCLUSION
Islamic banking is at an incipient stage. The existing legal framework does not permit Islamic Banking. Only selective activities like equity investment is possible, while trade finance aspects like taking title to goods is not possible. A lot of amendments need to be carried out in the prevalent legal set up. Appropriate models need to be selected and implemented to suit society's diverse financial needs. Islamic Bank of Britain, Islamic banks of Thailand, Singapore and USA may be glaring models for Indian bankers. The reputed domestic and international banks along with the collaboration of RBI should be involved in the process of determining and implementing Islamic Banking products. The importance and relevance of Islamic banking in India in the context of "Financial Tsunami" that has taken place in recent times further enhances the need of Sharia banking. Also the political parties need economic rationality to convince majority of voters that Islamic banking is not being introduced to please Muslim voters but to genuinely boost faster and inclusive growth for the Indian economy. Obnoxious politics in the name of religion must be avoided.
Islamic banking could be a huge political issue. Certain parties might abhor the use of the word "Islamic" and could term it as anti-Indian. They might argue that the very concept of Sharia banking would go against the secular fabric of our country. We are already facing problems pertaining to Muslim Personnel Law and trying to implement Uniform Civil Code. Therefore, at this juncture, if we introduce Islamic banking in India, it will create more problems than solving the issue. Moreover, it may bring financial segregation in the economy.
The compartmentalization of Sharia compliant and Non Sharia Compliant banking might be used by certain vested interest to communalize the finance sector in India. Such questionably sane but unquestionably dangerous trend must be prevented with full might
With only minor changes in their practices, Islamic banks can get rid of all their cumbersome and sometimes doubtful forms of financing and offer a clean and efficient interest-free banking. Participatory financing is a unique feature of Islamic banking, and can offer responsible financing to socially and economically relevant development projects. This is an additional service that Islamic banks offer over and above the traditional services provided by conventional commercial banks. Such a system will offer an effective banking system where Muslims in India.
I personally believe to refer 'Islamic Banking' as 'Interest Free Banking' so that it could be looked through the broad economic kaleidoscope and not a narrow religious prism.
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7.2 SUGGESTIONS
India is eyeing a stake in the booming Islamic banking industry with its proposed implementation being assessed with great interest by the Indian policymakers. But they have to substantially modify the legal framework which governs the Indian banking system prior to offering Islamic banking financial services in the country. Under the current Indian banking laws, it is almost impossible for Islamic banking to be carried out in India due to the mandatory requirement for interest payments on deposits. The concept of profit-loss sharing or partnership is alien to the conventional banking framework of India and thus not allowed under the law. The tax treatment of Islamic finance products, unless reviewed, would be the biggest hindrance to the implementation of Islamic banking in India. India is ready to make waves in Islamic banking but not without their Governments permission to the conduct of Islamic banking in the country. With 150 million Muslim populations, India stood to gain advantage to pool around one trillion dollars Islamic investment funds from Gulf countries compared with its other non-Muslim counterparts. This will help the national current account and fiscal deficit in check.
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BIBLIOGRAPHY
REFERENCE BOOKS
ISLAMIC BANKING - An Introduction. Edited by V. SUBBULAKSHMI
WEBLIOGRAPHY
www.ro.uow.edu.au www.globalwebpost.com www.nubank.com www.ruralfinance.org www.bankinginfo.com www.sbp.org.pk Institute of Islamic Banking and Insurance - Musharakah on shari'ah Ruling www.kantakji.com waris abid bank expert: introduction os islamic banking www.crisil.com
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VIVEK COLLEGE OF COMMERCE

INTRODUCTION TO ISLAMIC BANKING.

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1.2 THE HISTORY OF ISLAMIC BANKING

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1.3 MEANING and DEFINITIONS

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1.4 BASIC CONCEPT

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1.5 PHILOSOPHY OF ISLAMIC BANKING AND FINANCE

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1.6 OBJECTIVE OF THE STUDY

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Chapter 2 ISLAMIC BANKING THEORITICAL VIEW

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2.1 ESSENTIALS OF ISLAMIC BANKING

II). Care for Others

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III). Productive Effort as a Means of Serving God

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IV). Application of the Shari'ah Rulings to Business

V). Mutual Consultation

VI). Treating Wealth as a Means and not an End

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VII). Proper Functioning of the Market

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VIII). Protection of Consumers

IX). Monopolies and Cartels

X). Zakat or Zakah

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XI). Qard Hasan

2.2 PRINCIPILES OF ISLAMIC BANKING

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I). Justice, equality and solidarity

II). Forbidden objects and creatures

III). Acquisition of property rights

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IV). Property (wealth) should be used in a rational but fair way.

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VII). The duality of risk

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2.3 PROHIBITION OF RIBA-THE MOST IMPORTANT ASPECT OF ISLAMIC BANKING

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2.3.3 REVELATIONS/VERSES IN HOLY QURAN REGARDING PROHIBITION OF RIBA/INTEREST

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2.3.4 REASONS FOR PROHIBITION OF RIBA

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(viii) Quard Hassan, a system of benevolent loans.

2.4.1 MUDARABAH (CAPITAL TRUSTS)

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2.4.4 BAI MUAJJALL (DEFERRED PAYMENTS)

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