ISLAMIC THEORY AND

FINANCE
FINAL PROJECT

Submitted by :
Moeed Rehman
Muhammad Ali
Badar-ul-Islam Khan Lodhi
Abdul Rafay Ali

Submitted to : Sir Khalid Hussain

Table of Contents
Introduction.................................................................................................................
..................3

Major modes of Islamic banking........................................................................4

Literature Review...............................................................................................7
Research Methodology.......................................................................................10
Critical Analysis.................................................................................................11
Investment based................................................................................................11
Trade Based........................................................................................................11
Ijarah...................................................................................................................11
Challenges...........................................................................................................13

INTRODUCTION :
In early golden Islamic age, forms of proto-capitalism and free markets were present in the
Caliphate, where an early market economy and an early form of mercantilism were developed
between the 8th-12th centuries, which some refer to as "Islamic capitalism". A vigorous
monetary economy was created on the basis of the expanding levels of circulation of a stable
high-value currency (the dinar) and the integration of monetary areas that were previously
independent. During this age, number of innovative concepts and techniques were introduced in
early Islamic banking which are still existing in this modern Islamic banking world, including
bills of exchange, the first forms of partnership (mufawada) such as limited partnerships
(mudaraba), and the earliest forms of capital (al-mal), capital accumulation (nama al-mal),
cheques, promissory notes, trusts startup companies, , transactional accounts, loaning, ledgers
and assignments. Organizational enterprises similar to corporations independent from the state
also existed in the medieval Islamic world, while the agency institution was also introduced
during that time. Many of these early capitalist concepts were adopted and further advanced in
medieval Europe from the 13th century onwards.
Banking plays a very significant role in the economic development of a country. After Partition
of India and Pakistan British Governments commission distributed the reserves between
Pakistan and India. In August 1947, various Banks transferred their headquarters and funds to
India. Before partition of Pak-o-Hind, some Banks were operated which were Chartered Bank,
Grind-lays Bank, Imperial Bank of India, Australasia Bank and Habib Bank. After the
independence of Pakistan, Muslim Commercial Bank Limited, Bank of Bahawalpur Limited,
Punjab National Bank and National Bank of Pakistan were providing banking facilities to
general public.

Meezan Bank :
Meezan Bank is publicly listed company, first incorporated on January 27, 1997. It started
operations as an Islamic investment bank in August of the same year, which has been licensed by
the 3State Bank of Pakistan to operate as an Islamic Commercial bank on 31st January 2002.
State Bank of Pakistan granted the Nations first full-fleged commercial banking license of
Islamic Banking to Meezan bank Ltd. It was a new era in banking Sector history in Pakistan that

Meezan Bank Ltd adheres strictly to the principles of Islamic Shariah with absolutely no
compromise, and is recognized as Pakistans truly premier Islamic Bank. Meezan Bank is
operating approximately more than 166 branches in 40 different cities. In addition, the 3State
Bank of Pakistan itself governs the activities of Meezan Bank and its Shareholders. Meezan
bank Ltd has a strong Balance sheet with excellent operating profitability, including a capital
adequacy ratio that has placed the Bank at the top of industry, a long-term entity rating of A+,
and a short-term entity rating of A1+. Meezan Bank has been one of the fastest growing banks in
the history of Pakistans banking sector. Average growth in deposits has been 55% per annum
during this period while the branch network grew from 4 to 201. The bank has developed an
extraordinary research and development capability by combining investment bankers,
commercial bankers, Shariah scholars and legal experts to develop innovative, viable, and
competitive value propositions that not only meet the requirements of todays complex financial
world, but do so with world-class service excellence which our customers demand, all within the
bounds of Shariah. The Bank has established a strong and credible management team comprised
of experienced professionals. Planning and managing the work efficiency is the key factor of the
Meezan Banks Managers.

Major modes of Islamic banking:

MURABAHA
Literally it means a sale on mutually agreed profit. Technically, it is a contract of sale in which
the seller declares his cost and profit. Islamic banks have adopted this as a mode of financing. As
a financing technique, it involves a request by the client to the bank to purchase certain goods for
him. The bank does that for a definite profit over the cost, which is stipulated in advance.
IJARAH
Ijarah is a contract of a known and proposed usufruct against a specified and lawful return or
consideration for the service or return for the benefit proposed to be taken, or for the effort or
work proposed to be expended. In other words, Ijarah or leasing is the transfer of usufruct for a
consideration which is rent in case of hiring of assets or things and wage in case of hiring of
persons.

IJARAH-WAL-IQTINA
A contract under which an Islamic bank provides equipment, building or other assets to the client
against an agreed rental together with a unilateral undertaking by the bank or the client that at the
end of the lease period, the ownership in the asset would be transferred to the lessee. The
undertaking or the promise does not become an integral part of the lease contract to make it
conditional. The rentals as well as the purchase price are fixed in such manner that the bank gets
back its principal sum along with profit over the period of lease.
MUSAWAMAH
Musawamah is a general and regular kind of sale in which price of the commodity to be traded is
bargained between seller and the buyer without any reference to the price paid or cost incurred
by the former. Thus, it is different from Murabaha in respect of pricing formula. Unlike
Murabaha, seller in Musawamah is not obliged to reveal his cost. Both the parties negotiate on
the price. All other conditions relevant to Murabaha are valid for Musawamah as well.
Musawamah can be used where the seller is not in a position to ascertain precisely the costs of
commodities that he is offering to sell.
ISTISNAA
It is a contractual agreement for manufacturing goods and commodities, allowing cash payment
in advance and future delivery or a future payment and future delivery. Istisnaa can be used for
providing the facility of financing the manufacture or construction of houses, plants, projects and
building of bridges, roads and highways.
BAI MUAJJAL
Literally it means a credit sale. Technically, it is a financing technique adopted by Islamic banks
that takes the form of Murabaha Muajjal. It is a contract in which the bank earns a profit margin
on his purchase price and allows the buyer to pay the price of the commodity at a future date in a
lump sum or in installments. It has to expressly mention cost of the commodity and the margin of
profit is mutually agreed. The price fixed for the commodity in such a transaction can be the
same as the spot price or higher or lower than the spot price.

MUDARABAH
A form of partnership where one party provides the funds while the other provides expertise and
management. The latter is referred to as the Mudarib. Any profits accrued are shared between the
two parties on a pre-agreed basis, while loss is borne only by the provider of the capital.
MUSHARAKAH
Musharakah means a relationship established under a contract by the mutual consent of the
parties for sharing of profits and losses in the joint business. It is an agreement under which the
Islamic bank provides funds, which are mixed with the funds of the business enterprise and
others. All providers of capital are entitled to participate in management, but not necessarily
required to do so. The profit is distributed among the partners in pre-agreed ratios, while the loss
is borne by each partner strictly in proportion to respective capital contributions.
BAI SALAM
Salam means a contract in which advance payment is made for goods to be delivered later on.
The seller undertakes to supply some specific goods to the buyer at a future date in exchange of
an advance price fully paid at the time of contract. It is necessary that the quality of the
commodity intended to be purchased is fully specified leaving no ambiguity leading to dispute.
The objects of this sale are goods and cannot be gold, silver or currencies. Barring this, Bai
Salam covers almost everything, which is capable of being definitely described as to quantity,
quality and workmanship.

LITERATURE REVIEW
In 1963, Islamic banking came into existence on an experiment basis on a small scale in a small
town of Egypt. The success of this experiment opened the doors for a separate and distinct
market for Islamic banking and finance and as a result, in 1970s Islamic banking came into
existence at a moderate scale and a number of full-fledge Islamic banks was introduced in Arabic
and Asian countries. Most of these Islamic banks were in Islamic countries. Having started on a
small scale, Islamic banks and non-banking financial institutions are now in operation even on
more intensive scale. Today, Islamic banks are operating in more than sixty countries with assets
base of over $166 billion and a marked annual growth rate of 10%-15%. In the credit market,
market share of Islamic banks in Muslim countries has risen from 2% in the late 1970s to about
15 percent today (Aggarwal and Yousaf 2000). These facts and figures certify that Islamic
banking is as viable and efficient as the conventional banking.
To adhere to the teachings of Islamic Law (Shari'ah) avoid paying and receiving Riba, avoid
Gharar, investing in profit-sharing ventures, avoid investing in such business that are unethical
and impermissible, and making socially responsible investments are the distinguishing points
as well as goals of all Islamic banks. How well these Islamic financial institutions have
performed and to what extent they have been successful in achieving these goals have been the
question marks for the scholars, researchers, and the stakeholders.
Although the phenomenon of Islamic Banking and finance has emerged in recent years and
despite the considerable development of Islamic banking sector, the studies focusing on the
efficiency of the Islamic banks are still limited in number Most of the studies that have been
conducted, generally evaluate the performance of Islamic banks with regards to the relationship
between profitability and bank characteristics. Bashir (2000) and, Hassan & Bashir (2003)
employ bank level data and perform regression analysis to determine the underlying
determinants of Islamic performance. Samad & Hassan (2000) and Kader & Asarpota (2007)
apply financial ratio analysis to assess the performance of the Malaysian Islamic 11
Stakeholders: current account holders creditors, Musharka financing partners, Mudarabah
investment account holders, managers, employees, Islamic community, regulatory agencies.
Samad and Hassan (2000) evaluate intertemporal and interbank performance in profitability,
liquidity, risk and solvency, and community involvement of an Islamic bank (Bank Islamic
Maalysia Berhad (BIMB) over 14years for the period 1984-1997. The study is intertemporal in
that it compares the performance of BIMB between the two time period 1984-1989 and 19901997. This is not a new method (Elyasiani 1994). To evaluate interbank performance, the study
compares BIMB with two conventional banks (one smaller and one larger than BIMB) as well as
with 8 conventional banks. Using financial ratios to measure these performance and F-test and Ttest to determine their significance, the results show that BIMB make statistically significance
improvement in profitability during 1984-1997, however, this improvement when compared with

conventional banks is lagging behind due to several reasons. This result is consistent with that of
Samad (1999) and Hassan (1999). The study also reveals that BIMB is relatively less risky and
more solvent as compared to conventional banks. These results also conform to risk-return
profile that is BIMB is comparatively less profitable and less risky.
Abdus Samad (2004) in his paper examines the comparative performance of Bahrains interestfree Islamic banks and the interest-based conventional commercial banks during the post Gulf
War period 1991-2001. Using nine financial ratios in measuring the performances with respect to
(a) profitability, (b) liquidity risk, and (c) credit risk, and applying Students t-test to these
financial ratios, the paper concludes that there exists a significant difference in credit
performance between the two sets of banks. However, the study finds no major difference in
profitability and liquidity performances between Islamic banks and conventional banks.
Kader and Asarpota (2007) utilize bank level data to evaluate the performance of the UAE
Islamic banks. Balance sheets and income statements of 3 Islamic banks and 5 conventional
banks in the time period 2000 to 2004 are used to compile data for the study. Financial ratios are
applied to examine the performance of the Islamic banks in profitability, liquidity, risk and
solvency, and efficiency. The results of the study show that in comparison with UAE
conventional banks, Islamic banks of UAE are relatively more profitable, less liquid, less risky,
and more efficient. They conclude that there are two important implications associated with this
finding: First, attributes of the Islamic profit-and-loss sharing banking paradigm are likely to be
associated as a key reason for the rapid growth in Islamic banking in UAE. Second, UAE Islamic
banks should be regulated and supervised in a different way as the UAE Islamic banks in
practice are different from UAE conventional banks.
Saleh and Rami (2006) in order to evaluate the Islamic banks performance in Jordon, examine
and analyze the experience with Islamic banking for the first and second Islamic bank, Jordan
Islamic Bank for Finance and Investment (JIBFI), and Islamic International Arab Bank (IIAB) in
Jordon. The study also highlights the domestic as well as global challenges being faced by this
sector. Conducting profit maximization, capital structure, and liquidity tests as performance
evaluation methodology, the paper finds several interesting results. First, the efficiency and
ability of both banks have increased and both banks have expanded their investment and
activities. Second, both banks have played an important role in financing projects in Jordan.
Third, these banks have focused on the short-term investment. Fourth, Bank for Finance and
Investment (JIBFI) is found to have high profitability. Finally, the study concludes that Islamic
banks have high growth in the credit facilities and in profitability.
Bashir (2000) examines the determinants of Islamic banks performance across eight Middle
Eastern countries between 1993 and 1998. Using cross-country bank-level data on income
statements and balance sheets of 14 Islamic banks in eight Middle Eastern countries for each
year in the 1993-1998, the study closely examines the relationships between profitability and the
banking characteristics. After controlling for economic and financial structure indicators such as

macroeconomic environment, financial market structure, and taxation the study shows some
very important and interesting results.
First, the profitability measures of the Islamic banks react positively to the increases in capital
and loan ratios, which is intuitive and consistent with previous studies. Second, the study
highlights the empirical role that adequate capital ratios and loan portfolios play in explaining the
performance of Islamic banks. Third, the results indicate that customer and short-term funding,
non-interest earning assets, and overhead are also important for promoting banks profits. Fourth,
the results reveal that foreign-owned banks are more profitable than their domestic counterparts.
Fifth, keeping other things constant, there is evidence that implicit and explicit taxes affect the
bank performance measures negatively. Sixth, favorable macroeconomic conditions have
positive effect on performance measures of the bank. Finally, the results of the study show that
stock markets are complementary to bank financing.
Yudistira (2003) in his study makes an empirical analysis on efficiency and provides new
evidences on the performance of 18 Islamic banks over the period 1997-2000. Panel dataset for
this time period is extracted from non-consolidated balance sheets and income statements of
these Islamic banks with specific purpose of seeing the impact of recent financial crises on
efficiency of Islamic banks. This study is different from previous studies in that it utilizes nonparametric approach, Data Envelopment Analysis (DAE) to analyze the technical efficiency, pure
technical efficiency, and scale efficiency of Islamic banks. Being in line with the principle of
Islamic financial system, the intermediation approach is used to specify input-output variables of
Islamic banks. The study finds several results. First, the overall efficiency results indicate that
there is a small (at just over 10%) inefficiency across 18 Islamic banks, which is considerable as
compared to many conventional counterparts. Similarly, global crisis in 1998-1999 badly
affected the performance of Islamic banks; however, they performed better afterwards. Second,
the results show that small and medium sized Islamic banks faced diseconomies of scale which
suggests that M&A should be encouraged. Moreover, as compared to their non listed
counterparts, publicly listed Islamic banks are found to be less efficient. Lastly, Country specific
factors mainly determined the efficiency differences across sample data

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RESEARCH METHODOLOGY :
We have conducted a primary research and used interview and questionnaire as a data collection
technique. We have adopted a qualitative approach. Qualitative research aims to get a better
understanding through firsthand experience, truthful reporting, and quotations of actual
conversations. It aims to understand how the participants derive meaning from their
surroundings, and how their meaning influences their behavior.
We conducted an interview with the manager of Meezan Bank's branch which is situated in I-9
Islamabad , he gave us the details about the modes of financing that we targeted. The interview
was semi-structured and three interviews were conducted. Different questions were asked by the
group members. The questions were regarding the products that we selected and course. Approx
10 to 15 questions were asked and the manage was able to answer them all accept 1 because of
the lack of time.
We also used secondary sources of data collection. Secondary data is the data which is readily
available. We took data form different sources such as Wikipedia , MeezanBank.com etc. Details
given by the manager were analyzed with the course work we had studied until now in our
subject Islamic Theory and Finance. The modes of finance that we studied were efficiently and
effectively adopted by the MeezanBank.
The basic focuses of the bank is the prohibition of interest and satisfy their customers. we learnt
that mostly Islamic banks deals in assets. They make investment and contracts to generate the
halaal profit and satisfy their customers

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CRITICAL ANALYSIS :
Investment based
Musharakah
The Meezan Bank uses the diminishing Musharakah. According to the information available on
banks website, in diminishing Musharakah the financier and the client participate either in joint
ownership of a property, equipment or joint commercial enterprise.
The share of financier will be divided into the number of units. The client will purchase units one
by one periodically until he is the sole owner of the property.
The procedure of Musharakah as use by bank is same as we studied in our class. Meezan Bank
uses Musharakah in providing home financing to its clients or customers.

Trade Based
Mudarabah
This is a kind of partnership where one partner gives money to another for investing in a
commercial enterprise. The investment comes from the first partner who is called Rab-ulMaal while the management and work is an exclusive responsibility of the other, who is called
Mudarib and the profits generated are shared in a predetermined ratio.
The Meezan Bank offers its services whenever, client is interested to start trade based business.
The initial investment of any business depends upon the overall volume of the business.

Ijarah
"Ijarah" is a term of Islamic fiqh. Lexically, it means 'to give something on rent'.
In the Islamic jurisprudence, the term 'Ijarah' is used for two different situations. In the first
place, it means 'to employ the services of a person on wages given to him as a consideration for
his hired services." The employer is called 'mustajir' while the employee is called 'ajir', while the
wages paid to the ajir are called their 'ujrah'.
The second type of Ijarah relates to the usufructs of assets and properties, and not to the services
of human beings. 'Ijarah' in this sense means ' to transfer the usufruct of a particular property to
another person in exchange for a rent claimed from him.' In this case, the term 'Ijarah' is

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analogous to the English term 'leasing'. Here the lessor is called 'Mujir', the lessee is called
'mustajir' and the rent payable to the lessor is called 'ujrah'.
The rules of Ijarah are very much analogous to the rules of sale, because in both cases something
is transferred to another person for a valuable consideration. The only difference between Ijarah
and sale is that in the latter case the corpus of the property is transferred to the purchaser, while
in the case of Ijarah, the corpus of the property remains in the ownership of the transferor, but
only its usufruct i.e. the right to use it, is transferred to the lessee.
Lease as a mode of financing
Lease is not originally a mode of financing. It is simply a transaction meant to transfer the
usufruct of a property from one person to another for an agreed period against an agreed
consideration. However, certain financial institutions have adopted leasing as a mode of
financing instead of long term lending on the basis of interest.
This transaction of lease may be used for Islamic financing, subject to certain conditions. It is
not sufficient for this purpose to substitute the name of 'interest' by the name of 'rent' and replace
the name of 'mortgage' by the name of 'leased asset'. There must be a substantial difference
between leasing and an interest-bearing loan. That will be possible only by following all the
Islamic rules of leasing.
The procedure of Ijarah is same as we studied in class. The Meezan bank offers Ijarah on homes
and cars.

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CHALLANGES
Despite the impressive growth, the Islamic banking industry is facing a number of
challenges that are preventing it from attaining an even higher pace of growth. Some of
the most important issues are identified below.

SHORTTERM LIQUIDITY MANAGEMENT

The lack of investment avenues, especially shortterm, has been one of the major problems faced
by Islamic Financial Institutions (IFIs) in Pakistan. IFIs cannot invest in conventional interest
based sovereign debt instruments such as Tbills and Pakistan Investment Bonds. Therefore,
short term liquidity management has been a key challenge.

REGULATORY AND TAX REFORMS

Government patronage and regulatory/tax reforms play a pivotal role for any industry to grow
with leaps and bounds. On the international front, governments like United Kingdom and
Malaysia are offering relaxed rules and taxation for tapping the great demand for Shariah
compliant investment by Muslim investors, specially from the Middle East.

HUMAN CAPITAL

Since inception of the industry, the supply of trained or experienced human resource has lagged
behind the expansion of Islamic banking. There is a dearth of qualified bankers who are well
versed in Islamic laws as well as contemporary economics and finance. Currently, few
universities and training institutes are offering courses in Islamic finance but they also face lack
of competent human resources to conduct these courses.

INVESTMENT AVENUES

Islamic principles stipulate certain conditions that need to be adhered to while developing
Islamic banking products. Having left with no choice due to the absence of attractive
investment avenues, Islamic banking products mainly rely on asset based financing to generate
returns for their depositors.

STANDARDIZATION OF CONTRACTS

The introduction of various Shariah standards by Accounting and Auditing Organization for
Islamic Financial Institutions (AAOIFI) has started to bring some uniformity into the
Shariah based legal framework of the Islamic finance industry but efforts are needed to
bring these agreements in conformity with the local taxation and related laws so as to make
them more acceptable among all users.

PERCEPTION OF USERS

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Due to unsatisfactory experiences in the name of Islamic Banking in the past, some Pakistani
customers are now skeptical about the authenticity of Islamic banking practices. Part of it could
be attributed to psychological tendency to stick to the decades old banking habits and perception
of banking. Most customers have opinions that are based on misinformation and represent lack
of understanding of Fiqh issues. Changing these perceptions has been one of the greatest
challenges for Islamic banks that can only be addressed through collective efforts by all,
specially the media.

BENCHMARK

Using the conventional interest based benchmark (KIBOR) as the base of pricing an Islamic
financial product puts Islamic banks as well as their customers at the mercy of movements in the
interestbased money market. Also, a negative perception is created among the clientele
that there is no real difference in Islamic banking products as these are also using the same
interest based benchmark. It is argued that Islamic banks should have their separate benchmark
for investment pricing. This was not possible initially due to limited market, however, some
Pakistani banks have now taken the initiative and work has already started to develop an Islamic
benchmark.