Amanah

Theory of Islamic Banking

Prof. Dr. Sayyid Tahir
IIIE, IIUI (1981-2011), IIUM (since 2011)

08 June 2005

Muamalat Institute, Jakarta

(First-time Presentation)

Some Points for Reflection

In the real life, there are:
Needs at fund-seekers end
Concerns at the level of savers the ultimate
investors
Banks address concerns of the owners of funds
and help to meet needs of the fund-seekers
Interest-based banking has a long tradition. Interest is
price of capital, and helps in efficient allocation of
scarce capital.
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Interest-Based Banking

Banks borrow from savers (depositors) and

lend to investors (fund-seekers).
There is a lender-borrower relationship
between banks and savers and also
between banks and investors.

Existing banking, therefore, rests on loan

transaction and its variants.

Interest-based banks are both financial

intermediaries and financial institutions.
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Rationale for Islamic Banks 1

(same as that for interest-based banking)

Whenever there exists some gap or space

between two parties, a third party can come into
the picture!

Likewise, whenever there is a financial gap, a

role for a financial institution exists. This is the
rationale for modern banking.

There can always be argument about the way in

which financial institutions may come into the
picture and perform their role, because most of
the time there exist more than one ways of
doing anything.
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Rationale for Islamic Banks 2

That Shariah is a way of doing things, implies

that Islamic banking is a real possibility. Thus,
there can be no qualms about the existence of
Islamic banks that would plug financial gaps in
the economy whether an Islamic economy or
otherwise.

The only questions that call for answers are:

How would Islamic banks come into the
picture?
How would they perform their role?

Foundations for Shariah-Compliant Thinking

[27 :]

We have put forth for men, in this Quran every kind of parable, in
order that they may receive admonition. [Az-Zumur 39: 27]

See also Al-Kahf, 54 and Al-Asraa, 89.

2.

The basic Ahkam of the Shariah are given at the

micro (individual) level for the primary cases
trading, leasing, partnership, loaning, etc.
All other Ahkam are generalizations of the said
Ahkam.

3.

Logically speaking, Islamic alternatives in the

domain of banking ought to be developed in the
light of the aforesaid Ahkam.

Foundations for Shariah-Compliant Thinking

Some Parameters for Thinking:
1.

No riba.

2.

No gharar

3.

General Shariah-compliance, in addition to no

riba and no gharar. For example, avoidance
of haram, not clubbing two mutually exclusive
exchanges in a single transaction, respect of
Ahkam for trading, etc.

4.

The Shariah is about pursuing legitimate goals

in Shariah-recognized ways.
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A Suggested Approach for Defining Role

Function of Islamic Banks and Islamic
Financial Instruments

Take a real life case.

See how an Islamic bank might come into the
picture in a gainful manner.
Identify the transaction modes that might
facilitate the banks role.
Check the Shariah conditions for those
transaction modes.
See how the overall transaction may work.
Work out the financial instrument.
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Potential Cases with Some Role for Islamic

Banks
Some Instances in which financial gaps exist:
1.

A person wants to buy a thing while he does not

have cash to meet payment needs.

2.

A producer needs working capital.

3.

A party, without sufficient means, wants a thing

on lease.

4.

A businessman (or, a mill) needs working

capital.

5.

An individual wants to invest his savings, while

he has other commitments.
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Role Function of Islamic Banks - 1

Case 1: A Client wants to buy, say, a fridge while
he does not have cash to meet payment
needs. Murabahah Financing
(1) Loan

Bank

(2) Cash

Client
(4) Principal +
Interest

Client

(4) Price with

a Markup
(3) Fridge

Supplier
(3) Fridge

(1) Cash

Supplier

Bank
(2) Fridge

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Role Function of Islamic Banks - 2

Case 2: A Client (Producer) wants working capital
Trade-based Mode: Salam Financing
(4) Principal
+ Interest

Bank

(6) Sale
Proceeds

Client

(4) Goods
(3) Inputs

(1) Loan
(2) Expenses

(1) Financing

Client

Bank
(2) Goods

(4) Sale
Proceeds
(3) Goods

Output
Market
Factor
Markets

Output
Market
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Role Function of Islamic Banks - 3

Case 3: A Client, say PIA, wants to lease planes from
Cathy Pacific Airways but does not have the
required cash. Ijarah (or, Lease) Financing
(1) Loan

Bank

PIA

(4) Deferred
Rental

Bank
(3) Sub-Lease

CP

(3) Lease

(4) Principal
+ Interest

PIA

(2) Lease
Money

(1) Lease
Money

CP

(2) Lease
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Role Function of Islamic Banks - 4

Case 4: A Client (Businessman) needs working capital
Partnership Mode: Musharakah Financing
(4) Principal
+ Interest

(5) Capital +
Profits

Client

Bank

Economic
Activity

(2) Investment

(1) Loan

(4) Capital + Share in Profits

Client
(1) Capital
by both

Joint
Venture

Bank
(4) Capital + Share in Profits

(3) Capital +
Profits
(2) Investment

Economic
Activity
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Role Function of Islamic Banks - 5

Case 5: An individual wants to invest his savings while he has
other commitments

Modarabah or Musharakah

(4) Principal
+ Interest

(3) Principal
+ Interest

Bank

Saver

Economic
Activity

(2) Financing

(1) Loan

(4) Capital + Share in Profits

Saver
(1) Capital
by both*

Bank

Joint
Venture

(3) Capital +
Profits
(2) Investment

(4) Capital* + Share in Profits

Economic
Activity

* Zero capital by Bank in Modarabah

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Islamic Financial Instruments

What is a financial instrument?
A financial instrument is a piece of paper or a set
thereof based on one or more underlying
exchanges between two parties that gives rise
to financial rights and obligations for the
concerned parties.
A financial instrument is based on contract(s)
between two parties.
A financial instrument replicates the associated
transaction process.
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A Simple Murabahah Financing Instrument

(MFI)
Purchase Agreement
1. Offer & Acceptance: The Seller
offers to sell and the Bank
agrees to buy the thing (as
below)
2. Complete specification of the
merchandize
3. Price and total value
4. Payment Terms

Sale Agreement

5. Delivery matters [To Agent]

6. Right of recourse
7. Permission for the Bank for
onward sale

1. Offer & Acceptance: The Bank

offers to sell and the Client
agrees to buy the thing (as
below)
2. Complete specification of the
merchandize
3. Price and total value
4. Payment Terms [Installments
Schedule]
5. Delivery matters [As Agent]
6. Right of recourse
7. Covers to protect Banks
financing

[Signed by reps of Seller & Bank]

Banks rep may be a 3rd party.

[Signed by reps of Bank & Client]

Banks rep may be a 3rd party.

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Structures of Other Financial Instruments

Salam Financing

Ijarah Financing

1.

A Purchase Agreement between

the Bank and the Producer
seeking working capital

1. A Purchase Agreement (or a

Lease Agreement with provision of
sub-leasing) between the Bank
and the Owner of the asset.

2.

A Sale Agreement between the

Bank and the Final Buyer.

Note:
Obligations of the Producer
seeking financing, would stand
discharged with delivery of the
merchandize.

2. A Lease Agreement between the

Bank and its Client.

Note:
The Bank may need to enter into
separate agreements with third
parties for maintenance and
similar other requirements for
lessors.
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Structures of Other Financial Instruments

Musharakah Financing Deposits Side
A single partnership agreement
between the Bank and the
Client

Note:

With zero capital contribution

by the Client, the same
would become Modarabah
Financing agreement.

Modarabah Agreements with

return-conscious depositors
Musharakah Agreements with
return-conscious but
somewhat risk-averse
depositors
Loan Agreements with
depositors interested in safekeeping of their money with
flexibility in its use.

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A Set of Islamic Financial Instruments

1. Murabahah Financing Instrument (MFI)
2. Salam Financing Instrument (SFI)
3. Ijarah Financing Instrument (IJFI)
4. Musharakah Financing Instrument (MUFI) or
Modarabah Financing Instrument (MOFI)

Some other financial instruments are also

conceivable.
The MUFI and MOFI are to be seen as financial
instruments when applied to deposit mobilization.

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Working of the Islamic Banking Model

FINANCING

Mute Investments
Investments involving
SFI,
Value-added Activity

MFI, IJFI

MFI,

IJFI, MUFI
MOFI

DEPOSITS

Current Accounts
Term Deposits
General Savings Deposits
Deposits with Stable Income Flows
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Nature of Islamic Banks

While Islamic banks will come into the picture
as trader, lessor, partner, etc., they will
nevertheless be pure financial institutions.
The above will happen because economic
considerations will encourage Islamic banks to
delegate jobs demanding material ()
commitments to third parties for a fee

Caution:
Islamic banks cannot pursue the delegation
course to the point of negation of their own
role function.

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Islamic Banking Model vs. The Conventional

Banking Model 1
Savers
(Depositors)

Banks

Investors
(Fund-seekers)

Existing Interface
Financial Intermediation based on Loan Transaction

Savers
(Depositors)

Banks

Investors
(Fund-seekers)

Shariah-based Interface
Financial Intermediation based on Several Transactions
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Note: Islamic banking should not be confused with universal banking.

Islamic Banking Model vs. The Conventional

Banking Model 2
The Differences:
1.
2.
3.
4.

There shall be at least one most of the time

more than one financial instrument to address
any conceivable need.
The role function of the banks will change:
Islamic banks will be economic agents, not just
financial intermediaries.
There may be debt but no credit in the
economy.
Financial flows will be tied to real flows, and will
bring about greater harmony between financial
and real sectors of the economy.
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Some Fresh Requirements for Islamic

Banking 1
1. Standardization or financial instruments, their
pricing formulas and associated procedures
2. Credit rating system for the clients, besides
innovative financial products
3. Development of real market linkages to support
trade-, lease- and partnership-based financing

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Some Fresh Requirements for Islamic

Banking 2
4. Institutionalization of recovery of debt:
Recognition of debt as first charge on the
debtors assets (beyond a prescribed
minimum), pre-registration of financing
agreements, debt-collection agencies
5. Accounting
6. Reorientation and training of bank staff
7. Public awareness
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Some Regulatory Issues

1. Shariah compliance in both letter and spirit
2. Measures against misuse of Islamic financing
3. Fresh approach to risk management and
capital adequacy requirements
4. New prudential regulations, with renewed and
sharper focus on accounting matters
5. Modified approach to reserve requirements

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Review of Selected Existing Practices of

Islamic Banking
Islamic banking started in the 1970s without a
proper working model.
The existing Islamic banking is Banking under
Shariah Supervisory. The Shariah side is
exclusive prerogative of the Shariah scholars.
From a legal and banking point of view, the
difference is thin between deposit products
offered by conventional banks and Islamic
banks.
Islamic banks are mostly relying upon trade- and
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lease-financing.

Murabahah Financing Theory

1. Application

The
Client

ent
m
e
e
Agr
e
l
a
3. S

The
Bank

6. Installments
5. Delivery
4. Payment matters settled
2. P
urch
a

se A
gree
m

ent

The
Supplier
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Murabahah Financing Practice

5. Acceptance of the Offer +
Setting the Clients payment obligations
4. Confirmation of possession +
Offer to Purchase from the Bank

Bank

1. Master Murabahah Agreement

Client

2. Agency Agreement
3-A. Purchase Order as agent of Bank +
Payment Advice to Bank

3-B Payment to the Seller

3-C Delivery +
Possession

Seller
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Existing Interest-based Financing

Closing: Payment of Principal plus Interest + Penalty, if necessary

Bank

1. Master Financing Agreement

Client

3-A. Purchase Order (not as agent of

Bank) + Payment Advice to Bank

3-B Payment to the Seller

Seller
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Bai bi Thaman Ajil

The presenter would like to stand corrected
on the following points:
1.

The Client buys a thing from the Supplier in

his name.
2. The Bank buys the same thing from the
Client at his cost price to the Supplier.
3. The Bank sells back the same thing to the
Client at a marked-up price to be paid latter
in installments.
Thus, the Bank is buying and the selling from the
same party.
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Ijarah Financing Theory

1. Lease Agreement

The
Bank
2. Payment

3. Car

The Car
Dealer

4. Car lease ending with ownership

The Client

5. Down-payment + Rental
Agency Relationships
(for maintenance & other matters)

Some Other Points:

1- Insurance, Maintenance Expenses,
Applicable Taxes and their likes,
responsibility of owner, the Bank.
2- Rental can be fixed to accommodate all
economic considerations at the Bank level.
3- There can be clauses in the agreement to
accommodate sale of the car to the client,
during or at the end of the lease period.

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Ijarah Financing in Practice

The existing lease financing is a hire-purchase
arrangement that is negation of the Shariah principle of
not combining two mutually exclusive exchanges in one
contract.
The rental is fixed at some benchmark (such as central
banks lending rate) plus some percentage points. This is
contrary to the Shariah notion of fixing the rent in
advance.
Directly or indirectly, all responsibility for maintenance of
the asset is placed on the shoulders of the Client, against
the Shariah principle for leasing.
Sometimes lease agreements go into effect before
delivery of the asset, while the lease period is counted
from the date of signing of the lease contract.
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THANK YOU

10 June 2005

Muamalat Institute, Jakarta

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