INTRODUCTION TO ISLAMIC FINANCEMuslims are prohibited by their religion to deal in interest (riba) in any way. Giving and receiving as well as witnessing are all prohibited. Thus an Islamic banking system cannot pay any interest to its depositors; neither can it demand or receive any interest from the borrowers. Nor could the banks witness or keep accounts of these transactions. But the lender is entitled to the return of his capital in full. This is a Qur’anic injunction. The proposed system complies with these fundamental Islamic requirements.
Islam not only prohibits dealing in interest but also in liquor, pork, gambling, pornography and anything else, which the Shariah (Islamic Law) deems Haram (unlawful). Islamic banking is an instrument for the development of an Islamic economic order.
HISTORY
The first modern experiment with Islamic banking was undertaken in Egypt under cover without projecting an Islamic image—for fear of being seen as a manifestation of Islamic fundamentalism that was anathema to the political regime. The pioneering effort, led by Ahmad Elnaggar, took the form of a savings bank based on profit-sharing in the Egyptian town of Mit Ghamr in 1963. This experiment lasted until 1967 (Ready 1981), by which time there were nine such banks in the country.
In 1972, the Mit Ghamr Savings project became part of Nasr Social Bank which, till date, is still in business in Egypt. In 1975, the Islamic Development Bank was set-up with the mission to provide funding to projects in the member countries. The first modern commercial Islamic bank, Dubai Islamic Bank, opened its doors in 1975. In the early years, the products offered were basic and strongly founded on conventional banking products, but in the last few years the industry is starting to see strong development in new products and services.
When the concept of Islamic banking with its ethical values was propagated, financial circles the world over treated it as a utopian dream. Having lived for centuries under the valueless capitalist economic system, they asked what ethics had to do with finance?
Attitudes are changing gradually and in the last few years' value neutral conventional banking has begun to trouble the conscience of an increasing number of people. There is a reluctance to hand over the funds to banks and financial institutions that invest in companies engaged in unethical and socially harmful activities. The emerging Islamic banking scene has succeeded in achieving general acceptance .
Attitudes are changing gradually and in the last few years' value neutral conventional banking has begun to trouble the conscience of an increasing number of people. There is a reluctance to hand over the funds to banks and financial institutions that invest in companies engaged in unethical and socially harmful activities. The emerging Islamic banking scene has succeeded in achieving general acceptance .
THE PRIME OBJECTIVE OF ISLAMIC BANKINGThe basic objective of commercial banking is capital guarantee. The capital entrusted to the bank by a depositor must be returned to him in full. The proposed system fully complies with this requirement. Islamic banking as practised today does not provide capital guarantee in all its deposit accounts. In many countries, this is one of the two main objections to permitting the establishment of islamic banks. Ther is no objection to paying zero profits on deposits.
Islamic banking refers to a system of banking or banking activity that is consistent with the principles of Islamic law (Sharia) and its practical application through the development of Islamic economics. Sharia prohibits the payment of fees for the renting of money (Riba, usury) for specific terms, as well as investing in businesses that provide goods or services considered contrary to its principles (Haraam, forbidden). While these principles were used as the basis for a flourishing economy in earlier times, it is only in the late 20th century that a number of Islamic banks were formed to apply these principles to private or semi-private commercial institutions within the Muslim community.
Islamic banking refers to a system of banking or banking activity that is consistent with the principles of Islamic law (Sharia) and its practical application through the development of Islamic economics. Sharia prohibits the payment of fees for the renting of money (Riba, usury) for specific terms, as well as investing in businesses that provide goods or services considered contrary to its principles (Haraam, forbidden). While these principles were used as the basis for a flourishing economy in earlier times, it is only in the late 20th century that a number of Islamic banks were formed to apply these principles to private or semi-private commercial institutions within the Muslim community.
The Islamic financial system employs the concept of participation in the enterprise, utilizing the funds at risk on a profit-and- loss-sharing basis. This by no means implies that investments with financial institutions are necessarily speculative. This can be excluded by careful investment policy, diversification of risk and prudent management by Islamic financial institutions.
It is possible, that investment in Islamic financial institutions can provide potential profit in proportion to the risk assumed to satisfy the differing demands of participants in the contemporary environment and within the guidelines of the Shariah.
The concept of profit-and-loss sharing, as a basis of financial transactions is a progressive one as it distinguishes good performance from the bad and the mediocre. This concept therefore encourages better resource management. Islamic banks are structured to retain a clearly differentiated status between shareholders' capital and clients' deposits in order to ensure correct profit-sharing according to Islamic Law.
During the Islamic Golden Age, early 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 the Islamic Golden Age, early 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.
SHARIAH
The linguistic meaning of the word Shariah is a non-exhaustive source of water from which people satisfy their thirst. Thus, the linguistic significance of Shariah is that the Islamic laws are effectively a source of guidance. As water is the fundamental basis for life, the Islamic laws are an essential source for guiding human life. Shariah is composed of all the laws derived from the legislative sources of Islam. These laws are not just limited to areas covering marriage or divorce; rather, the Islamic laws cover every action performed by an individual or a society. The term Shariah is also a synonym for Fiqh.
The Application of Shariah is not only limited to areas covering divorce or marriage. It covers the relationship between Man and Allah (swt), Man and Himself, and Man and Man. In addition, to the method for applying these rules, implementing any rule requires having the knowledge of the situation, the rule, and the method. As an example, there is a general principal in Islam that a thief's hand should be cut off. However, if the individual steals food while hungry, then this general principal is not applied in this particular situation. Consequently, the knowledge of how and when to apply a rule is obligatory.
Misapplication of the Shariah is applying the Islamic laws related to Hudud (punishment) while at the same time implementing an economic system based on capitalism. Islamic laws related to punishment were revealed to protect the society in which Islam is being applied.
The implementation of the Islamic rules related to the economy necessitates the implementation of the rules of Zakah, Nafaqah, and Al-Jizyah, which in turn means the implementation of the economic system. The execution of the economic system requires the implementation of the Ibadaah, social system, rules related to the People of the Book, Islamic foreign policy, and rules related to the Khalifah all together. The Islamic system is inter-connected; one part helps the implementation of the other part.
HUKUM SHARII
The text of both Quran and Sunnah address many topics such as, stories of previous Ummahs, the Day of Judgment, and others. However, the text which specifically addresses our actions of what to do or what not to do is referred to as Hukm Sharii. The term Hukm Sharii, in Arabic, means the address of the Legislator related to our actions.
ISLAMIC JURISPRUDENCE
Fiqh, the term for Islamic jurisprudence, is a process by means of which jurists derive sets of guidelines, rules and regulations from the rulings laid down in the Qur'an and the teachings and living example of the Prophet Muhammad (pbuh), the Sunnah. Over the centuries, these have been formulated and elaborated upon by successive generations of learned jurists, through interpretation, analogy, consensus and disciplined research.
Islamic jurisprudence may be defined as a process by means of which jurists derive sets guidelines, rules and regulations (the Shari'ah) from the principles of the Qur'an and the Sunnah. Over the centuries, these have been formulated and elaborated upon by successive generations of learned jurists, through interpretation, analogy, consensus and disciplined research.
Islamic jurisprudence may be defined as a process by means of which jurists derive sets guidelines, rules and regulations (the Shari'ah) from the principles of the Qur'an and the Sunnah. Over the centuries, these have been formulated and elaborated upon by successive generations of learned jurists, through interpretation, analogy, consensus and disciplined research.
ISLAMIC JURISPRUDENCE AND FINANCE
“In Islam, finance, like all domains of human activity, is regulated by a set of guidelines and rules primarily introduced by the Qur'an and Sunnah.” Then, according to Dr Osama Mohamed Ali, an eminent Islamic jurist, “These were subsequently elaborated and developed by qualified jurists; hence the importance of jurisprudence in this specific area.”
Since Islam introduced general concerning the subject of finance centuries ago, contemporary legislators are responsible for organising this area of human activity by interpreting those principles and finding practical applications for them in the modern context. It is only in this manner that they will be able to establish the relevance of the guidelines set out in the Qur'an and the Sunnah.
PRINCIPLES
An Islamic bank is a financial institution which identifies itself with the spirit of Shariah, as laid down by the Holy Qur'an and Sunnah, as regards its objectives, principles, practices and operations. An Islamic bank does not normally lend money except interest-free loans which are termed as Qard Hasanah (Benevolent Loans) while loans on service charge, not exceeding the actual administrative cost of such loans, have also been permitted by Muslim Scholars.
To replace interest, the ideal mode of financing under the Islamic banking system is "Financing on Profit & Loss Sharing" (PLS) basis. Qard Hasanah is for the benefit of the individuals and the society at large. To safe-guard the interest of depositors/investors, these types of loans, as a matter of policy, do not constitute a significant source of financing by Islamic banks. However, if in any country, the Islamic System of Zakat is established and the Islamic State treasury starts functioning, the requirements of Qard Hasanah would primarily be met by the treasury.
An Islamic bank is a financial institution which identifies itself with the spirit of Shariah, as laid down by the Holy Qur'an and Sunnah, as regards its objectives, principles, practices and operations. An Islamic bank does not normally lend money except interest-free loans which are termed as Qard Hasanah (Benevolent Loans) while loans on service charge, not exceeding the actual administrative cost of such loans, have also been permitted by Muslim Scholars.
To replace interest, the ideal mode of financing under the Islamic banking system is "Financing on Profit & Loss Sharing" (PLS) basis. Qard Hasanah is for the benefit of the individuals and the society at large. To safe-guard the interest of depositors/investors, these types of loans, as a matter of policy, do not constitute a significant source of financing by Islamic banks. However, if in any country, the Islamic System of Zakat is established and the Islamic State treasury starts functioning, the requirements of Qard Hasanah would primarily be met by the treasury.
The bulk of financing by Islamic banks has to be equity oriented. In this mode of financing, the losses are shared by the financier along with the entrepreneur in the ratio of their respective capitals. The profits are, however, shared in an agreed ratio. The rates of returns are thus replaced by ratios.
While designing an alternate to interest-based system, it was realized that large scale resorting to Profit and Loss sharing system of Islamic banking could pose serious risks and hazards to Islamic banks due to wide-spread tendency to adopt un-ethical accounting practices to conceal true profits, high rate of illiteracy and host of other reasons. It was therefore, considered necessary to devise various other modes of financing in addition to Mudaraba & Musharka based on Profit and loss sharing system and of course, Qard-Hasan. These modes being the second line fixed return techniques include the following:
i) Murabaha (Cost-plus sale).
ii) Mu'ajjal (Deferred payment sale).
iii) Salam (Purchase with deferred delivery).
iv) Istis'na (Made to order).
v) Ijara (Leasing).
vi) Ju'ala (Loans with a service charge).
It is important to note that Islam wants that in case the entrepreneurs earn profit from the finances provided to them by banks, these must be shared with the banks. The banks, on the other hand, must share their profit with their depositors / investors. A large number of depositors would thus hopefully be able to get significantly higher rates of return from the banks leading to over-all prosperity. It will be only then that justice would be ensured between the parties and the banks would start moving towards the path of making a positive contribution towards the achievement of socio-economic objectives.
Islamic banking is now over 25 years old. It is however, observed that, despite all the good intentions, Islamic banks world-wide have generally sheltered themselves in comfort zone by persisting with the second line fixed return techniques for bulk of their financing operations and that too within the bench-marks of interest-based system.
As the single largest mode of financing adopted by Islamic banks is on the basis of Murahaba, it is now proposed to briefly examine this mode. Islamic banking has the same purpose as conventional banking except that it operates in accordance with the rules of Shariah, known as Fiqh al-Muamalat (Islamic rules on transactions). The basic principle of Islamic banking is the sharing of profit and loss and the prohibition of riba (usury).
There are several other approaches used in business deals. Islamic banks lend their money to companies by issuing floating rate interest loans. The floating rate of interest is pegged to the company's individual rate of return. Thus the bank's profit on the loan is equal to a certain percentage of the company's profits. Once the principal amount of the loan is repaid, the profit-sharing arrangement is concluded. This practice is called Musharaka. Further, Mudaraba is venture capital funding of an entrepreneur who provides labour while financing is provided by the bank so that both profit and risk are shared. Such participatory arrangements between capital and labour reflect the Islamic view that the borrower must not bear all the risk/cost of a failure, resulting in a balanced distribution of income and not allowing lender to monopolize the economy.
And finally, Islamic banking is restricted to Islamically acceptable deals, which exclude those involving alcohol, pork, gambling, etc. Thus ethical investing is the only acceptable form of investment, and moral purchasing is encouraged. In theory, Islamic banking is an example of full-reserve banking, with banks achieving a 100% reserve ratio.
Islamic banks have grown recently in the Muslim world but are a very small share of the global banking system. Micro-lending institutions founded by Muslims, notably Grameen Bank, use conventional lending practices and are popular in some Muslim nations, especially Bangladesh, but some do not consider them true Islamic banking. However, Muhammad Yunus, the founder of Grameen Bank and microfinance banking, and other supporters of microfinance, argue that the lack of collateral and lack of excessive interest in micro-lending is consistent with the Islamic prohibition of usury (riba).
Islamic banking made its debut over a quarter a century ago. At present 200 Islamic banks and financial institutions, operating in 27 Muslim and 16 non-Muslim countries, are managing a portfolio of about $200 billion.
FINANCING ON PROFIT AND LOSS BASIS
The real alternate to interest on loans in an Islamic framework is financing on PLS basis- a shift from debt based transaction to investment based funding. It is believed that the financing on PLS system of Islamic banking in a conducive environment would not only ensure a healthier financing portfolio and of course higher rates of return to depositors but would also lead to optimum allocation of resources for over-all economic growth and welfare of the society, individually and collectively.
It is however, accepted that the banks allowing financing on PLS basis are exposed to risk of losses as even a profitable company may sustain genuine loss due to various factors even beyond their control. The assuming of this risk is the essence of PLS mode of financing as all business transactions have an inseparable risk factor. It should not therefore, deter banks from making funds available on PLS basis to sound entities in feasible projects in the normal course of business.
CONCLUSION
The first full-fledged Islamic Bank was established in Dubai in 1975. In 1995, GCC countries accounted for 15 percent of the paid up capital, 27 percent of the assets, 34 percent of the deposits and 28.8 percent of the net profit of the Islamic banks world-wide. The Islamic banks in GCC countries are therefore, in an ideal position to take a lead to shift the bulk of financing operations to PLS system of Islamic banking.
It is now time that Islamic banks and financial institutions resolve to gradually enhance their share of financing on PLS basis and reduce the share of financing on the basis of Murabaha, Bai Mu'ajjal and the like modes of financing.
If Islamic banks succeed in demonstrating a practical example of socio-economic justice by gradually enhancing their financing on PLS basis and also achieve further satisfactory operational results, there is no reason why more cooperation would not be extended to them by the European, American and other interest-based banks. Some of these conventional banks may even be tempted to adopt PLS system of financing in their subsidiaries & affiliates operating under the banner of Islamic banking.
The first full-fledged Islamic Bank was established in Dubai in 1975. In 1995, GCC countries accounted for 15 percent of the paid up capital, 27 percent of the assets, 34 percent of the deposits and 28.8 percent of the net profit of the Islamic banks world-wide. The Islamic banks in GCC countries are therefore, in an ideal position to take a lead to shift the bulk of financing operations to PLS system of Islamic banking.
It is now time that Islamic banks and financial institutions resolve to gradually enhance their share of financing on PLS basis and reduce the share of financing on the basis of Murabaha, Bai Mu'ajjal and the like modes of financing.
If Islamic banks succeed in demonstrating a practical example of socio-economic justice by gradually enhancing their financing on PLS basis and also achieve further satisfactory operational results, there is no reason why more cooperation would not be extended to them by the European, American and other interest-based banks. Some of these conventional banks may even be tempted to adopt PLS system of financing in their subsidiaries & affiliates operating under the banner of Islamic banking.
The dawn of an era of justice can, therefore, be visualised where the fruits of the Islamic system would be available to a large number of people leading to over-all social and economic prosperity.
