Introduction to Islamic Banking
Islamic Banking is a new type of banking. It is based on the Quranic norms forbidding usury and any transactions, including granting of loans or credits, that involve interest. The economic rationale for eliminating riba (interest) and establishing the Islamic Banking System is based on values of justice, efficiency, stability and growth. It is assumed that under the system of Islamic banking, the industrial and/or commercial risk is shared more equitably between the entrepreneur and the capital owner and the returns on investment are shared among the investors on the basis of their proportionate capital. The conventional banks tend to serve the most creditworthy borrowers, while the Islamic banking system presumably looks for the most productive and profitable projects.
The origin of Islamic banking can be traced back to the practice of mudaraba by the Prophet Muhammad. The Prophet was mudarib (agent) for his wife. She entrusted her capital or merchandise to him for trading and got back the principal with an agreed share of the profit. As a reward for his labour (and entrepreneurship), the Prophet (mudarib) received his share of the same. He, however, was not liable for losses resulting from the exigencies of travel or from an unsuccessful business venture.
Modern Islamic banking concepts came from the historical practice of the concept of a ‘three-tier mudaraba’, (1) there is the individual called Rab-Al-Mal, who wishes to invest capital, (2) The mudarib (agent) to whom the Rab-Al-Mal entrusts his capital by contract and (3) The entrepreneur with whom the mudarib signs a contract and passes the capital originally entrusted to him by the Rab-Al-Mal.
Islamic Banking v/s Conventional Banking – Comparison
An Islamic bank is similar to a conventional bank in almost all functions. However there are some fundamental differences in the way they operate. The main difference is that while conventional banking operates on interest the Islamic Banking does not operate on interest (Riba) since it is forbidden in Sharia. However Islamic law does not state whether the seller of the product or the recipient of services should be muslim. The table below lists some of these basic differences.
|Function||Islamic Banking||Conventional Banking|
|Main Principle||The customer shares the profit and loss with the bank. High degree of risk with variable returns||The customer obtains the fixed interest from the bank and does not share the loss|
|Stability||High degree of stability||Low degree of stability|
|Treatment of Interest||Uses profit and loss structure (PLS) as interest is banned.||Interest based on the products|
|Profitability||PLS is based on the partnership (musharka) or joint investment without participation in management (mudharaba). Based on markup principle, leasing contrast (ijara)||High concentration leads to higher interest rates which lead to higher profitability. Higher rates of inflation lead to higher profit margins|
Principles of Islamic Banking
The islamic banking is based on the is principles of Sharia and Sunnah. There is no specific legal framework for banks. In case required the reference is made to Fiqh Muamalat which contains the Sharia rules. The basic principle of Islamic Banking is sharing of profits and losses and prohibition of riba (usuary / interest). The money movement whether deposit or loan is by way of sale / purchase agreement under various concepts. Under most of the contracts for financing the bank purchases the goods being financed and sells it to the customer on deferred payment.
Sharia forbids giving or taking Interest (riba) in any form, any transaction relating to banned items like alcohol, tobacco, pork, any transactions relating to speculation (Gharar), gambling or any activity that is not permitted under Sharia. The banks distribute profits among the deposit accounts. But the rate at which the profits may be distributed can not be agreed upfront.
Every Islamic bank is required to form a Sharia Advisory Committee to advise them and ensure the bank complies with Sharia rules .
Evolution of Islamic Banking
The first attempt to establish an Islamic financial institution took place in Pakistan in late 1950s with the establishment of a local Islamic bank in a rural area. Borrowers of the bank did not pay interest on the credit advanced, but a small charge was levied to cover the bank’s operational expenses. Although the experience was encouraging, two main factors were responsible for its failure. First, the deposits made in the bank were to be held for long and the depositors, who were mostly the landlords found that with increasing number of borrowers the gap between the amount of capital available and that of the credit demanded had become very large. Secondly, the depositors showed considerable interest in the way their money was lent out but the bank staff did not have complete autonomy over the bank’s operations and therefore, could not always satisfy the customers in this regard.
The second experiment with Islamic banking was conducted in Egypt between 1963 and 1967 through the establishment of the Mit Ghamr Savings Bank in a rural area of the Nile Delta. The bank’s operations were based on the same Islamic principles of no-interest to depositors or from the borrowers. Unlike the Pakistani case, the borrowers made deposits in the bank for credit facilities. On the basis of success in the experiment more branches were soon opened in different parts of Egypt to develop a network of local savings banks. The project suffered a setback due to political unrests in the country but was revived in 1971 under the name of Nasser Social Bank, which became the first Islamic bank in the urban setting based in Cairo.
Following the example of Egypt, Islamic banking emerged in Malaysia in 1963 and in Dubai in 1975. In 1975, the Muslim countries founded Islamic Development Bank as a multinational corporation to support social and economic developments in Muslim nations within the Islamic Framework.
A number of Islamic Banks were opened in the seventies. Faisal Islamic Bank of Sudan, Faisal Islamic Bank of Egypt, Bahrain Islamic Bank, Philippine Amanah Bank, Islamic Finance House of Luxembourg to name a few.
The first Islamic Bank in Saudi Arabia was established by Al-Rajhi Company who were earlier in currency exchange and commercial activities. The bank started operations in 1985 under the name of Al-Rajhi Banking Investment Corporation. Later they developed active relationships with major manufacturing and trading companies in Europe and the US. The success of Al-Rajhi in operating profitably in different regions of the world motivated the Saudi government to go for full-fledged Islamic banking.
Glossary of Terms
|Amana||Something held in TRUST. Money held in Current Accounts is termed as Amana. Other example could be holding someone’s property in trust by an express contract or sometimes as an implication of contract.|
|Bai al Dayn||Debt financing: the provision of financial resources required for production, commerce and services by way of sale/purchase of trade documents and papers. Bai al-Dayn is a short-term facility with a maturity of not more than a year. Only documents evidencing debts arising from bona fide commercial transactions can be traded. Factoring of permitted nature is done through Bai Al Dayn contract under Islamic Banking.|
|Bai al Inah||Sale and buy back agreement. The financier sells the asset to the customer on deferred payment basis and then immediately purchase the asset on cash basis at a discount. This is used as a financing technique for granting loans under Islamic Banking.|
|Bai Mu’ajjal||Credit Sale or deferred payment contract. It is a financing technique in Islamic Banking and is a contract under which seller allows the buyer to pay the price of the commodity at a later date. The payment may be full or in part installments.|
|Bai Salam||Advance payment for the goods to be purchased (excluding gold and silver). The underlying condition is that the goods must be defined and the delivery date is fixed. This is mostly used in Trade Finance. Advance payment bills, preshipment loans and agriculture finance are done under this contract. In Agriculture finance where the bank advances money for various inputs, receives a share in the crop, which the bank sells in the market.|
|Bai Mithaman Ajil||This contract refers to the sale of goods on a deferred payment basis. Equipment or goods requested by the client are bought by the bank which subsequently sells the goods to the client an agreed price which includes the bank’s mark-up (profit). The client may be allowed to settle payment by installments within a pre-agreed period, or in a lump sum. Similar to a Murabaha contract, but with payment on a deferred basis.|
|Fiqh||Islamic Jurisprudence. All the rules governing Islamic economics are derived from Shariah and Sunnah and are available in Fiqh.|
|Gharar||Uncertainty. Transactions of speculation in nature or for the item not in hand or doubtful to obtain. Gambling is an example of Gharar. Under Islam all transactions of speculative nature are banned.|
|Halal||Anything permitted under Shariah|
|Haram||Anything banned under Shariah like earning / paying Interest (Riba), excessive profit earning, speculation, gambling, liquor, prostitution.|
|Hawala||Bill of exchange, promissory note, cheque or draft. Technically, a debtor passes on the responsibility of payment of his debt to a third party who owes the former a debt. Hawala is a mechanism for settling international accounts, by book transfers|
|Ijarah||Lease / Rent. Letting the use on Lease. It is contract of land or machinery lease at a fixed rent. This is the mode of financing under Islamic Banking|
|Ijarah wal Iqtin or
Al Ijarah Thumma Al Bai (AITAB)
|Hire / Purchase. It is same as Ijarah except that at the end of contract the leased item is sold to the client at a price. The rental (to be paid periodically, generally monthly) and the purchase price ( to be paid at the end of contract) are agreed in the beginning while executing the contract.|
|Istisna||Progressive financing. A contract of acquisition of goods by specification or order where the price is paid progressively in accordance with the progress of a job. An example would be for the purchase of a house to be constructed, payments are made to the developer or builder according to the stage of work completed. This type of financing along with bai salam are used as purchasing mechanisms, and murabaha and bai muajjal are for financing sales.|
|Kafalah||Surety. Under this contract the guarantor takes the responsibility for the default / non performance of the third party. It is used for issuing bank guarantees under Islamic Banking.|
|Mudarabah||Trust Financing. Partnership contract where one party provides the funds while the other provide the expertise and management. The later party is called mudarib (entrepreneur).
The profits earned or accrued from the partnership are shared among both parties in the agreed ratio. However any losses are only on account of the party providing the capital.
|Mudarib||The party in the mudarabah contract that provides expertise and manages the process. They are also called the enterpreneurs|
|Muqaradah||An agreement under which one party leaves their goods (stock-in-trade) with another party to sell these goods. The profit is for the owner of the goods. This type of contract is also used as an alternative to Mudarabah contract|
|Murabaha||It is a contract of sale under which the seller declares their cost and the profit. It is a mode of financing in Islamic Banking. Letter of Credits are issued under this type of contract.|
|Musharkah||Joint Venture. It is a financing technique in Islamic Banking and is an agreement under which the bank provides funds which are mixed with the funds of business enterprises and others. The profit is shared in the agreed ratio but the losses are shared strictly in the ratio of the capital provided by each provider.|
|Qard Hasan||Good Loan. A loan transaction in which the client obtains the cash from the bank to be repaid on a stipulated future date without any interest or increase in amount.|
|Riba||It is defined as receiving any monetary advantage in a business transaction without giving a just counter value. Interest or increase in the loan or deposit amount at a rate defined upfront is an example of Riba.|
|Shirkah||It is a partnership contract between 2 or more parties to launch a business to earn profit.|
|Suftajal||It is a type of banking instrument that is used for the delegation of credit during the Muslim period, especially the Abbasides period. It was used to collect taxes, disburse government dues and transfer funds by merchants. It was the most important banking instrument used by traveller merchants. In some cases suftajahs were payable at a future fixed date and in other cases they were payable on sight. Suftajah is distinct from the modem bill of exchange in some respects. Firstly, a sum of money transferred by suftajah had to keep its identity and payment had to be made in the same currency. Exchange of currencies could not take place in this case. Secondly, Suftajah usually involved three persons. ‘A’ pays a certain sum of money to ‘B’ for agreeing to give an order to ‘C’ to pay back to ‘A’. Third, a Suftajahs could be endorsed. The Arabs had been using endorsements (hawala) since the days of the Prophet Muhammad.|
|Sukuk||Sukuk is a financial certificate. In Islamic Banking it is called the bond. These comply with the Islamic Laws a nd its investment principles of No Interest. These are classified according to their tradability and non tradability in the secondary markets.|
|Ushur||It was an important source of revenue for the muslim countries. It used to be imposed on the merchants for internal or external trade. For muslim merchant it was the same as 2.5% annual Zakat on merchandise. For Christians and jews merchants (called dhimmi) it was 5% ie double that of muslim merchant. For the merchants of foreign countries who were not related to muslims it was 10% ie double that of dhimmis.|
|Takaful||This is a form of Islamic insurance based on the Quranic principle of Ta’awon or mutual assistance. It provides mutual protection of assets and property and offers joint risk sharing in the event of a loss by one of its members. Takaful is similar to mutual insurance in that members are the insurers as well as the insured. Conventional insurance is prohibited in Islam because its dealings contain several haram elements including gharar and riba, as mentioned above.
|Wadia||Deposits on trust. It is a contract whereby the person leaves the valuables as trust for safe keeping. In Islamic Banking Current and savings accounts are held under this contract.
|Wakala||An absolute power of attorney.
|It is an obligatory periodic levy on all muslims who have wealth or income above a certain defined limit with the object to take away a part of the wealth from the well-to-do. These funds are used for the welfare of poor and needy.
Some Common Terms
Ijarah financing is similar to leasing. A bank buys an asset for a customer and then leases it to the customer for a certain period at a fixed rental charge. Shariah (Islamic law) permits rental charges on property services, on the precondition that the lessor (bank) retain the risk of asset ownership.
The Ijarah contract must satisfy the certain conditions, the important ones being:
- The purpose of renting the asset and the services that the asset is supposed to provide must be clearly known to both the parties.
- The ownership and the responsibility for the maintenance of the asset remains with the lessor .
- The Ijarah contract is terminated as soon as the asset stops giving the services for which it was rented. However in case the asset is damaged during the contract period, the ijarah contract remains valid.
- The price of the asset at which it may be sold to the lessee at the expiry of the contract can not be determined upfront. It is to be determined and agreed only at the expiry of Ijarah contract.
- It is not obligatory for the lessee to buy the asset at the end of contract.
2 Mudaraba (Trust Financing)
The term refers to a form of business contract in which one party brings capital and the other personal effort. The proportionate share in profit is determined by mutual agreement. But the loss, if any, is borne only by the owner of the capital, in which case the entrepreneur gets nothing for his labour. The financier is known as ‘rab-al-maal’ and the entrepreneur as ‘mudarib’. As a financing technique adopted by Islamic banks, it is a contract in which all the capital is provided by the Islamic bank while the business is managed by the other party.
The profit is shared in pre-agreed ratios, and loss, if any, unless caused by negligence or violation of terms of the contract by the ‘mudarib’ is borne by the Islamic bank. The bank passes on this loss to the depositors. There is no loss sharing in a Mudaraba contract.
Profit and loss sharing is more accurate description of the Musharkah contract. The Mudaraba contract may better be represented by the expression profit sharing Mudaraba is an Islamic contract in which one party supplies the money and the other provides management in order to do a specific trade. The party supplying the capital is called owner of the capital. The other party is referred to as worker or agent who actually runs the business. In the Islamic Jurisprudence, different duties and responsibilities have been assigned to each of these two.
As a matter of principle the owner of the capital does not have a right to interfere in to the management of the business enterprise which is the sole responsibility of the Agent x. However, he has every right to specify such conditions that would ensure better management of his money. That is why sometime Mudaraba is referred as sleeping partnership. An important characteristic of Mudaraba is the arrangement of profit sharing.
The profits in a Mudaraba agreement may be shared in any proportion agreed between the parties before hand. However, the loss is to be completely borne by the owner of the capital. In case of loss, the capital owner shall bear the monetary loss and agent shall lose the reward of his effort. Mudaraba could be individual or joint.
Islamic banks practice Mudaraba in its both forms. In case of individual Mudaraba an Islamic bank provides finance to a commercial venture run by a person or a company on the basis of profit sharing. The joint Mudaraba may be between the investors and the bank on a continuing basis. The investors keep their funds in a special fund and share the profits without even the liquidation of those financing operations that have not reached the stage of final settlement. Many Islamic Investment Funds operate on the basis of joint Mudaraba.
3 Murabaha (Cost-Plus Financing)
Sale on profit. Technically a contract of sale in which the seller declares his cost and profit. This has been adopted as a mode of financing by a number of Islamic banks. As a financing technique, it involves a request by the client to the bank to purchase a certain item for him. The bank does that for a definite profit over the cost which is settled in advance. Some people have questioned the legality of this financing technique because of its similarity to riba or interest.
In its modern form Murabaha has become the single most popular technique of financing amongst the Islamic banks all over the world. It has been estimated that 80 to 90 percent of financial operations of some Islamic banks belong to this category. The Murabaha mode of finance operates in the following way: The client approaches an Islamic bank to get finance in order to purchase a specific commodity. An interest-based bank would lend the money on interest to this customer. The customer would go and buy the required commodity from the market. This option is not available to the Islamic bank, as it does not operate on the basis of interest. It can not lend the money on interest. It can not lend money with zero interest rate, as it has to make some money to stay in the business.
Some portion of total finance may be offered as an interest free loan, however, the banking institutions have to make profit in order to stay in business. Hence, what course of action is open to the bank? The Murabaha model offers a solution. The bank purchases the commodity on cash and sells it to the customer on a profit. Since the client has no money, he buys the commodity on deferred payment basis. Thus, the client got the commodity for which he wanted the finance and the Islamic bank made some profit on the amount it had spent in acquiring the commodity.
There are a number of requirements f or this transaction to be a real transaction to meet the Islamic standards of a legal sale. The whole of Murabaha transaction is to be completed in two stages. In the first stage, the client requests the bank to undertake a Murabaha transaction and promises to buy the commodity specified by him, if the bank acquires the same commodity. Of course, the promise is not a legal binding. The client may go back on his promise and the bank risks the loss of the amount it has spent. In the second stage, the client purchases the good acquired by the bank on a deferred payments basis and agrees to a payment schedule. Another important requirement of Murabaha sale is that two sale contracts, one through which the bank acquires the commodity and the other through which it sells it to the client should be separate and real transactions.
The Murabaha form of financing is being widely used by the Islamic banks to satisfy various kinds of financing requirements. It is used to provide finance in various and diverse sectors e. g. in consumer finance for purchase of consumer durable such as cars and household appliances, in real estate to provide housing finance, in the production sector to finance the purchase of machinery, equipment and raw material etc. However, probably the most common and the most popular application of Murabaha is in financing the short-term trade for which it is eminently suitable. Murabaha contracts are also used to issue letters of credit and to provide financing to import trade.
(Cost-plus financing) This is a contract sale between the bank and its client for the sale of goods at a price which includes a profit margin agreed by both parties. As a financing technique, it involves the purchase of goods by the bank as requested by its client. The goods are sold to the client with a mark-up. Repayment, usually in instalments is specified in the contract.
4 Musharkah (Venture Capital)
Musharkah is another popular techniques of financing used by Islamic banks. It could roughly be translated as partnership. In this technique two or more financiers provide finance for a project. All partners are entitled to a share in the profits resulting from the project in a ratio which is mutually agreed upon. However, the losses, if any, are to be shared exactly in the proportion of capital proportion.
All partners have a right to participate in the management of the project. However, the partners also have a rig ht to waive the right of participation in favour of any specific partner or person. There are two main forms of Musharkah: Permanent Musharkah and Diminishing Musharkah. These are briefly explained below:
a. – Permanent Musharkah
In this form of Musharkah an Islamic bank participates in the equity of a project and receives a share of profit on a pro rata basis. The period of contract is not specified. So it can continue so long as the parties concerned wish it to continue. This technique is suitable for financing projects of a longer life where funds are committed over a long period and gestation period of the project may also be long.
b. – Diminishing Musharkah
Diminishing Musharkah allows equity participation and sharing of profit on a pro rata basis but also provides a method through which the equity of the bank keeps on reducing its equity in the project and ultimately transfers the ownership of the asset on of the participants. The contract provides for a payment over and above the bank share in the profit for the equity of the project held by the bank. That is the bank gets a dividend on its equity. At the same time the entrepreneur purchases some of its equity. Thus, the equity held by the bank is progressively reduced. After a certain time the equity held by the bank shall come to zero and it shall cease to be a partner. Musharkah form of financing is being increasingly used by the Islamic banks to finance domestic trade, imports and to issue letters of credit. It could also be applied in agriculture and Industry.
Islamic Bank -Typical Landscape
Given below is a typical landscape for an Islamic Bank. The support functions, since these are similar in both types of banking have been excluded from the diagram.
Islamic banks offer the deposit services similar to the conventional banks. The products strictly conform to the Sharia rules.
There are two broad categories of deposit accounts,
- Investment Deposits where the earnings are shared with the depositors after offsetting the management expenses, but losses are passed on to the depositor without management expenses which are to be borne by the bank. Profit (Loss) ration depends on the duration of deposit. Since the losses are also shared, there is no guarantee for the principal amount.
- Demand Deposits are guaranteed for the principal amount as no profit or loss is shared.
The deposits are accepted under a contract of deposit that allows the bank to use the funds at their will for investment. Even though the money is accepted by the bank on profit sharing basis the depositor is not considered as a share holder in the bank.
1. CURRENT ACCOUNT (WADI’A/QARD)
As in the case of conventional banks, the current account is essentially a safekeeping arrangement between the depositors and the bank, which allows the depositors to withdraw their money at any time and permits the bank to use the depositors’ money for liquidity purposes.
This account gives no return to the depositors and more often than not, the banks make no service charges in this regard.
As in the case of conventional banks, Islamic banks provide a broad range of related services that ensure easy access to withdrawals whenever and wherever needed, such as, Checking facility, ATM cards, Charge Cards, Traveler’s Checks, Phone Banking, Branch Service, Standing Instructions, Statement request, Balance enquiry, remittances and the likes.
This product is based on various alternative Shari’a models such as:
- Wadi’a-wad-dhamana or guaranteed deposits
- Under this mechanism, the deposits are held as amana or in trust and utilized by the bank at its own risk.
- The depositor does not share in the risk or return in any form.
- Any profit or loss resulting from the investment of these funds accrues entirely to the bank.
- Another feature of such deposits is the absence of any condition with regard to deposits and withdrawals.
- The term “wadi’a account” or “trust account” is used for such deposits.
- Qard or benevolent loan by the depositor
- In this case, the bank operates “qard hasan current account”.
- As in above, the bank is free to utilize these funds at its own risk.
- The depositor in its role as the lender is not entitled to any return as the latter would constitute riba.
- In fact, any kind of benefit passed on to the depositor that is a part of the agreement, is deemed to be riba.
- The qard hasan model is less popular than the wadi’a model among bankers because banks would like to provide additional benefits to their depositors for marketing purposes.
- Under qard hasan framework, benefits to a lender (the depositor in this case) are rightly looked at as being against the spirit of this model.
2 SAVINGS ACCOUNT (WADI’A /MUDHARABA)
This deposit account serves the need for the safekeeping of one’s surplus funds while providing a modest return.
Here, the bank has the discretion to periodically pay the depositors a positive return, depending on its own profitability. Such payments are considered lawful in Islam since they are not a condition for lending, nor are they predetermined.
The savings account holders are issued with savings books and are allowed to withdraw their money as they please.
The objective of a modest return is provided by using alternative models.
2.1 Wadi’a Model
This model is similar to the one of current deposit. This model is quite popular in South East Asian countries.
- The principal amount of deposit is guaranteed. The bank guarantees the withdrawal of funds from this account anytime the customer may wish to do so.
- Savings deposit however, differs from current account deposit in that the bank now provides a return to the depositor, purely at its discretion as a gift. Such gift is not part of the contract.
- Generally, the gift or reward on deposit is granted if the customer meets the minimum deposit required under this account. Such reward is variable in nature since it is profit based and is discretionary on the part of the bank.
2.2 Mudharaba Model
The bank now requires the depositors to authorize the bank (or appoint the bank as mudharib) for the purpose of investing the funds. Depositors however, have the right of withdrawal.
- Profits are calculated on the basis of the minimum balance maintained for a time period (say, a month). The minimum balance maintained is deemed as the investment for that time
- A minimum balance is required to be maintained in order to qualify for a share in profits.
2.3 Al Qard Al Hasan Model
This model is primarily used by Iranian banks.
- As in the case of current accounts, this model essentially views deposits as loans from savers to the banks.
- The functioning of such product is similar to wadi’a-based products highlighted above.
- Although no dividends are payable to qard hasan depositors, banks provide a range of benefits including non-contractual gifts to their customers.
3 INVESTMENT (MUDHARABA) DEPOSITS
This is the core deposit product of an Islamic bank. The product is based on the concept of mudharaba and as such, is also known as profit-and-loss sharing (PLS) deposit or participatory deposit.
It can be seen as the Islamic counterpart of the conventional fixed deposit product that cannot be withdrawn prior to a maturity date. At times such deposits allow withdrawal, but only at the cost of foregoing the profit share.
The profit-sharing ratio varies from bank to bank and from time to time, depending on supply and demand conditions. The rate of return could be positive or negative, but in practice, the returns are usually positive and quite comparable to the rates that conventional banks offer on their term deposits.
Islamic banks always bear in mind that since investment accounts are based on the Mudharaba principle, there is always a chance that the rate of return could be negative. In that case, they should remove the loss incurred from the deposit account. Such a scenario would disrupt the system by decreasing the bank’s credibility. To prevent that imbalance in the system, Islamic banks set aside part of their profit in a stabilization fund to compensate for losses so that depositors have a stable return
There are several types of investment deposits:
3.1 General Investment Deposits
This is a popular deposit product of Islamic banks under which an investment pool is established. The pool includes investment deposits of different maturities.
- The funds are not tied to any specific investment project but are utilized in different and continuous financing operations of the bank.
- Profits are calculated and distributed at the end of the accounting period, which is either three months, six months or one year.
3.2 Special Investment Deposit
This deposit account is similar in all respects to general investment deposit except that the depositor should meet the required minimum to invest in this product, and the holders of the special investment accounts (usually government and large corporations) have the option to choose specific projects that they wish to invest their funds in. As a result, the funds in special investment accounts normally end up in large popular investment projects and institutions known for their solid credibility and high rates of return.
- The modes of investment of the funds and the ratio of profit distribution may usually be individually negotiated.
3.3 Limited and Unlimited Period Investment Deposits
As the name suggests, investment deposits under the limited contract are accepted for a specified period, which is mutually determined by the depositor and the bank. The contract terminates at the end of the specified period but profits are calculated and distributed at the end of the accounting period.
In case of the unlimited, the period is not specified. Deposits are automatically renewable unless a notice of three months is given to terminate the contract. No withdrawals or further deposits are permitted in this kind of contract, but customers are allowed to open more than one account. The profits are calculated and distributed at the end of the accounting period.
Islamic banks make use of accessible funds through three key types of financing modes that do not have any interest component, viz Sharing, Sales and Leasing modes. All the different financing products offered by any Islamic bank revolves around one these three modes only.
Islamic Banks, like conventional banks, offer many financing products including Trade Finance. These are similar in nature to conventional banks but differ in the way these are handled / processed. Financing mostly is by bank purchasing the commodity and then selling it to the customer as per underlying contract.
1 Term Financing
In Islamic Banking term financing facility is available under Murabahah concept. The Bank will purchase the asset from the customer/vendor on cash term and sell it to the customer on deferred term. The difference between the 2 prices is the profit charged by the Bank on the customer. Normally the customer pays back the Bank the sales price by fixed installments. The profit rate is fixed over the period of financing.
In Islamic Banking, leasing facility is available under Ijarah concept. The Bank will buy the asset from customer/vendor and rent/lease it out to customer for a period of time. The computation of the lease rental is equivalent to the lease rental in conventional banking. Ijarah is actually sale of benefit usufruct of the asset to the customer.
3 Hire Purchase
In Islamic Banking, Hire Purchase facility is available under Al Ijarah Thumma Al-Bai (AITAB) concept where the rental ends with sale. Under this facility, the Bank will purchase the vehicle and lease/rent it to the customer over a period of time. Upon completion of lease/rent price, the Bank will sell the vehicle to customer at nominal price.
4 Working Capital
Working capital facility under Islamic Banking is available under Murabahah Concept. The Bank purchases the raw material/ goods for trading that has been identified by the customer. The bank then sells these goods to the customer on mark up basis. The customer will have to settle the purchase price (customer’s purchase from the bank) upon maturity of the contract. Normally it is a short term financing between 30 and 180 days.
5 Project Finance
Project financing facility is available under Istisna’. Istisna is an order sale, a contract entered between buyer and seller where the asset is yet to be in existence and it has be manufactured. The release of fund will be done gradually in accordance with the progress of delivery of the asset. The customer will pay back the price, upon receipt of the payment. The profit will be the difference between the purchase and selling price.
6 Factoring Finance
Factoring (debt financing) facility is available under the Bai Al Dayn concept or debt trading. The Bank purchases the customers’ receivables at the discount and upon receipt of payment from the buyer, the customer will settle the amount due to the Bank. The period is between 30 and 180 days.
Islamic Trade Finance
Since Trade Finance transactions include cross border parties / banks, Islamic Banking offers Trade Finance products similar to that of conventional banking. However the operating principles comply with the Sharia rulings. The compliance of requirements like no interest, no dealings in forbidden items etc are more from the sale purchase perspective and are followed by the buyers/sellers in the agreement. The other requirements do not impact the other bank in case one leg of the deal is being handled by a conventional bank.
1 Letter of Credit
The letter of Credits under Islamic Banking are issued under Wakalah arrangement under Murabah or Musharakah contract.
The Bank acts as agent (wakil) for customer to import the goods by issuing Letter of Credit. Once the consignment arrives at the port, to enable the customer to collect the goods from the port, the customer has to pay the Bank the value of LC to obtain the bills of lading/ airway bills to enable them to claim the goods from the port. The Bank will charge the customer commission for the services rendered.
Such LCs can not have the interest component in them. Also there should be a clause stating that the LC is subject to UCPDC 600 without which it will not be accepted by the other banks.
The Letter of Credits are governed by International Chamber of Commerce through the rules contained in UCPDC 600. These rules do not apply to the LC unless it is specifically subjected to these rules.
2 Trust Receipt
There are two methods. First the Bank buys /imports the goods by issuing the Letter of Credit. Upon arrival of the goods and documents, the Bank sells the goods under Murabahah. The customer will settle the debt upon maturity.
Under the concept of Musharakah, upon arrival of document, the bill is paid jointly by the Bank and customer in the agreed ratio. Upon sale of the goods the customer will pay the Bank capital together with their share of profit.
3 Bankers Acceptance
For Import/Purchase, upon acceptance by the customer, a bill of exchange i.e. Acceptance Bill is drawn and later the bill is traded in the secondary market under the Bai Al Dayn contract. Upon maturity the customer will pay the holder the face value of the bill.
For Export/Sale, a facility is granted to the sellers to finance their usance (deferred payment) exports or domestic credit sales. The customer sells their debt to the Bank under Bai Al Dayn contract and an acceptance bill is drawn. This is done at a discount. On maturity the customer has to pay the holder of the bill, the face value.
4 Export Credits
For Pre shipment, a facility is granted to exporters (direct and indirectly) to prepare the eligible Islamic Banking goods (halal and permissible goods according to Sharia principles and as per Exim Bank Guidelines) prior to shipment. The Islamic principle mechanisms applicable are Murabahah (cost plus financing).
The sellers may receive preshipment finance from the buyers of the goods as advance payment. Such amounts are received under the concept of Bai al Salam. These may also be received under the red clause letter of credits.
For Post shipment, a facility is granted to direct exporters to finance their exports of eligible Islamic Banking goods (halal and permissible goods according to Sharia principles and as per Exim Bank Guidelines) on credit terms. This is done at a discount under Bai Al Dayn concept.
5 Foreign/Domestic Bill Purchase
This facility is granted under Bai Al Dayn concept to the seller to finance their trade debt, which arises from sale contract of goods (halal).
It is a short term financing facility for a period upto 180 days whereby the Bank purchases the customer’s right to the debt.
6 Shipping Guarantees
The delivery of goods arrived by ship can only be obtained only by surrendering the original Bill of Lading since it is a negotiable instrument and can be transferred to another party by endorsement. In case the documents including the Bill of Lading have not arrived but the goods have arrived at the sea port, Importer needs to arrange a bank guarantee in favour of the shipping company. This is called the shipping guarantee. Under Islamic Banking the guarantee is issued under Al Kafalah concept. The bank agrees to guarantee the liability of the importer in favour of the shipping company in case the shipping company receives a claim of goods under the shipment covered. The Bank charges commission.
7 Bank Guarantees
This is a facility given by the Bank under the concept of Al Kafalah, whereby the Bank agrees to guarantee a liability of a customer/applicant in case the latter defaults in fulfilling his obligations to the third party (beneficiary of guarantee).
The payment under the guarantee is made to the beneficiary for the default from the applicant.
Risks Associated with Islamic Banking
All the risks associated with conventional banking equally apply to Islamic Banking. Rather there are additional risks associated with Islamic products. The route cause of most of the risks are lack of training facilities and absence of any legal framework.
The Islamic banking concepts though are very old, the commercial use in the modern period started only in seventies. Moreover the entire Islamic Banking has a religious base. There is no legal framework in existence, the governance is through supervisory board which judges the situation / transactions on the basis of Sharia economic rules available in Fiqh Muamalat. These have lead to many additional risks getting attached to the Islamic Products. Some of these are:
1 Lack of Standardisation of Terms in Use :
There are no standard terms in use across most Islamic Banks. Though the basic concepts are followed the detailed and authentic interpretations do not exist. For any given situation the interpretation / ruling by the Sharia council /board prevails. These differ from person to person. For example even though Murabah contracts are widely accepted some Sharia councils put restrictions on particular contracts while the others do not. Such cases become prominent when the customers of two Islamic Banks enter into the contract and this contract is accepted by one bank but objected by the other.
2 Lack of Training Facilities:
Sufficient training facilities to train the Islamic Banking profession are not available due to variety of reasons.
3 Loan Repayment Defaults:
Penalties for defaults in repayment of loans are forbidden in Islamic Banking as such penalties are viewed as a form of Riba. Hence restructuring of loans in such cases is very difficult. The default events under Murabah, Mudarabah and Musharakah contracts are not clearly defined. Hence it is very difficult to identify a default in the finances under these contracts.
4 Collateral Securities:
Collateral securities to secure finances under Mudarabah and Musharakah concepts are not permissible. Both these concepts mainly drive the Islamic Banking.
5 Structured Audit:
Structured Audit facilities are not in place in Islamic Banking. Supervisory Board is required to confirm that all the activities / transactions in the bank conform to Sharia. The basic reference point for them is Fiqh Muamalat derived from the Shari’a and the Sunnah.
6 Inadequate Regulatory Controls:
The central banks of the counties where the Islamic banks are functioning do not have the legislation and tools for effective control and supervision over the operations of the Islamic Banks. Moreover in the counties where both conventional as well as Islamic Banking is practiced central banks face added problems in implementing the regulations to both in case such regulations interfere with the underlying concepts. One such example is implementation of Basel requirements for capital adequacy.
7 Basics of Basel:
The three pillars under Basel, namely (1) Minimum Capital Requirement, (2) Transparency and (3) Effective Supervision, that form the basic controls for effective risk management are inadequate in Islamic Banking.
8 Commodity Prices:
The Islamic Financing is mostly based on buying the commodity by the bank and then selling it to the customer. There is a risk of losses in disposing off the goods in case the customer fails to take delivery after these are procured by the bank.
9 Pricing and Credit Rating System:
The standardised pricing mechanisms for the Islamic Products are not available within Islamic banking system. This at times results into the loss of customer’s confidence and eventually leads to the revenue loss.
There is no formal internal rating system under Islamic Banking. These differ from bank to bank. Whatever ratings are available and in use are not supported by statistics. These carry a risk in interbank and cross border deals.