C O N T E N T S

C O N T E N T S Chapter #

CONTENT

Page No.

Table of contents

I

List of tables

V

List of figures

vi

Executive Summary

1

Chapter-1

Introduction Of Report

1.1

Brief Description

3

1.2

Main Objectives,

4

1.3

Problem statement

5

1.4

Research Methodology

6

1.5

Scheme of Study

6

Chapter-2

Literature

Review

(contemporary

research) 2.1

Historical Background

2.2

Nature and Meaning

12

2.3

Historic Background in Islam

15

2.4

Interest and its impact

15

2.5

The

concept

and

8

meaning

of

Islamic

20

interest

21

banking 2.6

Comparison

of

Islamic

and

free Banking 2.7

World wide efforts

2.8

Strategic

alliance

24 of

Islamic

and

26

conventional banking in Pakistan Chapter-3

Islamic Modes of Finance

3.1

Islamic

Alternatives

33 for

Interest

32

i

free financing 3.2

Development of Interest Free system

34

3.3

Financing by lending

36

3.4

Trade related modes of financing

36

3.5

Investment Modes of Financing

38

3.6

Other approved modes of financing

47

3.7

Review of progress

54

Chapter-4

Application

of

Islamic

Financing

in

Commercial Banks 4.1

Project Financing

60

4.2

Working Capital Financing

63

4.3

Import Financing

68

4.4

Export Financing

70

Chapter-5

Analysis And Discussion Of Finding Of Opinion Survey On Interest Free And Interest Based Banking

5.1

Views on Interest Based and Interest

73

Free Banking 5.2

Views

on

GoP

should

introduce

75

interest free banking 5.3

Views on Govt. efforts

5.4

Views

on

the

76

proposition

that

IFB

78

Views on Reforms in Islamic banking

80

ensures economic justice 5.5

sector are sufficient 5.6

Mixed

banking

needs

Improvement

and

81

be

83

Views on two parallel system should

85

IFB should be facilitated 5.7

Views

on

existing

structure

can

converted into IFB 5.8

ii

run at the same time 5.9

Preference of interest free bank as a

86

client 5.10

Preference for IFB for employment

5.11

Impact

of

Interest

free

banking

87 on

89

financial

92

businesses 5.12

Respondent

views

on

more

product necessary to be introduced 5.13

IFB can tackle the inflation factor

93

5.14

Respondents views on whether Islamic

95

banking offered is IFB Chapter-6

Conclusion and recommendations

98

Glossary

100

Bibliography

102

Questionnaire

104

iii

LIST OF TABLES Table

Content

Page

No. 5.1

No. Views on Interest based and Interest free

74

banking 5.2

Respondents views on GoP should introduce

75

interest free banking 5.3

Views on Govt. efforts

77

5.4

Views on the proposition that IFB ensures

79

economic justice 5.5

Reforms

in

Islamic

banking

sector

are

80

Mixed banking needs improvement and IFB

82

sufficient 5.6

should be facilitated 5.7

Existing structure can be converted into

83

IFB 5.8

Two parallel systems should run at the

85

same time 5.9

Preference

of

Interest

free

bank

as

a

86

client 5.10

Preference for IFB for employment

87

5.11

Impact of IFB on Businesses

90

5.12

More financial products necessary to be

92

introduced 5.13

IFB can tackle the inflation factor

94

5.14

Views on whether Islamic banking offered

95 iv

is IFB

LIST OF FIGURES Figure

C o n t e n t

Page

No.

No.

5.1

Interest based and interest free banking

74

5.2

GoP

should

introduce

Interest

free

76

introduce

Interest

free

77

Views on the proposition that IFB ensures

79

banking 5.3

GoP

should

banking 5.4

economic justice 5.5

Reforms

in

Islamic

banking

sector

are

81

Mixed banking needs improvement and IFB

82

sufficient 5.6

should be facilitated 5.7

Existing structure can be converted into

84

IFB 5.8

Two parallel systems should run at the

85

same time 5.9

Preference

of

interest

free

bank

as

a

87

client 5.10

Preference for IFB for employment

88

5.11

Impact of IFB on large business

91

5.12

Respondents

views

on

more

financial

92

v

products necessary 5.13

IFB can tackle the inflation factor

94

5.14

Views on whether Islamic banking offered

96

is IFB

EXECUTIVE SUMMARY The

principal

animus of the study is to amalgamate

the

managerial theoretical knowledge of Islamic banking as it applies in practice. Primary and secondary data like books, articles and questionnaire are used in research. Today the world

economic

resulted

in

system

that

concentration

is of

based wealth

on in

interest the

hands

has of

selected creating monopoly and widening the gap between the rich and the poor. In contract Islam encourages circulation

vi

of wealth and regards its role as important to an economy as the flow of blood to our human body. Economic

justice

requires

a

viable

economic

system.

Supported by an efficient banking system. Interest based banking

has

proved

to

be

inefficient

as

it

fails

to

equitably distribute wealth which is necessary for the well being

of

making.

On

the

other

hand

Islamic

banking

is

efficient and ensures equitable distribution of wealth thus laying

foundation

for

an

inflation

free

economy

and

socially responsible banking. The research team has done very important surveys, which show us the people perception about interest free banking. Results of the survey indicate that people do prefer and desire

for

interest

free

banking

system,

and

have

no

specific complaints about such a system. It is possible to motivate the general public and introduce interest free banking system with high possibility of success in the future. Government efforts would be highly appreciated and would enhance the level of satisfaction of the public. Told to us By Allah and His Prophet Muhammad (S.A.W.). So by this report may be the team learns how to do that which will at end make us prosperous in this earthly living not by individual, society but whole country and Islamic bloc. This report will also try to enhance readers understanding on

Islamic

economic

system

and

Islamic

banking

system,

which is part of it.

vii

CHAPTER # 1

INTRODUCTION A STUDY OF ISLAMIC MODES OF FINANCING BY COMMERCIAL BANKS 1.1) BRIEF DESCRIPTION: One of the significant developments in the Muslim world during the last decade and half is the emergence of Islamic banking,

which

has

appeared

as

a

powerful

movement.

viii

Although

some

attempts

to

reorganize

banking

activities

along the Islamic lines go back to the early 1960’s, the concept

of

Islamic

banking is even older. In fact, the

strong disapproval of interest by Islam and vital role of interest in the modern commercial banking system led Muslim thinkers

to

explore

the

ways

and

means

to

organize

commercial banking on an interest free basis. However, for a long time, the idea of Islamic banking remained a mere wish. Many discussions have been initiated about the methodology to

be

adopted

financing

for

with

replacing

present-day

interest

based

Islamic financing. Unfortunately, many

of

our planners, economists and financial experts, as well as the dozen of business and industry, are not fully aware of the

requirement,

or

the

wisdom,

of

abolishing

interest,

with particular reference to a modern economy. While

Muslims

generally

consider

that

Islam

prohibits

interest, the full extent and nature of the prohibition is not commonly understood. There is also a feeling in some quarters

that

bank

interest

is

different

from

usury

or

interest on consumption loans. It is, therefore, necessary to

discuss,

in

detail,

Islam’s

preaching

on

interest,

before taking up ways and means of adopting interest-free (Islamic) banking and finance. Unlike their counter parts elsewhere, Islamic bankers do not expect to advance money and receive a predetermined sum on

a

fixed

date

in

the

future.

Under

the

Shariah,

the

bedrock of the Islamic faith, they are instead responsible for ensuring that money is invested in viable projects,

ix

with reliable borrowers. If the project succeeds the banker shares the profit. If it fails he suffers losses.

1.2) MAIN OBJECTIVE: Main

objective

overview

of

of

this

Islamic

research

banking

and

is

to

present

financing,

an

people’s

attitude and preferences towards interest free banking.

1.2.1) Justification There is a strong need for a riba-free banking system. Where

the

product

concept

was

not

acceptable

it

was

primarily due to confusion between riba-free and profitfree. People perceive a number of emotional benefits from a product that is based on the tenets of Islam. The objective is

to

tenets

alleviate of

Islam.

the

feeling

There

is

of also

guilt a

by

belief

following that

the

Islamic

banking will help fight the ills of the economy of the country. This

research

report

is

significant

because

People

of

Pakistan are Muslim and live in Islamic system and People have to live and abide by Islamic Rules and regulations as told to us By Allah and His Prophet Muhammad (S.A.W.). So by this report may be the team learns how to do that which will at end make us prosperous in this earthly living not by individual, society but whole country and Islamic bloc. This report will also try to enhance readers understanding on

Islamic

economic

system

and

Islamic

banking

system,

which is part of it.

1.2.2) Limitation of proposed research

x

The

study

has

focus only on those areas which are

closely related to the research topic. Facts and figures which

although

may

be important but do not have direct

impact on the research topic have been ignored, because of the time and resources constraint, it may not be possible to cover a large sample of borrowers and make in depth study of some aspects. The

most

serious

limitation

from

which

the

study

suffered was the non-availability of some related data for analysis purposes.

1.3) PROBLEM STATEMENT; Application of Islamic banking in Pakistan has been a rapidly

growing

tendency

in

the

recent

years,

the

direction of which is towards interest free banking. This study has concentrated on appraising the nature and extent of the applications of Islamic modes of financing in commercial banks. The analysis on behavior and attitude of people towards interest free banking in contrast to interest driven banking has also been a part of the research theme. 1.4) Research Methodology: The study is based on secondary as well as primary data. The Specific methodology is developed after review of existing literature on the relevant subject. The technique of Preliminary interviews and questionnaire with informed persons mainly in the relevant sectors. The sample size of the research is 28. The methodological approach is however outlined below:

xi

1.4.1) Secondary sources: The team used secondary data & tried to get benefit from different books, newspapers articles and already research done by different people and organizations such as SBP and Ministry of Finance Pakistan.

1.4.2) Primary Sources: Primary

data

has

been

supplemented

by

interviews

and

questionnaire with

1. Bank officers. 2. Businessmen. 3. Religious Scholars

4. University professors and other informed person. 1.5) SCHEME OF study: This report has been divided into six chapters, which cover the following topics. First

chapter

includes

introduction,

the

objectives,

methodology and justification of the study and scheme of the report. Second

chapter

includes

literature

review,

history

and

background of interest, its prohibition and Islamic view point. Third

chapter

includes

the

Islamic

modes

of

financing,

Fourth chapter is towards application of Islamic financing in commercial banks.

xii

Fifth chapter is based on the analysis of survey, findings based on people’s preference of Interest free banking and interest based. Last chapter is summary, conclusion and recommendations.

CHAPTER # 2

LITERATURE REVIEW INTRODUCTION Riba is prohibited in Islam. The strict prohibition and condemnation of riba appears at four different places in the Holy Qur’an. There are also numerous Ahadith (Sayings, deeds

or

tacit

approvals of the Holy Prophet of Islam,

xiii

Peace Be Upon Him), wherein prohibition and condemnation of riba is ordained in all forms and intent. In the recent past, a controversy has arisen that interest paid by banks on deposits or charged on advances does not tantamount to riba and is hence permissible. Imran ahmed,(1995) says, It is also argued that the Arabic word

riba

means

usury

and

not

bank

interest.

It

is,

therefore, proposed to discuss the true nature and meaning of riba, usury and interest, so that we can understand and ascertain whether interest comes within the purview of riba as stipulated in the Shariah.

2.1) HISTORICAL BACKGROUND: According to Council of Islamic Ideology,(1980), Even prior to the dawn of Islam, over 1400 years ago, the majority of ancient philosophers and almost all the religions of the world had prohibited money lending as a business; riba, interest or usury. If one goes back into history, as far as one can, it would be found that lending and borrowing as a transaction between members of a society was started as a commercial

operation

after

the

switching

over

from

the

barter system to the money system. Money lending with the earning motive became a common phenomenon in most of the societies of the world, but people engaged in this business were generally not regarded respectable during any period of history. Asif

shah,(1995)says,

The

doctrine

of

famous

Greek

philosopher Aristotle was, that a piece of money cannot beget another piece, as the sole natural object of the use of money was to facilitate exchange and that money cannot be

used

as

a

source of accumulating money at interest.

xiv

Aristotle, therefore, rejected interest on the basis that ‘money is sterile’ and accordingly compared money to ‘a barren

hen,

which

lays

no

eggs’.

Plato

too

condemned

interest. In the early years, the Roman Empire had also prohibited earnings on money lending. According

to

Council

of

Islamic

Ideology,(1980),

It

is

interesting to note that in AD 605; just before the dawn of Islam, on a tempestuous day, a spark of fire caught the curtains of Ka’ba (House of ALLAH in Makkah) resulting in serious

damages

reconstruction

to

of

the

building.

For

the

repair

and

the building, contributions were asked

from the general public living in the locality. It was, however, only

solemnly

pure,

clean

announced and

that

honestly

for

the

earned

Holy

money

Building, should

be

donated; prostitutes and usurious people were specifically debarred

from

contributing

anything.

It

is,

therefore,

obvious those even among the pagans of Arabia, in the dark days of civilization usury and interest were considered to be the money earned by unethical means. Anwar Muhammad, (2000) says, the end of thirteenth century saw the decline of the influence of Orthodox Church and the rise of secular powers. As a consequence, the charging of interest,

which

was

forbidden

started being tolerated. 1700)

money

began

to

by

the

Church

gradually,

In the Mercantile Era (1500 – be

used

on

a

large

scale

for

commercial transactions and assumed the role of a factor of production like land and interest on capital was equated to the payment for renting of money, similar to the rent of land. Anwar Muhammad, (2000) says, In 1740, the city of Verona, issued

a

bond

at

4%

interest,

which

led

to

a

lot

of

xv

controversies.

The

Benedict

XIV

wrote

to

the

Bishop

of

Italy, firmly emphasizing that it was a sin to take profit beyond the principal amount given as loan. He specifically condemned various pleas such as profit on loan was moderate or that the loan was given to rich person or that it was to be used for production purposes. According to Hasan,(2007),journal, In this connection, it is

significant

to

note

that

after

the

establishment

of

political supremacy of Islam over a greater part of the world, the prohibition of usury or interest, which was also considered as undesirable among non-Muslims, was enforced more strictly. The prohibition of riba, usury or interest, by Islam is, therefore, nothing new. Islam allows profits through

trade

but

prohibits

interest

because

of

the

negative effects of the fixed interest-being loans. Maulana Shafi,(1997) says, As the times passed by, Muslims gradually which

began

were

political

to

being

lose ruled

ascendancy

political

supremacy

by

and

them,

passed

on

to

in

places,

accordingly

Europe.

the

Although

in

England during the Middle Ages, charging of interest was opposed by the Church and prohibited by the state but with the decline in the influence of the Church and religion, the

practice

of

usury

and

interest

reappeared

notwithstanding the fact that the charging of usury and interest was still condemned by Christianity. During this period, the doctrine that ‘sale transaction is similar to interest

deal’

legislation Formerly,

to

revived

legalize

interest

individuals lending.

was

who

The

were

western

and

the

interest

income engaged

was in

governments

with

new

dimensions.

restricted the

socio-economic

enacted

business structure

to of was

those money then

xvi

organized in such a manner that any person who had little savings

could

be

assured

of

interest

income

without

investing in any business directly. With the advancement of this system and growth in economic activity, it has now become

almost

impossible

to

participate

in

any

economic

activity without either charging or paying interest. The Holy Prophet of Islam, Peace Be Upon Him, had predicted this over 1400 years ago. In the above paragraph, it has been mentioned that laws were

framed

for

legalizing

interest

transactions

as

a

consequence of decline in the influence of the Church. Dr. Nijat Ullah, (1994) says, It was during this period that a step was taken to Christening of interest (which may originally have been a Hebrew or Greek word) resulting in the complete transformation of its sense. The two terms, interest

and

usury,

thus

developed

were

given

different

treatment, as interest was declared lawful and usury was prohibited. The word “interest” indicated a reasonable and moderate rate as against usury, which was symbolized as an excessive rate of return. Laws were framed for legalizing the

charging

transactions.

and

paying

The

rates

of of

interest

on

interest

money were,

lending however,

controlled. During the reign of King Henry VIII in 1745, national laws were changed to permit interest but a maximum rate of interest of 10% per annum was fixed. The economists of those periods argued that the law must fix lower rates of interest to facilitate growth of business. Accoring

to

Maulana

shafi,(1997),

To

conclude,

it

seems

interesting to give a brief review of the article on usury in the Encyclopedia of Religion and Ethics. It says that usury and interest were considered one and the same thing.

xvii

Usury

was

not

used

in

its

modern

sense

of

excessive

interest and it meant interest generally. Judaism, however, later allowed that God could recover interest from non-Jews only

as

a

privilege

granted

to

faithful

Israelite.

The

Christians had similar views about usury and interest. The early Fathers totally disapproved usury. The decision of Canonist Conscious was that money lending did not justify a charge. Augustine placed usury in the category of crime and denounced the usurers as breed of vipers that gnaw the womb that

bears

them.

A

canon

of

the

third

Lateran

Council

directed that, manifest usurers shall not be admitted to Communion, nor, if they die in their sin, shall receive Christian burial. It was, however, not until 1830 that Holy Office allowed that interest could lawfully be taken for money lent to merchants who were in profitable trade.

2.2) NATURE AND MEANING: According to Qadeeruddin Ahmed, (1994), Riba is an Arabic word

which

“growth”

means

and

“increase”,

refers

to

the

“addition”, additional

“expansion”

amount,

or

which

a

lender recovers from the borrower according to a fixed rate over

and

above

the

principal

amount.

In

the

New

Encyclopedia Britannica, usury is explained as compensation for the use of money regardless of the amount, according to earlier

English

law.

The

Concise

Oxford

Dictionary,

however, defines usury ass “Practice of lending money at exorbitant interest, especially at higher interest than is legal”.

2.2.1) According to Hughes, riba is a term in Muslim Law as:

xviii

“An excess according to legal standard of measurement or weight, in one or two homogeneous articles opposed to each other in a contract of exchange and in which such excess is stipulated as an obligatory condition on one of the parties without any return. The word riba appears to have the same meaning as the Hebrew “neshec” which included gain, whether from the loan of money or goods or property of any kind. In Mosaic Law, conditions of gain for the loan of money or goods were rigorously prohibited”. According to text in Oxford Advanced Learner Dictionary, (2002), Riba refers to “excess, addition and surplus” while the associated verb implies “to increase, to multiply, to exceed, to exact more than was due, to practice usury”. Lane’s, Lexicon presents a synthesis, which transcends and covers most of the earlier authentic definitions of riba. It

says

that

increase”,

the “to

“addition”,

“to

common

meanings

augment”, make

more

that

emerge

“swelling”, than

what

is

are:

‘to

“forbidden”, given”,

“the

practicing or taking of usury or the like”, “an excess” or “an addition”, “an addition over and above the principal sum” [that is lent or expended]. According

to

Ahmed,

(1995),

It

will

thus

be

seen

that

originally the word usury meant the fact or practice or lending money at interest. It came to mean, in later use, the practice of charging, taking or contracting to receive excessive or illegal rates of interest for money given as loan. Usury before reformation amounted to taking of any amount of interest than what is authorized by law. It is, therefore, clear that interest charged on a loan is nothing but usury in the original sense of the word. Subsequently, laws were enacted specifying the limits within which usury

xix

could be tolerated. These limits prescribed by law came to be known as interest. According to Encyclopedia Americana– International edition, (1999),

“Interest

is

a

charge

for

the

use

of

money…

Interest has not always been considered a legitimate or even

moral

payment.

Until

the

end

of

middle

Ages,

any

charge for a loan was generally considered to be usury. The teachings of Christians, Judaic and Islamic religion, all condemned in varying degrees, the taking of interest. In more recent times, however, usury has come to be regarded as only the charging of illegal rates of interest.” Encyclopedia

Americana,(1999),

explains

usury

as:

“previously interest meant payment to compensate for a loss suffered by the lender, whereas usury signified a charge for the use of money”. According to Stiengass, the word interest by and large has now

been

accepted

and

understood

as

riba.

It

is

now

proposed to discuss the prohibition of riba, as ordained by Islam.

2.3) Historic Back Ground in Islam: Anwar Muhammad, (2000) is of the view, the word “Banking” has been defined to mean the accepting for the purpose of lending

of

investment,

of

deposits

of

money

from

the

public, repayable on demand or otherwise, and withdraw-able by

cheque,

draft,

and

order

or

otherwise.

Accordingly,

banking has two aspects:

1.

Deposits

accepting

and

negotiation

of

certain

credit instruments. 2.

Financing in the form of investment or lending. xx

One of the significant developments in the Muslim world during the last decade and half is the emergence of Islamic banking which has appeared as a powerful movement. Although some attempts to reorganize banking activities along the Islamic lines go back to the early 60’s, the concept of Islamic

banking

is

even

older.

In

fact,

the

strong

disapproval of interest by Islam and vital role of interest in the modern commercial banking system led Muslim thinkers to

explore

banking

the

on

an

ways

and

means

to

organize

commercial

interest free basis. However, for a long

time, the idea of Islamic banking remained a mere wish.

2.4) INTEREST & ITS IMPACT: Interest,

which

is

the

kingpin

of

modern

banking

and

financial system, serves as a powerful tool of exploitation of

one

‘haves’

segment and

of

society

‘have-nots’

by

and

another.

acted

as

a

It

has

barrier

created to

the

achievement of maximum welfare for the maximum number of the people. Saddiqi in (1993) was of the view, it is in this context that Islam forbids interest and it is for the achievement of the egalitarian objective of Islam that the Muslim world is now embarked on the task of Islamizing the financial system by unfettering it from the clutches of interest. The institution of interest is wholly repugnant to the teaching of Islam. Indeed there is a consensus among Muslim scholars that ‘Riba’ is prohibited in all forms and manifestations. The

injunctions

of

the

Holy

Quran

in

this

regard

are

unambiguous and clear. The Quran says: “Those who swallow ‘Riba’ cannot rise up save as he ariseth whom

the

devil

has

prostrated

by

(his)

touch.

That

is

xxi

because they say: Trade is just like ‘Riba’, whereas Allah permitted

trading

and

forbade

‘Riba’.

He

unto

whom

an

admonition from his Lord cometh and (he) refraineth (in obedience thereto), he shall keep (the profits of) that which is past and his affairs henceforth is with Allah. As for him who returneth (to ‘Riba’) such are rightful owners of the Fire. They will abide therein. Allah has blighteth ‘Riba’, and made ‘Sadaqat’ fruitful. Allah loveth not the impious and guilty.”

2.4.1) Similarly at another Point: According to Qadeeruddind, (1994), Let us begin by trying to

understand

what,

according

to

the

Quran

and

Sunnah,

constitutes ‘interest’. The Quranic term for interest is ‘Riba’ which is used in the Quran, in 11 places in its literal sense to denote an increase, addition, growth or height, and in 9 places in the economic sense as generally employed by the Arabs. The transactions to which the term ‘Riba’ was applied during pre-Islamic Arabia are recorded in major Muslim works, as follow: 1. A seller would allow credit to the buyer and if the amount was not paid in time, the date was extended after increasing the amount payable. 2. A borrower would promise to pay an agreed sum in addition to the principal, in return for the time allowed for repayment. 3. A loan for an agreed period would attract a fixed monthly

amount

as

interest.

If

repayment

was

xxii

delayed,

the

loan

term

was

extended

and

the

payment

was

amount of interest was increased. In

all

these

transactions,

the

additional

called ‘Riba’. No distinction was made between productive (for trade, agriculture or transportation) or consumption loans. As a rule, unpaid interest was compounded, but the term ‘Riba’ embraced both simple and compound interest. The type of additional payment is further referred to as ‘Ribaan-Nasia’. Ahmed,

(1995)

says,

another

term

‘Riba-al-Fazal’

was

applied to the credit exchange of different quantities of like goods. For a kilo of wheat given today, a kilo and half (say) would be returned after a year. This obviously amounts to interest, though paid is kind and not in cash. According

to

Nawazish

ali

zaidi,(1987),

Thus

from

the

earliest days of Islam, ‘Riba’ has unanimously been taken to

signify

‘anything of value received by a lender,

in

addition to principal, in consideration of the time the loan

remains

outstanding’.

In

its

essential

form,

therefore, the ‘Riba’ of Jahiliyah Arabia was no different from the ‘interest’ of the modern age.

2.4.2) QURANIC INJUNCTIONS ON RIBA Having thus established what was meant by ‘Riba’ during the time of the Prophet (So, the Quranic verses concerning Riba are quoted below:

xxiii

1. (We punished the Jews…) because they practiced ‘Riba’ though it was forbidden… (Chap 4: 160-161) 2. …. Do not consume Riba, increasing and again increasing …. (Chap 3: 130-132)

3. Those exacting Riba turn rabid…. Because they argue: Trade (ba’y) is like Riba, whereas Allah permits ba’y but forbids Riba…. Allah has blighted Riba. (Chap 2: 275-276)

4. …. Forego outstanding Riba. If you won’t be warned of war from Allah and His Prophet (S). (Chap 2: 278-279) The Quran obviously had no need to define Riba, since it was a well-known term in general use and there was no likelihood of ambiguity or misunderstanding.

2.4.3) THE PROPHET (S) ON RIBA The foregoing Quranic injunctions on Riba are elucidated by several Ahadith of the Prophet (S), as shown below; 1. At Hajjat-ul-Wida, the Prophet (S) announced the annulment of all Riba claims. Only the principal was henceforth repayable to the creditor.

xxiv

2. The

pact

between

the

Prophet

(S)

and

the

Banu

Thaqeef provided that they would be entitled to recover only their principle from their debtors. 3. The Prophet (S) pact with the Christians of Najran stated

that

protecting Later,

he

them

the

(S) if

would

they

Najranites

be

absolved

practiced were

usury

banished

from

(Riba).

when

they

resorted to usury. 4. The

Prophet

(described

(S)

also

earlier)

and

forbade

Riba-al-Fazal

emphasized

that

such

increase in kind was Riba, hence not permissible.

2.4.4) The following Ahadith testify to the gravity of Riba: 1.

Allah has cursed all who take or give interest,

or testifies or transcribes such a transaction. (Thus, anyone even remotely connected with Riba, is accursed). 2.

The sin of Riba exceeds thirty-six Zina.

3.

Riba has seventy degrees, the least being worse

than material incest. (This emphasizes how heinous the act of Riba is regarded by Allah). 4.

The Prophet (S) enjoined upon creditors not to

receive any presents from their debtors. (This would indirectly open the way to interest). 5. some

On the night of Me’raj, the Prophet (S) saw persons

in

a

river

of

blood

and

others

with

xxv

snakes in theirs bellies. He learnt that these people had taken Riba in their earthly lives. And as a general rule, the Prophet (S) ordained that even where there was some doubt between the permissible (halal)

and

the

forbidden

(haram)

the

doubtful

(mutashabihat) should also be forsaken.

2.5) THE CONCEPT AND MEANING OF ISLAMIC BANKING: The Holy Quran does not lay down any injunctions regarding deposit

taking

or

negotiation

of

credit

instruments.

It

merely prohibits a certain mode of financing i.e. interest based financing. Banking in the form of deposit accepting or financial intermediation did not exit at the time of the advent of Islam. In the early days of Islam, financing was done on a personal basis. The role of credit was, however, limited to trade and loan financing. Investment funding was virtually unknown. Anwar

Muhammad,

(2000) was of the view, the concept

of

interest free financing in varying degrees and forms has deep historic roots in both secular theory and religious belief. effort

The on

past

the

five

part

years

of

the

have

witnessed

government

to

a

resolute

bring

about

a

radical change in the country’s banking field so that the interest based system (as developed, refined and practiced by

the

western

financial

institutions)

is

replaced

in

totality with a Riba free system to conform to the basic teachings of Islam. The Quran has, at a number of places, explicitly and categorically forbidden Riba in any form; and

for

source,

those the

undoubtedly

who

practice

Quran this

has

has been

or

derive

prescribed ordained

income harsh

for

the

from

this

punishment; welfare

of

xxvi

mankind

and

consequently,

it

should

be

our

effort

as

(2002)was of the view, The Ulema and

an

Muslims to conform to the Quranic injunctions. Ayub

Muhammad,

element of the learned class have equated the Arabic word ‘Riba’ with interest rather than usury; needless to say, all religious and all social-political systems have been against usury and in the modern day western states, laws have been in place prohibiting usury. As regards interest, the western financial system equates it as cost of capital, while the Ulema have taken the narrowest meaning of Riba and correlated modern day interest with it. Thus, it means that if Riba and interest is one and the same thing, then it is essential that interest or Riba should be eliminated. The prevailing interest based system has failed to solve the socio-economic problems of mankind. The institution of interest runs counter to the vision of a just economic and social order envisaged by Islam. As stated by the council of Islamic Ideology of Pakistan, the main rationale for prohibition of interest stems from the concept of justice between man and man which is the cornerstone of the Islamic philosophy of social life. Uncertainty is inherent in a business enterprise. “O

ye

who

believe;

devour

not

your

substance

among

yourselves unlawfully, but let it be a trading among you by mutual agreement.” (Chap 4: 29) Asif Shah, (1995) says, The fixity of return on capital irrespective of the operation results of the business is unfair both to the user and the provider of funds. The borrower

is

required

to

pay

interest

irrespective

of

xxvii

whether he earns profits or suffers losses. Non-payment of interest can have serious repercussions and may even lead to liquidation of the enterprise, which is neither in the interest of the entrepreneur nor in the interest of the economy as a whole. The prevailing interest based financial system hampers capital formation and optimal allocation of scarce resources in the economy. Islam, on the other hand, encourages productive activity and does not allow gain from financial activity without participation in profit and loss.

2.6)

COMPARISON

BETWEEN

ISLAMIC

&

INTEREST-BASED

BANKING: According

to

Ali,

(1987),

the

main

objective

of

an

interest-based bank is to maximize profits through banking activities

mainly

lending.

This

system

which

is

not

conditioned in its operations by any religious commandments is now well established throughout the world. The following are some of the economic impacts of the policies generally pursued by these institutions: 1.

A comparatively smaller number of borrowers have

been greatly benefited at the cost of a large number of

depositors.

interest credit

of

These

their

rating

banks

major

who

generally

clients

also

pass

due

to on

act

in

their

the high

substantial

remunerative business to them. 2.

An imbalance has been created in various sectors

of the economy, because the flow of credit is largely connected with the income generated from the advances thereby, even ignoring the priority sectors, in some cases.

xxviii

3.

They

also

contribute

to

create

inflationary

tendencies, at times. 4.

To

safeguard

their

interest,

these

banks

are

harsh when the borrower suffers losses or the value of security is depreciated, but they soften the terms of advances when the borrowers are prospering.

5.

The conventional banks and the few families who

control them have “access to other people’ capital”, observes

Kotz

wealthiest through

(1978).

and

most

banks.”

stockholders financial

in

He

points

powerful

These and

banks

creditors

corporations.

Mishan,

out

that

capitalists are

also

of

the

“the

operate

the

major

largest

non-

observes that “…

it

would be irrational for the lender to be willing to lend

as

much

to

the

impecunious

as

to

the

richer

members of the society, or to lend the same amounts on the same terms to each” Galbraith

(1975:295)

rightly

points

out

that

“those

who

least need to borrow and those who are most favored are in the planning system. Those who most rely on borrowed funds, or are least favored, are in the market system.” This situation is unacceptable to Islam. Dr. Nijat, (1994) says The Islamic banks on the other hand: 1.

Contribute

towards

economic

development

and

prosperity within the doctrine of Islamic justice and offer

an

alternate

financial

system,

which

steers

clear of interest.

xxix

2. bank

Pass on the profit earned by entrepreneurs from financing

to

a

much

larger

number

of

depositors/investors who place their funds with them. 3.

Restrict

financing

to

activities

which

are

ethical and socially desirable. 4.

Check inflation and create the capacity to absorb

shocks in recession. 5.

Are human and humane and practically sympathize

with those who most need funds or are in temporary distress or who suffer business losses. This is done by profit and loss sharing, Zakat and beneficent loans. 6.

Operate for maximization of profit but within the

framework, as Islamic banks are also profit oriented and not charitable organizations.

2.7) World Wide Efforts in Introducing Interest Free Institutions: Siddiqui, Islamic

(l988) banking

says, was

the

first

undertaken

modern in

experiment

Egypt

under

with

cover,

without projecting an Islamic image, for fear of being seen as

a

manifestation

of

Islamic

fundamentalism

which

was

anathema to the political regime. The pioneering effort, led by Ahmad El Najjar, took the form of a savings bank based on profit-sharing in the Egyptian town of Mit Ghamr in l963. This experiment lasted until l967 (Ready l98l), by which time there were nine such banks in the country. These banks, which neither charged nor paid interest, invested mostly by engaging in trade and industry, directly or in partnership with others, and shared the profits with their

xxx

depositors

Thus,

they

functioned

essentially

as

saving-

investment

institutions rather than as commercial banks.

The Nasir Social Bank, established in Egypt in l97l, was declared

an

interest-free

commercial

bank,

although

its

charter made no reference to Islam or Shari’ah. The

IDB

was

established in l974 by the Organization

of

Islamic Countries (OIC), but it was primarily an intergovernmental bank aimed at providing funds for development projects in member countries. The IDB provides fee- based financial services and profit-sharing financial assistance to

member

countries.

The

IDB

operations

are

free

of

interest and are explicitly based on El–

Ashkar,

(1987)says,

In

the

seventies,

changes

took

place in the political climate of many Muslim countries so that

there

was

no

Islamic

financial

Islamic

banks,

longer

any

institutions

both

in

strong under

letter

and

need cover.

to A

spirit,

establish number came

of

into

existence in the Middle East, e.g., the Dubai Islamic Bank (l975), the Faisal Islamic Bank of Sudan (l977), the Faisal Islamic Bank of Egypt (l977), and the Bahrain Islamic Bank (l979), to mention a few. The Asia-Pacific region was not oblivious to the winds of change. The Philippine Amanah Bank (PAB) was established in l973 by Presidential Decree as a specialized banking institution without reference to its

Islamic

character

in

the

bank's

charter.

The

establishment of the PAB was a response by the Philippines Government to the Muslim rebellion in the south, designed to serve the special banking needs of the Muslim community. El– Ashkar,(1987)says, Islamic banking made its debut in Malaysia in l983, but not without antecedents. The first Islamic financial institution in Malaysia was the Muslim

xxxi

Pilgrims Savings Corporation set up in l963 to help people save for performing hajj (pilgrimage to Mecca and Medina). In l969, this body evolved into the Pilgrims Management and Fund Board or the Tabung Haji as it is now popularly known. The Tabung Haji has been acting as a finance company that invests the savings of would-be pilgrims in accordance with Shari’ah, but its role is rather limited, as it is a nonbank financial institution. The success of the Tabung Haji, however, provided the main impetus for establishing Bank Islam

Malaysia

fledged Haji

Berhad

Islamic

also

(BIMB)

commercial

contributed

which

bank

l2.5

in

per

represents Malaysia.

cent

of

a

The

BIMB's

fullTabung

initial

capital of M$80 million. BIMB has a complement of fourteen branches in several parts of the country. Plans are afoot to open six new branches a year so that by l990 the branch network of BIMB will total thirty-three. EL_Ashkar, (1987) says, Reference should also be made to some

Islamic

countries

financial

where

Muslims

institutions are

a

established

minority.

There

in

was

a

proliferation of interest-free savings and loan societies in India during the seventies (Siddiqui l988). The Islamic Banking

System

established

in

(now

called

Luxembourg

in

Islamic l978,

Finance

represents

House),

the

first

attempt at Islamic banking in the Western world. There is also

an

Islamic

Bank

International

of

Denmark,

in

Copenhagen, and the Islamic Investment Company has been set up

in

Melbourne,

Australia.

An

investment

Company

was

established in Bahamas in 1977 as a multinational holding Company under the name of Islamic Investment Company, ICC Ltd. Its purpose is to establish ‘Mudarbah’ (partnership) companies

in

various

parts

of

Islamic

countries.

The

xxxii

company

has

established

two

‘Mudarbah’

subsidiaries

in

Sharjah and Pakistan. The second example of Islamic banking in the west comes from

Luxemburg,

where

the

Islamic

Banking

System

International Holding was established in 1978 as a Joint Stock Company. Its purpose is to establish international Islamic banks in different parts of western countries to participate in investment projects in Islamic & non-Islamic countries.

2.8)

Strategic

alliance

of

Islamic

and

conventional

banking in Pakistan: According

to

Nawazish,

(1987),

Under

the

new

corporate

culture, believing in emerging trend is a fine thing, but placing

those

strength.

beliefs

To

this

onto

execution,

effect,

a

is

a

courageous

test

of

step

with

conviction, which led Al-Meezan Bank to form an alliance with

ABN

AMRO

beginning.

to

Such

perspective,

provide Riba-free services, is a good

step

which

is

required

would

not

to

only

see

be

in

a

followed

broader by

the

consequences, but also have a direct bearing on our local banking industry. Ayub

Muhammad,

(2002)

says,

since

Islamic

banking

is

passing through the age of infancy, it has been striving to establish getting

its

credibility.

recognition.

Islamic

banks

and

At

It

present

financial

is

slowly

there

but

are

at

institutions,

gradually, least

200

operating

globally and are going to multiply during the next decade, to

cover

larger

area

of

the

world.

It

is

also

an

encouraging sign and happy augury that Islamic banking is receiving

support

from

the

government

too.

Malaysia

has

xxxiii

upgraded the status of Islamic banking units divisions, to offer

Islamic

banking

alongside

conventional

banks.

In

Indonesia, few private banks have converted into Islamic financial

institutions.

More

than

40

rural

banks

are

operating under Shariah rules. Thailand has opened Islamic banking counters in Government Savings Bank (GSB). This is a healthy sign which needs to be followed and vigorously maintained by other Muslim states. According to Akram khan,(1992), Acknowledging the tangible impact of such growing trend within regional and global banking industry, various off-shore foreign banks in the Gulf and other part of the world do not want to lag behind and lose any opportunity to keep their organizations alive in

this

evaluating

specific their

establishing

growing

By

re-

operational strategies, these banks

are

Islamic

area

banking

of

competition.

units/divisions

to

offer

Islamic banking operations alongside conventional banking in their organizations. According to The News (March 2007), Al-Meezan and ABN AMRO banks with joint strategic action have not only welcomed the emerging trend in the banking, but also communicate their beliefs with conviction towards a just cause, by offering equal opportunity to all clients to avail Ribafree services being a long-awaited need of Muslim society in Pakistan. The said alliance would bring about an inept change in the fundamental approach of proactive managers of our banking industry as well as to arrest their sense of drift to accept new trends emerging on the horizon of contemporary banking in other parts of the world.

xxxiv

However, the said alliance has unique role to play and may yield desired results in given circumstances such as: Al-

Meezan

transform

being

an

investment

the

non-interest

bank

may

banking

contribute system

to

more

sophisticated and forge greater linkages with conventional banking. Al-Meezan is suitably placed to re-evaluate its strategy from

time

financial

to

time

products

to

add

more

through

value

innovative

to

its

ideas

Riba-free so

as

to

survive the competition – even stay ahead of it. Al- Meezan bank would be in a better position to promote trust

and

develop

a

sense

of

security

among

clients.

Establishing its credibility through its persistent efforts to create awareness and efficacy of Islamic banking system in existing financial structure etc. ABN AMRO being a conventional bank, through this alliance has an important and rather strategic role to play in the local banking industry. It may identify niche markets and can

have

a

suitable

competitive

advantage

over

other

commercial banks and financial institutions. Ayub

Muhammad,(2002)says,

In

the

light

of

realignment

trends sweeping the global banking industry, at the same time

seeing

conventional financial

the

adoption

banking

by

institutions

of

Islamic

regional

has

given

banking

alongside

conventional

banks

rise

empowering

to

the

and

belief that our proactive and enterprising bankers being the harbingers of our local banking Industry, would take cognizance

of

such

unprecedented

change

and

would

positively respond to the emerging trend, which is need of

xxxv

the

hour

to

welcome

a

passive

revolution

in

our

local

banking industry too. According to Muhammad Akram, (1992), therefore, with the modest confidence and cautious optimism, we believe that any positive step in this regard is not only going to earn a substantial backing within our banking industry but also very

encouraging

and

healthy

response

from

business

community too. Moreover, it has been an ardent desire that our

professional

feeling

of

conventional

superiority

bankers

complex

and

may view

shrug the

their

emerging

opportunities and trends in its right perspective and play their positive role in bridging the difference and evolve a required

consensus

to

introduce

Islamic

banking

in

the

light of new arrangements taking place globally. Should interest free banking be allowed by local commercial banks and financial institutions (e.g. NBP, HBL, UBL, NDFC and PICIC), it could be a milestone in the career of these enterprising managers. They may leave a precious legacy of trend-setters in our banking industry. The torch hopefully, they are going to lit will no doubt glow in the coming century. Mr. Jamshed, (1996) says, the alliance between Islamic bank and conventional bank has revealed that what was lacking previously is the sincerity of purpose – will to change and commitment

to

cause,

not

lack

of

resources.

Now

it

is

optimistically believed that our banking industry doesn’t need any further brain storming sessions, marathon meetings or an exhaustive assignment to introduce Islamic banking alongside

conventional banking. Simply these managers

of

conventional banking industry must get rid of disempowering beliefs

by

breaking

their

old

pattern

of

thinking

and

xxxvi

replacing

them

with

conviction

to

act

and

follow

the

emerging regional trend in banking industry in true spirit. In this regard, a docile initiative of Al-Meezan investment bank in the form of a working alliance with ABN AMRO is the right

step

in

the

right direction at the right moment.

Introduction of the trend in Pakistan may become a tiny spark

followed

by

a mighty flame in our future banking

industry, should our thoroughly professional bankers imbued with sprit of service inclined to read the trend correctly and allow Islamic banking operations to see the light of the day in their institutions.

CHAPTER # 3

ISLAMIC MODES OF FINANCING In

God

we

trust”

is

inscribed

on

the

American

dollar

whereas Pakistani rupee says “Rizq-e-Hilal ain ibadat hay” (an honest earning is worship). In America there are institutions created to ensure trust, not in God, but between the parties, which results a trade in dollars, while in Pakistan “Rizq-e-Hilal is practically extinct. The American economy is booming while Pakistani economy is sliding towards recession. According to Akram Khan, (1992), Interest is one of the motives of the modern banking and financing concepts and it is very much difficult to remove it, without shaking the system to its base.

xxxvii

Interest in the Islamic terminology is called as “Riba” and “Riba” is strictly prohibited in Islam. Still all over the world unluckily including many Muslim countries banking and financing is done with interest motives. Anwar Muhammad, (2000) says, Interest plays a vital role in the

modern

economy

that is the regulation in supply

of

money control of credit, fixation of exchange rates, and in determining the interest climate. Imran, (1996) says, Interest is also called as mark up, Riba, service charges, or “suod”. The modern banking and financing in fact has the following basic principles i.e., return, risk and liquidity. All the banks whether Islamic or western are classified as variations

of

the

same

theme.

American

economic

systems

i.e., free market economy, closer to Islamic system than the system in Pakistan. The main spirit of the Islamic system is a free enterprise and this is what is being practiced in America.

3.1 ISLAMIC ALTERNITIVES FOR INTEREST FREE FINANCING: Islamic

economist

wants

to

get

rid

of

Riba,

because

religion strictly forbids it. But they have yet to suggest an

alternative

system

and

explains

its

working

in

the

present day conditions, Quran

has

already

explained

it.

According

to

one

explanation of Sura Al-Baqarah, “Even if the funds are invested in trade, agricultural or industry, one stands the change either of making a profit

xxxviii

or incurring a loss during the period of time in question. Hence an interest-bearing transaction entails either a loss on one side and a profit on the other, or an assured and fixed profit on one side and an uncertain and unspecified profit on the other.” It is this, which could lead to the exploitation of one person at the hands of the other, some thing the Quran finds totally abhorrent. Ayub Muhammad, (2002)says, Islam also argues that in an interest bearing transaction a person gains money without working for it; it is said that he simply lives off the hard work and earnings of others and that “by its very nature, interest breeds meanness, selfishness, apathy and cruelty towards others. It leads to the worship of money and destroys fellow feelings.” Pakistan was created in the name of Islam on August 14, 1947, since then the interest is playing the cardinal role in

the

resources

of the allocation of the economy. The

principle of interest as the guiding force is diametrically opposed to the Islamic system. The

previous

governments

(except

that

of

late

president

Zia-ul-Haq) could not and did not dare to change the welldug system based on interest. The government led by late president

Zia-ul-Haq

revolutionary

steps

accepted to

make

the the

challenge

country

&

according

took to

Islamic pattern

According to Saddiqi, (1993), The government is of the firm view that “Riba” implied on all types of interest and there is no disagreement over this issue among scholars. Interest

xxxix

has become such an integral part of modern western banking concept that it can be removed without shaking the whole structure from the base. In an Islamic system, there is no place for the capital to be

given

at

interest.

There

are

12

Islamic

modes

of

financing. State Bank of Pakistan for has approved these complementary

in

the

entire

transactions

of

commercial

banks since July 1985. 3.1.1) Non-Interest Based Financing Over the last decade or so, a series of changes have been introduced in the legal framework and the operations of Pakistan’s

financial

progressively

system,

eliminate

with

the

interest-based

intent

to

transactions

from

the economy. The strategy has been to devise a spectrum of financial instruments, which at one end are quite close to present

prevailing

practices,

and

at

the

other

end,

represent an Islamic perspective on conducting business. Council of Islamic Ideology, (1980) says, a phased strategy was

adopted

by

the

government

regarding

introduction

of

Islamic modes of financing in banking and other financial institutions, groups

of

with

the

experts,

advice

under

the

of

various

overall

committees

umbrella

of

and the

Council of Islamic Ideology. Here is an assessment of the government’s efforts in this area and the progress that has so far been made towards achieving the goal of Islamization of the financial system in the country. It also seeks to discuss

the

eliminating

rationale interest

and from

the

progress

financial

made

so

transaction

far at

in the

institutional level. 3.2) Development of Interest-Free System:

xl

Imran, (1995) is of the view, A panel of economists and bankers were appointed by the council for examining the technical

aspects

transforming

the

and

recommending

banking

system

ways

into

and

an

means

for

interest-free

system. On receipt of an interim report from the panel in 1978,

the

council

elimination contained

of

an

submitted

interest

alternate

a

from

detailed the

mechanism

report

economy.

to

The

replace

on

the

report

interest

in

domestic banking transaction but observed that the interest could

not

be

eliminated

from

international

trade

transactions by single country. According to Asrar,(1993), The Council’s report dealt in broad terms, but comprehensively, with the

major

issues, problems and strategy relating to elimination of interest

from

commercial

banks,

specialized

financial

institutions, central banking and government transactions. It also dealt with modalities of financing arrangements for different sectors of the economy on an interest-free basis. In view of the complexity of the task, the report suggested that elimination of interest might be made gradually under a phased program spread over a period of three years. It also laid down a plan of action with an order of priority for

elimination

recommended

of

interest

elimination

from

of

different

interest

sectors.

from

It

government

transactions in the first phase, followed by elimination of interest

from

the

commercial

banks

eliminating

finally

assets side of the operations of the and in

other

financial

deposits

of

the

institutions, banks

becoming

interest free in the true sense of the term. The report emphasized interest

that in

the

the

ideal

Islamic

banking

and

techniques financial

to

replace

sector

are

xli

profit/loss

sharing.

However,

the

report

gave

due

recognition to the difficulties that would have risen as a result of changing the whole system to profit/loss sharing in

one

step.

certain

other

profit/loss Muaajal

It

therefore,

methods

sharing

(deferred

gave

being

like

qualified

used

leasing,

sale),

approval

to

in

conjunction

with

hire

purchase,

Baiye

investment

auctioning

and

financing on the basis of normal rate of return. However, cautioning against the danger that such methods could open a back door for interests, it emphasized that their use could be kept to the minimum extent that may be unavoidable necessary

under

given

conditions

and

that

their

use

as

general techniques of financing must never be allowed. Ayub Muhammad, (2002)says, The Council recognized that in order to re-shape the banking system on Islamic footing, it was essential to make necessary changes in the existing banking laws so as to bring them in conformity with the Islamic legal and ethical rules. The Council took note of the reservations about the operations of profit and loss sharing system as the main mode of financing to replace interest in Pakistan, in the prevailing circumstances. The council

(1980)

accordingly

financing

as

a

temporary

Pakistan,

in

line

with

recommended measure.

the

The

council’s

some State

modes

of

Bank

of

recommendations,

specified the following twelve modes of Islamic financing which have been further classified into three categories.

3.3) Financing By Lending: This category includes the following two modes.

•

Loans with Service Charge

xlii

These are interest-free loans on which the bank may recover a service charge not exceeding the proportionate cost of operations, excluding the cost of funds and provision for bad and doubtful debts. The State Bank will determine the maximum service charge permissible to each bank from time to time. •

Qarz-e-Hasna

These are loans given on compassionate grounds, free of any interest or service charge, and repayable if and when the borrower is able to pay.

3.4) Trade Related Modes of Financing: This category includes the following modes. •

Mark - up

According to Saddiqi H.,(1993), It is a sale in which the margin of profit or mark-up to the seller is mutually greed upon between the buyer and seller in advance. The payment of sale price may be either in lump sum or in installments. In

this

mode,

the

financial

institutions,

instead

of

lending, make purchase of portion of the company’s assets or inputs, which are subsequently sold back to the company when

the

Instead

loan of

a

fills

due

penalty

at

for

a

price

the

late

including

mark-up.

payments,

timely

repayment of loans provides rebates on the agreed mark-up. Although,

mark-up

was

introduced

to

provide

short-term

financing, the State Bank, in 1985, extended this mode to term financing as well. At present, mark-up financing is the

main

instrument,

which

is

issued

by

the

financial

system for working capital loans. Given the characteristics of bank’s asset operations, which are largely short term

xliii

and oriented towards financing domestic and import trade as well as input requirements of the industry and agriculture, they are amenable to mark-up lending operations. This is the most popular mode of financing in Pakistan at present. •

Markdown

Through

this

mode,

trade bills and notes of credit are

purchased on the basis of markdown in price. Markdown here refers to reduction in price below the original sale price, usually prices,

because

of

special

a

decrease

sales,

in

soiled

the

general

and

damaged

level

of

goods,

overstocking and competition.

•

Buy-back

Under the buy-back arrangement, clients sell some moveable or immovable goods to bank and immediately buy-back the same

at

higher

price (with mark-up payable at a future

date). There is also a provision for levy of liquidated damages in case of client’s default. Certain categories of documentary bills are also purchased and sold under the buy-back agreement. •

Leasing

It is relatively a new method of long-term financing under which the lessor retains the ownership of the asset and lessee

has

possession

and

use

of

assets

on

payment

of

specified rentals over a specific period. •

Hire purchase

In this system, banks and other financing institutions can provide finance for purchase of various fixed assets under

xliv

joint ownership arrangement. In addition to repayment of the principal, they would receive a share in the nature of net rental out of the profits earned on t he assets. •

Development Charge

Financing for development of property on the basis of a Development Charge.

3.5) INVESTMENT TYPE MODES OF FINANCING: It includes the following. •

Musharaka Or Profit And Loss Sharing (PLS)

It is a temporary in that both the customer and the bank contribute financially on the basis of sharing profit and loss

(PLS).

operate

Under

and

this

manage

the

arrangement, venture,

the

while

customer the

bank

will will

evaluate and monitor the performance. •

Equity Participation

This will allow the banks to purchase shares of the listed corporations. •

Participation

Term

Certificates

(PTC)

&

Modaraba

Certificates Accoring

to

Saddiqi

Certificates

(PTCs)

H.,(1993), are

The

negotiable

Participation instruments

Term

and

are

issued by a company upon terms and conditions contained in an

agreement

in

consideration

of

any

fund,

money,

accommodation received or to be received b y the company whether

in

cash

or

in

specie

or

against

any

promise,

guarantee, undertaking or indemnity issued to or in favor

xlv

or benefit of the company. Instead of receiving interest, s in the case of debentures, the holders of PTCs share in the profit and losses of companies. Modaraba certificates are the share certificates issued to the subscriber of funds for

the

business

of

corporate

body

registered

Modaraba

Company under Modaraba Companies & Modaraba (Floatation & Control)

Ordinance,

Certificate issued

to

means the

1980,

in

terms

of

which

Modaraba

a certificate of definite denomination

subscriber

of

the

Modaraba

acknowledging

receipt of money subscribed by him. •

Rent sharing

According to Hasan,(2007),journal, This will allow banks to form partnerships with their clients in the purchase of property on the basis of sharing in the rental or any other income from the property. Although the State Bank of Pakistan has described 12 modes of financing, the banks in Pakistan have, by and large, confined their main operations to the following modes: •

Loans with service charge/Mark-up

•

Buy-back agreement.

•

Hire purchase.

•

Musharaka/Modaraba.

The following section elaborates upon the prevailing modes of financing in terms of their concept, application and mechanism

as

to

financial

system.

how they have fitted into the existing It

also

touches

upon

other

financial

instruments, which though come under the domain of Islamic

xlvi

banking,

but

their

application

has

been

limited

to

a

certain extent.

Modes of Financing: Imran, (1996)says, The Sharia and financial experts have identified two categories i.e. direct and indirect forms of financial

accommodation. The first category includes the

Qarz-e-Hasna and Profit-Loss Sharing System. The indirect financial accommodation system has been described in three major categories: (a) Trade-based Modes, (b) Leasing-based modes, and (c) the Service-based modes. Under the direct accommodation system, risk bearing is in exact proportion of the investment of the concerned parties and is for the entire

period

of

the

use

of

funds.

Whereas

under

the

indirect financial accommodation, the level of risk bearing can be different and substantially reduced, but not totally eliminated. The

modes

of

financing

falling

under

both

direct

and

indirect forms of financial accommodation are described as follows: Qarz-e-Hasna System Under

this

principal postpone

amount. the

borrower’s ability

system,

to

commercial

the He

repayment

lender

is

the

a

obliged

claim to

principal

only

on

reschedule amount,

the or

if

the

condition is such that he does not have

the

pay.

of

also

has

However, this mode is not feasible for

organizations

like

banks,

and

branches

of

nationalized commercial banks in Pakistan do not use this system for their usual operations.

xlvii

Equity - Based Financing The

PLS

financing

may be both for an indefinite period

(stocks or shares) or a definite period (in the nature of temporary or Redeemable Capital). It may take three forms, namely, Modaraba or simple profit loss sharing, Musharaka or

partnership,

and

the

corporation

or

a

joint

stock

company. Modaraba Technically, in Modaraba one party provides the necessary capital and the other party provides human capital that is needed for the economic activity to be undertaken. This maybe

termed

as

an

agency partnership. In this type

of

contract, the bank supplies full financing to an agentmanager

(Modarib)

for

trading

and

industrial

purposes

whereas the Modarib contributes in the form of his skill and

experience.

In

consideration,

he

gets

an

agreed

percentage of the profit actually realized. This form of contract reflects directly how Islamic concepts value labor or pure human behavior. In case, no profit is realized or a loss occurs from normal business or natural causes, the bank bears all the loss and the Modarib receives no reward for his efforts. According Modaraba

to is

obtained Commercial

Hasan,(2007),

an

investment

through banks

sale serve

of

journal,

fund

for

which

certificate either

as

conceptually, to

resources

a are

subscribers.

managers

or

as

subscribers. In Pakistan, the sponsor of a Modaraba has to be

a

company

and

must be registered under the Modaraba

Companies and Modaraba (Floatation and Control) Ordinance, 1980. The Modarib provides management expertise along with

xlviii

not less than 10% of the total amount of the Modaraba fund offered

for

subscription, while the Modaraba certificate

holders subscribe 90%. Besides, a Modaraba company solely engaged in the floatation and management of Modaraba cannot be registered unless its paid-up capital stands at not less than Rs. 2.5 million. A

Modaraba

specific

can

be

purpose)

or

multipurpose it

can

(having

either

be

more

fixed

than or

one

for

an

indefinite period of time. A Modaraba floated for a fixed period of time, or for a specific purpose, gets terminated automatically as soon as its period expires, or its purpose is accomplished. The following conditions have been set out for a Modaraba under the Modaraba Companies and Modaraba (Floatation and Control) Ordinance, 1980: •

Modaraba shall be a legal person. It shall sue and be sued in its own name;

•

Assets

and

liabilities

of

each

Modaraba

shall

be

separate and distinct from each other as well as from that of the Modaraba Company; •

For

each

Modaraba,

separate

bank

account,

funds,

assets and liabilities shall be maintained; •

No Modaraba shall be liable for the liabilities or be entitled

to

benefit

from

the

assets

or

any

other

Modaraba or Modaraba company. The company of a Modaraba is tax exempt if not less than 90% of its profit in a year is distributed to the Modaraba certificate holders. A Modaraba, an Islamic mode of finance revised as part of the Islamization of the economy during the eighties, is

xlix

conceptually similar to a close-ended limited partnership where

a

management

company

provides

expertise

while

investors provide capital. Shares of the Management Company as

well

as

certificates

of

investment

by

the

passive

investors are traded on the stock exchange. The Modaraba form

of

organization,

therefore,

does

not

define

its

activities; so long as its activities are sanctioned as “Islamic” by a religious board, it can engage in almost any line of business. About 70% of Modaraba income comes from leasing, less than 1% comes from banking and stock market investments, and the remainder comes from trading and other lines of business. Modarabas were especially popular with sponsors because they had the advantage of being exempt from income tax. This exemption has now been withdrawn for Modarabas that because operational more than three years ago. A Modaraba Ordinance was enforced in 1980 for promoting business in accordance with the injunction of Islam, which prohibits Riba. As a result, the efforts for interest free business were initiated in the country, and in 1985, two Modarabas

named

Modaraba

were

B.R.R. formed

Capital and

Modaraba

listed

on

and

the

First

Habib

Karachi

Stock

Exchange. Although the pioneering Modarabas were small and limited

in

scope

of

Grindlays

Modaraba,

Sanaullah

Modaraba,

activity, First

the

floatation

of

First

Modaraba

and

First

Prudential

proved

to

be

a

turning

point

in

Modaraba business and therefore, a number of such companies were formed in the country. So

far

primarily

the

specialized

credit

institutions,

especially the Banker’s Equity Ltd, have managed Modarabas. The

first

Modaraba

Company

in

the

private

sector

was

l

incorporated

in

November

1982

and

floated

its

first

(multipurpose) Modaraba enterprise in early 1985, valued at Rs. 25 million. Modaraba certificates are traded and quoted on the stock exchange. The government policy of privatization and deregulation of the economy and easing of fiscal and banking regulations have opened new avenues of investment thus diversifying the financial sector. In this context, Modarabas along with new investment banks will play a pivotal role in strengthening and developing the capital market activities.

Musharaka Like

Participation

Term Certificates (PTCs) no statutory

definition of Musharaka has been specified. However, the Musharaka

contract

is

financial

institution

bilateral and

the

arrangement

user

of

between

funds.

the

Moreover,

Musharakah contracts are not documented in the form of a negotiable

instrument

and

cannot

be

traded

like

other

financial assets on the capital market. According to Qadeeruddin, (1994),

Musharaka or partnership

is a form of business arrangement in which partners pool their

capital

and

labor

to

undertake

any

commercial/industries. In the context of Islamic banking, Musharaka is described as a joint venture between a bank and a business entity geared for certain operations and may terminate

within

a

specified

period

of

time,

or

when

certain conditions are met. Musharaka contract may be for any specific project up to its completion or in the form of redeemable “Decreasing

investment

by

Musharaka”.

the This

bank can

–––– be

also

explained

known in

as the

context of medium and long-term operations where a ‘self-

li

liquidating’

form

of

partnership

can

be

agreed

upon;

whereby the ownership of the whole project or operation, would be transferred to the partner (customer) after an agreed period during which the bank would have retrieved its

principal

and

would have shared in the profits and

losses realized during that period. While

Musharaka

companies

typically

provide

long-term

capital for industrial investment, they have so far been used

to

fund

the

working

capital

requirements

of

the

industrial and trade sectors not as a loan but as akin to cash credit or overdraft accounts in which operations could be

carried

out

by

deposit

and

withdrawal

of

funds.

Musharaka companies are deemed to be temporary partnerships under which the commercial bank and the client share in the profit or loss generated by the working capital supplied by each

to

the

arrangement

project.

is

drawn

In

up

practice,

on

the

the

basis

profit-sharing

of

future

profit

projections that, in turn, are based on past averages, duly adjusted

according

to

the

future

plans

and

projections

overall state of the economy, and the industry in which the firm

operates.

responsibilities,

The

client,

receives

an

for

his

agreed

managerial

proportion

of

projected profits from the partnership, with the balance divided

between

the

bank

and

the

client

in

a

mutually

agreed ratio within the maximum and minimum ratios laid down by the State Bank of Pakistan. If a loss results, it is to be shared by the client and the bank in the ratio of their contributions to the funds employed in the project.

Corporation

lii

The ‘Corporation’ or the business of joint stock companies is well known. Modern corporation constitutes a combination of

Modaraba

and

Sharika

al-Inan.

It

is

a

type

of

partnership in which the amount of capital of the partners and

the

ratio

of

profit

distribution

may

be

disproportionate, power of appropriation in the property or participation in the affairs of Musharaka may be different and each partner is an agent to the other partners. All shareholders are partners. Some of them who also act as directors

are

like

Modaribs

by

virtue

of

their

responsibility for management of the company. This form of business

is

Islamic.

However,

speculative

and

other

unhealthy practices need to be eliminated and the rights and obligations of the directors of companies rationalized.

3.6) Other Approved Modes of Financing: According

to

Qadeeruddin,

(1994),

The

bulk

of

financing

under the Islamic system is equity oriented. In this mode of

financing,

the

risk

and

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.

Equity

financing

may

be

carried

out

in

various forms including participation in equity of joint stock companies or share in partnership or in the form of temporary equity on profit and loss sharing basis for the working capital requirements for a specific period. As the financing

under

this

sharing,

Islamic

mode

banks

is

based

pay

more

on

profit

and

loss

attention

to

the

profitability of the project and not merely on collateral. According to the Council of Islamic Ideology, (1980),Some other modes of financing have also been in practice in the

liii

Islamic

framework,

usually

referred

to

as

second-line

techniques, like Bayie Muajjal-Murabaha (usually translated as

mark-up

technique),

Ijara

(Leasing),

Hire-purchase,

Bayie Salam (deferred sale), Ju’alah (service charge), etc. the Council of Islamic Ideology in its report (1980) had observed that these secondary type of modes, though free of interest

element

presented should

in

be

in

the

the

form

used

context to

of

in

the

which

Islamic

minimum

they

have

financial

extent

been

system,

that

may

be

unavoidably necessary, so that the same could not become a back-door

for

difficulties

faced

based/Musharaka these

modes

interest. in

practical

system, under

However,

various

in

view

application Islamic

supervision

of

of

of

banks

equity-

are

their

the using

religious

supervisory boards. Salient features of these modes are as follows: Murabaha (Sale for Mark-up) This

is

the

case

where

a

partner

approaches

the

bank

requesting a certain item (be it a commodity or machinery or raw materials) be bought and/or acquired for him for a specific price. He would indicate in advance his agreement to re-purchase this item from the bank at a profit to be agreed

upon

with

the

bank,

in

advance.

So

the

profit

element is pre-determined. Although the profit element is known, which makes it look like interest; it is not so. Bayie Muaajal (Deferred Sale) The term ‘Bayie Muaajal’ as recommended by the Council of Islamic

Ideology

was

based

on

the

technique

of

Bayie

Murabaha. It has been defined as a sale in which the margin of profit is mutually agreed upon between the buyer and the

liv

seller. Payment of the sale price along with the agreed profit may be immediate or deferred (in the case of banks, it will mostly be deferred) and either in lump sum or in installments. For this kind of transaction to be consistent with

the

Shari’ah

satisfied. tangible

First, goods

rules, goods

and

certain

to

not

conditions

be

traded

papers

or

must

should credit

be

be

real,

documents.

Secondly, the seller should take possession of the goods, before selling them to the client. Third, the rate of markup should not be tied to the length of period over which the financing is to be provided and the price should be settled once for all and there should be no change in it after finalizing of the sale contract. Bayie Salam (Deferred Delivery Sale) In

this

transaction,

advance

payment

is

made

to

the

producer / manufacturer / supplier for deferred supply of the

specified

goods at a future date. The jurists have

unanimously treated it as a permissible mode of business provided the following important conditions are met: only those commodities would be eligible that can be precisely determined in terms of quality and quantity; period for delivery of goods on the specified date and place. It is also argued that commodity purchased through Bayie Salam is not to be re-sold without taking its physical possession. Because

of

particularly

its

specific

suited

characteristics,

Bayie

Salam

is

for agricultural financing. The bank

can enter into an agreement with the farmer for the future purchase of agricultural products and make the payment at the time of contract. The assets of the farmer could be used

as

against

collateral

for

fraud

negligence,

or

the

amount but

of any

finance

to

guard

financial

loss

lv

incurred in the operation will have to be fully borne by the financing bank. Ijara (Leasing) The capital market in Pakistan has witnessed a rapid growth in leasing business in the context of the Islamization of the financial system. With certain conditions, leasing is an

approved

mode

forms.

Leasing

lesser

grants

of

is

Islamic

a

financing

contractual

right

to

the

along

with

agreement, lessee

other

whereby

to

use

the his

property/specific assets for a specified period of time, in consideration of a certain payment known as rent. According to Ali zaidi,(1987), In Ijara or leasing mode of financing, assets are given out on lease to credit-worthy clients

and

the

ownership

lessor.

The

lessee,

of

however,

assets enjoys

remains

with

the

of

the

possession

leased out assets in accordance with the provisions of the contract concluded between the lessor (financial company) and the lessee (borrower). Financing under Ijara or leasing largely remains unrelated to size of assets or capital base of the lessee, but depends principally on the ability of his cash flow to service payments of the lease rentals. Under this mode of financing, no restriction is imposed on the type of assets to be leased out. The rental charged to the lessee is computed in a way to recover the cost of the leased out assets covering the operating cost of the lessor along with some element of profit. Ijara funds,

appears

to

be

especially

insufficient

assets

suitable

for and

those

means

to

raise

enterprises,

capital

base

to

investment which

meet

hold normal

collateral requirements. The basic security under an Ijara

lvi

contract is ownership of equipments. The title of ownership of equipments remain with the leasing company, and in case of

a

serious

default

on

the

part

of

the

lessee,

the

equipments are repossessed. Mohsin

Khan,(1985),journal,

says,

It

must

be

emphasized

that the modern leasing is compatible with the Islamic mode of Ijara financing, as it is based on the same fundamental concept of Ijara according to which one does not have to own an asset in order to enjoy its benefits. Lease can be classified into two types namely, financing lease and operating lease. In case of financing lease, the lessor

enters

into

a

contract

by

which

all

the

cost

invested can be recovered, and the lessee uses the leased out equipments accordingly, as if he has purchased them on loan. Under this type of lease, the lessee is furnished with

the

equipments,

that

is,

loan

in

kind,

and

the

contract term is relatively longer which is almost equal to service

life

of

the

leased

out

equipments.

It

is

not

possible for the lessee to cancel the agreement before its expiry

date

even

if he finds the leased out equipments

necessary during the term. From this, it follows that in lease

financing,

the

lessee

assumes

the

risk

of

obsolescence and incurs maintenance cost of the leased out equipments during the contract term. In case of operating lease, the lessor, on the other hand, does

not

necessarily

expect

to

recover

all

the

cost

invested while entering into a contract. In this type of leasing system, the lessee uses the equipments only for a desired period and major consideration is given to the use of

equipments.

Unlike

financing

lease,

the

lessee

can

generally cancel the contract in the operating lease before

lvii

its

expiry

date.

This

leasing

system

takes

charge

of

maintenance of the leased out equipments. By offering such a

service,

the

leasing

companies

keep

the

leased

out

equipments in good conditions so that they can sell them to other users in the market without loss. Leasing

in

Pakistan

International leasing

Finance

companies

subsidiaries Modarabas pressures

began

of

are

an

Corporation

have

banks

been

or

also

amongst

with

other 25

(IFC)

formed

involved

almost

investment in

in

1981.

since

financial

the Many

then

as

institutions.

leasing.

operating

of

Competition

leasing

companies

have promoted specialization. Leasing practices are varied with some leasing companies requiring additional collateral to be pledged, while others prefer to lease only to betterknown

companies.

In

general,

leasing

is

restricted

to

equipment with a ready resale value. Leases have started financing

longer

maturities

and

the

proportion

going

to

finance equipment has increased, owing to tax incentives. In the last five years, the leasing industry in Pakistan has been growing at the rate of 70 to 80% per annum. The leasing industry provides about 3% of the capital funds in the country and has total assets of about Rs. 6 billion. Notwithstanding this remarkable growth, its 3% contribution to capital investment is still low compared to the 7% in some other Asian countries. Leasing

companies

Pakistan,

dating

means

finance

to

are to

a

the

growth

relatively late

1980s.

without

new

phenomenon

Leasing

using

in

provides

normal

a

overdraft

facilities and has the advantage enabling less expense to be claimed on taxes. Leasing companies have shown steady progress

over

the

years.

The

first

leasing

company

was

lviii

listed on the stock exchange in 1985. For the next two years, no leasing company was floated. Leasing regulations were being processed, and as such there was a break on permission for new leasing companies. As a consequence of the new regulations framed for leasing business, companies incorporated under the Companies Ordinance 1984, were not allowed to engage in leasing business. Special permission had to be sought from the relevant authorities for this purpose and a minimum capital of Rs. 50 million was made a pre-requisite for getting the Certificate of Commencement of Business. As of August 15, 1994, there were 22 leasing companies

listed

Modarabas

have

on

the

also

stock

exchange.

undertaken

leasing

Most as

of

their

the main

business. Recently, local, as well as foreign banks, DFIs and investment banks have also entered the leasing market. The

Asian

credit

Development

to

five

Bank

leasing

(ADB)

has

companies.

allowed

Year-wise

lines

of

listing

of

leasing companies is as follows: Notwithstanding its phenomenal growth, the contribution of leasing to total investment financing is quite paltry, at around

3%

as

against

30%

in

advanced

industrialized

countries. Leasing has grown quite rapidly over the last five years. Competition

has

increased,

and

presently,

there

are

22

leasing companies listed on the stock exchange with a total paid

up

capital

of

that

are

engaged

become

quite

Modarabas industry

has

Rs. 2.04 billion along with several in

leasing.

competitive,

Although it

is

the still

dominated by 4 large players which represent about three fourth

of

Development

the

leasing

Leasing

business.

Corporation

These (NDLC)

are

National

(30%),

First

lix

Grindlays

Modaraba

(17%),

Orix

Leasing

(14%)

and

First

B.R.R. Capital Modaraba (11%). Ijara Wa-Iqtina’ (Hire Purchase) A hire-purchase agreement is a hiring agreement along with a condition that at the end of the hire, the lessee will take ownership of the hired article by purchasing the same. Such an agreement may be considered as a synthesis of two contracts i.e. a trading contract and a hiring contract. The transfer of title depends on the nature of the deal in respect of payment, either lump sum or by trenches. When the amount of acquisition value and the agreed rent is paid in full, the complete ownership is passed on to the hirer. Given its nature, the hire-purchase mode of financing has been

used

machinery,

primarily and

for

consumer

the

acquisition

durables.

Since

of

equipment,

banks

cannot

increase the amount of installment to cover losses in the event of delays in payments, there is room for misuse of this

mode,

thus

necessitating

closer

scrutiny

of

loan

the

bank

application by banks. Istisna’a (Turnkey) It

is

a

form

of

turnkey

contract

whereby

undertakes directly or by deputing the client or through a third party to finance the erection and commissioning of factories or projects at a fixed cost, including the bank’s profit. While the bank will pay the price of the equipment, etc, forthwith, the client will deliver the plant at any specified date. This can be adopted where an arrangement already exists for sale of the said plant to the client or any third party.

3.7) REVIEW OF PROGRESS: lx

The process of Islamization of the financial system was initiated

in

1979-80,

institutions

in

financial

the

when

the

public

activities

specialized

sector

toward

credit

reoriented

non-interest

their bearing

operations. Subsequently, the legal framework of Pakistan’s financial and corporate system was modified to accommodate changes

necessitated

interest-free

by

system

the

on

an

planned

economy

switchover

wide

basis.

to In

an June

1980, a new financial instrument called Participation Term Certificate

(PTC)

was

introduced

to

replace

debentures.

These certificates were based on the principle of profit and lost sharing, aimed at providing medium and long-term funds

for

industrial

and

other

financing.

Moreover,

to

regulate financing on the basis of Modaraba [a contract between the bank and an agent/manager (Modarib) where the bank

supplies

full

financing

for

trading

and

industrial

purposes and the Modarib contributes in the form of his work

and

experience], a comprehensive Modaraba Companies

Ordinance was also promulgated in June 1980. Anwar

Muhammad,(2000)says,

commercial system

banks

by

were

opening

introduction

of

institutions

had

interest-free mark-up

avenues

pricing

interest

from

Certificates

as

their

were

1981,

partially

PLS

PLS to

In

brought

deposit

of a

ways

banks to

use

investment. first

step

advances,

introduced

while

to

operations under

counters.

accounts, find

the

the

funds

started

towards

the

financial

these

in

with

eliminating

Participation

substitute

new

After

and

Banks

of

for

Term

existing

interest-based capital requirements of their clients on the basis sharing

Musharaka basis)

(temporary for

provision

partnership of

finance

on to

profit/loss trade

and

lxi

industry in the corporate sector on a selective basis. Two other

arrangements,

introduced

for

financing

fixed

industrial investment were ‘Leasing’ and ‘Hire-purchase’. Under

the

former,

a

commercial

bank

or

financial

institution rented the equipment to project sponsors for a given payment over a pre-determined period while under the latter,

the

agreed

payment

included

an

element

for

the

acquisition of equity as well as rent. The specific terms of all three instruments were left to be negotiated freely between the commercial bank or financial institution and the project sponsor. The period 1979 to 1985 saw a fairly active policy on the part of the government to Islamize the financial system. The original intention of the government was to eliminate interest

from

all

domestic

banking

and

financial

transactions within a period of three years beginning from February 10, 1979. Though this time framework did not prove practicable, the government seemed to be in earnest to move speedily towards attaining the goal of an interest free economy. At first, a parallel system was put in operation in which savers had the option to keep their savings in interest bearing or in profit-loss sharing savings media. In June 1984, it was announced by the government that the parallel system would end in the course of 1984-85 in as far

as

financial

the

operations

institutions

of

commercial

banks

and

other

were

concerned.

Accordingly,

the

entire assets side of the banks was transformed into noninterest-based commitments,

modes which

of

were

financing, allowed

to

except run

into

for

past

maturity

according to the original terms of the contract. The other exception

related

to

lending

of

foreign

loans,

which

lxii

continued to be governed by the terms of the loans. New steps

were

instituted

on

January

1,

1985,

to

formally

transform the banking system over the following six months to one based on no interest, thereby completing the first phase of bringing the entire financial system under Islamic principles. As of that date, all finance provided by banks to the government, public sector corporations, and public or private joint stock companies is to be only on the basis of

the

specified

financing. allowed

From

to

Islamic (non-interest-bearing) modes July

accept

1,

any

1985,

no

banking

interest-bearing

company

deposits

of was

except

foreign currency deposits, which continued to earn fixed interest rate. As of that date, all deposits accepted by a banking company share in profit and loss of the banking company,

except

deposits

received

in

current

account

on

which no interest or profit is given by the banking company and whose capital sum is guaranteed. According

to

liabilities

Nawazish,(1987),

side

comprehensive

of

the

banking

The

picture

system

has

on

the

undergone

a

change since the introduction of interest-

free-banking. Saving and time deposits no longer earn a fixed

return.

Banks

declare

profits,

payable

on

these

deposits at six-monthly intervals based on their operating results, and these vary from period to period and from bank to bank. The rates of profit are worked out by a formula that determines net profit accruing to a bank and allocates them

to

the

maturities. assigned

remunerative Allocations

to

are

liabilities

maturities.

The

compatible

with

liabilities based

according

on

according

to

different

to

their

their

weights relative

system has in general been found to Islamic

teachings

except

the

fact

be

that

lxiii

profits declared by banks contain a substantial element of interest.

While

bank

liabilities

(other

than

foreign

currency deposits) are composed of either current account deposits, on which no profit is distributed by the bank, or PLS deposits, three broad categories of non-interest modes of financing by lending, that is, loans not carrying any interest, on which the banks may recover a service charge, and

also

Qarz-e-Hasana

compassionate financing,

grounds).

including

(interest-free

Second,

mark-up,

loans

on

there

is

trade-related

purchase

of

trade

bills,

lending on a buy-back basis, leasing, hire purchase, and financing for development of property on the basis of a development

charge.

The

State

Bank

of

Pakistan

fixes

maximum and minimum rates of charges on these from time to time.

Third,

financing,

lending

can

including

participation Certificates,

and

take

place

Musharakah

under

investment

(Partnership),

equity

purchase of shares, Participation Term

Modaraba

Certificates,

and

rent

sharing.

While the State Bank of Pakistan determines the ratio for sharing

profits,

losses are proportionately shared among

all the financiers. Mohsin,

(1985),is

of

the

view,

Transactions

with

the

government, however, are still based on interest; moreover, the government obtains financing through the sale of bonds, purchase of which b y the private sector is facilitated by the

provision

April

1,

entities,

of

1985,

bank all

including

credit

finance

at

fixed

provided

individuals,

is

rates.

to

also

Effective

private limited

sector to

the

specified modes. As of July 1, 1985, no banks can accept any interest bearing deposits, and all existing deposits become subject to PLS rules. Deposits in current account

lxiv

continue to be accepted as in the past, that is, with no share in the profit or losses of banks (equivalent to no interest previously). Foreign currency deposits and loans from abroad, however, continue to be exempted from the new regulations. ranges

of

guides

for

The

State

charges

Bank

for

the

commercial

introducing

new

modes

of

various

banks. of

Pakistan

specifies

modes

The

of

stress

financing

lending

has

without,

broad

as

as

been

on

far

as

possible, altering the basic functioning and structure of the banking system. There

have

been

effectiveness

no

of

changes

monetary

in

policy;

the

instruments

and

bank

supervisory

and

regulatory controls have also remained broadly unchanged. Based on guidelines issued by the State Bank of Pakistan, commercial

banks

have

modified

their

procedures

and

practices to accommodate the new system. The first phase of transformation that is, shifting from interest-based

on

non-interest-based

banking,

has

been

largely completed without major problems. However, further shifts toward a system based entirely on PLS principles (rather

than

on

mark-up),

equity

participation,

and

the

absence of guarantees on deposits and loans, will entail basic changes in the economy and the society ––– changes that

will

be

time-consuming

and

difficult

to

implement.

Important pre-requisites for such a transformation would be a further deregulation of the banking system and increased competition,

changes

in

the

attitude

of

banks

towards

medium-term and long-term lending, comprehensive retraining of staff of handle project-type lending operations, reform of the auditing systems to more accurately determine true profit

levels,

establishment

of

an

efficient

capital

lxv

market, growth of a secondary financial market including specialized

investment

banking

institutions,

the

establishment of an efficient judicial arbitration system, and a new legal framework to allow speedy settlement of disputes and protection for borrowers.

CHAPTER # 4

APPLICATION OF ISLAMIC FINANCING IN COMMERCIAL BANKS 4.1) PROJECT FINANCING: The concept of Musharakah and Mudarabah is based on some basic principles. As long as these principles are fully complied with, the details of their application may vary from before touching the details.

1.

Financing through Musharakah and Mudarabad does

never

mean

participation

the in

advancing the

of

business

money.

and

in

It

the

means

case

of

Mushartakah, sharing in the assets of the business to the extent of the ratio of financing. 2.

An

investor/financier

incurred

by

the

business

must to

share

the

the

extent

loss

of

his

financing. 3.

The partners are at liberty to determine, with

mutual consent, the ratio of profit allocated to each one

of

them,

which

may

differ

form

the

ratio

of

lxvi

investment.

However,

the

partner

who

has

expressly

excluded himself form the responsibility of work for the business cannot clam more than the ratio of his investment.

4.

The loss suffered by each partner must be exactly

in the proportion of his investment. Keeping in view these basic principle project financing is discussed below In the case of project financing, the traditional method of Musharakah

or

Mudarabad

can

be

easily

adopted.

If

the

financier wants to finance the whole project the form of Mudarabah can come into operation. If investment comes from both sides, the form of musharakah can be adopted. In this while

the

investment

comes

from

both,

a

combination

of

Musharakah and Mudarabad can be brought into play according to the rules already discussed. (Nawazish Ali,1987). According

to

Fuad_ul_Qmar,(2000),

Since

Musharakah

or

Mudarabad would have been effected from the very inception of the project, no problem with regard to the valuation of capital should arise. Similarly the distribution of profits according tot eh normal accounting standards should not be difficult. However, if the financier wants to withdraw from the Musharakah, while the other party wants to continue the business,

the

latter

discussed

in

detail

can

purchase

later

on

the (while

share

shall

discussing

be the

financing of working capital). 4.1.1) FINANCING OF A SINGLE TRANSACTION According to Fuad_ul_Qmar,(2000), Musharakah and Mudarabad can be used more easily for financing a single transaction.

lxvii

Apart

from

fulfilling

their

day

to

day

needs

of

small

traders, these instruments can be employed for financing imports and exports. An importer can approach a financier to finance him for that single transaction of import alone on the basis of Musharakah or Mudarabad. The banks can also use these instruments for import financing. If the letter of credit has been opened without any marking, the form of Mudarakah can be adopted and if the L/C is opened with some margin, the form of Musharakah or a combination of both will be relevant. After the imported goods are cleared from the port, their sale proceeds may be shared by the importer and the financier according to a pre-agreed ratio. When goods are imported, the ownership of the goods shall remain with the financier to the extent of the ratio of his investment. This Musharakah can be restricted to an agreed term, and if the imported goods are not sold in the market up to the expiry of the term, the importer may himself purchase the share of the financier, making himself the sole owner of the goods. However, the sale in this case should take place at the market rate or at a price agreed between the parties on the date of sale, and not at preagreed price at the time of entering into Musharakah. If the price is pre-agreed the financier cannot compel the client / importer to purchase it. Maulana Shafi (1997), was of the view, Musharakah will be even easier in the case of export financing. The exporter has a specific order form abroad. The price on which the goods will be exported is well known before hand, and the financier can easily calculate the expected profit. He may finance him on the basis of Musharakah or Mudarabah, and may

share

the

amount

of

export

bill

on

a

pre-agreed

lxviii

percentage. In order to secure himself form any negligence on

the

part

condition

of

that

the it

exporter, will

be

the

the

financier

may

responsibility

put of

a

the

exporter to export the goods in full conformity with the conditions of the L/C. in this case. If some discrepancies are found, the exporter alone shall be responsible, and the financier

shall

be

immune

from

any

loss

due

to

such

discrepancies, because it is caused by the negligence of the exporter. However being a partner of the exporter, the financier will be liable to bear any loss, which may be caused

due

to

any

reason

other

than

the

negligence

or

where

finances

are

misconduct of the exporter. 4.2) WORKING CAPITAL FINANCING: According

to

Maulana

mufti,

(1997),

required for the working capital of a running business, the instrument

of

Musharakah

may

be

used

in

the

following

manner: •

The capital of the running business may be evaluated with mutual consent:

• The

value

of

the

business

can

be

treated

as

the

investment of the person who seeks finances his share of investment. The Musharakah may be affected for a particular

period,

like

one

year

or

six

months

or

less. Both the parties agree on a certain percentage of the profit to be given to the profit to be given to the financier which should not exceed the percentage of his investment, because he shall not work for the business. On the expiry of the term, all liquid and non-liquid assets of the business are again evaluated,

lxix

and the profit may be distributed on the basis of this evaluation. According

to

Fuad,

(2000),

although

according

to

the

traditional concept, the profit cannot be determined unless all

the

assets

of

the

business

traded

as

“constructive

liquidation” with mutual consent of the parties, because there is no specific prohibition in shariah against it. It can

so

mean

that

the working partner has purchased

the

share of the financier in the assets of the business, and the price of his share has been determined on the basis of valuation keeping in view the for example, the total value of the business of ‘A’ is 30 units, ‘B’ finances

another

20 units, raising the total worth to 50 units, 40% having been contributed by ‘B’ and 60% by ‘A’. it is agreed that ‘B’ shall get 20% of the actual profit’s t the end of the term, the total worth of the ‘B’ is purchased to 100 unit. Now, if the share of ‘B’ is purchased by ‘A’ he should have paid to him 40 units, because he owns 40% of the assets of the business. But in order to reflect the agreed ration of profit in the price of his share, the formula of pricing will

be

business

different. shall

be

Any

increase

in

the

of

the

divided between the parities in

the

ratio of 20% and 80% because this ratio

value

was determined in

the contract for the purpose of disturb action of profit. Since

the

increase

in

the

value

of

the

business

is

50

units, these 50 units are divided at the ratio of 20:80, meaning thereby that ‘B’ will have e earned 10 units. These 10 units will be added to his original 20 units, and the price of this share will be 30 units. According to Shafi,(1997), In the case of loss, however, any decrease in the total value of the assets should be

lxx

divided

between

them

exactly

in

the

ratio

of

their

investment, i.e. in the ratio of 40/60. therefore, if the value of the business has decreased n the above example, by 10 units reducing the total number of units to 40, the loss of 4 units shall be borne by ‘B’ (being 40% of the loss). These 4 unit shall be deducted from his original 20 units and the price of his share shall be determined as 16 units. •

Sharing in the gross profit only: Financing on the basic of Musharakah according to the above procedure may be difficulty in a business having a large number of fixed assets, particularly in a running industry, because

the

depreciation problems

valuation or

giving

of

all

appreciation rise

to

its may

assets

and

create

accounting

deputes.

In

such

their cases,

Musharakah may be applied in another way. According to Dr. Nijat ,(1994), The major difficulties in these cases arise in the calculation of

indirect expenses,

like deprecation of the machinery, salaries of the staff etc. in order to solve this problem, the parties may agree on

the

principle

that instead of net profit, the gross

profit will be distributed between the parties, the is the indirect

expense

shall

not

be

deducted

from

the

distributable profit. It will mean that all the indirect expenses shall be borne by the industrialist voluntarily, and only direct expenses like these of raw material direct labor, electricity etc. But

since

building

the

shall be borne by the Musharakah.

and

industrialist staff

to

the

is

offering

Musharakah

his

machinery,

voluntarily,

the

percentage of his profit may be increased to compensate him to some extent.

lxxi

Let us take practical example. Suppose a ginning factory has a building worth Rs.22 million, plant and machinery valuing Rs.2 million and the staff is paid Rs.50,000/- per month. The factory sought finance of Rs.5000,000/- form a bank on the basis of Musharakah for a term of one year. It means

that

after

one

year

the

Musharakah

will

be

terminated, and the profits accrued up to that point will be distributed between the parties according to the agreed, ratio. While deterring the profit, all direct expense will be

deducted

from

the

income.

The

direct

expenses

may

include the following. 1.

The amount spent in purchasing raw material.

2.

The wages of the labor directly involved in processing the raw material.

3.

The expense for electricity consumed in the process of ginning.

4.

The bills for other services directly rendered for the Musharakah.

So far as the building, the machinery and the salary of other staff is concerned, it is obvious that they are not meant for the business of the Musharakah alone, because the Musharakah

will

terminate

within

one

year,

while

the

building and the machinery are purchased for a much longer term in which the ginning factory will use them for its own business which is not subject to this one year Musharakal. Therefore the whole cost of the building and the machinery cannot be borne by this short-term Musharakah. What can be done at the most is that the depreciations caused to the building

and

the

machinery

during

the

term

of

the

Musharakah is included in the expenses.

lxxii

But

in

practical

determine

the

terms,

cost

it

of

will

be

depreciation

very and

difficult it

may

to

cause

disputes also. Therefore there are two practice al ways to solve this problem. El– Ashkar,(1987),says, In the first instance, the parties may agree that the Musharakah portfolio will pay an agreed rent tot eh client for the use of the machinery and the building owned by him. This rent will be paid to him form the Musharkah fund irrespective of profit or loss accruing to the business. The second option is that instead of paying rent to the client, the ratio of his profit is increased. 1.

Running

Musharakah

products:

Many

account

financial

on

the

basis

institutions

of

daily

finance

the

working capital of an enterprise by opening a running account for them from where the clients draw different amounts at different intervals, but at the same time, they keep returning their surplus amounts. Thus the process of debit and credit goes on up to the date of maturity, and the interest is calculated on the basis of daily products. Keeping

in

view

the

basic

principle

of

Musharakah

the

following procedure may be suggested for this purpose. •

A

certain

percentage

of

the

actual

profit

must

be

allocated for the management. •

The

remaining

percentage

of

the

profit

must

be

allocated for the investors. •

The loss, if nay should be borne by the investors only in exact proportion of their respective investment.

lxxiii

•

The average balance of the contributions made to the Musharkah account calculated on the biases of daily products shall be treated as the share capital of the financier. • be

The profit accruing at the end of the term shall calculated

on

daily

predict

basis

and

shall

be

distrusted accordingly. Maulana Shafi,(1997),says, If such an arrangement is agreed upon between the parties, it does not seem to violate any basic principle of the Musharakah. However this suggestion needs further consideration and research by the experts of Islamic

jurisprudence.

parties

have

agreed

to

Practically, the

it

principle

mean that

that the

the

profit

accrued to the Musharakah portfolio at the end of the term will be divided on the capital utilized per day, which will lead to the average of the profit earned by each rupee per day. The amount of this average profit per rupee per day will be multiplied by the number of the days each investor has put his money into the business which will determine his profit entitlement on daily product basis agreement can be made. The bank will pay the remaining amount and the goods that ate being imported will be owned by both of them according to there share of investment. 4.3) IMPORT FINANCING: According to Dr. Siddique, (1994), Musharakah can be used for Import Financing as well. There are two types of bank charges on the letter of credit provided to the importer: 1.

Service charges for opening an LC

2.

Interest charged on LCs, which are not opened on full margin.

lxxiv

Collecting service charges for this purpose is allowed, but as interest cannot be charged in any case, experts have proposed two methods for financing Lca. 1.

Based on Musharakah / Mudarabah

2.

Based on Murabahah

4.3.1) Musharakah / Mudarabah: This is the best substitute for opening the LC. The bank and

the

importer

can make an agreement of Mudarabah

or

Musharakah before opening the LC. If the LC is being opened at zero margin then an agreement of Mudarabah can be made, in which the bank will become Rqb-ul-Maal and the importer Mudarib. The bank will own the goods

that

are

being

imported

and

the

profit

will

be

distributed according to the agreement. If

the

LC

agreement

is can

being be

opened

a

margin

then

a

Musharakah

made. The bank will pay the remaining

amount and the goods that are being imported will be owned by both of them according to their share of investment. The bank and importer, with their mutual consent can also include a condition in the agreement, whereby: Musharakah or Mudarabah will end after a certains time period even if the goods are not sold. In such a case, the importer will purchase the bank’s share at the market price. 4.3.2) Murabahah: At present Islamic banks are using Murabahah, to finance LC. These banks themselves import the required goods and then

sell

these

goods

to

the

importer

on

Murabahah

agreement.

lxxv

Murabahah financing requires the bank and the importer to sign

at

least

two

agreements

separately;

one

for

the

purchase of the goods, and the other for appointing the importer as the agent of the bank (agency agreement). Once these two agreements are signed, the importer can negotiate and finalize all terms and condition with the exporter on behalf of the bank. 4.4) EXPORT FINANCING: According

to

El–

Ashkar,(1987),

A

bank

plays

two

very

important roles in Exports. It acts as a negotiating bank and charges a fee for this purpose, which is allowed in shariah. Secondly it provides export-financing facility to the exporters and charge interest on this service. These services are of two types 1.

Pre shipment financing

2.

Post shipment financing

As

interest

cannot

be charge in any case, experts have

proposed certain methods for financing exports. Pre Shipment Financing The

most

Musharakah

appropriate or

method

Mudarabah.

Bank

for

financing

and

exporter

exports can

make

is an

agreement of Mudarabah provided that the exporter is not investing;

other

wise

Musharakah

agreement

can

be

made.

Agreement in such case will be easy, as cost and expected profit is known. The exporter will manufacture or purchase goods and the profit obtained by exporting it will be distributed between them according to the predefined ration.

lxxvi

A problem that can be encountered by the bank is that if the exporter is not able to deliver the goods according to the terms and conditions of the importer, then the importer can refuse to accept the goods, and in this case exporter’s bank will ultimately suffer. This problem can be ratified by

including

agreement

a

that,

condition if

in

exporter

Mudarabah violates

or

Musharakah

the

terms

and

conditions of import agreement then the Bank will not be responsible

for

any

loss

which

arises

due

to

this

negligence. This condition is allowed in Shariah as the Rabb-ul-mal is not responsible for any loss that arises due to the negligence of Mudarib. Murabahah Murabahah is being used in many Islamic Banks for export financing. Banks purchases goods that are to be exported at price

that

is

less

than

the

price

agreed

between

the

exporter and the importer. It then exports goods at the original price and thus earns profit. Muhabahah financing requires bank and exporter to sign at least two agreements separately, one for the purchase of goods

and

the

other for appointing the exporter as the

agent of the bank (that is agency agreement). Once these two agreements are signed, the exporter can negotiate and finalize all the terms and conditions with the importer on behalf of the bank. Post Shipment Financing Post shipment finance is similar to the discounting of the bill of exchange. Its alternate Shariah compliant procedure is discussed below:

lxxvii

Ahsan Ali (1996) was of the view, that the exporter with the bill of exchange can appoint the bank as his agent to collect receivable on his behalf. The bank can charge a fee for this service and can provide interest free loan to the exporter, which is equal to the amount of the bill, and the exporter will give his consent to the bank that is can keep the amount revived from the bill as a payment of the loan. Here two processes are separated, and thus two agreements will be made. One will authorize the bank to collect the loan on his behalf as an agent, for which he will charge a particular fee. The second agreement will provide interest freeloan

to

the

exporter,

and

authorize

the

bank

for

keeping the amount received through bill as a payment for loan. These Shariah

agreements because

are

correct

collecting

and

fee

for

allowed service

according and

to

giving

interest free loan is permissible.

lxxviii

CHAPTER # 5

PRESENTATION OF RESEARCH AND ANALYSIS OF QUESTIONAIRE. This chapter is based on the research conducted to know the opinion of selected persons on different aspects of the interest

free

respondents and

and

were

religious

questionnaire

interest

bankers,

scholars. their

based

banking.

businessmen,

The

informed

They

were

interviewed

response

have

been

survey persons, through

reported

and

discussed in this chapter, question by question.

5.1) VIEWS ON INTEREST BASED AND INTEREST FREE BANKING: The

first

question

inquired

into

the

preference

of

the

respondents about interest free based banking system as in Table 5.1. As many as 92.9% respondents favored interest free banking system, 3.6% respondent were not clear and sure, and only 3.6% favored interest based banking system.

lxxix

TABLE 5.1 Views on people response on Interest Based and Interest Free Banking Respondents Category

Favor interest based

Favor interest free

#

#

%

No response Not sure

%

#

%

Total Responden ts #

1. Bankers

1

14.3

5

71.4

1

14.

7

2. Businessmen 3. Other informed

0 0

0 0

7 7

100 100

0 0

3 0 0

7 7

person 4.

0

0

7

100

0

0

7

1

3.6%

26

92.8

1

3.6

28

Religious

Scholars Total

Figure: 5.1 Interest Based & Interest Free Banking 93

100 80 60 40 20

4

4

0 Favor interest based

Favor interest free

No response Not sure

lxxx

Mostly people favored IFB system because of their faith and belief without any concrete reason, as per their religions believes. believe

It in

is

established

Islamic

mode

that

of

respondent’s

financing

due

hold

to

firm

religion

factor. They belief in this system, that it is fair.

5.2)

VIEWS

ON

GOP

SHOULD

INTRODUCE

INTEREST

FREE

BANKING: The vast majority of respondents 92.6% suggested that the govt. of Pakistan should introduce interest free banking system while 3.5% were not in favor of this system and rest of 3.6% kept their response reserved.

TABLE 5.2 Respondents Views on GOP should Introduce Interest Free Banking Respondents Category

Yes

No

Not Sure

Total Respondents

#

%

# %

#

%

1. Bankers

5

71.4

1 14.3

1

14. 3

7

2. Businessmen

7

100

0 0

0

0

7

informed 7

100

0 0

0

0

7

Religious 7

100

0 0

0

0

7

1 3.6

1

3.6

3. Other person 4. Scholars Total

26 92.6

28

lxxxi

Figure: 5.2 GOP should introduce interest free banking 4.0% 4.0%

Yes No Not Sure 93.0%

An important aspect which has emerged from current study was

that

laws

and

regulations

are

present,

and

Supreme

Court of Pakistan has already given its ruling regarding that.

But

the

Government

is

reluctant.

The

Government

should slowly and gradually implement it.

5.3) VIEWS ON GOVERNMENT EFFORTS: The respondents were asked whether Government efforts so far

made

respondents

are

upto

expressed

the

mark

their

or

views

not

Maximum

indicating

of

the

that

the

Government efforts about introducing interest free banking system

are

not

satisfactory.

Table

5.3

and

the

chart

clearly describe that 89.3% respondents are not satisfied with the efforts and only 7.1% are of the opposite view while 3.6% have no idea about Government efforts.

lxxxii

TABLE 5.3 Views on Govt. Efforts Yes

Respondents Category

1. Bankers 2. Businessmen 3. Other informed person 4.Religious Scholars Total

No

No response / idea # %

Total Responde nts

#

%

#

%

0 1 1

0 14.3 14.3

7 6 6

100 85.7 85.7

0 0 0

0 0 0

7 7 7

0

0

6

100

1

14.3

7

2

7.1

25

89.3

1

3.6

28

Figure: 5.3 GOP should introduce interest free banking 3.6

7.1

Yes No No response / idea

89.3

Here once again people expressed Government efforts that the Government is just doing lip service and no serious efforts are in progress as people see no solid/concrete form. According to their views, Government is divided over

lxxxiii

this issue because some minds are of capitalist thinking and are slaves of the west.

5.4)

VIEWS

ON

THE

PROPOSITION

THAT

“IFB

ENSURES

ECONOMIC JUSTICE” As per 5.4 “IFB ensures economic justice in the country and society,” As many as 89.3% of the respondents says that the proposition was right as where 7.1%

did not agree with the

view and 3.6% were not sure on it. It is established that IFB is one of the factors that ensure economic justice, as proper distribution of wealth is done. So it creates economic justice. Islam

accepts

the

basic

system

of

market

economy,

like

right of innate ownership, freedom of enterprise and the competitive environment of business and industry. The Holy Prophet (Peace be upon him) is reported to have allowed the competitive

price

mechanism

to

balance

the

demand

and

supply of goods for efficient allocation of resources. The limitations are only to take care of some moral, religious and cultural perceptions that give a place to the state to ensure the desired norms. Such limitations are necessary for Islamic Shariah.

lxxxiv

TABLE 5.4 Views on the proposition that “IFB Ensures Economic Justice” Respondents Category

Agree

1. Bankers

Don’t agree

Not Sure

Total Respondents

#

%

#

%

#

%

5

71.4

1

14.

1

14.

3

7

3

2. Businessmen

7

100

0

0

0

0

7

3.

informed

7

100

0

0

0

0

7

Religious

6

85.7

1

14.

0

0

7

1

3.6

28

Other

person 4. Scholars

3

Total

25

89.3

2

7.1

Figure: 5.4 Views on the proposition that IFB Ensures Economic Justice 7.10%

3.60%

Agree 89.30%

Don’t-Agree Not Sure

lxxxv

5.5) VIEWS ON WHETHER REFORMS IN ISLAMIC BANKING SECTOR ARE SUFFICIENT It is generally held that Government has been trying for introduction

of

an

interest

free

banking

system.

Respondents were give their views that, 57.1% subjects were not satisfied with the sufficiency of these reforms. Only 3.6%

subject

respondents

expressed were

not

their sure

satisfaction

whether

these

while

39.3%

reforms

are

sufficient or not sufficient.

TABLE 5.5 Views on “Reforms in Islamic Banking Sector are Sufficient” Respondents Category 1. Bankers

Agree #

%

Don’t agree # %

Not Sure # %

1

14.

3

42.9

3

42.9

7

Total Responden ts

3 2. Businessmen 3.

Other

0

0

3

42.9

4

57.1

7

informed 0

0

5

71.4

2

28.6

7

Religious 0

0

5

71.4

2

28.6

7

3.6

16

57.1

11

39.3

28

person 4. Scholars Total

1

lxxxvi

Figure: 5.5 Views on Reforms in Islamic Banking Sector are Sufficient 39.30%

3.60%

Agree

57.10%

Don’t-Agree Not Sure

it

is

established

that

Government

create

awareness

in

public by using media about Islamization of banks.

5.6) VIEWS ON MIXED BANKING OR PARALLEL SYSTEM NEEDS IMPROVEMENT AND IFB SHOULD BE FACILITATED: as in table 5.6, as many as 71.4% subjects were in favor of converting

existing

system

into

an

interest

fee

banking

system, 7.1%, were against it and 21.4% subjects were not sure about mixed banking improvements.

lxxxvii

TABLE 5.6 Views on “Mixed Banking Needs Improvement and IFB should be facilitated” Respondents Category

Agree

Don’t agree

Not Sure

Total Respondents

#

%

#

%

#

%

1. Bankers

5

71.4

2

28. 0 6

0

7

2. Businessmen

6

85.4

0

0

1

14. 3

7

informed 6

85.7

0

0

1

14. 3

7

4. Religious 3 Scholars

42.6

0

0

4

57. 1

7

20 71.4

2

7.1 6

21. 4

28

3. Other person

Total

Figure: 5.6 Views on“Mixed Banking Needs Improvement and IFB should be facilitated 21.40%

7.10%

Agree Don’t-Agree 71.40%

Not Sure

lxxxviii

5.7) VIEWS ON CONVERSION OF EXISTING STRUCTURE INTO IFB. The

respondents

were

asked

whether

in

their

view

the

existing structure can be converted into IFB views but no clear majority opposed or favored it, However, relatively a large number of respondents, accounting for 46.4% of the total did not support this proposition. As where 42.6% were of the view that existing structure can be converted into IFB system, while 10.7% are strictly against IFB system and they are of the view that this structure cant be converted into IFB system. 57% Bankers who were the main opponents of this system are not sure whether existing structure can be converted into IFB system or can not be converted.

TABLE 5.7 Views on Existing Structure Can be Converted into IFB Respondents Category

person 4.

Not Sure # %

Total Respondents

%

#

%

1

14.

2

28. 4

57.

7

5

3 71.

0

6 0

2

1 28.

7

informed 4

4 57.

0

0

3

6 42.

7

Religious 2

1 28.

1

14. 4

6 57.

7

6 12 42.

3

3 10. 13

1 46.

28

7

4

2. Businessmen Other

No

#

1. Bankers

3.

Yes

Scholars Total

6

Figure: 5.7

lxxxix

Views on Existing Structure Can be Converted into IFB 46.40% 42.60%

Yes No 10.70%

Not Sure

5.8) VIEWS ON “TWO PARALLEL SYSTEMS SHOULD RUN AT THE SAME TIME” xc

Most of the respondents (71.4%) indicated that it would not be possible or feasible to run two parallel systems i.e., interest free and interest based banking system while 28.6% subjects

were

of

the

opinion

that

two

parallel

systems

could run at the same time table 5.8.

TABLE 5.8 Two Parallel Systems should run at the same time Respondents Category

Yes

No

Total Respondents

#

%

#

%

1. Bankers

3

42.6

4

57. 1

7

2. Businessmen

2

28.6

5

71. 4

7

3. Other person

informed

1

14.3

6

85. 7

7

Religious

2

28.6

5

71. 4

7

8

28.6

20

71. 4

28

4. Scholars Total

Figure: 5.8 Two Parallel Systems should run at the same time 28.60%

Yes 71.40%

No

xci

5.9) PREFERENCE OF INTEREST FREE BANK AS A CLIENT 96.4% of the respondents opted to be the clients of an interest free bank and only 3.6% opted for interest based banking system. This factor is very encouraging for IFB system banks that the overwhelming portion of public belonging to different segments of the society prefer to be clients of the IFB (Interest Free Bank). So interest free banks can attract large portion of deposits and can launch different schemes.

TABLE 5.9 Preference of Interest Free Bank as a Client Respondents Category

Yes

No

Total Respondents

#

%

#

%

1. Bankers

6

85.7

1

14. 3

7

2. Businessmen

7

100

0

0

7

3. Other person

informed

7

100

0

0

7

Religious

7

100

0

0

7

27

96.4

1

3.6

28

4. Scholars Total

xcii

Figure: 5.9 Preference of Interest Free Bank as a Client 3.60%

Yes No

96.40%

5.1O) PREFERENCE FOR IFB FOR EMPLOYMENT Most of the respondents 78.6%, prefered to become employees of the interest free bank (IFB). The remaining 21.4% did not want to become employees of interest free bank as they were having good career of their own and were satisfied with their work.

TABLE-5.10 Preference for IFB for Employment Respondents Category

#

%

#

%

Total Respondents

1. Bankers

6

85.7

1

14.3

7

2. Businessmen

6

85.7

1

14.3

7

3. Other person

informed

5

71.4

2

28.6

7

Religious

5

71.4

2

28.6

7

22

78.6

6

21.4

28

4. Scholars Total

Yes

No

xciii

Figure: 5.10 Preference for IFB for Employment 21.40%

Yes

78.60%

No

It is established thatEncouraging factor for interest free banks are that they can get employees from a large pool of candidates available to join and to be part of the interest free

banks.

bank,

who

So will

they can get qualified people for their run

interest

free

bank

effectively

and

efficiently.

xciv

5.11) IMPACT OF INTEREST FREE BANKING ON BUSINESSES (SMALL, MEDIUM, AND LARGE) In

this

respect,

ascertained respectively.

impact

on

of

small,

Most

of

interest

medium

the

free

and

respondents

banking

big are

is

businesses

of

view

that

interest free banking create positive impact on all these businesses and in return the economy of the country will get

benefit.

(Small

business

67.9%,

medium

64.3%

&

big

60.7% positive impact as is clear Table 5.11). The second largest proportion of subjects belongs to not sure or no idea category; 28.6%, small, 35.7%medium and 35.7% whether

big/large this

businesses

will

have

in

positive

turnover, or

have

negative

no

idea

impact

on

businesses. And only 3.6% in small businesses, 0% in medium businesses and 3.6% in large businesses were of the view that it will have negative impact on businesses, which is very less portion of respondents.

xcv

TABLE 5.11 Respondents view on Impact of IFB on Businesses (Small, Medium, Big). Respondents Category

Total Respondent s

Small Businesses Positi ve Impact

1. Bankers

7

# 6

2. Businessmen

7

4

3. Other Informed Persons 4. Religious Scholars Total

7

5

7

4

28

1 9

Negativ e Impact

% 85. 7 57. 1 71. 4

# 1

57. 1 67. 9

Medium Businesses

Not sure

Positiv e Impact

# 0

% 0

# 5

0

% 14. 3 0

3

4

0

0

2

42. 9 28. 6

0

0

3

4

1

3.6

8

42. 9 28. 6

5

18

Negativ e Impact

Large Businesses

Not Sure

% 71. 4 57. 1 71. 4

# 0

% 0

# 2

0

0

3

0

0

2

57. 1 64. 3

0

0

3

0

0

10

Positiv e Impact

% 28. 6 42. 9 28. 6

# 5

42. 9 35. 7

4

3 5

17

Negati ve Impact

Not Sure

% 71. 4 42. 9 71. 4

# 0

% 0

# 2

1

3

0

14. 3 0

57. 1 60. 7

0

0

3

1

3.6

1 0

2

% 28. 6 42. 9 28. 6 42. 9 35. 7

Figure-5.11 Impact on IFB on large business 36%

60% 4%

positive impact negative impact not sure

5.12)

RESPONDENT

VIEWS

ON

MORE

FINANCIAL

PRODUCTS

NECESSARY TO BE INTRODUCED When

the

products

respondents of

IFB

were

need

to

asked be

whether

more

introduced,

financial

53.6%

of

the

respondents said. Yes while 32.1% of the subjects said No. the remaining 14.3% were not sure whether more products are necessary or not asked; Table 5.12.

TABLE 5.12 Respondent views on more financial products necessary to be introduced Respondents category

Yes

No

Not Sure # %

Tot al

#

%

#

%

1. Bankers

3

42.9

2

28.6

2

28. 6

7

2. Businessmen

3

42.9

2

28.6

2

28. 6

7

3. Other Persons

informed

6

85.7

1

14.3

0

0

7

Religious

3

42.9

4

57.1

0

0

7

15

53.6

9

32.2

4

14. 3

28

4. Scholars Total

Figure: 5.12 Respondent views on more financial products necessary to be introduced 14.30%

Yes 32.20%

53.60%

No Not Sure

In

5.12

under

results,

interest

Views of respondents that how credit

free

banking

will

be

backed.

In

this

question almost all of the respondents said that in Islam trust is the main thing on the basis of which loan will be repaid by the businessmen and they will not show losses. So

the banks should finances the business which maintains proper accounts and have enough collateral. One thing more, management participation, which is key component, is

essential

and

shows

surety

that

credit

will

be

backed.

5.13) IFB CAN TACKLE THE INFLATION FACTOR In question regarding inflation factor, it was found that 64.3% of the subjects were not sure whether interest free banking

system

can

tackle

the

inflation

factor

or

not.

Because they are of view that only economist know about this sure. 32.1% of the respondents defended that IFB can tackle the inflation factor, only research is essential to completely get rid of it or handle it while 3.6% are of view that interest free banking system can handle inflation factor.

TABLE 5.13 IFB can Tackle the Inflation Factor Respondents

Yes

No

Not Sure

To ta l

#

%

#

%

#

%

1. Bankers

2

28.6

1

14.3

4

57.1

7

2. Businessmen

1

14.3

0

0

6

85.7

7

informed 2

28.6

0

0

5

71.4

7

Religious 4

57.1

0

0

3

42.6

7

9

32.1

1

3.6

8

64.3

28

3. Other Persons 4. Scholars Total

Figure: 5.13 IFB can Tackle the Inflation Factor

64.30%

32.10% Yes No

3.60%

Not Sure

5.14)

RESPONDENTS

VIEW

ON

WHETHER

ISLAMIC

BANKING

SYSTEM CALLED TO BE IFB. A question was asked to know about the respondent opinion about

the

appropriate

term

/

name

of

Islamic

banking

whether it should be called Islamic banking or interest free banking or some other name should be given to it. Most of

the

respondents

(64.3%)

were

not

sure

that

what

is

offered as Islamic banking or where interest free banking,

25%of the respondents agreed while 10.7% didn’t agreed to it. Islamic banking in Pakistan is actually a change management issue

and

is

being

handled

as

a

religious

and

a

legal

issue. There is tremendous need for this type of banking both at the micro and the macro level. If people don’t handle

it

appropriately

people

would

lose

a

major

opportunity and an important need of the people. All

Pakistanis

business

banking

have

to

brand

because

if

the

the

Islamic

proposed

banking system

as

is

a

balanced banking system there why is it branded as Islamic banking?

TABLE 5.14 Respondents view on whether Islamic banking offered is IFB Respondents

Yes

No

Not Sure

Tot al

#

%

#

%

#

%

1. Bankers

2

28.6

0

0

5

71.4

7

2. Businessmen

2

28.6

1

14.3

4

57.1

7

3.

informed

2

28.6

1

14.3

4

57.1

7

Religious

1

14.3

1

14.3

5

71.4

7

7

25

3

10.7

18

64.3

28

Other

Persons 4. Scholars Total

Figure: 5.14 Respondents view on whether Islamic banking offered is IFB 25.00%

64.30%

Yes No

10.70%

Not Sure

It

is

perceived

that

only

Islam

prohibits

interest,

therefore, any banking that does not allow interest-based contracts

is

Islamic

banking.

But

the

belief

that

only

Islam prohibits interest is incorrect. In fact Judaism and Christianity also prohibit interest. By calling it Islamic banking it not only has to explain the shortcomings of interest based banking but it also has to explain the assumptions of Islam as religion. Solution

for

banking.

The

pronounceable,

this brand easy

is

that

we

business to

should banking

remember,

and

call is

it

short,

most

business easily

importantly,

explains the nature of the product well in terms of its unique selling proposition. This branding strategy will also enable us to position it as

a

system.

functionally That

viable

banking

because

any

banking

supports business is considered functional.

With such positioning the proposed system gets removed from

the religious platform and is positioned on the business platform.

CHAPTER # 6

CONCLUSION AND RECCOMENDATIONS

The

preceding

discussion

makes

it

clear

that

Islamic

banking is not a negligible or merely temporary phenomenon. Islamic banks are here to stay and there are signs that they will continue to grow and expand. Even if one does not subscribe

to

the

Islamic

injunctions

against

the

institution of interest, one may find in Islamic banking some innovative ideas, which could add more variety to the existing financial network. Results of the survey indicate that people do prefer and desire

for

interest

free

banking

system,

and

have

no

specific complaints about such a system. It is possible to motivate the general public and introduce interest free banking system with high possibility of success in the future. Government efforts might be highly appreciated and would enhance the level of satisfaction of the public. With sufficient efforts and training the existing system can be converted into interest free banking system. If impossible to do so at once, government may take gradual steps to interest free banking system. Interest free system is more economical benefited. Every person was involved in profit and loss . One of the main selling points of Islamic banking, at least in

theory,

concerned

is

that,

about

profitability

of

the

unlike

conventional

viability

of

the

banking, project

it

is

and

the

the operation but not the size of

the

collateral. Islamic banks on a profit-sharing basis would finance

good

projects,

which

might

be

turned

down,

by

conventional banks for lack of collateral. It is especially in this sense that Islamic banks can play a catalytic role in stimulating economic development. In practice, however,

Islamic banks have been concentrating on short-term trade finance which is the least risky. Part

of

the

explanation

is

that

long-term

financing

requires expertise which is not always available. Another reason

is

that

there

are

no

back-up

institutional

structures such as secondary capital markets for Islamic financial tendency

instruments. to

It

is

possible

also

that

the

concentrate on short-term financing reflects

the early years of operation: it is easier to administer, less

risky,

and

the returns are quicker. The banks may

learn to pay more attention to equity financing, as they grow older. Islamic banks tend to behave as though they had a captive market

in

the

Muslim

masses

who

will

come

to

them

on

religious grounds. Many Muslims find it more convenient to deal

with

shifting

conventional their

banks

deposits

and

between

have

no

problem

Islamic

about

banks

and

conventional ones depending on which bank offers a better return. This might suggest a case for more Islamic banks in those countries as it would force the banks to be more innovative and competitive. Another solution would be to allow the conventional banks to undertake equity financing and/or to operate Islamic 'counters' or 'windows', subject to strict compliance with the Shariah rules. There is need for

specialized

Islamic

financial

institutions

such

as

mudaraba banks, murabaha banks and Musharika banks which would compete with one another to provide the best possible services.

GLOSSARY •

Al-Wadiah

Safe Keeping

•

Bai'muajjal

Deferred-Payment Sale

•

Bai'salam

Pre-Paid Purchase

•

Baitul Mal

Treasury

•

Fiqh

Jurisprudence

•

Hadith

•

Hajj

Pilgrimage

•

Halal

Lawful

•

Haram

•

Ijara

Leasing

•

Iman

Faith

•

Mithl

Like

•

Mudaraba

Profit-Sharing

•

Mudarib

Entrepreneur-Borrower

•

Muqarada

Mudaraba

•

Murabaha

Cost-Plus Or Mark-Up

•

Musharaka

Equity Participation

•

Qard Hasan

•

Qirad

Mudaraba

•

Rabbul-Mal

Owner Of Capital

•

Riba

Interest

Prophet's Commentary on Qur'an

Unlawful

Benevolent Loan

(Interest Free)

•

Shariah

Islamic Law

•

Shirka

Musharaka

BIBLIOGRAPHY a)

The Council of Islamic Ideology, June 1980, ‘Report on Elimination of Interest from the Economy’ Government of Pakistan;.

b) Modes

Anwar Muhammad, 2000; ‘Islamicity of Banking and of

Islamic

Banking’,

International

Islamic

University, Malaysia.

c)

Ayub

Muhammad, Dec. 2002, “Islamic Banking

and

Finance Theory and Practice’, 1st Edition, State Bank of Pakistan Karachi.

d)

Saddiqi H. Asrar, 1993, ‘Practice and Law Banking

in Pakistan’, 5th Edition. Laureate Packages, Karachi.

e)

BBC

News

South

Asia

September,

2002,

www.bbcnews.com. f)

The News (March 2007),

g)

2007-08, Economist magazine.

h)

Hasan, June, 2007, “business journal”.

i)

AL QURAN, Chapters 2,3 and 4.

j)

Asif

Jamshed

shah,

1995,

strategic

issues

in

riba

and

Islamic banking, chairman, bank of Punjab.

k)

Imran

Ahmed

Khan,

1995,

concept

of

Islamic banking, Niazi publications.

l)

Dr. Nijat ullah Siddique, 1994, banking without

interest, Islamic publications.

m)

Oxford advanced dictionary.

n)

El– Ashkar, 1987, Islamic banking.

o)

Encyclopedia

American,

International

Edition,1999. p)

Muhammad

akram

khan,

1992,

Islamic

banking

in

Pakistan, Islamic education congress.

q)

Maulana

mufti

shafi,1997,

Issues

of

interest

including commercial interest, urdu bazaar Karachi.

r)

Nawazish

ali

zaidi,1987,

Eliminating

interest

from banks in Pakistan, Royal book company.

s)

Justice(Rtd)

qadeeruddin

ahmed,

1994,

what

is

riba, Salimco printer Karachi.

t)

Fuad_ul_Qmar,

2000,

Islamic

banking(theory

and

practice), Zed books,UK.

u)

Mohsin Khan,1985, Journal of Monetary Economics,

Islamic Interest Free Banking.

v)

Ahsan

Ali,1996,

Socio-Economic

Rationale

Interest-Free Financing and Certain Conceptual. w)

Kotz,1978.

x)

Galbraith,1975.

for

QUESTIONNAIRE A

research

on

application

of

Islamic

financing

in

commercial banks is in progress and your valued opinion is required for this. So kindly fill it up and return it in time. Thanks in advance for your cooperation. Name: ………………………….…….

Age: ……………………………

Educational Qualification: …………………. Occupation: ……………………

1.

Do you prefer interest based banking or interest free banking? Interest Based

No

Yes

Why?………………………………………………………………….. ………………………………………………………………………………………………………………………………………… ………………… a) Interest free

No

Yes

Why? ………………………………………………………………………………………………………………………………………. 2.

If yes to Q1 (b) do you recommend that Government of Pakistan should introduce interest free banking system in whole of Pakistan and How?

3.

Government

efforts

banking is satisfactory?

made

so

far

for

interest

free

Agree

Don’t Agree

Not Sure

Please elaborate ………………………………………………………………………………………………………………………………………. 4.

Interest free banking ensures economic justice in the

country?

Agree

Don’t Agree

Why: ……………………………………………………………………… 5.

Present Islamic reforms in banking are sufficient?

No 6.

Yes

Not Sure

Existing mixed banking system needs to be improved and complete interest free banking should be facilitated?

No 7.

Yes

Not Sure

The existing structure can be converted into interest

free banking system?

No 8.

Yes

Not Sure

Two parallel systems i.e., interest free and interest based banking should run at the same time?

No 9.

If

Yes you

have

the

opportunity

to

choose

bank,

as

a

client, will you prefer to become client of interest free bank?

No 10.

If

Yes you

have

employee,

the

will

you

interest free bank?

No

Yes

opportunity prefer

to to

choose become

bank

as

an

employee

of

11.

What impact the Islamic financing will have on small businesses (Having turnover less than Rs.5 Million? ______________________________________________________ ______________________________________________________ ______

12.

If you Favor IFB (Interest Free Banking) do you think more financial products are necessary to be introduced into the financial market.

No

Yes

If Yes, what kind of products? ______________________________________________________ ______________________________________________________ ____________ 13. Under IFB how it will be ensured that loan will be returned back by businessmen as they show losses. ______________________________________________________ ______________________________________________________ ____________ 14.

Under IFB how inflation factor will be tackled. ______________________________________________________ ______________________________________________________ ____________

15.

Do you think that what is being offered, as Islamic Banking

is

not

Islamic

Banking

Banking?

No

Yes

Not sure

but

Interest

Free

16.

Please comment/ give your views on any aspect of the IFB, not covered by afore stated questions, but which are important in your opinion. ______________________________________________________ ______________________________________________________ ____________