Islamic Banking

ISLAMIC BANKING ASSIGNMENT # 1

CONTENTS

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1. Introduction to banking

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2. What is Bank

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3. Evolution of Islamic Banking

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4. Salient features of Islamic Banking

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5. Islamic modes of financing

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6. Difference b/w Islamic & Conventional Banking

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"O those who believe, fear Allah and give up what still remains of the riba if you are believers. But if you do not, then listen to the declaration of war from Allah and His Messenger. And if you repent, yours is your principal. Neither you wrong, nor be wronged." [Al-Baqarah 2:278-279]

ISLAMIC BANKING v/s COMMERCIAL BANKING

INTRDUCTION TO BANKING:History of bank is as old as human society. Forever since man came to realize the importance of money as medium of exchange, the necessity of a controlling or regulating agency or institution was naturally felt. The work „BANK‟ is derived from the word „BANCUS‟ or „BANQUE‟ which means a bench. Other authorities hold the opinion the work „BANK‟ is derived from the German word „BACK‟ which means „joint stock fund‟. Later on, when the Germans occupied major part od Italy, the work „BACK‟ was Italianized into „BANK‟ Modern banking system was introduced into the Muslim countries at a time when they were politically and economically at low ebb, in the late 19th century. The main banks in the home countries of the imperial powers established local branches in the capitals of the subject countries and they catered mainly to the import export requirements of the foreign businesses. The banks were generally confined to the capital cities and the local population remained largely untouched by the banking system. The local trading community avoided the “foreign” banks both for nationalistic as well as religious reasons. However, as time went on it became difficult to engage in trade and other activities without making use of commercial banks. Even then many confined their involvement to transaction activities such as current accounts and money transfers. Borrowing from the banks and depositing their savings with the bank were strictly avoided in order to keep away from dealing in interest which is prohibited by religion. With the passage of time, however, and other socio-economic forces demanding more involvement in national economic and financial activities, avoiding the interaction with the banks became impossible. Local banks were established on the same lines as the interestbased foreign banks for want of another system and they began to expand within the country bringing the banking system to more local people. As countries became independent the need to engage in banking activities became unavoidable and urgent. Governments, businesses and individuals began to transact business with the banks, with or without liking it. This state of affairs drew the attention and concern of Muslim intellectuals. The story of interest-free or Islamic banking begins here.

WHAT IS BANK:Primarily the banking is business of dealing in money and instruments of credit. Banks were traditionally differentiated from other financial institutions by their principal functions of accepting deposits–subject to withdrawal or transfer by check–and of making loans. According to Negotiable Instruments Act (1881) defines:“Bank is an institution transecting the business of accepting, for the purpose of lending or investment, of deposits of money from the public repayable on demand or otherwise, and withdraw able by cheques, draft order or otherwise and includes any post office saving bank”.

EVOLUTION OF ISLAMIC BANKING:-

In Muslim communities limited banking activity, such as acceptance of deposits, goes back to the time when the Prophet Muhammad was still alive. At that time, people deposited money with the Prophet or with Abu Bakr Siddique, the First Khalif of Islam. The first modern Islamic bank, established in Egypt in 1972, was called Nasser's Social Bank. Islamic accounting, an essential tool for the success of Islamic banks, is said to have been developed contemporaneously at the University of Cairo. Islamic banking operations are not limited to Arab soil, or Islamic countries, but are spreading throughout the world. One reason is the "growing trend toward transcending national boundaries, and unifying Muslims into a political and economic entity that could have a significant impact on the pattern of world trade. ...Since Muslims are inclined to follow Islamic traditions, there is a tendency to establish an Islamic economic system in every Islamic nation. .. and to restore Shariah Law as the basic source for legislation" Islamic banking is no longer confined to concepts and ideas only. The Islamic banking and financial framework has developed into a full-fledged system and discipline. The concept has become clear to a great extent by now as to what are its basic requirements for compliance with Shariah. The earliest Islamic bank raced serious challenges ranging from general suspicions about their viability to a common mistrust about their intentions. Since then, the Islamic banks have been steadily growing to a remarkable level at this stage. During the last decades, financial instruments used by Islamic banks have developed significantly, both on assets and liability sides. Many instruments have been developed to mobilize financial surpluses. A number or Islamic banks have launched investment instruments in the form of certificates with short-term maturities or have established funds earmarked for certain investments. Accordingly, Islamic financial institutions are operating at present in one form or the other, in around 70 countries of the world.

SALIENT CHARACTERISTICS OF ISLAMIC BANKING;An Islamic bank is a full service intermediary financial institution that abides by the Islamic law. However/ some writers like to see in Islamic banks more than a financial institution. This is not true. In a paper, Kuran (1997) said, "Islamic banking defies the separation between economics and religion. It invokes religious authority in a domain that modem civilization has secularized” One must know the difference between Shariah, as a law, and religion. The only authority exercised on Islamic banks is that of their respective boards of directors and the supervision of central banks. The commitment of Islamic finance to abide by the Islamic law determines its main characteristics. This commitment is manifested is redefining its modes of operation and relationships between the financial intermediary on one hand, and the suppliers and users of funds on the other hand, in order to make them compatible with Shariah The actual practice of Islamic banking over the past three decades and the rise of Islamic banks as a new species of banks reveal three innovations in the banking traditions

1. New kind of relationship between banks and depositors, 2. Integration of financial and real market in financing, 3. Incorporation of ethics and moral values in investment and financing decisions. Islamic Banking brings economic empowerment to Muslims in the areas of operation. It helps Muslim businesspersons, through financial aid, to remain competitive. It also leads towards the creation of job opportunities for Muslims as well as Non-Muslims. It is a basis for expansion into the Islamic Economic System since the establishment of each Islamic Bank is also the creation of another bank to co-operate with others in the International web of Islamic Banks. Thus also creating a link for international interests. It provides investors with flexibility in the types of accounts within which they could channel their investment. It thus links capital to labour and reduces expenditure, to levels, related with the type of investment, the value thereof and its period. Islamic Banks enable the saving of monetary resources for the future as shown by the Yusuf (A.S.) and in a methodology approved by Allah. This thus leads to the protection of wealth. Sponsoring Islamic activity & the mobilization of resources for International Islamic Support not only investment, but moral as well, i.e. relief towards Muslim refugees and victims of war, etc. Islamic Banks facilitate international and local trade, provide foreign exchange services and profitably invest the Muslim fraternity's surplus wealth in conformity to Islamic principles through economically acceptable development and social projects indispensable for the Muslim Ummah.

ISLAMIC MODES OF FINANCING:The important modes of financing are 1. 2. 3. 4. 5.

Musharakah Mudarabah Murabaha Salam Istisna 6. Ijaraha Musharakah Musharakah means a relationship established under a contract by the mutual consent of the parties for sharing of profits and losses in the joint business. It is an agreement under which the Islamic bank provides funds, which are mixed with the funds of the business enterprise and others. All providers of capital are entitled to participate in management, but not necessarily required to do so. The profit is distributed among the partners in pre-agreed ratios, while the loss is borne by each partner strictly in proportion to respective capital contributions. Mudarabah

A form of partnership where one party provid es the funds while the other provides expertise and management. The latter is referred to as the Mudarib. Any profits accrued are shared between the two parties on a pre-agreed basis, while loss is borne by the provider of the capital. Murabaha Literally it means a sale on mutually agreed profit. Technically, it is a contract of sale in which the seller declares his cost and profit. Islamic banks have adopted this as a mode of financing. As a financing technique, it involves a request by the client to the bank to purchase a certain item for him. The bank does that for a definite profit over the cost, which is settled in advance. Salam Salam means a contract in which advance payment is made for goods to be delivered later on. The seller undertakes to supply some specific goods to the buyer at a future date in exchange of an advance price fully paid at the time of contract. It is necessary that the quality of the commodity intended to be purchased is fully specified leaving no ambiguity leading to dispute. The objects of this sale are goods and cannot be gold, silver or currencies. Barring this, ′Salam covers almost everything, which is capable of being definitely described as to quantity, quality and workmanship. Istisna It is a contractual agreement for manufacturing goods and commodities, allowing cash payment in advance and future delivery or a future payment and future delivery. Istisna can be used for providing the facility of financing the manufacture or construction of houses, plants, projects, building of bridges, roads and highways. Ijaraha A contract under which an Islamic bank finances equipment, building or other facilities for the client against an agreed rental together with a unilateral undertaking by the bank or the client that at the end of the lease period, the ownership in the asset would be transferred to the lessee. The undertaking or the promise does not become an integral part of the lease contract to make it conditional. The rental as well as the purchase price are fixed in such manner that the bank gets back its principal sum along with profit, which is usually determined in advance.

DIFFERENCE BETWEEN ISLAMIC BANKING AND CONVENTIONAL BANKING:The Shari‟ah essentially means a way of doing things. This ought to reflect in the working of Islamic banks at all levels: from doing transactions to record-keeping and the skill-profile of the manpower. The conventional banks may not move into the turf of the Islamic banks if there are fundamental differences between the requirements of interest-based banking and Islamic banking. Otherwise, chances are that interest based banks may give Islamic banks a run for their money through “Islamic windows”.

Islamic Banks: The features of Islamic Banking Operations under Shariah percept are enumerated below to identify the basic differences between Conventional and Islamic Banks. Conventional:Money Bank

Client

Money+ Money (Interest)

Islamic:-

Goods & Services Bank

Client

Money The fundamental difference between Islamic banks and the existing commercial banks is the avoidance of riba in Islamic banking. Islamic banks are also universal or multi purpose banks and not purely commercial banks - a cross-breed between commercial banks and investment banks, investment trusts and investment-management institutions. Since the Islamic bank would share in the risks of the consignment, venture, business or indemnity, it would need to be more careful in the evaluation of applications. The activities of the bank will be based on the commercial transactions allowed in Islam, including mudarabah, ijara, bai bi-thamin ajil and murabahah. The objectives of these Islamic banks in general have been to promote, foster and develop the application of Islamic principles, law and tradition to the transaction of financial, banking and related business affairs. The main principles followed by the Islamic banks are: (a) prohibition. of interest in all forms of transactions; (b) undertaking business and trade activities on the basis of legitimate profits; and (c) giving zakat.

Where the normal banking practices do not clash with the Islamic principles, the Islamic banks have adopted the current banking practices an(l procedures. Where any clash arises, the lslamic banks have devised their own practices and procedures to accomplish their banking activities. In some cases a Syariah Advisory Committee is constituted to advise the bank on the operations of the banking business in order to en sure that they do not involve any element which is not approved by the religion of Islam. In Islamic banking on the assets side, investments can be undertaken using profit sharing modes of financing (Mudarabah and Musharakah) and fixed-income modes of financing like Murabahah (cost-plus or mark-up sale), installment sale (medium/long term Murabahah), Istisna„/ Salam (object deferred sale or prepaid sale) and Ijarah (leasing). The funds are provided only for such business activities which are Shariah compatible, but in the case of commercial banking on asset side banks provide the facilities of running finance, cash finance, agriculture finance etc which all are interest based and pre determined rate of interest is being charged from them. On the liability side, deposits can be made either in current accounts or in investment accounts. The former is considered in Islamic banks as Qard hasan (interest-free loan) or Amanah(trust). These have to be fully returned to depositors on demand. Investment depositors are rewarded on the basis of profit and loss sharing (PLS) method and these deposits share the business risks of the banking operations. Using profit sharing principle to reward depositors is a unique feature of Islamic banks. This feature along with the different modes of financing and the Shari„ah compliant set of business activities change the nature of risks that Islamic banks face. In conventional banking on liability side deposits can be made in term deposit, current deposit, saving deposit , on saving and term deposit the account holder gets the fixed rate of interest every month or annually but the treatment of current account is as like of Islamic banking. Moreover Islamic banks receive two types of deposits: (a) deposits not committed for investment which take the form of current accounts or savings accounts; and (b) deposits committed for investment which are called investment accounts. The current account is operated in the same way as it is operated in the conventional banking system, but the saving accounts and investment accounts are operated differently. 1. Savings account This is an account where customers can deposit their savings. Though the depositors allow the bank to use their money, they get a guarantee of getting the full amount from the bank. The bank guarantees their savings but is not obliged to pay any rewards to the savers. Some banks, however, may pay cash rewards from their profits at the end of the financial year or give some privilege to the holders of these accounts as for example providing financial assistance for small projects. 2. Investments accounts The account holder authorises the bank to invest the money in any of its projects and after the expiry of the specified period the account holder will get an agreed share of the profits. The facilities that are provided by the Islamic bank will in general be similar to those provided by other commercial banks. Its customers can maintain current accounts and

deposit accounts, however no interest is payable. In addition, the customers can deposit their moneys in the investment accounts in which the profits and h will be shared with the bank. The Islamic bank can also provide services for the transmission and transfer of money, the purchase and sale of currency and the financing of trade documents, for all of which the Islamic bank can charge commissions. In addition, the Islamic banking business provided by the bank includes the methods of mudarabah, musyahrakah, bai bi-thamin ajil, murabahab, wadiah and ijara. The other differences are, a) Relationship:Basically the relationship between Islamic Bank and its customers is not of debtor and creditor, but it is something of sharing risk and rewards. So the relationship emerges as Mudarib and Rabbul Maal. This basic assumption leads to the following two things. No predetermined fixed return on customer‟s deposits.No liability on the part of Islamic Bank being Mudarib to owners of deposits (Rabbul Maal) to return their funds in full on demand except the deposits in current account and provided the Bank has not been negligent in investing the funds to earn profit. No predetermined fixed return on customer‟s deposits.No liability on the part of Islamic Bank being Mudarib to owners of deposits (Rabbul Maal) to return their funds in full on demand except the deposits in current account and provided the Bank has not been negligent in investing the funds to earn profit b)Sharing Profit/Loss:Islamic Bank share profit in pre-determined and declared ratio and the capacity of Mudarib and in case of loss they sacrifice the management services rendered for operational activity. Islamic Bank, however, shares the loss on investment of its equity. This ensures justification equity and equality for correct payment of profit or sharing loss. c) Finances to customer :Unlike conventional bank, Islamic Bank does not allow cash loans. Islamic Bank invests funds either through participation (Musharka / Mudarbah) or in the form of Islamic Instrument like Murabaha and Ijarah Funds and other Islamic compliant mode of financing. d) Multi-purpose bank:Islamic Bank deals in short term, medium term and long-term investment in various modes of financing including equity participation. So it is a multi-purpose Bank, functions as commercial as well as investment bank and plays the role of Non-Banking Financial Institution (NBFI). e) Use of financial resources:-

Islamic Banks uses the financial resources in productive activities thereby developing society as a whole, while conventional Bank attracts financial resources and lends them without directing towards business or productive preposition to earn profit. Although the profit is also kept in mind by Islamic banking too but the same is not the main objective. f) Equity base banking:Islamic Banking is basically equity based as funds are employed in shirkah to share profit, while the conventional has no concern to this effect. It only places funds at the disposal of the borrower for a fixed return. g) Value Oriented: Islamic Banking system is value oriented while conventional banking system is valueneutral. Islamic Bank shares profit earned by the Bank‟s Funds while Conventional Bank has no concern with the generation of income or sustaining loss by utilization of funds. h) Review & Audit:Islamic Bank is required to be viewed by Shariah audit in addition to the normal audit, while the conventional bank is satisfied with statutory audit only. It is important to mention that the Shariah does not prohibit all gains on capital. It is only the increase stipulated or sought over the principal of a loan or debt that is prohibited. Islamic principles simply require that performance of capital should also be considered while rewarding the capital. Profit has been recognized as „reward‟ for (use of) capital and Islam permits gainful deployment of surplus resources for enhancement of their value. However, along with the entitlement of profit, the liability of risk of loss rests with the capital itself. No other factor can be made to bear the burden of the risk of loss. Financial transactions, in order to be permissible, should be associated with tangible real assets. At macro level, this feature of Islamic finance can be helpful in creating better discipline in conduct of fiscal and monetary policies.