Islamic Banking Industry

Islamic and Conventional Banking: Basic difference between conventional and Islamic banks: The most obvious difference between conventional and Islamic banking is prohibition of interest as a legitimate source of revenue. In the Islamic context, it is recognized that risk cannot be avoided and consequently guarantees to income and revenue from extending credit cannot logically flow. As a result of the prohibition depositors are not creditors but investors when depositing funds with intent to make capital gains. This is a fundamental difference between an investor in an Islamic context and creditor in a conventional context. An investor, by definition is one of the financiers of the enterprise, liable for its debts to the extent of the investments and receives dividend if and only if profits are generated. Alternatively, the creditor, as a debenture holder, lends the money without the risk of owning and/or operating the capital goods and claims profit regardless of the outcome of the venture. Solvency of the borrower and not the failure of the venture constitute the major risk taken on by a creditor. Conventional banking does not follow one pattern. In Anglo-Saxon countries, commercial banking dominates while in Germany, Japan, Switzerland and the Netherlands universal banking dominates. Commercial banking is based on pure financial intermediation model, whereby banks mainly borrow from savers and then lend them to enterprises or individuals. They make their profit from the margin between the borrowing and lending rates of interest. Commercial banks are prohibited from trading and their shareholding is severely restricted to a small portion of their net worth, however, Islamic banks hold considerable amount of equity and commodity trading is an integral part of Islamic banking operations. The process of bank lending is however, subject to some problems that can make it inefficient. Borrowers usually know more about their own operations than lenders. Acting as lenders banks face this information asymmetry. Because borrowers are in a position to hold back information from banks, they can use loans obtain for purposes other than those specified in the loan agreement exposing banks to unknown risks. Such problems are known as moral hazards. By contrast, universal banks are allowed to hold equity and carry out operations to carry out trade and insurance which lie beyond the sphere of commercial banking. Universal banks are better equipped to deal with information asymmetry than their commercial counterparts. They finance their business customers through a combination of shareholding and lending. Shareholding allows universal banks to sit on the board of directors of their customers business which enables them to monitor use of their funds at a low cost. The reduction of the monitoring cost adds efficiency to the banking system and reduces chance of business failure. As we have noticed, many Islamic financing modes involve trading. Islamic banks can establish companies that finance the credit purchase of commodities and as

well as assets. Those companies will buy commodities and assets and sell them to their customers on basis of deferred payment. However, this may involve equity participation. We may therefore say that Islamic banking is closer to universal banking model. Islamic banks would benefit from this by using combination of shareholding and other Islamic modes of finance like Mudarabah, Musharakah etc. Credit worthiness remains relevant but the crucial role is played by productivity and profitability of the project financed. Under the principle of Mudarabah an investor bears the risk of losing the capital invested by the Islamic bank, which means the investment risk is similar to that of shareholders of conventional banks which bear the risk to losing their capital as equity owners of the corporation. A duty arises out of relationship a such that the bank must defer to the management, investors and shareholders alike in the decision making process. Islamic banks, as part of open and transparent procedures concede the right of investor’s to monitor the performance of their investments and associated risks which, however, is not the case in conventional banks. Another difference is of the accounting practices. The exclusion of interest in Islamic banking coupled with import of specifically Islamic-oriented taxes requires that banks engaging in Islamic finance would definitely have different reporting requirements vis-à-vis conventional accounting. One of the most striking differences is of the classification of corporate identity. In the Islamic context, Proprietary theory to enterprise is applied where the proprietor/owner is the primary point of interest. The assets are assumed to be owned by the proprietor and as such liabilities are obligations of the proprietor unless otherwise stated. In the conventional context, entity theory to a financial institution is applied which states that the firm is considered to have its own existence and legal personality of its own. The entity theory is premised on the fact that assets are equal to entities. Islamic modes of financing: Ideal mode of financing under the Islamic banking is financing on profit and loss basis (PLS). The bulk of financing is equity oriented. In this mode of financing losses are shared by financier along with entrepreneur in the ratio of their respective capitals. The profits are, however, shared in an agreed ratio. Various other modes of financing and products are as follows. ○

Murabaha (Cost-plus sale): This concept refers to a sale at a price, which includes profit margin agreed to by both the parties. The purchase and selling price along with other cost must be clearly mentioned at the time of sale agreement. The bank is compensated for the time value of money in the form of profit margin. This is a fixed income loan and has a fixed rate of interest determined by the profit margin. The bank is not

○

○

○

○

○

○

○

compensated to for time value of the money outside the contract terms i.e. the bank cannot charge additional interest on late payments; however, the asset remains in the name of the bank until the loan is paid in full. Bai’ Bithaman Ajil (Deferred payment sale): This concept refers to a sale on deferred payment basis, at a price which includes profit margin agreed to by both parties. This is similar to Murabaha except that the debtor pays one single installment at the time of maturity of the loan. Bai’ al-Inah (Sale and buy back agreement): The financier sells an asset to its customer on deferred payment basis and immediately buys back on cash at a discount. The buying back agreement allows the bank to assume ownership of the asset in order to protect against default without explicitly charging interest in the event of late payment or insolvency. Bai’ Salam (Purchase with deferred delivery): Bai’ Salam means a contract in which advance payment is made for goods to be delivered later on. It is necessary that the quality of goods intended to be purchased is specified with no ambiguity leading to dispute. The objects of this sale are goods and cannot be gold, silver or currencies. Sukuk (Islamic bonds): Sukuk is the Arabic name for a financial certificate but can be seen as an Islamic equivalent of bond. However, fixed-income, interest-bearing bonds are not permissible in Islam. Hence, Sukuk are securities that comply with the Islamic law and its investment principles, which prohibit the charging or paying of interest. Financial assets that comply with the Islamic law can be classified in accordance with their tradability and non-tradability in the secondary markets. Sukuk grants the investor share of the asset along with the cash flows and risks associated with such ownership. The central merit of sukuk structure is that it is based on real underlying asset. Ijarah (leasing): Literally Ijarah means lease, rent or wage. Ijarah means selling benefit or use or service for a fixed price or wage and for a fixed period. After the agreed period asset reverts back to the bank, however, it can be transferred to the user if there was a second contract at time of the first contract of leasing that the asset will be transferred to the user at an agreed price. Wadiah (Safekeeping): In Wadiah a bank is deemed as keeper and trustee of funds. A person deposits funds in the bank and the bank guarantees refund of the entire amount deposited. The depositor at banks discretion may be rewarded with hibah (gift) as a form of appreciation for the use of funds by the bank. In this case bank compensates depositors for the time value of money (i.e. pays interest) but refers to it as a gift because it does not officially guarantee payment of the gift. Istisna (Order contract): In Istisna commodity is transacted before it has come into existence. It means to order a manufacturer to

manufacture a specific commodity for the purchaser. It is necessary for Istisna that the price is agreed with consent of both the parties and all specifications of the product to be manufactured are given. Islamic banks use Al-Istisna Al-Tamwili which consists of two contracts. The first is concluded between the beneficiary and the bank in which price is payable by the purchaser in the future, in agreed installments and the bank undertakes to deliver the requested manufactured commodity at an agreed time. The second contract is between the bank and the manufacturer to manufacture the product according to prescribed specifications. The manufacturer undertakes to deliver the product to the bank on the date prescribed in the contract which is the same date as that stated in the first Istisna contract.

○ Musharakah (Active Partnership): Musharakah is a word of Arabic origin which literally means sharing. In the context of business and trade it means a joint enterprise in which all the partners share the profit or loss of the joint venture. Interest predetermines a fixed rate of return on a loan advanced by the financier irrespective of the profit earned or loss suffered by the debtor, while Musharakah does not envisage a fixed rate of return. Rather, the return in Musharakah is based on the actual profit earned by the joint venture. The financier in an interest-bearing loan cannot suffer loss while the financier in Musharakah can suffer loss, if the joint venture fails to produce fruits. In the modern economic system, it is the banks which advance depositors' money as loans to industrialists and traders. If industrialists having only ten million of their own acquire 90 million from the banks and embark on a huge profitable project, it means that 90% of the project has been created by the money of the depositors while only 10% has been created by their own capital. If this huge project brings enormous profits, only a small proportion i.e. 14 or 15% will go to the depositors through the bank, while all the rest will be gained by the industrialists whose real contribution to the project is not more than 10%. Even this small proportion of 14 or 15% is taken back by the industrialists, because this proportion is included by them in the cost of their production. The net result is that all the profit of the enterprise is earned by the persons whose own capital does not exceed 10% of the total investment, while the people owning 90% of the investment get no more than the fixed rate of interest which is often repaid by them through the increased prices of the products. On the contrary, if in an extreme situation, the industrialists go insolvent; their own loss is no more than 10%, while the rest of 90% is totally borne by the bank, and in some cases, by the depositors. In this way, the rate of interest is the main cause for imbalances in the system of distribution, which has a constant tendency in favor of the rich and against the interests of the poor.

○ Diminishing Musharakah: Another type of Musharakah is Diminishing Musharakah. According to this concept financier and his client participate in a joint venture. The share of the financier is divided further in units and it is understood that the client will purchase his share one by one periodically thus increasing his own share till all the units of financiers are purchased by him as to make him the sole owner of the property.

○ Mudarabah (Passive partnership): In Mudarabah there is an investor who invests in a commercial project but does not interfere in the management of the project. The fund provider is Rab-ul-Maal and the person who manages is called a modarib. If the venture is profitable modarib and Rab-ul-Maal share profits on pre-determined basis and if the venture fails Rab-ul-Maal loses his money and the modarib’s efforts are wasted.

Islamic finance, as a viable financial alternative to the conventional banking model, differentiates itself based on four factors: The strict prohibition of interest, limitations on the nature of business, restrictions on the level of incalculable risk and/or uncertainty associated with a transaction and the re-structuring of the relationships between contractual participants. Investing in Islamic financial instruments ensures that the money to be made doesn’t originate from sources that many may find morally problematic. NOTE: Almost all aspects of Islamic banking are controversial. With reference to articles of Najam ul Hassan, CEO Gulf African Bank; Tarik Rashid CEO Tarik Rashid (Pvt) LTD.

Takaful and Insurance: Basic difference between Takaful and Insurance: Insurance is a very important tool for risk management. It is used to transfer risk from one entity to another in exchange of a premium. Insurance is a commutative contract between the client and the insurance company i.e. it is a sale contract with an intention to make profit. Insurance companies work on the ‘law of large numbers’ which states that as the number of exposure units increases the actual results are likely to become close to expected results. A large number of people give premium to the company in exchange of transferring their risk. Premiums are received keeping in mind the risks associated with each ‘Insured Interest’. From these premiums a pool is made which is under the ownership of the company and it is used to indemnify for losses arising

in the future; from the pool investments are made in almost all avenues including interest based investments. Returns from the investments remain property of the insurance company. Scholars have no objection with the principle of insurance but its mechanism raise questions. Insurance is a sale contract between the company and the client and by Shariah Law any ambiguity/uncertainty in a sale contract is not permissible. The uncertainty arises from the perspective of future losses; the company and the client both are not aware of future misfortunes. Secondly and most importantly conventional insurance invests in interest based instruments and returns generated from such investments are harram. Another point of concern in relation to Interest is that when a client pays premium for a sum insured and incase of loss it recovers more than the amount paid from the pool which is under the ownership of the company, this in its pure sense is riba, however, in takaful the premiums or contributions remain the property of policy holders/participants and they contribute with an intention of helping each other (donation; normally non-refundable). Takaful is not a sale contract, it is a non-commutative contract which allows uncertainty but with an intention to minimize it as it is not for profit but for mutual assistance. Takaful pool is called Participants Fund (as it is owned by them) from which claims are dispatched and non-riba investments are made. Returns generated from the investments are distributed back to the participants. So in takaful risk is not transferred but rather shared by participants. As takaful is based on Islamic principles and recognizes that risk cannot be avoided and is not in one’s hand the rate charged to the clients is same, emphasizing on the concept of equality. Different Models of Takaful: Mudarabah Model: In a Modarabah model the Takaful Company/Takaful Operator (TO) acts as a Modarib (entrepreneur) and the Takaful Participants as Rab-ul-Maal (Capital providers). As modarib the TO manages both investments and underwriting activities on behalf of the Takaful Participants. In return, the TO is remunerated by a predetermined percentage share in the investment profit and/or underwriting surplus, which usually would be stated explicitly in the Takaful Contract. The TO and the Takaful Participants cannot unilaterally alter the agreed ratio of sharing investment profits and/or underwriting surplus once the contract is signed. Any financial losses occurred from the investment and underwriting activities are to be borne solely by the Takaful Participants as Rab-ul-Maal, provided that the losses are not attributable to TO’s misconduct or negligence. In this regard the TO can expect to to make profits only by ensuring that the expenses of managing the Takaful operation are less than the total share of investment profit and/or underwriting surplus. Wakalah Model: Under this model, the TO and the Takaful Participants form a principal-agent relationship whereby the TO acts strictly as an agent on behalf of

the Takaful Participants as the principal, to run both the investment and underwriting activities. In return for the services rendered by the TO as Wakil (agent), TO receives a set upfront fee called Wakalah Fee. The Wakalah Fee must be pre-agree and written the Takaful Contract. For the To the Wakalah Fee is expected to cover the total sum of: (a) management expenses; (b) distribution cost including remuneration; (c) a margin of operating profit to the TO. In addition, Wakalah Model may permit the TO to receive part of the remuneration as wakil in the form of a performance-related fee as an additional incentive. A performance-related fee as agreed in the Takaful Contract is typically related to underwriting. Wakalah-Modarabah Model: Under this model the Wakalah Model is adopted for underwriting activities, while modarabah contract is employed for the investment activities. Core Principles of Takaful: i.

Tabarru: Tabarru or donation, is the contribution (premium) given to the Takaful Company with the intention of Ta’awun or mutual assistance. This type of donation is normally irrecoverable. ii. Ta’awun: Concept of Ta’awun, or mutual assistance, is another core principle of Takaful, with participants agreeing to mutually compensate each other for specified losses. As Takaful has been perceived as a form of cooperative or mutual insurance, the initial objective is not to gain profit but to mutually assist one another. iii. Prohibition of Interest: Conventional insurance involves the element of Riba. Hence, it is important that investments in Takaful fund and Shareholders fund are Riba Free.

NOTE: Some aspects of Takaful might be debatable.

With reference to article of Muhammad Ayub, Senior Joint Director SBP; IFSB’s Exposure Draft for Takaful.

Scholars: Mufti Taqi Usmani (Pakistan), Professor Salih Tug (Turkey), Sheikh Muhammad Al-Tayyeb Al-Najjer (Egypt), Mufti Hassaan Kaleem (Pakistan), Dr. Imran Usmani (Pakistan).