Applied Islamic Banking

By:
Prof. Dr. Mohd. Ma’sum Billah
masum@applied-islamicfinance.com
masum2001@yahoo.com
+6019-3699542

Islamic finance is emerging as a rapidly to be a part of the financial sector in the Islamic world. Islamic finance was practiced mostly in the Muslim world throughout the Middle Ages, fostering trade and business activities with the development of credit. Islamic finance is not restricted to Islamic countries only, but is spreading wherever there is a Muslim community. According to some estimates, more than 100 financial institutions in over 45 countries practice some form of Islamic finance, and the industry has been growing at a rate of more than 15 percent annually for the past five years. The market's current annual turnover is estimated to be $70 billion, compared with a mere $5 billion in 1985 and is projected to hit the $100 billion mark by the turn of the century.

Islamic financial system simply describes as ‘interest-free’ or ‘Islamic’ banking. The Islamic financial system is not limited to banking but covers capital formation, capital markets and all types of financial intermediation. The foundation of Islamic financial system goes beyond the interaction of factor of production and economic behavior where the Islamic system emphasis on the ethical, moral, social and religious dimensions to enhance equality and fairness for the good of society as a whole. The system encourages risk sharing, promotes entrepreneurship and discourages speculative behavior.

The basic framework for an Islamic financial system is a set of rules and laws referred to as Shari’ah, governing economic, social, political and cultural aspects of Islamic societies. Shari’ah creates from the rules dictated by the Quran and its practices and explanations in Sunnah by Prophet Muhammad. The basic principles of an Islamic financial system can be summarized as follows:

Prohibition of riba, a term literally means an excess or surplus over and above the loan capital and transaction. It is also known as ‘usury’ or ‘interest’ as unjustified increase in capital for the earning of which no appropriate effort was made. In Islamic law it means increase in the principal without any contract of sale and the spirit of Shariah prohibits it. Islamic encourages the earning of profits but forbids the charging of interest because profits determined successful entrepreneurship and additional wealth while interest determined as a cost that is accrued irrespective of the outcome of business operations and may not create wealth if there are a business losses.

A prohibition against riba is contained in the Quranic verses Surah Al -Baqarah:

“O ye who believe! Fear Allah and give up what remains of your demand for usury, if ye are indeed believers. If ye do it not takes notice of war from Allah and His Apostle…..”

The provider of financial capital and the entrepreneur share business risks in return for shares of the profits. Because interest is prohibited, suppliers of funds become investors instead of creditors.

Money is treated as potential capital that is becomes actual capital only when it joins hands with other resources to undertake a productive activity. Islam recognizes the time value of money, but only when it acts as capital, not when it is "potential" capital.

An Islamic financial system discourages hoarding and prohibits transactions featuring extreme uncertainties, gambling, and risks.

Islamic markets offer different instruments to satisfy providers and users of funds in a variety of ways in sales, trade financing, and investment Basic instruments include cost-plus financing (murabahah), profit-sharing (mudaraba), leasing (ijara), partnership (musharaka), and forward sale (bay' salam). These instruments serve as a great potential for financial innovation and expansion in Islamic financial markets. Some of the more popular instruments in Islamic financial markets are:

Murabahah is a deferred sale finance which is the sale of goods at the same price paid in the first place for its purchase with a surcharge is considered as a profit. Murabahah sale is allowed on condition that the second buyer knows the original price and the amount of profit. If it is discovered that the first buyer had lied to the second buyer about the real original price the second buyer has right of option to return the goods and recover the price or to pay the original price and the profit. Murabahah is one of the most widely instruments used for short-term financing which is based on the traditional idea of purchase finance. The investor agrees to supply specific goods or commodities, incorporating a mutually agreed contract for resale to the client and a mutually negotiated margin. There are 75 percent of Islamic financial transactions are cost-plus sales.

Most of the Islamic banks and financial institutions are using Murabahah as an Islamic mode of financing and most of their financing operations are based on Murabahah.

This is why this term has been taken as a method of Islamic banking operation. Murabahah can be determined where the seller discloses the actual cost he has incurred in acquiring the commodity and then he adds some profit which could be in lump sum or on a percentage. Murabahah are distinguishing from other kinds of sale that the seller in Murabahah tells the purchaser how much cost he had incurred and how much profit he is going to be charged in addition to the cost.

Mudarabah is an agreement between two or more parties to participate in a business whereby one of the parties provides capital to other party on the contractual agreement to share the profits of the commercial venture by pre-assigned percentage. Mudarabah is a form of contract made between the party with the investor, who entrusts money to the working partner with his experience and to invest that capital in trade and commerce to receive an agreed share of the profits for his part in management and then return to the investor who is the principal and the pre-agreed share of the profit. Any loss is suffered by the provider of the capital while the working partner loses the profit of his effort.

In a valid mudarabah the investor is not liable for loss beyond the amount of the capital he has paid. The division of the profit between two parties must necessarily be on a proportional basis and cannot be lump sum or a guaranteed return. Mudarabah was valid only if the capital is in the form of cash or either money or gold and silver. So the rejection of commodities and goods as capital for mudarabah contract lies in the fact that the price of these goods may changed between the days of signing the mudarabah contract.

In the Islamic law mudarabah primarily viewed as a commercial contract that is one which the investment would be used in trade of realizing the profit.

Partnership is defined as a “contract between two or more parties, with the capital or in labor on contribution of labor or skill or in credit on understanding that they shall share the profits, in specified proportions, as well as the losses. In principle, Islamic fiqh legitimizes different forms of partnership, which are governed by different sets of rules and basic provisions. The contractual or commercial partnership is divided into main types, regarding the level of authority and the financial liability of partners.

The word shirkah or sharikah, understood primarily as common property, arises for example through inheritance, gift or indissoluble combination. The term syarikah in a wide sense was originally a thing belonging to several persons in every smallest part of it in a proportion to shares allotted to each. It is also mentioned in Surah Ta Ha 20:29-33:

“When Moses prayed to Allah to make Harun, his brother, a partner in his great mission to Pharoah: “And give me a Minister from my family, Martin, my brother, to add to my strength through him, and make him share my task.”

Musharakah will, therefore, be used in the case of large users of funds to establish investment that is not expressly forbidden by Islamic law. The musharakah contract is a well known instrument for serving both short and medium term financing. These short terms investment will enable the bank to earn profits, without blocking its capital for a longer period, and giving flexibility for the bank to use the funds in certain operations within an agreed period of time. Hence, the profit and loss will be shared on the basis of capital contribution, after allowing for cost incurred in running the musharakah transactions. The essential difference between mudarabah transaction and the musharakah financing is that the loss is to be borne exclusively by the bank in mudarabah, but in musharakah loss is shared in relation to the respective capital contributions. They are defined as a share in the venture’s result.

The law of partnership in Malaysia is governed by the Partnership Act (PA) 1961.

Another popular instrument, accounting for about 10 percent of Islamic financial transaction is leasing. Leasing is designed for financing vehicles, machinery, equipment, and aircraft. Different forms of leasing are permissible, including leases where a portion of the installment payment goes toward the final purchase (with the transfer of ownership to the lessee.

Hire purchase financing is known in Arabic as al-ijarah wa al-iqtina. It means “reward”, which was used before Islam and has now been adapted to modern needs in transport, industrial commercial and construction sectors. It is of a short duration. If the lessee wishes to buy the property he will enter into agreement, whereby he pays the full price by installment, at the end of which the property is transmitted to him.

In a deferred-payment sale (bay’mu’ajjal), delivery of a product is taken on the spot but the delivery of the payment is delayed for an agreed period. Payment can be made in a lump sum or in installments, provided there is no extra charge for the delay.

If the mode of payment is not mentioned in the contract, the case has to be referred to the practice of the custom based on the legal maxim which dictates “what is directed by custom is as though directed by law” and “a thing known by common usage is like stipulation which has been made”. However, if the custom is silent about it, the law assume that the price be paid immediately. The Hanafis did not allow the price to be deferred or paid by installments unless it is mentioned in the contract, and the period or installments must be clear and definite. Thus, if it is not definite and clear the sale is voidable.

In the Islamic banking system, there are many modes of operation to suit the financial needs of the clients whether individuals or corporations. In addition to these operations, Islamic bank can offer the scheme of purchase with deferred delivery. In this transaction, known in Islamic law as (bay’al-salam), in which it is similar to a forward contract where delivery of the product is in the future in exchange for payment on the spot market.

Here's a basic example: A miller and grain farmer conclude an agreement today for the delivery of a specified quantity and quality of grain on an agreed future date, let's say six months ahead. The important element of this transaction is that the price to be paid for the grain is fixed on today's date. The primary reason for the immediate price determination is to remove the uncertainty for both parties of what the actual spot price for grain would be six months from now. Either party may stand to lose or gain a great deal from this uncertainty if the price movement is against him or in his favor but it does not bode well for one's financial planning. Since the parties face risk in the opposite directions of price movement, it will make financial sense for them to meet and agree on a price, which will suit both of them, to eliminate the price movement risk in the commodity (called "hedging the price"). The grain farmer then knows what input costs he can safely invest in his harvest to still turn a profit; the miller, on the other hand, knows at what price he can sell flour into a competitive market six months into the future and can plan and market his product accordingly.

What has been explained above is a forward contract. The derivative element present in this simple set of fact is that, from the first day subsequent to this contract being concluded, the contract itself gains a value derived from the underlying price movements and future expectations of the spot price of grain on the agreed delivery date.

The advantage of (bay’ al-salam) is that it combines two Islamic forms of transaction simultaneously. First, it contains the element of an interest free loan contract in that the former has an advantageous advance made to him whom he returns in the form of agricultural goods rather than money. He uses the advance payment to purchase the seeds and the like, and thus the harvest is the result of advance rather than of his own capital investment. Secondly, it resembles a mudarabah set up whereby the bank provides the capital and the farmer uses his agricultural expertise to employ the capital productivity.

Islamic banks may finance turn-key transactions which will involve processing of raw materials into a finished product. This form of financing could be used for new or additional buildings and renovations as well as working capital for the production of goods. The bank may levy fixed profit above the total cost over the period agreed upon.

The Shari’ah encourages that the al-qard al-hasan, be used as a supplementary measure in the form of riba-free loans. Islamic banks are willing to provide such loans free of riba to small businessman or farmers in need of loan of short duration. However, the scope for loans to needy individuals or financing projects with a social dimension will have consequences on the social behavior of society. Islamic banks can offer riba-free loans for such matters as education and medical expenses of some of clients. The Islamic bank can offer overdrafts as well as al-qard al-hasanunder the following conditions:-

The bank examines the loan for a short term and its purpose;
The loan could be small and for the limit specified by the board regarding duration and value; and
When securities, guarantees and other safeguards are provided by the customer satisfy the bank.

It is important, but not necessary, for the borrowers to be account-holders in order to obtain qard al-hasan facility. Obviously, before the loan is made to those, who require urgent qard, the applicant’s financial reputation is scrutinized and his ability to repay the debt is ascertained.

Islamic financial markets are operating far below their potential because Islamic banking by itself cannot take root in the absence of the other necessary components of an Islamic financial system. A number of limitations will have to be addressed before any long-term strategy can be formulated:

A uniform regulatory and legal framework supportive of an Islamic financial system has not yet been developed. Existing banking regulations in Islamic countries are based on the Western banking model. Similarly, Islamic financial institutions face difficulties operating in non-Islamic countries owing to the absence of a regulatory body that operates in accordance with Islamic principles. The development of a regulatory and supervisory framework that would address the issues specific to Islamic institutions would further enhance the integration of Islamic markets and international financial markets.
There is no single, sizable, and organized financial center that can claim to be functioning in accordance with Islamic principles. Although stock markets in emerging Islamic countries such as Egypt, Jordan, and Pakistan are active, they are not fully compatible with Islamic principles. The stock markets in Iran and Sudan may come closest to operating in compliance with Islamic principles. Moreover, the secondary market for Islamic products is extremely shallow and illiquid, and money markets are almost nonexistent, since viable instruments are not currently available. The development of an interbank market is another challenge.
The pace of innovation is slow. For years, the market has offered the same traditional instruments geared toward short- and medium-term maturities, but it has not yet come up with the necessary instruments to handle maturities at the extremes. There is a need for risk-management tools to equip clients with instruments to hedge against the high volatility in currency and commodities markets. In addition, the market lacks the necessary instruments to provide viable alternatives for public debt financing.
An Islamic financial system needs sound accounting procedures and standards. Western accounting procedures are not adequate because of the different nature and treatment of financial instruments. Well-defined procedures and standards are crucial for information disclosure, building investors' confidence, and monitoring and surveillance. Proper standards will also help the integration of Islamic financial markets with international markets.
Islamic institutions have a shortage of trained personnel who can analyze and manage portfolios, and develop innovative products according to Islamic financial principles. Only a limited number of Islamic institutions can afford to train their staffs and deploy resources in product development.
There is lack of uniformity in the religious principles applied in Islamic countries. In the absence of a universally accepted central religious authority, Islamic banks have formed their own religious boards for guidance. Islamic banks have to consult their respective religious boards, or shari’ah advisors, to seek approval for each new instrument. Differences in interpretation of Islamic principles by different schools of thought may mean that identical financial instruments are rejected by one board but accepted by another. Thus, the same instrument may not be acceptable in all countries. This problem can be addressed by forming a uniform council representing different schools of thought to define cohesive rules and to expedite the process of introducing new products.

The scope of Islamic financial instruments is very wide, the study is, therefore, not exhaustive, it has to focus on certain areas which are considered more relevant to the present business practices. The work attempted to highlight the development of Islamic commercial doctrines and to show the vast treasure of juristic ideas of the classical fiqh some of which remain relevant to the present needs and some others need to be conciled.

It is felt that if this work succeeds in exposing some of the fundamental concepts of Islamic commercial theories which are fundamentally based on justice and refined ethics, it may lead to better understanding of the Shari’ah approach towards a just economic, commercial and financial system.

It is observed that Islamic financial system was closely related to the business culture of a particularly society.