Practical Paradigm of Islamic Money Market

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

INTRODUCTION

Money in Islam takes a unique and challenging look at how money has operated in Islamic society and at how Islamic theoretical framework have influenced perceptions of money. In this assignment, we draw upon historical, data and policy analysis to present a comparative study of monetary theories, including recent treatment of money by Islamic economists. Discussion covers the nature of joint venture, stock markets, banks and financial intermediaries, price stability, and international trade. At a time when various theories of money are contending against each other for a better understanding of the relationship between money and regulotary framework imposed, this work sheds prioneering light in this area, and will be of interest to academics, graduates and researchers internationally.

Currently there are no markets that would satisfy the liquidity, profitability, security and Shariah compatibility needs of Islamic banks or banks that offer Islamic financing alongside the conventional systems. Under Shariah laws, a money market cannot trade or discount debt. Interest is also strictly forbidden.

With the introduction of endogenous money in Islam, the meaning of demand and supply of money disappears. That is because neither central banks nor financial intermediaries can create money exogenously. Exogenous money exists in the form of promissory notes created by commercial banks with statutory reserves. In the endogenous monetary system a quantity of money enters economic activity in response to the financing of real sectoral activities.

Money flow thereafter changes in volumes through recursive interrelationships with the level of economic activity. Now as economic activity increases, an extra quantity of money is released. Subsequently, this increased quantity of money enhances more of the activities, and the banks respond. The nature of loan transactions by commercial bank is determined by discourse among the clients, the bank and the monetary authorities on the appropriateness of the activities for financing. Such a discourse rather than being cumbersome, can be regulated by means of manuals developed through the experience of discourse among agents.

They are the result of evolving perspectives on ahkam as-shari’ah governing the endogenous causal interrelationships between money and real sectoral activities with the social well-being in mind.

CENTRAL IDEA.

When Bank Negara Malaysia set out to introduce Islamic banking in Malaysia in the early 1980s, it had in mind a two-phased approach. In the first phase, the bank wanted to ensure that the Islamic banking system contained all the three important components of a viable banking system, namely a large number of Islamic financial instruments to meet the various needs of the Muslim business community, a large number of financial institutions providing Islamic financing facilities and an Islamic inter bank money market. The Islamic inter bank money market, by linking the institutions and the instruments, was expected to provide depth to the Islamic financial system.

Malaysia’s first Islamic bank, Bank Islam Malaysia Berhad (BIMB) was set up in 1983, licensed under section 3 (4) of the Islamic Banking Act 1983. The first 10 years were concentrated on developing a large number of Islamic financial instruments. By early 1993, a total of 21 Islamic financial products had successfully been introduced, to meet the needs of the Muslim business community in Malaysia.

The next step was to create a large number of financial instruments offering Islamic products. Bank Negara implemented this in 1993 by allowing existing commercial banks, finance companies and merchant banks to offer Islamic banking services on a parallel basis with their conventional banking services. The scheme was called Skim Perbankan Tanpa Faedah (IBD OF) or Interest-Free Banking Scheme. By the end of 1993, two of the three components for a viable Islamic banking system were already in place.

What remained missing was the third component, namely and Islamic Inter bank Money Market (IIMM). Bank Negara introduced this on January 3, 1994. The scope of activities of the IIMM included the purchase and sale of Islamic financial instruments among market participants (including the Bank), inter bank investment activities through the Mudaraba Inter bank Investment (MII) Scheme and a cheque clearing and settlement system through an Islamic Inter bank Cheque Clearing System (IICCS).

The Islamic financial instruments that are currently being traded in the IIMM on the basis of Bai al Dayn, are the Green bankers acceptances, Islamic accepted bills, Islamic mortgage bonds and Islamic private debt securities. The total cumulative volume of transactions in the IIMM since January 1994 is about RM2.5 billion ($1 billion).

In addition, financial institutions can sell Government Investment Issues (GIIs) to the Central Bank as and when required to meet their liquidity needs. GIIs are government securities issued on an Islamic basis, which financial institutions can also buy from the Central Bank, depending on availability.

Although there were no major teething problems during the implementation of the IIMM, one drawback the scheme continues to face is the inadequate amount of tradeable Islamic papers. Efforts will have to be expanded to create a critical mass of Islamic financing papers that can be easily traded in the IIMM.

Al-Mudaraba Interbank Investment

The Al-Mudaraba Interbank Investment (MII) enable IBD of banks, (defined to include Bank Islam Malaysia), to obtain funds from another IBD of bank on a Mudaraba (profit-sharing) basis. The period of investment is from overnight to 12 months. The minimum amount of investment for the MII is RM50,000. The rate of return is based on the rate of gross profit before distribution for investments of one year of the receiving bank, while the profit-sharing ratio is negotiable.  When an IBD OF bank obtains investment from another IBD of bank for any period, the principal invested is repaid at the end of the period, together with a share of the profit arising from the use of the fund by the receiving bank. All profit calculations are based on above formula.

Islamic Inter bank Cheque Clearing System

IBD of commercial banks also participate in the Islamic Interbank Cheque Clearing System (IICCS) at the Kuala Lumpur Automated Clearing House (KLACH). Currently these banks are required to maintain an IBD of clearing account at the Bank Negara on a Al-Wadiah Yad Dhamanah (guaranteed safe-custody) basis. Bank Negara Malaysia allocates and squares the positions of the surplus and the deficit banks at the midnight clearing. Any surplus funds of the IBD of commercial banks at the midnight clearing are automatically invested with the deficit banks, by applying the same formula used in the MII:

X = Prt (k)  36500

The profit sharing ratio used for the calculation of profit is fixed at 70:30 in favour of the provider of the funds. Surplus funds distributed to the deficit banks are allocated on the following principles:

* Where the total surplus is larger than the total deficit, the total investment of a surplus bank (for example, Bank Bumiputra) is calculated as follows:

Bank Bumiputra’s surplus x Overall deficit Overall surplus

* The funds derived from the formula are first invested with the bank with the largest deficit, and any remaining balance to the next deficit bank and so on;

* Where the total surplus is less than the total deficit, the entire surplus of each bank is invested on the principle that the bank with the largest surplus first invests with the bank with the largest deficit.

Government Investment Certificate (GIC)

Government Investment Certificates were introduced in 1983, with the establishment of the Islamic bank. The government issued for the first time non interest bearing Government Investment Certificate to meet the special needs of the bank and other corporations who are interested in these securities. The Islamic bank governed by Shariah law, is not allowed to hold interest bearing government securities. The Government Investment Act 1983 under which certificates are issued, provides certificates with maturities of one year or more to be issued and for dividend instead of interest, to be paid on the certificates.

Cagamas Mudharabah Bonds

Cagamas Mudharabah Bonds were introduced in 1 March 1994. Cagamas Mudharabah Bonds involved with the purchase of Islamic housing debts by Cagamas from institutions that provide Islamic housing finance to their clients and staff. The issuance of bonds are based on Al-Mudharabah concept by Cagamas for finance these purchases. The purchase of housing debt on Islamic principles by Cagamas is managed based on the Bai’ Al-Dayn concept whereas the issued of Cagamas Mudharabah bonds is based on the All-Mudharabah concept. Under this concept the bondholder and Cagamas will share profits according to ratios agreed earlier together. The agreements pertaining to the purchase of housing debt based on Islamic principles will be sealed between Cagamas Berhad and Bank Islam Malaysia Berhad. Cagamas will purchase housing debts amounting RM30 billion from Bank Islam. As a result of this agreements, a total of RM30 billion of Cagamas Mudharabah Bonds is created. Government has distribute RM30 billion worth of bonds to financial institution that offer Islamic banking.

Islamic Accepted Bills (IAB)

Islamic Accepted Bills as an order to a bank by a bank customer to pay a sum of money at a future date. When the bank endorses the order for payment as accepted, it assumes responsibility for ultimate payment to the holder of the acceptances. This bills can be used for import or purchase and export for sales, with one condition, the trade of “halal” goods. The details are as follows:-

1. IAB-Import or Purchase

The customer can approach the bank to provide financing for his working capital requirements to purchase stock and inventories, spares and replacements, or semi finished goods and raw materials. First the bank purchases or appoints the customer as its agent to purchase the required goods on its behalf and settles the purchase price from its own funds. Then, the bank sells the goods to the customer at an agreed price comprising its purchase price and a profit margin and allows the customer to settle this sale price on a deferred term of 30 days, 60 days or 90 days or other period. Lastly, on the due date the customer pays the Bank the agreed sale price on maturity date of the financing. Islamic Accepted Bills can be traded in the secondary market.

2. IAB-Export or Sales

The bank finances exports and sales under the principle of Bai Al-Dayn. Under this bill, an exporter who wishes to avail himself of this facility, prepares export documents as required under the sale of contract or letter of credit. He represents these documents to the Bank to be purchased. As the export documents have to be sent to the buyer overseas, the exporter is requests by the bank to draw another Bill of Exchange drawn on the bank. This bill is known as IAB-Exports. The IAB-Exports can be traded in secondarymarket.

 “Green” Bankers Acceptance

Banks may purchase BA issued by other banks (inclusive of conventional banks) provided that it is a “halal” BA. To be considered as “halal”, the BA must be:-

a.An export or sales BA
b. Drawn to finance “halal” goods or commodity.

Repurchase Agreements

Although the application of repo in Islamic banking is not exactly the same as the conventional repo, the conceptual framework is still the same. Thus repo in conventional banking is an agreement under which a seller of securities undertakes to repurchase the securities from a buyer at an agreed price on a specified future date. However in Islamic banking, the agreement to repurchase back the securities is just an agreement and not a condition for the contract to be settled. Thus this means that there are two contracts involved in Islamic repo. The first one is to sell the securities and the second one is to purchase back the securities. The first contract is an outright sale and thus the buyer of the securities is not oblige to sell back the securities to the original buyer if he does not wants to as the title has been fully transferred to the buyer. Thus in the accounting entries of the seller, the transaction is recorded as contingent liability/asset of the bank and not a direct liability. Thus in the first leg of transaction where the securities is sold to the buyer, the transaction is still recorded as contingent liability. However, if the buyer decides not to sell back the securities, the eligible liabilities will cease from the seller’s account.

Sell and Buy Back Agreement (Islamic Repo) Under the Sell and Buy Back Agreement (SBBA), the transacting parties shall enter into two  separate agreements as follows:

First agreement – the seller (owner) of INI sells and the buyer (investor) buys the instrument at a specified price agreed by both parties; and  

Second agreement – a forward purchase agreement whereby the buyer (investor) promises to sell back the INI to the original owner who shall buy it back at a specified price on a specified future date.

Ownership of the INI shall be transferred to the buyer (investor) upon conclusion of the first agreement of the SBBA. An INI may be sold under SBBA, subject to the following conditions:
(i) An Issuer shall not buy its own INI under SBBA; and
(ii) The tenor of the SBBA must be within the tenor of the INI used for the transaction. 

The INI used for the SBBA is not required to be delivered, unless otherwise agreed by the two transacting parties. Where the SBBA transaction involves an INI that does not pay interim dividends or coupon profits (as in the case of NIDC), the amount of proceeds receivable by the seller under the first agreement of the SBBA shall not exceed the nominal value of the INI.

A licensed financial institution may provide on a regular basis a two-way quotation either by quoting rates or profit-sharing ratio to indicate its willingness to enter into SBBA. Upon it release, the Guidelines on Sell and Buy Back Agreement shall govern SBBA transactions-involving INI

Islamic Private Debt Securities

Islamic Private Debt Securities (IPDS) has been introduced since 1990. At the moment, IDS have been introduced using different types of Syariah concept namely through Bai Bithaman Ajil, al-Musharakah, al-Mudharabah, Qardhu ul Hassan, Murabahah etc. Under the concept of Bai’ Bithaman Ajil the financiers will purchase an asset from the borrower and later resell the assets at a higher price which contain the cost and profile element. The loan which arise from the finance will be securitised through the issuance of two notes that is the primary notes which is equivalent to the asset price that is purchased by the financiers from the borrower and secondary notes which is equivalent to the profit value of the resell price.   Both of these notes will be traded in the secondary market under the concept of Bai’ al Dayn.

Through Qardhu ul Hassan, the issuer of the notes will be able to arrange the repayment of the loan which was given by the parent company. The IDS note is the evidence of debt for the amount which is yet to be repaid. Through the IDS, the loan will be repaid by liquidating the IDS after certain period of time.   The IDS is issued together with the Transferable Subscription Right (TSR). The TSR is the form of a “gift” (hibah) to the holder of the papers. The IDS is an alternative to the issuance of the conventional zero coupon bond.

THE QURAN AND SHARIAH RULING ON MONEY MATTERS.

On Interest

"Allah will deprive usury of all blessing, but will give increase for deeds of charity" (Quran 2: 276).

Narrated Jabir ibn Abdullah: Allah's Messenger cursed the accepter of interest and its payer, and one who records it, and the two witnesses; and he said: They are all equal (Muslim).

Abu Huraira related that the Prophet said: On the night of the Miraj I came upon a group of people whose bellies were like houses. They were full of snakes which could be seen from outside their bellies. I asked Gabriel who they were, and he told me that they were the people who had practiced Riba (Interest). (Ahmad, Ibn Maja)

Abdullah ibn Hanjalah related that the Prophet said: A dirham of Riba (interest) knowingly taken by a man is a sin worse than committing Zina (fornication) 36 times (Ahmad, Daraqutni).

Zakah-what you owe from your money

"And they are ordained naught else than to serve Allah, keeping religion pure for Him, as men by nature upright, and to establish worship and to pay the poor-due (Zakah). That is true religion." (Quran 98:5)

Abbas related that a man asked the Prophet, Tell me what should I do to be admitted to Paradise and he (the Prophet) answered: Worship Allah associating nothing with Him, observe Salat, pay Zakah and strengthen the ties of kinship. (Bukhari, Muslim)

Inheritance and wills

"And unto each We have appointed heirs of that which parents and near kindred leave; and as for those with whom your right hands have made a covenant, give them their due. Lo! Allah is ever Witness over all things" (Quran 4:33)

Ibn Umar related that the Prophet said: It is the duty of a Muslim man who has something which is to be given as a bequest not to have it for two nights without having his will written regarding it. (Bukhari, Muslim)

Anas related that the Prophet said: If anyone deprives an heir of his inheritance, Allah will deprive him of his inheritance in Paradise on the Day of Resurrection. (Ibn Maja)

How do you earn your money?

Abu Huraira narrated that the Prophet said: A time will come upon the people when one will not care how one gains one's money, legally or illegally. (Bukhari)

It is reported by Jabir that the Prophet said: The flesh and body that is raised on unlawful sustenance shall not enter Paradise. Hell is more deserving to the flesh that grows on one's body out of unlawful sustenance. (Ahmad).

Abu Said related that the Prophet said: The truthful and trustworthy businessman will be in the company of Prophets, saints and martyrs on the Day of Judgment. (Darimi, Tirmidhi)

Debts

It is narrated by Abu Musa Ashari that the Prophet said: After the major sins which must be avoided, the greatest sin is that someone dies in a state of debt and leaves behind no asset to pay it off. (Darimi)

Loans

Abu Qatadah related that the Prophet said: If anyone would like Allah to save him from the hardships of the Day of Resurrection, he should give more time to his debtor who is short of money, or remit his debt altogether. (Muslim)

Strive with your wealth

"Believers are merely those whose hearts feel wary whenever God is mentioned and whose faith increases when His verses are recited to them. On their Lord do they rely. Those who keep up prayer and spend some of what We have provided them with are truly believers" (Quran 8:2-4).

Asmah related that the Prophet said: Spend, and do not count, lest Allah counts against you. Do not withhold your money, lest Allah withholds from you. Spend what you can. (Bukhari, Muslim)

Abu Huraira related that the Prophet said: The Lord's commandment for every one of His slaves is, ‘Spend on others, and I will spend on you'. (Bukhari, Muslim)

The poor and your wealth

"Hast thou observed him who belieth religion? That is he who repelleth the orphan, and urgeth not the feeding of the needy" (Quran 107: 1-3).

Safwan ibn Salim related that the Prophet said: Anyone who looks after and works for a widow and a poor person is like a warrior fighting for Allah's cause, or like a person who fasts during the day and prays all night. (Bukhari)

Hoarding

"O you who believe! Lo! many of the (Jewish) rabbis and the (Christian) monks devour the wealth of mankind wantonly and debar (men) from the way of Allah. They who hoard up gold and silver and spend it not in the way of God, unto them give tidings (O Muhammad) of a painful doom" (Quran 9:34).

Charity and punishment

It is narrated by Anas bin Malik that the Prophet said: Verily charity appeases the wrath of Allah and eases the sufferings of death. (Tirmidhi)

Extravagance

"Give the kinsman his due, and the needy, and the wayfarer, and squander not (your wealth) in wantonness. Lo! the squanderers were ever brothers of the devils, and the devil was ever an ingrate to his Lord" (Quran 17:26-27).

Amr ibn Shuaib, on his father's authority said that his grandfather related that the Prophet said: When you eat, drink, give charity and wear clothes, let no extravagance or pride be mixed up with what you do. (Ibn Maja, Nasai).

Being a Miser

Abu Huraira narrated that the Prophet said: Every day two angels come down from Heaven and one of them says, 'O Allah! Compensate every person who spends in Your Cause,' and the other (angel) says, 'O Allah! Destroy every miser'.(Bukhari).

Abu Said Khudri related that the Prophet said: There are two habits which are never present together in a believer: miserliness and bad manners (Tirmidhi).

Jabir reported that the Prophet said: Avoid doing injustice to others, for on the Day of Judgment, it will turn into manifold darkness, and safeguard yourself against miserliness, for it ruined those who were before you. It incited them to murder and treating the unlawful as lawful. (Muslim)

Moderation in giving

"And let not thy hand be chained to thy neck nor open it with a complete opening, lest thou sit down rebuked, denuded" (Quran 17:29).

(In reference to the slaves of Allah) "And those who, when they spend, are neither prodigal nor grudging; and there is ever a firm station between the two" (Quran 25:67).

Bribery

"And eat not up your property among yourselves in vanity, nor seek by it to gain the hearing of the judges that you may knowingly devour a portion of the property of others wrongfully" (Quran 2:188).

Contentment

Abu Huraira narrated that the Prophet said: Wealth is not in having vast riches, it is in contentment. (Bukhari, Muslim).

Envy in wealth

Ibn Masud said I heard the Prophet saying: There is no envy except in two: a person whom Allah has given wealth and he spends it in the right way, and a person whom Allah has given wisdom (i.e. religious knowledge) and he gives his decisions accordingly and teaches it to the others. (Bukhari).

Women and Charity

Ibn Abbas narrated that the Prophet went out for the Eid prayer on the Eid day and offered a two Rakat prayer; and he neither offered a prayer before it or after it. Then he went towards the women along with Bilal. He preached [to] them and ordered them to give in charity. And some (amongst the women) started giving their forearm bangles and earrings. (Bukhari)

The Best Charity

Abu Huraira narrated that the Prophet said: The best charity is that which is practiced by a wealthy person. And start giving first to your dependents. (Bukhari)

On Begging

Narrated Hakim bin Hizam that the Prophet said: The upper hand is better than the lower hand (i.e. he who gives in charity is better than him who takes it). One should start giving first to his dependents. And the best object of charity is that which is given by a wealthy person (from the money which is left after his expenses). And whoever abstains from asking others for some financial help, Allah will give him and save him from asking others, Allah will make him self-sufficient. (Bukhari)

Abu Huraira related that the Prophet said: He who makes a habit of asking from others reaches out for a brand of Fire, so let him refrain or continue, as he desires. (Muslim)

Business conduct

Jabir related that the Prophet said: May Allah show mercy to a man who is kind when he sells, when he buys, and when he makes a claim. (Bukhari)

APPLICATIONS

Since the 1970s, Islamic banking has emerged as a new reality in the international financial scene. Its philosophies and principles are however, not new, having been outlined in the Holy Qur'an and the Sunnah of Prophet Muhammad (p.b.u.h.) more than 1,400 years ago. The emergence of Islamic banking is often related to the revival of Islam and the desire of Muslims to live all aspects of their live in accordance with the teachings of Islam

In Malaysia, separate Islamic legislation and banking regulations exist side-by-side with those for the conventional banking system. The legal basis for the establishment of Islamic banks was the Islamic Banking Act (IBA), which came into effect on 7 April 1983. The IBA provides BNM, the Central Bank of Malaysia, with powers to supervise and regulate Islamic banks, similar to the case of other licensed banks. The Government Investment Act 1983 was also enacted at the same time to empower the Government of Malaysia to issue Government Investment Certificates (GIC), which are government securities issued based on Syariah principles. As the GIC are regarded as liquid assets, the Islamic banks could invest in the GIC to meet the prescribed liquidity requirements as well as to invent their surplus funds.

The first Islamic bank established in the country was Bank Islam Malaysia Berhad (BIMB) which commenced operations on 1 July 1983. In line with its objectives, the banking activities of the bank are based on Syariah principles. After more than a decade in operations, BIMB has proved to be a viable banking institution with its activity expanding rapidly throughout the country with a network of 80 branches and 1,200 employees. The bank was listed on the Main Board of the Kuala Lumpur Stock Exchange on 17 January 1992.

The long-term objective of BNM is to create an Islamic banking system operating on a parallel basis with the conventional banking system. However, similar to any banking system, an Islamic banking system requires three vital elements to qualify as a viable system, i.e.:-

In addition, an Islamic banking system must also reflect the socio-economic values in Islam, and must be Islamic in both substance and form. Recognizing the above, BNM adopted a step-by-step approach to achieve the above objective. The first step to spread the virtues of Islamic banking was to disseminate Islamic banking on a nation-wide basis, with as many players as possible and to be able to reach all Malaysians. After a careful consideration of various factors, BNM decided to allow the existing banking institutions to offer Islamic banking services using their existing infrastructure and branches. The option was seen as the most effective and efficient mode of increasing the number of institutions offering Islamic banking services at the
lowest cost and within the shortest time frame. Following from the above, on 4 March 1993 BNM introduced a scheme known as "Skim Perbankan Tanpa Faedah" (Interest-free Banking Scheme) or SPTF in short. In terms of products and services, there are more than 40 Islamic financial products and services that may be offered by the banks using various Islamic concepts such as Mudharabah, Musyarakah, Murabahah, Bai’ Bithaman Ajil (Bai’ Muajjal), Ijarah, Qardhul Hasan, Istisna’ and Ijarah Thumma Al-Bai’.To link the institutions and the instruments, the Islamic Interbank Money Market (IIMM) was introduced on 4 January 1994.

In October 1996, BNM issued a model financial statement for the banking institutions participating in the SPI requiring the banks to disclose the Islamic banking operations (balance sheet and profit and loss account) as an additional item under the Notes to the Accounts.

As part of the effort to streamline and harmonize the Syariah interpretations among banks and takaful companies, BNM established the National Syariah Advisory Council on Islamic Banking and Takaful (NSAC) on 1 May 1997 as the highest Syariah authority on Islamic banking and takaful in Malaysia.

On 1 October 1999, a second Islamic bank, namely Bank Muamalat Malaysia Berhad (BMMB) commenced operations. The establishment BMMB was the effect of the spin-off following the merger between Bank Bumiputra Malaysia Berhad (BBMB) and Bank of Commerce (Malaysia) Berhad (BOCB). Under the merger arrangement, the Islamic banking assets and liabilities of BBMB, BOCB and BBMB Kewangan Berhad (BBMBK) were transferred to BBMB, while the conventional operations of BBMB, BOCB and BBMBK were transferred to BOCB accordingly. In addition, BMMB was given 40 branches of BBMB and BBMBK in various locations throughout Malaysia and a staff workforce of 1,000, migrated from BBMB, BOCB and BBMBK

ISSUES

A number of Islamic investment companies in Malaysia have crumbled, collapsed, vanished or simply gone bust in the last two years. This is real bad news for all those who looked towards these companies or institutions as a halal (legitimate) avenue for investment of their hard-earned savings. If conventional banks fail, it is merely failure of individual institutions. But in case of Islamic investment companies, the very credibility of the concept has come into question because they had been set up on the premise and promise of interest-free business. Money that vanished into the thin air belonged to earners from the Gulf, pensioners, widows and community owned trusts engaged in welfare activities.

It is estimated that nearly RM 1 million deposited with these bodies have either been spirited away or gone into such investments that are not likely to return to those who expected them to yield profits. The rise and fall of several of these investment companies has coincided with the boom and bust of speculative businesses such as share market or real estates. It is therefore not difficult to imagine where the investors’ money lies locked. The situation raises two vital issues. First, the Islamic investment lacks a regulatory mechanism in the country without which the system would continue to be vulnerable to the vagaries of market as well as beneficiaries. The depositors’ will remain insecure. Second, one needs to question the wisdom behind hitching - nay staking - the hard-earned money of Muslim investors onto the unstable speculative businesses of share market and real estate. A third but significant aspect is that a good chunk of deposits had been mobilized by appealing to Islamic sentiments rather than any sound business proposition. And sentiments do not govern businesses.

These factors are disheartening to say the least and are likely to affect the confidence of the Muslim depositors. What is more painful is that quite a few fly-by-night operators managed to make forays into the interest-free business and have cheated the gullible Muslims by appealing to their sentiments. A clutch of companies in Asia acted in the true blade company’s style through an advertisement blitz in the local dailies. Depositors were lured by expensive gifts, immediate dividends etc. It was downright fraud. In Malaysia the Islamic investors’ money fell victim to the artificial boom in real estates. A handful of builders gobbled up small investors’ savings and the Islamic investment agencies are clueless about prizing out the funds. But the only non-Muslim mutual fund company, that began to attract such funds from 1996 onwards, has been distributing dividends for the last two years. What an irony!

Surprisingly no Muslim organization has taken notice of the series of closures, failures and frauds by the so-called Islamic financial companies. At stake is not merely the money but the otherwise useful concept of interest free business.

What could be inferred from the episode is that the Islamic investments are totally unsafe. Any smart operator can defraud the gullible Muslims by promising high gains. What he needs to do is to practice the art of giving impressive dividends for the first few months. The depositors have no control within the businesses run by borrowers and can be easily duped because the promise is all about profit-and-loss sharing. The concept has though been turned into institutions, but there is no regulatory body or mechanism to discipline the financial institutions. If these financial institutions decide to wager their fortunes in the wobbly share market, the depositor have no role except to watch helplessly.

In Malaysia, often counseled pragmatism rather than being guided by sentiments. The failure of Islamic financial institutions has given us the hard knock of realism. It is a classic instance of how our own action could rubbish a valuable Islamic principle. In the world of business, rhetoric, sentiments and fantasy have absolutely no role to play. One has to be hardheaded to bridge the gap between the rhetoric and the action.

IMPLICATIONS

Deriving a firm's cost of capital without referring to a fixed and pre-determined rate such as an interest rate has immense implications for Islamic financial markets. Extensive research on q theory of investment suggests that it is possible to determine an industry-wide as well as an economy-wide q ratio. An industry-wide q ratio can very well serve the purpose of establishing the cost of capital for new firms entering the industry and as an indicator of efficiency relative to others in the same industry for existing firms. Similar to the concept of an industry-wide q ratio, an economy-wide q ratio can be used to determine a rate that reflects economy-wide marginal efficiency of capital or internal rate of return for efficient allocation of financial resources. Existence of an economy-wide benchmark has implications at both the micro- and macro-level. At the micro-level, such a benchmark can facilitate the pricing of assets, utilizing an equity-based reference rate. At the macro-level, it will help develop secondary markets, an Islamic money market, and an interbank market and contribute toward financial innovations. All these factors are known to be roadblocks to further development and growth of Islamic financial markets.

Development of a secondary market will enhance liquidity in the market and provide an extended maturity structure to investors. Establishment of a money market and an interbank market will have a great impact on the way Islamic financial institutions operate, since the problem of unavailability of funds at extreme short maturity will be resolved. No doubt, the financial innovations during the 1980s and 1990s changed the international financial markets in a revolutionary fashion. Similarly, financial innovations will introduce new products to Islamic financial markets to equip borrowers and lenders with the tools to better manage business and financial risk. Another promising arena for applying an economy-wide q is in the way governments in Islamic countries formulate economic policies and raise funds for social sector projects. Central banks can perform monetary operations to achieve economic objectives by influencing q since this ratio is the principal link between the financial and real sector of the economy.

Governments can finance public sector projects by issuing equity-based securities where expected dividend is determined by the market price of government securities (discounted value of streams of expected earnings at a prevailing rate of return) and social rate of return (discounted value of stream of expected earnings derived from government surpluses). Since q is the ratio of the social rate of return to the expected rate of return on financial capital, governments have an incentive to invest only if q exceeds unity. Investors will invest in equity-based government securities provided the rate of return is comparable to the market rate of return.

An Islamic financial system requires elimination of any fixed and pre-determined interest rate and thus closes the door to any form of debt instruments. Instead, it promotes equity participation and direct sharing of risks and rewards. In simple terms, although the system prohibits a fixed and predetermined interest rate on capital, it fully recognizes return on investment. As compared to a conventional debt-based system where capital is rewarded on the basis of a rate fixed ex-ante or determined by the expectations of the future demand and supply of capital, an Islamic money market system calls for rewarding the capital on the basis of ex-post (actual) return on capital. Whereas market interest rate plays the role of an equilibrium rate for financial intermediation and a benchmark for making efficient investment decisions in a conventional system, so far no equivalent substitute has been available for an equity-based system to determine the internal rate of return or the marginal efficiency of investments.

The Islamic money system recognizes that investment decision-making will have to be based on the concept of rate of return on capital as it participates in real sector activities and not on the opportunity cost of capital as represented by the interest rate. Though discounting expected future stream of cash flows based on a risk-adjusted expected rate of return does not violate any Islamic principle, and standard techniques for project evaluation are acceptable, the issue is how to determine the so-called "risk-adjusted expected rate of return," or cost of capital, in the absence of a system-wide benchmark or reference rate.

Thus far, the literature on Islamic economics and finance has not developed techniques to determine a rate of return at the firm (micro) or economy (macro) level so that investments can be compared for efficient allocation of capital. In the absence of such a reference rate or benchmark, Islamic financial institutions have resorted to adopting a proxy rate borrowed from their counterparts in the conventional system. It has become a common practice to use the London Inter-Bank Offer Rate (LIBOR) as a reference rate for mark-up instruments or a benchmark to price trade financing instrument and Islamic leasing funds. Without a doubt, this practice is questionable and raises several concerns. Practitioners claim that this arrangement is temporary until a better substitute and viable solution is offered.

This model is based on Tobin's q theory of investment and attempts to devise a benchmark compatible with the Islamic financial system.

PRACTICAL

Currently, Islamic money markets are dominated by short-term trade financing instruments. According to some estimates, 80 percent of investment is being channeled through the "cost-plus" (murabaha) mode of financing. The common practice in the market is to use the LIBOR as the reference rate for mark-up. Similarly, the LIBOR is used for pricing and measuring the performance of Islamic leasing funds. In the absence of LIBOR, the prevailing market interest rate would serve the same purpose. 

Historically, several factors have contributed to the establishment of this practice. First, Islamic financial institutions required a common reference rate to integrate with international capital markets. Second, as Western banks entered into the Islamic financial markets, they required a comparable benchmark against their cost of funding in the conventional system, which happened to be the LIBOR. These institutions treated the murabaha mode as synonymous with the conventional money market, which was based on the LIBOR.

Finally, in those markets where Islamic financial institutions coexisted with conventional banks, the LIBOR became a benchmark for competition in attracting depositors.

The prevalent practice is defended by the arguments that, in the case of the murabaha mode of financing, a practice to charge the LIBOR-based "mark-up" is still Islamic because it is part of the sale agreement price between two parties; and, in case of leasing funds, the LIBOR is used for pricing and performance measurement purposes only and does not influence the actual rate of return on the investment. Further, the LIBOR provides price transparency and global real-time accessibility, which facilitates ease of operation and integration of Islamic and international financial markets. Irrespective of various justifications provided for the practice, obviously the use of any interest rate as part of a mark-up (pricing or performance) is not acceptable because interest rate does not represent real rate of return in the economy as intended by Islamic principles. Although ease of use is the reason cited, the real reason is the lack of a more suitable measure. Finding a practical solution for a benchmark compatible with Islamic principles requires an understanding of the concept of cost of capital in the context of an Islamic financial system. The cost of capital provides a common reference point for comparing heterogeneous investments and provides insight into how firms make investment decisions

Cost of Capital in an Islamic Money Market System

By prohibiting interest, Islamic injunctions do not imply that the opportunity cost of capital represented by interest rate in a conventional system is zero. In an Islamic framework, the incentive for the firm to invest will solely depend on prospective profitability. A profit-maximizing firm will continue investing until the marginal productivity of capital becomes equal to the opportunity cost of capital; therefore, "cost of capital" in the Islamic system can be represented by the rate of return on alternate opportunities for investment of comparable risk. It has also been demonstrated that there is a rate of return in Islamic capital markets serving opportunity cost of capital, and this rate of return is also closely related to the rate of return in the real sector of the economy.

In the Islamic money market system, determination of prospective profitability and the rate of return on investments of the same risk class play a pivotal role in determining the relative cost of capital.

Tobin's q theory of investment suggests the use of information in asset markets, especially the stock market, in knowing the profitability of investment. The theory relates investment to the ratio of market to replacement value of capital and suggests that when the stock market functions properly, the future profitability of investment will be solely summarized by q. It is a simple arbitrage argument. If the market valuation of capital held by a firm exceeds the cost of capital on the open market, then the firm can increase its value by investing. Tobin argues that if q exceeds unity, the value of capital investment would exceed its costs, and the firm would have incentive to invest.

A recent model presented by Mirakhor utilizes this concept of q in deriving the cost of equity capital of a firm in the Islamic money market system. In its simple form the model states:

r = ( Y / V ) (1 - d + dq )

where:
        r = Firm's cost of capital or shareholder's required rate of return.
        Y = Value of expected earnings for the next year.
        V = Present value of the firm's stock of capital. Since there is no debt financing in the Islamic system, it is equal to value of the firm.
        d = Sum of fraction of expected earnings retained by the firm and the expected rate of stock financing expressed as ratio of firm's expected earnings.
        q = Firm's q ratio.

The model implies that a firm's cost of capital (r) is a function of a firm's q ratio and the firm's market value (V), stream of expected future earnings (Y), ratio of retained earnings, and new stock financing. The q ratio can be simply derived by dividing the value of the firm (V) determined by the market price of the firm's stock by the replacement costs of firm's assets such as equipment, land, receivables, and marketable securities. The cost of capital will fluctuate with the fluctuations in the q ratio, thus signaling the prospects of an investment project. For example, we are interested in finding the cost of capital for a firm with future expected earnings for next year (Y) of $1,000,000 and equity value of $10,000,000 (since there is no debt financing, value of the firm is equal to equity value).

Based on the historical data, it is known that the firm finances future projects through retained earnings and new equity issues amounting to 20 percent of its earnings (d = .20). If the firm's q ratio is 1, its cost of capital will be 10 percent as the following shows:

1 = $1,000,000/$10,000,000 ( 1 - .2 + (.2 . 1) )

The figure below gives a graphical representation of cost of capital for the same firm with varying q ratios. It is obvious from the graph that cost of capital has a linear relationship with q. A firm with q lower than 1 will have a cost of capital lower than the return on equity (10 percent in this case) whereas, firms with q greater than 1 will require higher cost of capital.

A firm's market value reflects the profitability of existing capital. The q ratio is an indication of how much this market value can increase by additional investment, also known as marginal q. Marginal q - the ratio of market value of an additional unit of capital (shadow price of capital) to its replacement cost - is the critical determinant of the firm's investment decision making but is not observable since the shadow price of capital is not observable. Instead, what is observable (in principle) is the average q - ratio of the market value of existing capital to its replacement cost.

Hayashi rigorously proved a relationship of average q with marginal q-based information in stock market valuation. A relationship of equality between average and marginal q will hold provided conditions of perfect competition in product market and linear function of homogenous technology of production and adjustment costs are satisfied. For competitive firms (price-takers), this relationship is strong because the unobservable shadow price is directly linked to the stock market valuation of existing capital. If one of these conditions is violated, then the average q is no longer equal to the marginal q; however, a relationship may still exist. For example, in firms with monopolistic position (price-makers), average q is higher than marginal q by what is legitimately called the monopoly rent, and it is marginal q that is relevant for investment. Several empirical studies have utilized average q as a proxy for marginal q.

Pricing assets using q has several advantages over other methods. First, the market value of the firm is an indicator of future profitability as perceived by investors' expectations rather than the past performance of the firm. Second, since market value is subject to adjustment by variations in expected profits, q incorporates an automatic adjustment for risk independent of any methodology employed by capital markets to determine risk premium. The value of q should be equal to unity only if profits are high enough to compensate for shareholders risks. Finally, as compared to other asset pricing models (capital assets, arbitrage, or option pricing models), a model based on q is subject to less measurement errors.

Despite its considerable theoretical appeal, empirical evidence linking q to investment decision-making of firms has received mixed reviews in the literature. Using Japanese corporate data, a recent time-series study examined the roles of marginal q (based on time-series techniques) and average q (using stock market valuation) in the q-based investment function. Although the study found poor performance of investment function based on average q, it also found, as expected, that entrepreneurs attach much significance to q.

Although the proposed q-based model is theoretically compatible with the Islamic money market system, one reservation about this approach could be that successful application of a model depends on the degree of development and efficiency in existing stock markets. Since most Islamic countries are developing countries where capital and financial markets are not fully developed and are not integrated with international financial markets, data are subject to noise and distortion, thus contaminating the information content of q and investors' decision making. This reservation is more valid and applicable in determining an economy-wide benchmark based on time series to calculate an average q; however, it is not necessarily a barrier to calculating a q as a benchmark. This is particularly true for firms, banks, and even government projects, thus providing a benchmark conforming to Islamic principals, which excludes the fixed interest rate.

Recently, another model has been presented by Haque and Mirakhor to address the same benchmark issue. Unlike the q model, the Haque-Mirakhor model attempts to develop an economy-wide index based on major indicators of domestic and international equity market performance to serve as a benchmark for issuing government papers.

The suggested index is designed as a weighted average of domestic stock market index, international equity returns, and return on government's development projects. Inclusion of both domestic and international indices makes it efficient in terms of its ability to eliminate any arbitrage opportunity and discourages speculative behavior. A similar approach can be taken for determining a benchmark for the private sector. Whereas the Haque-Mirakhor model provides guidelines for a macro-level benchmark, the q-based model can still provide a benchmark at the micro-level.

Nevertheless, the concept of a q-based benchmark is a ground-breaking innovation that requires further refinement. Given the right set of parameters, it may help solve the problem of defining a benchmark for Islamic financial markets.

JUSTIFICATION

The pragmatists have to adjust the concept of money, which, in the shariah, is equivalent to 'coin' and a mere medium of exchange. In the shariah, money cannot be sold for money, that is more for less, and it should not have a 'price'. This definition of money, espoused by the idealists, has been modified in the interests of practicality. This adjusted concept of money exists quite comfortably with notions of the value of money in relation to time, of present value being higher than future value, and of it being possible to charge a sum against time in certain types of debt.
"Law is in Islam a process of discovery. Just as the physical scientist believes that the laws of physics exist as an absolute, waiting to be discovered rather than invented, so the Muslim legal scholar believes that the shariah has been created by God and his role is to discover and articulate it rather than invent it."
by Imad-ad-Dean Ahmad.

Islamic money markets need the rule of law to operate. The Qur'an explicitly favors productivity and free-interest trade. It is not ascetic, but encourages moderation in matters of consumption. It not only favors rules of contract and commerce but also actually specifies many of them.

Based upon the fact that the primary function of banks is to deal with "money", one cannot speak about “banking" without referring to money. Hence, it seems a "must" to understand money first. Otherwise many Miss-interpretations may arise as the result.

Interest and profit, although being clear concepts, have been subjected to many misunderstandings. To be sure, let us make them clear at the outset. Interest and profit are rewards to money and capital investment, respectively. In other words, capital investment produces profits and money produces interest. Furthermore, it has constantly and mistakenly written and quoted by some writers that the price of money is 1 (unity). One is the exchange rate of money with itself; but the price of money is interest (rate).

Some of our findings about the nature and role of profits closely correspond to those of Prof. Adrian Wood in his seminal book “A Theory of Profits ". With the abolishment of interest (as it has in Islamic school of economic thought), the LM curve loses its total validity and becomes redundant and useless.

All in all, interest is a normative concept (basically discussed in schools of economic thoughts), which can neither be proved nor refuted by use of scientific tools of analysis. It is a value judgement. In evaluating an economic system, economists are supposed to take it for granted.

Assertions:

1. In economics we are basically dealing with two inter-related concepts; one is legal (or conventional) concept and the other is real concept. To distinguish one from another, one does not need to focus on the physical features of each one. All contractual agreements like marriage, ownership, organizational hierarchy, money, interest, and the like fall into the first category; while human beings, commodities, buildings, amenity, and the like are included in the second category. Each one of these two concepts is able to produce the other or be transformed into it. Let us call these two properties “Completeness" and “Reflexivity", respectively. Hence, money itself being a legal concept is capable to producing another legal concept (actually its derivative) called "interest" or to produce real concept like capital equipment.

2. Money as a potential capital is a legal (conventional) concept capable of being transformed into actual capital. A simple example would be Mudarabah contract, among others, in which as soon as one person's money is legally combined with another person's labour force, the nature and the function of money is changed into capital. Given that in an Islamic framework there is no reward to money lending (i.e. interest being zero) yet capital (i.e. money's transformed version) is eligible for part of the profit earned.

3. Various modes of contract available to Islamic banks are the major source of transforming money deposits of individuals and firms into capital (or asset). Any type of financing under any modes of contract by these banks will essentially increase the value of the asset of the economy. However, some modes of contract like Musharakah and installment sales (originated by firms) increase the productive capacity of the economy. Any positive change in the firm's asset values (rather than their capital values which is by itself a vague concept responsible for some obscurities) can be called “investment". Following this practice it is easy to calculate, rather than to estimate, the amount of investment, which has taken place in an economy during one specific year with relatively high precision. This can be done by reading the asset values off the current balance sheets, firms submit to tax authorities. By putting asset values, instead of capital, into the production function, not only it becomes more precise, but also meaningful. Firms' rate of profit is, hence, logically defined as the ratio of profit to their assets. Since the value of firms' assets is normally greater than their value of capital, therefore, the rate of profit defined as the ratio of profit to the value of capital, underestimates the true rate of profit.

4. Based upon J. M. Keynes' criticism on the classical economist’s inability to recognize speculative demand for money in the presence of interest (rate), it can easily be shown that interest is both necessary and sufficient condition for speculation. In other words, there is a two-way relationship between interest and speculation. It is probably for this reason that he has also recognized commodities rates of interest in addition to money rate of interest that he was much concerned about. That is, whenever a commodity is speculated upon a specific rate of interest would emerge. With the abolishment of interest, speculative motive of the demand for money, logically derived from interest, would disappear. Speculation, which necessarily entails artificial risk in any market, be it in money, bond, gold, commodities and the like, is not permissible in an Islamic setting. All of these can safely be taken under the heading of "gambling".

A corollary to the above assertion is that with the disappearance of bond market stocks are expected to be exchanged in an Islamic stock market based upon their book values. In terms of Tobin's Q this quotient is supposed to be close to unity (one). It is because in a world with perfect markets, economic value (EV) and replacement cost (RC), will coincide. This brings the quotient to unity. An implication of this is that in a world with perfect markets valuing the firm would be easy; i.e. we could read the economic value of the firm off the current balance sheet. Risk is essentially interwoven with investment. It can be considered "natural" and hence permissible in Islam. However, impermissibility of artificial risk may be grounded upon the fact that any income received by speculator will eventually bring about excess demand for goods and services (without the speculator having any share in productive activities). This excess demand, in turn, becomes the main source of inflation.

Let us conclude discussing about this assertion by citing two statements correctly made by Prof. Gardner Ackley:

a) "Speculation - if mistaken - tends ultimately to be self -correcting in any commodity market.”

b) " ...the real cause of unemployment is speculative demand for money".

5. The natural consequence of elimination of interest, as said earlier, is the elimination of money market. Hence, the major motive to use money is for transaction purposes, which underlies the structure of ordinary demand and supply schedules for goods and services. Furthermore, based upon the logical statement that "the speculative motive is derived from money's use as an asset, as a store of value", money can no longer possess the "store of value function" in an Islamic framework.

In the absence of interest, money market and speculation, and all monetary policy tools used in conventional banking, would lose their validity in Islamic banking. Let us call the policy followed in this new setting "Financial Policy". The unique and powerful tool of financial policy is to determine the share of profit relative to that of capital for all investment projects submitted to Islamic banks. This is probably the most important role a central bank can play in an Islamic banking. There are many factors underlying the determination of this share, especially in the face of natural risk.

This share if effectively used would make bank's sources of finance properly channelled into asset building processes without worrying about money whirlpool to emerge. To determine equilibrium in this market the relative profit rate of the Islamic bank (call it financier) to that of the investor (call it the financee) can be constructed. This rate is especially useful in cases where different risks are involved. To prepare a list of different risks involved in various investment projects is another important task of a central bank.

6. Western economists have always and justifiably been worried about unnecessary expansion of money supply the volume of which is hard to control by central banks. This is due to the fact that considerable portion of it (very difficult to determine if not impossible due to uncertainties involved in interest rates) goes to money whirlpool. This is probably the reason Prof. Milton Friedman in his paper addressing the problem of stabilization policy has advocated the Required Reserve Ratio (RRR) to be raised to one hundred percent. It is clear that such a banking, if possible, would lose its own entity and merely becomes safe-deposit office. If Islamic banks are prohibited to lend on interest nonetheless different modes of contract, as mentioned earlier, are available to them to finance specific needs of both firms and individuals upon their proper requests. If constant and effective supervision is conducted on a random basis by the central bank the chances are very slim a money market, which could be outlawed, to be developed. So the kernel of Islamic banking is Profit and Loss Sharing (PLS). By preparing accurate information and making them available to the general public, central bank in Islamic banking system would be able to provide symmetric information and prevent moral hazard, to a great extent.

7. Money's inability to be a tradable entity and its production and volume being closely watched by the central bank (which is apart of the public sector), seems appropriate to be classified as "Impure Public Good" in an Islamic state. For the sake of brevity some properties of (impure) public goods which also apply to money, in this setting, will be outlined as follows:

a) Non-existence of money market.

b) Elimination of speculation.

c) Demand for it can be constructed by vertical summation of individual demands.

d) Externality of money can be derived from its capability of becoming actual capital; hence, government's (i.e. central bank's) intervention. Furthermore, it benefits each person simultaneously and is thus equally available to each person. Simultaneous benefit is not a "must" for a "thing" to be public. A good example is highway. Highways do not generate simultaneous benefit to all individuals; they are equally available to all individuals. Non-exclusion principle also applies here. Additional individuals looking for money may be added at zero marginal cost.

e) Indivisibility of money refers to its purchasing power and not its physical character.

f) Its velocity is greater than unity implying that one is not supposed to "capture" it as opposed to the case of private good whose velocity is unity implying that it can be "captured".

A caveat is in order here. Money has two distinct attributes; one at micro and the other at a macro level. At the micro level, it is part of the asset of an individual possessing it. But at macro level it cannot be added to the assets of the economy. To count money as wealth (or asset) of a nation will lead one to commit both fallacy of composition and double counting problem. This property of money may be the only one that makes it distinct from other "public goods". This could probably be the consequence of money being the medium of exchange.

8. Removal of interest and all its derivatives (i.e. lending on interest, money market and speculation) from an economy will lead Islamic banks to finance investment projects through PLS. The criteria to be used by such banks are both profitability and feasibility of the projects. Hence, projects compete with each other on the bases of their Internal Rates of Return (IRR). However, the criterion used by a potential investor is IRR of a specific project. The role of the central bank in determining arrays of IRRs for different sectors and various activities is highly valuable in channelling resources into proper projects.

Ranking IRRs in descending order, an investor would first choose the project with the highest IRR. However, the rule, which seems appropriate in choosing the amount to be invested, is "cut-off rate". The maximum amount one investor is willing to invest in a project is determined by the IRR of the next project whose value is almost equivalent to the chosen project, without it being "the opportunity cost" of capital.

Cut-off rate, seems to us, has long been mistakenly interpreted as opportunity cost. In investment decision making most of the times we are ~ dealing with the cut-off rate concept (even in an interest based economic system) but very rarely with opportunity cost. In capitalistic system, rate of interest is justifiably used as the opportunity cost of capital. It is well justified that interest rate is essentially determined independently from the rate of return in the real sector of the economy. However in the absence of interest, projects compete with each other to obtain finance from Islamic bank on the basis of their IRR because there is no other alternative. Comparison among various IRRs brings about the role of cut-off rate without anyone of them becoming opportunity cost of another project. Cut-off rate functions as a signal to show an investor up to what point he should invest and where to stop and select another project. Interdependencies among various investment projects produce cut-off rate the special character and function of which differ from those of interest rate.

The reason, seems to the people, that we often fail to distinguish between these two concepts is the interdependence condition. Furthermore, choosing one, IRR of one project as the opportunity cost of another project in the same activity (on the basis of the principle of next best alternative) will lead one to a whole range of so-called opportunity cost list, none of which have possibly the same value. Hence, different cost calculations in the same activity. Whereas cut-off rates could be numerous for many producers in the same activity without making them run into any problem.

In the absence of interest rate there is nothing to compare IRR of an investment project with. Therefore, we can conclude that in an Islamic economy opportunity cost of capital is zero. The foregoing statements were justified on the basis of economic logic; accountants do not seem to have any reason to believe otherwise. One final remark can be added to above statements. Opportunity cost of capital can also be used as the cut-off rate but the reverse is not true.

After their feasibility and profitability have been confirmed by Islamic bank's qualified personnel, projects become eligible to obtain finance; furthermore, the projects themselves become collateral for finance. Central bank's role in providing guidelines about both of these two aspects will certainly be appreciated by Islamic banks.

As long as there are unemployed factors of production suitable to be utilized in investment, projects have to be financed by Islamic banks no matter how much money is required to finance them. This gives appropriate apparatus to materialize the assertion made by S. M. Bagher Sadr when he says; "Tools of production are treated servants in Islam and man the master". It is the right of labour, in Islam, not to be kept unemployed.

In the final analysis, every piece of bank note coming out of an Islamic bank in response to financing an investment project can be called Certificate of Asset Building (C.A.B.). These C.A.B.'s are appropriate both to production and household sectors.

9. In dealing with various modes of contract, Islamic banks finance profitable and appropriate projects. Appropriateness of projects are expected to be determined by the central bank; however, to determine which projects are more profitable to finance is the task of each individual Islamic bank. Central bank's task is to instruct Islamic banks to give priority to those projects, which are more compatible with the country's economic plan (be it either explicit and written or unwritten and implicit).

Islamic modes of contract can be classified into two broad categories:

1. Those with variable return and (2) with fixed return. Musharakah and Mudarabah contracts fall into the first classification and Instalment Sales, Hire-Purchase, Joalah, and the like into the second one. Musharakah (i.e., PLS) has well and rightly been recognized as the core of Islamic banking. In Mudarabah contract labour has no responsibility as to any loss that may occur provided that it had done its best. The second class of contracts may be defined as auxiliary contracts, which could be used in conjunction with and after the first category has been utilized. Risk is involved with the first type but the second is risk less which is more appealing to Islamic banks. To reduce or even to eliminate the burden of risk from the shoulders of investors it requires another paper, which IS beyond the scope of this presentation.

However, to make sure that the guideline controlling the complementarity of the second type contracts has properly been observed, the Islamic central bank is supposed to keep close eye on the contracts signed by each individual Islamic bank. I skip going into the mechanism of how the burden of risk can be lessened or even eliminated; to determine the degree of risk in different sectors and regions throughout the country. This is another crucial task of an Islamic central bank. This will facilitate the task of Islamic banks in determining the relative share of their own profit vis-à-vis that of the investor. This task not only is beyond the capabilities of an individual Islamic bank, but also provides a uniform procedure for all Islamic banks for various sectors, locating in different regions of the country.

10. Whether an Islamic bank uses the variable or fixed- rate-of-return contract, accountants are very keen about costs that are supposed to be deducted from, total revenue. Accountants who are responsible to approve and submit both balance sheets and profit and loss statements to tax authorities do not accept anything under the heading of cost from neither of the two types of contracts provided that they have been financed by Islamic banks. It is a fact that economists use these two valuable documents for economic analysis and their own interpretations without being able to adjust them on the basis of their own interpretation of cost. Nevertheless, neither of the two professions (accounting and economics) can deny that the Islamic banks' share of profit paid by investors (i.e. financees) is in fact sort of dividend which is essentially determined after all costs have been subtracted from revenue and hence can no longer be considered cost.

To sum up the role of a central bank in an Islamic state, we come up with six different crucial functions to be performed at different levels of rigorousness:

a) Active participation in the process of preparing economic development plan.

b) Informing individual Islamic banks about the priorities of investment projects as outlined in the country's economic development plan at different regions and various sectors.

c) Calculating and submitting to Islamic banks the profit shares of banks relative to those of capital for different projects at various regions and sectors.

d) Calculating and submitting to Islamic banks the value of risk involved in different projects, different regions, and various sectors of the country.

e) Constant inspection and supervision to make sure that projects have properly been financed relative to the priorities and the value of risks.

f) After making sure that Islamic banks have concisely followed the central bank's instructions they can safely be allowed to gradually reduce RRR down to zero.

Let us admit that monitoring cost in Islamic banking compared to the conventional banking is relatively high. However, potential benefits as to its effects on reducing unemployment and keeping prices constant over-shadow the cost. Most important, distribution of income and wealth is expected to be more equitable than otherwise. Such a scheme of distribution guarantees sustained economic development. The role of an Islamic central bank in a uniform distribution of information and prevention of moral hazard cannot be overstated.

Whether it is the Islamic banking or the realization of Keynes' expectation to reach full employment, it is yet to be seen. In closing our comments, we would like to cite what Keynes has to say about this whole issue: "If I am right in supposing it to be comparatively easy to make capital goods so abundant that the marginal efficiency of capital is zero, this may be the most sensible way of gradually getting rid of many of the objectionable features of capitalism."

Nonetheless it seems that these two models, in the final analysis, converge. He, in this respect, admits that "...it is to our best advantage to reduce the rate of interest to that point relatively to the schedule of the marginal efficiency of the capital at which there is full employment."

CONCLUSION

As a conclusion, Malaysia today have an ambitious agenda lined up for Islamic banking in the twenty-first century. It is certainly an era of exceptional opportunities and challenges for Islamic financial institutions and their regulators. Developing the industry and designing the regulatory and supervisory framework for Islamic banking while pacing the waves of globalization would demand more intensive and sophisticated co-operation between the authorities, regulators, financial entities and market participants.

Governments have a vital role to play in providing the essential support and infrastructure, whilst regulators have to formulate a flexible framework that addresses the distinct features of Islamic banking without sacrificing prudential standards. While we work together, each meeting our responsibilities and reinforcing the other in facing up to the daunting challenges and in riding the waves of globalisation, it is of utmost importance that we must not lose sight of the shore.

That thought is profound. Islamic banking is now at a threshold of exciting developments. The tides of Islamic banking are bringing once again greater co-operation, collaboration and understanding of the magnificent splendour of Islam. Deriving strength from our rich traditions, we have the real opportunity to establish a financial model for the rest of the world to follow.

For strengthening the regulatory setup and making it acceptable for multinational financial institutions, development of Shariah compliant liquid money market instruments, designing prudential rules to reflect the specific risk characteristics of Islamic financial contracts and development of internationally accepted accounting standards are necessary. In order to operate the system on sustainable basis, we would also need integration of financial markets in Islamic countries. Despite development of instruments and Standards as described above, the Islamic financial market remains largely segmented. Besides efforts for developing instruments and the framework, Islamic countries will have to re-design their plans and priorities.