Islamic Banking Sector

Introduction The Islamic banking today has become most popular and reliable financial system in the world. It appeared on the world scene as active player over three decades ago. But as many of us know most of the principles which is based on Islamic Banking , commonly accepted by the all over the world goes for centuries than the decades. Islam as a religion very clearly prohibits the Riba the interest, so the basic principle of Islamic banking is the prohibition of Riba (Usury or Interest) base transactions. The origin of the modern Islamic bank can be traced back to the very birth of Islam when the Prophet himself acted as an agent for his wife's trading operations. Islamic partnerships (mudarabah) dominated the business world for centuries and the concept of interest found very little application in day-to-day transactions. Such partnerships performed an important economic function. They combined the three most important factors of production, namely: capital, labour and entrepreneurship, the latter two functions usually combined in one person. The capital-owner contributed the money and the partner managed the business. Each shared in a pre-determined share of the profits. If there was a loss, the capital-provider lost his money and the manager lost his time and labour. Islamic Banking Principles In a modern economy banking plays the pivotal role for most financing needs of individuals, families and even businesses. Thus it is understandable that as the field of Islamic finance developed, Islamic banking occupied the eminent position among the broad category of Islamic financial institutions. Understanding Islamic banking and financing must begin with the recognition that Islam considers the entire life of its adherents, including trade and finance, as part and parcel of the religion. Before going to discuss history of Islamic banking, we look at the principle behind the Islamic banking. Similar to socially conscious investing, Islamic finance is governed by a number of substantive principles based on a number of positive commands (injunctions) and negative commands (prohibitions). First, according to Islamic law, many sectors or products are specifically prohibited (e.g., gambling, pornography, alcohol, conventional banking/insurance) and therefore no trade or financing can be applied to transactions related to such products. Secondly, riba is forbidden in Islam. Based on the presumed riba-interest equivalence, interest is also thus regarded as prohibited and all interest-based investments are unlawful according to traditional Islamic law. On the basis of this particular prohibition, all conventional banking and financing based on interest is Islamically regarded as unacceptable.

The Quran -Surah 02- Al Baqarah verse 275 Those who devour Riba will not stand (especially for judgement before Allah) except as stands one whom Satan by his touch has driven to madness. That is because they argue : Business and Riba similar to each other .But Allah has made business Halal and He is made Riba Haram. Those who after receiving this warning (concerning the Haram of Riba) from their Lord ,(now) desist (from Riba) , may keep whatever they had previously earned (as Riba) ; and their case (will now be judged by) Allah (alone ,i.e. the Islamic State will not deal with that matter); but those who return (to Riba even after this revelation of the Quran ) are companion of fire (of Hell) ; they abide therein (forever). Thirdly, debt (dayn) or loan is not recognized in Islamic law as a valid form of financing. Since debt/loan is an interest-based instrument, except qard al-hasana (charitable or interest-free loan), Muslims cannot lawfully earn any return or yield from any debt-based instruments. This has generally caused shunning all fixed-return based transactions or depository accounts. Fourthly, Islamic law subjects all contracts to a set of procedural principles and thus not all types of financing contracts are permissible. Thus, for example, Islamic law does not allow any contractual agreement involving a product which is not in the constructive possession of the seller at the time of the transaction. Also, any contract vulnerable to gharar (excessive uncertainty) or speculation is not permissible either. Furthermore, subject to prohibition of riba, certain commodities such as gold, silver and a number of food staples cannot be traded except in equal measure and on the spot (no deferral). Fifthly, Islamic law requires that any investment type transaction, including savings accounts, must be also within a framework of equitable loss and risk sharing. Thus, the valid avenues for Muslims to invest are generally equity-based. Apart from these broad and other specific parameters, all trades (buy/sell) transactions are generally permissible. History of Islamic Banking In the1960s, Muslim thinkers began to explore ways and means of organising commercial banking on an interest-free basis, economists dismissed their work as wishful thinking. But, in 1963, in Mit Ghamr, in Egypt, the first Islamic interest-free bank came into being. Mt Ghamr was a rural area and the people were religious. They did not place their savings in any bank, knowing that interest was forbidden in Islam. In these circumstances, the task was not only to respect Islamic values concerning interest, but also to educate the people about the use of bank. The pioneering efforts by Ahmad El Najjar brought this bank into existence, whose key principle was profit sharing (non-interest based philosophy of Shariah). By the end of 1976 there were 9 such banks in the country. These banks neither charged nor paid interest but their activities were mostly limited to trade and industries where these banks invested directly or as partners of depositors. Hence, functionally these banks were working more as financial institutions rather commercial banks. In 1971, Nazir Social Banks is known to be the first commercial bank in Egypt, though its charter never made references to Shariah. The first bank explicitly based on Shariah principles was established by the Organization of Islamic countries (OIC) in 1974, called Islamic Development Bank (IDB).

This bank was primarily engaged in intergovernmental activities for providing funds for development projects running into member countries. Its business model involved fees for financial services and profit sharing financial assistance for projects. With time, during the 1970s several Islamic banks came into existence, including the Dubai Islamic Bank (first Islamic private commercial bank, 1975), the Faisal Islamic bank of Sudan (1977) and the Bahrain Islamic bank (1979). Others from the Asia Pacific region include the Philippine Amanah Bank (PAB), formulated under presidential decree. Iran passed its usury free banking laws in 1983. All banks are nationalized. In accordance with the school of Islamic law followed in Iran, depositors may get rewards on their savings provided they are not committed in advance. Financing of domestic and external trade is done on mark up basis. But sharing modes do play a significant role in financing agriculture and industry. Interest free loans are available for the poor to meet such needs as housing, their source being the state. Sudan launched Islamic banking in 1984 whose coverage was later extended to the entire financial sector in 1989. Sharing based modes of finance are used in agriculture and industry and the government is considering sharing based investment certificates to be sold to public, the funds so mobilized to be used in developmental projects. The poor state of the economy stands in the way of the market playing any significant role in the process. But the recent phenomenon of oil as an increasing source of public revenue is likely to make a difference. Malaysia had its first officially sponsored Islamic bank in 1983. All other banks also offer Islamic financial products. Overall supervision vests in the countrys central bank, Bank Negara Malaysia, which has a board of Shariah scholars to advise it. Malaysian Islamic financial system allows sale of debt instruments based on receivables from sale of real goods and services and those based on leasing. The government issues bonds (Malaysian Government Investment Certificates, MGICs) to be redeemed at par but carrying coupons conferring financial benefits that vary. Malaysia has an active Islamic money market trading in assets based securities. 27 more banks were established in the same manner in the Gulf countries, Egypt, Sudan, etc. Many more were to follow all over the Muslim world. Also by 1985, over 50 conventional banks, some of them located at money centers like London, were offering Islamic financial products. This was followed by up by some of the major conventional banks establishing Islamic branches dealing exclusively in Islamic products. Citi-Islamic in Bahrain and Grindlays in Karachi were followed by the National Commercial Bank in Saudi Arabia establishing over 50 Islamic branches by 1990s. Indonesias Bank Muamalat, established 1994 under state patronage, has about 400 branches all over the country. Its financial operations follow the Malaysian model. There are other smaller Islamic banks too, e.g. the Shariah Bank. Turkey does not practice Islamic banking at the state level, but several Islamic banks were launched under special licenses in late eighties-early nineties. They are still functioning, along with other non-bank Islamic financial institutions.

Two Islamic banks operated in Europe for some years. Islamic Bank of Denmark was converted into an investment company and Al Barakah London had to stop deposit taking. As the Bank of England explained, a deposit taking institution had to guarantee its repayment in full in order to qualify for a banking license. As of now, western societies are served either by Islamic mutual funds or by grass roots initiatives at the community level financing the purchase of houses and other consumer durables. History of Islamic Banking in Pakistan Pakistan Islamized banking between 1979 and 1985 through a series of Ordinances issued by the Federal government and a number of circulars issued by the State Bank of Pakistan, the countrys central bank. Even though profit sharing replaced interest as the basis of time deposits and saving accounts, the actual rates paid are not market determined as all major banks were nationalized during the previous regime. On the assets side mark up became the main basis of bank finance for business. Some financial products based on profit-sharing were launched but their role in the market is minimal. Government finances remain conventional, burdened with huge interest based foreign and domestic debts. Private initiative played little role in the Islamization process and the market hardly got a chance to throw up Shariah compatible financial instruments . The whole process was conducted with some speed by the bureaucracy under orders from the top. Even the recommendation of the Islamic Ideology Council to make a start from the assets side was not heeded. Pakistan was among the three countries in the world that had been trying to implement interest free banking at comprehensive/national level. But as it was a mammoth task, the switchover plan was implemented in phases. The Islamization measures included the elimination of interest from the operations of specialized financial institutions including HBFC, ICP and NIT in July 1979 and that of the commercial banks during January 1981 to June 1985. The legal framework of Pakistan's financial and corporate system was amended on June 26, 1980 to permit issuance of a new interest-free instrument of corporate financing named Participation Term Certificate (PTC). An Ordinance was promulgated to allow the establishment of Mudaraba companies and floatation of Mudaraba certificates for raising risk based capital. Amendments were also made in the Banking Companies Ordinance, 1962 (The BCO, 1962) and related laws to include provision of bank finance through PLS, mark-up in prices, leasing and hire purchase. Separate Interest-free counters started operating in all the nationalized commercial banks, and one foreign bank (Bank of Oman) on January 1, 1981 to mobilize deposits on profit and loss sharing basis. Regarding investment of these funds, bankers were instructed to provide financial accommodation for Government commodity operations on the basis of sale on deferred payment with a mark-up on purchase price. Export bills were to be accommodated on exchange rate differential basis. In March, 1981 financing of import and inland bills and that of the then Rice Export Corporation of Pakistan, Cotton Export Corporation and the Trading Corporation of Pakistan were shifted to mark-up basis. Simultaneously, necessary amendments were made in the related laws permitting the State Bank to provide finance against Participation Term Certificates and also extend advances against promissory notes supported by PTCs and Mudaraba Certificates. From July 1, 1982 banks were allowed to provide finance for meeting the working

capital needs of trade and industry on a selective basis under the technique of Musharaka. As from April 1, 1985 all finances to all entities including individuals began to be made in one of the specified interest-free modes. From July 1, 1985, all commercial banking in Pak Rupees was made interest-free. From that date, no bank in Pakistan was allowed to accept any interestbearing deposits and all existing deposits in a bank were treated to be on the basis of profit and loss sharing. Deposits in current accounts continued to be accepted but no interest or share in profit or loss was allowed to these accounts. However, foreign currency deposits in Pakistan and on-lending of foreign loans continued as before. The State Bank of Pakistan had specified 12 modes of non-interest financing classified in three broad categories. However, in any particular case, the mode of financing to be adopted was left to the mutual option of the banks and their clients. The procedure adopted by banks in Pakistan since July 1 1985, based largely on mark-up technique with or without buy-back arrangement, was, however, declared un-Islamic by the Federal Shariat Court (FSC) in November 1991. However, appeals were made in the Shariat Appellate Bench (SAB) of the Supreme Court of Pakistan. The SAB delivered its judgment on December 23, 1999 rejecting the appeals and directing that laws involving interest would cease to have effect finally by June 30, 2001. In the judgment, the Court concluded that the present financial system had to be subjected to radical changes to bring it into conformity with the Shariah. It also directed the Government to set up, within specified time frame, a Commission for Transformation of the financial system and two Task Forces to plan and implement the process of the transformation. The Commission for Transformation of Financial System (CTFS) was constituted in January 2000 in the State Bank of Pakistan under the Chairmanship of Mr. I.A. Hanfi, a former Governor State Bank of Pakistan. A Task Force was set up in the Ministry of Finance to suggest the ways to eliminate interest from Government financial transactions. Another Task Force was set up in the Ministry of Law to suggest amendments in legal framework to implement the Courts Judgment. The CTFS constituted a Committee for Development of Financial Instruments and Standardized Documents in the State Bank to prepare model agreements and financial instruments for new system. Within a decade of the first private bank coming into existence in Dubai, the global industry had more than 50 such banks in the same country. Most banks were a result of private initiatives, whereas the first concrete government initiative was taken by the Iranian government, when in 1985 no bank was permitted to give or take interest. Interests was replaced with service charges of 4-8% and guaranteed minimum profits. The true phase of development of Islamic financial institutions actually occurred in the 1980s. Earlier initiatives were more inclined towards interest free Islamic banking, but the emergence of financial systems has evolved in the 80s. However, non payment of interest still remains the pivotal part of Islamic banking, whereas principles of Islamic finance such as property rights, sanctity of contracts and the rules of sharing risk are also supported