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M. Kabir Hassan, Rasem N. Kayed, and Umar A. Oseni: Introduction To Islamic Banking and Finance: Principles and Practice
M. Kabir Hassan, Rasem N. Kayed, and Umar A. Oseni: Introduction To Islamic Banking and Finance: Principles and Practice
M. Kabir Hassan, Rasem N. Kayed, and Umar A. Oseni: Introduction To Islamic Banking and Finance: Principles and Practice
Chapter 1
Introduction to Islamic
Banking and Finance
Subject Aims:
The key aim of this subject is to assist students in understanding the
theory and practice of Islamic banking, based on the contemporary
situations. At the end of the course, students will be able to:
The Qur’an
• The first source of the Shari’ah
• General and specific rules on religious, commercial, political,
economic, legal and social norms
• Emphasis on mutual consent and consensus among
consenting parties
• Prohibits exploitative measures:
– Excessive risk or uncertaintly (gharar)
– Usary or interest (riba)
• Mit Ghamr Local Savings Bank in Egypt of 1963 (“the first modern-day trial
of Islamic baking”)
• The new birth of modern Islamic finance took place in Dubai in 1975
through Dubai Islamic Bank as the first Islamic commercial bank in the
world. At the same time, IDB established and started Islamic Finance.
Learning Objective 1.2
Explain the historical
Origins and Historical Overview of development and
conceptual arguments of
Islamic Banking and Finance Islamic banking and
finance
• Retail banking
• Corporate banking
• Real estate
• Investment banking
In the News: The Vatican says Islamic Finance May Help Western Banks in Crisis
“The ethical principles on which Islamic finance is based may
bring banks closer to their clients and to the true spirit which
should mark every financial service,” (the Vatican’s official newspaper
Osservatore Romano)*
• *A Lorenzo Totaro 2009 'Vatican Says Islamic Finance May Help Western Banks in Crisis, Bloomberg.com, viewed on 17 February 2010
http://www.bloomberg.com/apps/news?pid=20601092&sid=aOsOLE8uiNOg&refer=italy
Islamic Banking and Finance around the world
"The LM Australian Alif Fund has been awarded 'Best New Product
2009' at the world's leading Islamic Banking and Finance awards in
Dubai for its innovative approach to Shariah-compliant investment,
beating a shortlist of prominent international Islamic institutions'‘
http://www.lmaustralia.com
What is Islamic Banking?
Definition:
“an Islamic bank is a financial institution whose statutes, rules
and procedures expressly state its commitment to the principle
of Shariah and to the banning of the receipt and payment of
interest on any of its operation…” (OIC)
Moreover, the Malaysian Islamic Banking Act 1983, defines an
Islamic bank as
“… a company which carries on Islamic business. Islamic business
means banking business whose aims and operations do not
involve any element which is not approved by the religion of
Islam…”
Thus, Islamic banking is banking that complies with Shari’ah or
Islamic law.
The Banking Business
1. Bank is an authorized deposit-taking institution (ADI)
2. Facilitates intermediation between savers and investors.
3. Transfer funds from surplus units to deficit units.
4. It manages payments and clearing systems (EFTPOS, Cards,
BPAY, Cheques,…)
In the News: The Vatican says Islamic Finance May Help Western Banks in Crisis
“The ethical principles on which Islamic finance is based may
bring banks closer to their clients and to the true spirit which
should mark every financial service,” (the Vatican’s official newspaper
Osservatore Romano)*
• *A Lorenzo Totaro 2009 'Vatican Says Islamic Finance May Help Western Banks in Crisis, Bloomberg.com, viewed on 17 February 2010
http://www.bloomberg.com/apps/news?pid=20601092&sid=aOsOLE8uiNOg&refer=italy
Islamic Banking and Finance around the world
Play
Old Testament
• If you lend money to one of my people among you who is needy, do
not be like a money lender; charge him no interest (Exodus 22:25).
• Do not take interest of any kind from him, but fear your God, so that
your countryman may continue to live among you (Leviticus 25:36).
• Do not charge your brother interest, whether on money or food or
anything else that may earn interest (Deuteronomy 23:19).
• Hath given forth upon interest, and hath taken increase: shall he
then live? He shall not live: he hath done all these abominations; he
shall surely die; his blood shall be upon him (Ezekiel 18:13).
New Testament
• But love ye your enemies, and do well, and lend, hoping for
nothing again; and your reward shall be great, and ye shall be
the children of the Highest: for he is kind unto the unthankful
and to the evil (Luke, 6:35).
In Judaism and Christianity, lending money in order to receive a
profit was strongly condemned. In the Talmud, Ezekiel
condemned interest as an abomination. He also likened
usurers to people who shed blood. In Judaism, the distinction
was made between Jews and gentiles. They tolerated charging
interest to gentiles, yet, were forbidden to practice it with their
own fellow brethren (Deuteronomy 23:20).
Pope Alexander III (12th Century) excommunicated usurers, which
in that period was seen as an extremely harsh punishment. In
1317 the Council of Vienna took a strong stance and issued a
law that usurers were to be excommunicated. However, by the
fifteenth century in Europe, usury practices gradually gained
ground and acceptance.
Riba ( ا لرباInterest or Usury)
• Riba is strongly prohibited in Islam. The many verses of the
Qur’an leave no question in this regard: “Allah has permitted
trade and forbidden riba.” (Qur’an: Surah Al-Baqarah 2:275).
The verses prohibiting riba are located in four Surahs of the
Qur’an; Surah Al-Baqarah 2:275-276, 278-280; Surah Aal
Imran 3:130; Surah An-Nisaa 4:161 and; Surah Ar-Room 30:39.
• Riba is further elaborated on in the Prophet’s Sunnah.
Numerous hadiths explain the details surrounding riba. In a
hadith narrated by the Prophet’s companion Jaabir: “Allah’s
Messenger cursed the one who accepts riba, the one who
gives it, the one who records it and the two witnesses to it,
saying, ‘They are all the same.’” (Collected By Muslim).
Types of Riba:
• There are two major categories of riba.
• The first category is known as Riba An-Nasee’ah which relates
to riba in debt. It increases with time (e.g. interest on
borrowed money). This is the most common type of riba today
and it relates to return of money on money at any rate (fixed
or floating, compounded or simple interest).
• Although gold and silver were the real currency at the time,
the Prophet described certain commodities that relate to riba.
These commodities are prohibited to exchange, same for
same, unless they are of equal amount, without increase. One
hadith states, “Gold with gold, silver with silver, wheat with
wheat, barley with barley, dates with dates, and salt with
salt; same quantity for same quantity, equal for equal;
transaction being made hand to hand (i.e. on the spot
payment)” (Muslim).
• Some scholars have stated that these commodities are only
limited to the six mentioned. Other scholars, by making Qiyas
(analogy), have stated that it can also include other
commodities that can be weighed, or other food, or specific
food which can be stored similar in nature to the six.
Riba Al-Fadl - Riba in Exchange (cont)
• However, gold and silver are the universal tenders like cash
money today. The remaining four commodities may have been
used in a similar fashion to currency.
• Another hadith mentions, “Do not sell gold for gold unless it is
the same amount for the same amount, and do not make one
amount greater than the other. Do not sell silver for silver
unless it is the same amount and do not make one greater
than the other.” (Bukhari and Muslim).
Riba Al-Fadl - Riba in Exchange (cont)
• The following narration sheds light on this form of riba with the
exchange of these types of commodities. A hadith mentions, “Once
Bilal brought Barni (a kind of dates) to the Prophet and the
Prophet asked him, ‘From where have you brought these?’ Bilal
replied, ‘I had some inferior type of dates and exchanged two Sa’s
(approximately 6 kilograms) of it for one Sa’ (approximately 3
kilograms) of Barni dates in order to give it to the Prophet to eat.’
Thereupon the Prophet said, Beware! Beware! This is definitely
Riba! Don’t do so, but if you want to buy (a superior kind of
dates), sell the inferior dates for money and then buy the superior
kind of dates with the money” (Bukhari).
• This hadith shows the prohibition of exchanging the same
commodity of a different measurement, yet it also displays the
alternative solution. That is to sell the dates, and buy the other
dates with the money.
Riba rules - summary
• The commentator of Sahih Muslim, Imam Nawavi has
summarized these rules in the following way:
• When the underlying ‘Illah of the two goods being exchanged is
different, shortfall/excess and delay both are permissible, e.g.
the exchange of gold for wheat or dollars for a car.
• When the commodities of exchange are similar, excess and delay
both are prohibited, e.g. gold for gold or wheat for wheat,
dollars for dollars, etc.
• When the commodities of exchange are heterogeneous but the
‘Illah is the same, as in the case of exchanging gold for silver or
US Dollars for Japanese Yen (medium of exchange) or wheat for
rice (the ‘Illah being edibility), then xcess/deficiency is allowed,
but delay in exchange is not allowed. (Ayub 2007, p.52)
Wisdom behind the prohibition of riba as put
forward by some scholars.
• It goes against mutual cooperation, generosity, and
spirit of partnership.
• Acquisition of property by wrongful means and harm to
the needy.
• Removal of the possibility for injustice and exploitation.
• Drives the capital-owner away from enterprise and real
economic activities that contribute to the welfare of
society (e.g. commerce, manufacturing, construction
and so on)
• Money is meant to be a medium of exchange and
standard of value for other goods. Riba violates the
entire rationale behind money and diverts money from
doing what it is meant to do.
2. The Prohibition of Gharar (Uncertainty)
Major Gharar
• Causes for alarm are the major or substantial forms of gharar
which are clearly condemned from a Shari’ah perspective. Major
Gharar will be simply referred to as gharar in the rest of the
lecture notes.
• Gharar can generally refer to the following:
• Lack of Transparency -The Shari’ah stipulates that
transparency must exist in order for contracts to be legitimate.
For example, the terms of the contract must be clear to both
parties involved in order to be just and fair. Under such
measures, individuals are protected from fraud, deceit and
exploitation.
• Deception - Gharar can also imply deceit.
Once Prophet Mohammad came upon a heap of grain in the
market of Madinah and thrust his hand onto it. His fingers felt
dampness. On being asked, the trader replied that rain had
fallen upon it. The Prophet observed, "Why did you not then
keep (the wet portion of) it above the dry grain, so that
people may see it? He who deceives, has nothing to do with
me” (Muslim). Therefore, relevant information cannot be
withheld.
• Selling what you do not have
Sanctity of Contract
• As excessive gharar is impermissible in Islam, the Shari’ah
emphasizes that contracts must include transparency and
honesty. Prices should be specified, there should be clarity of
the delivery details, quality of goods, quantity of goods etc.
The information should be available to all parties involved and
the outcomes of a contract should be free of ambiguity.
• When full disclosure is present, both parties eliminate or
reduce financial speculation and undue complexity in
contracts (due to gharar). This will include discloser of the risk
involved by providing as much information as possible for
buyers or investors.
3. Sanctity of Contract (cont)
• If two or more parties come together for a partnership (e.g.
musharakah), all parties should be aware of their profit-
sharing ratio, underlying assets involved, and other conditions
of the contract.
• The parties involved must mutually agree on the sale or
contract, albeit orally or preferably in written form, without
coercion.
• Contracts must be in accordance with Shari’ah principles.
Therefore, investments considered unethical, unlawful
(haram), unjust etc, would not be considered. Although riba
and gharar may not be involved, one must make sure that
other unlawful practices are not present. For example, it is
prohibited to finance a casino or deal with alcohol etc.
Case study: Riba & Gharar today
$2.5mil Profit
$7.5mil Profit
Musharaka - example
Home Purchase
Ownership %
Bank Customer
Bank Transfer of ownership 80%↓ 20%↑
Customer 70%↓ 30%↑
Payment for piece of 60%↓ 40%↑
property (eg. 10%)
50%↓ 50%↑
40%↓ 60%↑
Rent % Rent % 30%↓ 70%↑
20%↓ 80%↑
10%↓ 90%↑
Price 80% Price 20% 0%↓ 100%↑
Bank’s
Bank’s participation diminishes over
time
time until customer becomes
becomes sole
sole
owner of
of the property.
property.
Mudaraba (Trustee or Investment
Partnership)
• Such a contract requires one partner with the funds, known as
Rabb-ul-Mal (Owner of Wealth), and one partner is the
Mudarib (Entrepreneur, Fund Manager). There can be more
than one Mudarib to work together as partners with the Rabb-
ul-Mal.
• If the business or project is a success, the profit is shared
according to a pre-agreed ratio. Typically, the Rabb-ul-Mal
bears the risk of losing money, while the Mudarib loses time and
effort if the project does not bear fruit.
• The Rabb-ul-Mal may specify where they want the Mudarib to
invest their money (Al-Mudaraba Al-Muqayyada – specific or
restricted Mudaraba, eg. Specific type of business of place).
Otherwise, the Mudarib is free to invest where they best see fit
(Al-Mudaraba Al-Mutlaqa – unrestricted or general investment
(Mudaraba), unrestricted by time, place, activity and so on).
Mudaraba (Investment Partnership)
Share of profits
capital
Investor
Business
Profit
Mudarib management Venture
(entrepreneur)
Share of profits
Profit can not be a fixed amount (for PLS financing) but must be determined
by a pre-agreed ratio. In case of loss, the investor loses capital and the
mudarib loses time
time and
and effort. In
In the
the case
case of proven
proven negligence by the
the
mudarib,
mudarib, the mudarib may be liable
liable for
for capital
capital as well.
ISLAMIC BANKING - FIN5BNK
Murabaha (Cost Plus Sale) - Bai’ bithaman ajil (BBA, deferred payment) - Ijarah (Leasing)
- Bai’ As-Salam (Deferred Delivery Sale) - Bai’ Al-Istisna’ (Manufacturing Sale) - Bai’
Al-Istijrar (Suply Sale) - Qard Hasan
Contentious Instruments: Bai’ Al-Einah (Back to back repurchase) - At-Tawarruq
(Tripartate Sale) - Bai’ Al-Dayn (Sale of Debt, Bill discounting)
Goods Goods
(immediate (immediate
Goods delivery) delivery)
Bank
Supplier
$100,000 $130,000 Customer
(spot payment) (deferred
Bank must own payment,
the asset before including profit
selling it. mark up)
In Bai-al-Einah, identity
of the customer &
supplier is the same.
Goods Customer ends up with
$100 Bank $100 (cash) and
Customer (spot deferred debt of $110
payment) is created.
Goods Goods
(immediate (immediate
Goods delivery) delivery)
Bank
Supplier Customer
$100,000 $130,000
A
(spot payment) (deferred
payment)
*Representing Note:
deferred
payment of Selling more money (later) for
money. less money (now).
Eg $115.
Transfer of debt only allowed at
par value in order to prevent
creation of riba (interest).
Questions?
ISLAMIC BANKING - FIN5BNK
Main Deposit accounts: Current (Wadiah/Qard) account - Savings (Wadiah/Mudaraba) account - Investment (Mudaraba) account - Debit and Charge cards
Deposit Financi
accounts: Deposits
1.
Bank ng Equity-
Produc Based
Current (Financial ts Debt-
(PLS)
account Based
Intermedia (Non-PLS)
Deposit products (cont)
• Deposit accounts play a key role, not just for banks, but for the
economy in general. Much of the wealth kept within the trust of
a bank is utilized in investments, financing businesses etc. This in
turn helps the workforce and stimulates productivity via a
number of PLS and debt-based modes of financing. Islamic banks
therefore, with deposits from customers, utilize these modes of
financing to provide a sustainable service to the community.
• While mobilizing in a Shari’ah compliant manner, other issues
such as risk, return, liquidity, maturity, safety, and stability are
considered before offering the right deposit account that would
satisfy customers’ needs.
Current accounts
Debit Cards
• As offered by conventional banks, the debit card is a
useful alternative to credit cards. The card is merely a
prepaid card and therefore does not assist users by
falling into debt and most importantly, paying interest.
Debit cards fulfill the same purposes of credit cards
like online purchases (such as airline tickets). The
major difference is that customers must upload their
own money to use the debit card. Likewise, debit cards
also allow cash withdrawals from ATMs worldwide.
Some banks charge a monthly or annual access fee,
while some banks charge no fees.
In 2010 a ‘Halal-approved MasterCard’ was officially launched in
Canada. It is known as the iFreedom Plus MasterCard. Although
it is only a prepaid card, it was endorsed by a number of Muslim
scholars and likewise it offers a range of discounts when used
(such as 10% discount
with Etihad Airways).
Other Shari’ah Compliant Cards
• Other cards function for the purpose of providing the customer
with the means to purchase, however they incur a debt that
must be repaid. Islamic Charge cards for example, function
according to Al-Eenah or Tawarruq where the bank makes a
profit through the transactions. It is an attempt to replace the
credit card by means of supplying credit for customers. Yet it
bears the hallmarks of a real credit card and for that reason it
finds much criticism.
• Some banks promote Shari’ah compliant credit cards. These are
advertised as bearing no interest and no hidden costs. The
customer pays an annual fixed fee which can be paid monthly.
This fee is seen as ijarah for the services provided (or Ujrah).
There is a grace period like a conventional credit card contract,
thereafter penalties apply for late payments.
• Late Fees
According to Taqi Usmani, to incur a fee for the late payment
resembles Riba An-Nasee’ah (Riba of Debt) where the lender
would say, “pay up or pay riba (increase)”. However, some
scholars may tolerate a fee for overdue payments providing the
fee does not go to the bank, lessor, lender etc. It should be
stipulated that the fee will be given to a charity. This may act as
a deterrent for the debtor to delay payments.
ISLAMIC BANKING - FIN5BNK
• Liquidity management
means ensuring that the
bank has sufficient liquid
funds available for a smooth
running of its operation in
order to meet short term
financial obligations as and
when due.
Liquidity Management (cont)
Quantitative Screens
Debt/Asset Ratio
Interest-related Income
Monetary Assets
Industry screening:
The main concern relates to the type of industry the company is
involved in. The general rule is that most business activities are
permitted (halal) unless specifically prohibited by the Shariah. For
that reason, if the main business of the company is halal
(permissible) and Shariah prohibitions are avoided (e.g. Riba),
then shares of such a company are also permissible.
It is not acceptable to buy/sell shares of a company that is
involved with un-Islamic/unlawful (haram) products or services,
such as, gambling, alcohol, pork, tobacco products, interest based
financial institutions like banks and Insurance companies, adult
products and so on.
Business practices
Islamic principles relating to investing and trading stipulate that the
acquisition of shares, from an investor’s point of view, must also be
done in a Shariah compliant way. The following two principles must
be observed while investing:
2. Prohibition of speculation
Entering market as a speculator and thus making short-term
speculative investment decisions is not allowed (This is fundamental
difference between a true investor which is allowed and a
speculator).
Quantitative Screens
There are three types of quantitative screens:
1. Debt/Asset Ratio
Question of debt to asset ratio and how much has the company
borrowed? Usually it should not exceed 33%. What if it is interest
based? What if it is not? Is a ratio of 33% acceptable?
2. Interest-related Income
Does the company generate any interest or interest-related
income? (For instance, where earning interest is not their business,
but their surplus funds are placed in investments that yield interest
income). What if it is less than 5%? What if this 5% of the dividend
earnings is given in charity? Difference of opinions- Why?
Quantitative Screens (cont)
• 3. Monetary Assets
To invest in Shariah compliant companies, one has to be very
careful that non-liquid assets be over 51% (note that this ratio
is the matter of ijtihad). The reason is that money cannot be
traded except at par value.
i. Day Trading
Buying and selling on short-term price fluctuations (normally
within one day) is closer to gambling and speculation than
actual investing. Should it be prohibited?
Modes of Investing:
• Equity fund (investment in the shares of a joint stock company)
• Ijarah Fund (investment used to purchase assets for the purpose
of leasing)
• Commodity Fund (used for purchasing of different commodities
for the purpose of the resale)
• Murabaha Fund (sale on a cost plus basis, deferred payment
basis)
• Mixed Fund (Tangible assets must be over 51%. If liquidity and
debt exceed 50%, it can not be traded [it must be a closed- end
Fund])
Modes of Investing:
• However, point iii is the truly unique factor of the ICG model.
Such governance requires a Shari’ah Supervisory Board (SSB).
Industries that are Islamic, or provide Islamic windows, rely
heavily on the endorsement, assistance and advice of SSBs.
• Islamic corporate governance (ICG)
seeks to devise ways in which economic
agents, the legal system and corporate
governance can be directed by moral
and social values based on Shariah laws
(M Bhatti & I Bhatti, 2009).
• Model is also analogous to the
proposed OECD principles emphasizing
the mechanisms of business ethics,
decision-making, bookkeeping and final
accounts, and also of adequate
disclosure and transparency (M Bhatti
& I Bhatti, 2009).
principles:*
• 1. Ensuring the basis for an effective corporate governance framework.
• 2. The corporate governance framework should protect and facilitate
the exercise of shareholders’ rights.
• 3. The corporate governance framework should ensure the equitable
treatment of all shareholders, including minority and foreign
shareholders. All shareholders should have the opportunity to obtain
effective redress for violation of their rights.
• 4. The role of stakeholders in corporate governance is to be recognized
by creating wealth, jobs and sustainability of financially sound
enterprises.
• 5. Disclosure and transparency
• 6. The corporate governance framework should ensure the strategic
guidance of the company, the effective monitoring of management by
the board, and the board’s accountability to the company and the
shareholders. * (M. Bhatti & I. Bhatti, 2009)
• Islamic corporate governance as based on the ‘stakeholder
model’ of corporate governance as shown below.
• Others include:
• The International Islamic Financial Market (IIFM)
• The General Council for Islamic Banks and Financial Institutions (GCIBFI)
ISLAMIC BANKING - FIN5BNK
• Zakah is fard (compulsory) for the Muslim who has the nisab. If the
individual does not have the nisab, the obligation is lifted from
them. The nisab is regarded as a threshold. Those who have savings
at or above the nisab are obligated to pay Zakah.
• In the time of the Prophet, the nisab was fixed at twenty gold coins
(dinars) or two-hundred silver coins (dirhams). Whoever possessed
twenty gold coins was commanded to give ½ a gold coin (2.5% or
1/40) in Zakah. Those who had 200 silver coins were commanded to
give 5 silver coins. Twenty gold coins in the time of the Prophet
equated to 85 grams of gold and 200 silver coins equated to 595
grams.
• Therefore, to find the nisab equivalent today for money, one
must look to the current price of gold. There are scholars who say
that the nisab should be based on the value of silver as it is lower
in value and will enable an additional flow of funds to the needy.
In Australia August 2010, the value of 85 grams of gold
approximated AUS $3560. Anyone with this amount in net
savings or more is liable to pay Zakah. If we were to use the value
of silver to measure the nisab of money, the nisab would be
approximately AUS $375. Note that the prices of gold and silver
fluctuate, therefore, calculations must be based on current
values.
• Before one calculates their savings, they must take into
consideration any liabilities that must be paid. For example, each
year when Uthman (the third Caliph) would announce to the
people regarding Zakah, he would command the people to pay
their debts first, then calculate their Zakah on what remains.
Administration of Zakah
• Qatar is another hot spot for IBF in the Middle East. There are
four major Islamic banks in Qatar, namely Qatar Islamic bank
(1983), Qatar International Islamic bank (1991), Doha Islamic
Bank (2006) and Al Rayan Bank (2006).
• Other IFIs include; First Finance company, Investment House,
Al-Jazeera Islamic Company and Islamic Financial Securities
which mainly offers Islamic retail products and brokerage
services to Muslim clientele. Qatar Islamic Insurance company
has emerged as one of the leading insurance service providers
in the country.
Middle East Case (cont)
• The SBP took the first step towards Islamization by directing all
banking institutions to open PLS counters in 7,000 domestic
branches across the country from January 1981.
• The SBP allowed banks to invest PLS funds to finance interest-
free trading.
• The foreign banks working in Pakistan also showed keen
interest in adopting the new system. They sent their top
officials to overseas Islamic banks for training and better
understanding of the IBF practice
Malaysian Case