Demystifying Demystifying Islamic BankingIslamic Banking

An introduction to An introduction to Islamic BankingIslamic Banking

DedicationDedication

This presentation is dedicated to the This presentation is dedicated to the affected civilians during the uneven affected civilians during the uneven war imposed on Palestine by Israel.war imposed on Palestine by Israel.

Fundamental Questions Fundamental Questions

1.1. Why do we need a different type of Why do we need a different type of banks, while we already have an banks, while we already have an efficient banking system around us? efficient banking system around us?

2.2. How Islamic banks are different How Islamic banks are different from conventional banks?from conventional banks?

3.3. How the major products of Islamic How the major products of Islamic Banks are designed?Banks are designed?

Geographical Distribution of Islamic Geographical Distribution of Islamic banks banks

An Estimate of the industry An Estimate of the industry sizesize

Currently, there are estimated to be Currently, there are estimated to be over 265 Islamic banks with a market over 265 Islamic banks with a market capitalization in excess of US$ 13 billion. capitalization in excess of US$ 13 billion.

Total assets are estimated at over US$ Total assets are estimated at over US$ 262. 262.

Deposits in Islamic banks are estimated Deposits in Islamic banks are estimated to be over US$ 202 billion worldwide.to be over US$ 202 billion worldwide.

The average annual growth rate of the The average annual growth rate of the Islamic banking industry ranged Islamic banking industry ranged between 10-20% over the past decade.between 10-20% over the past decade.

International Dedicated International Dedicated OrgsOrgs

Accounting and Auditing Organization for Accounting and Auditing Organization for

Islamic Financial Institutions (Bahrain). Islamic Financial Institutions (Bahrain).

Islamic Financial Services Board Islamic Financial Services Board

(Malaysia). (Malaysia).

International Islamic Rating Agency International Islamic Rating Agency

(Bahrain)(Bahrain)..

Liquidity Management Centre (Bahrain).Liquidity Management Centre (Bahrain).

International Islamic Financial Market International Islamic Financial Market

(Malaysia).(Malaysia).

Conventional BankingConventional Banking

1.1. It has very rich history of more than It has very rich history of more than a thousand years across the world.a thousand years across the world.

2.2. Facilitates financial intermediation Facilitates financial intermediation with a view to ensuring efficiency.with a view to ensuring efficiency.

3.3. The The business business of a bankof a bank is lending is lending and borrowing. Accepts and borrowing. Accepts loansloans from from depositors in return for interest. depositors in return for interest. Extends Extends loansloans to finance-seekers in to finance-seekers in return for interest. return for interest.

Benefits of Islamic Benefits of Islamic BankingBanking

Completeness of financial marketCompleteness of financial market New products in the market will complement New products in the market will complement

existing conventional products enhancing customer existing conventional products enhancing customer choice.choice.

Competitiveness of financial marketCompetitiveness of financial market New products will strengthen competition in the New products will strengthen competition in the

financial market enhancing consumer surplus.financial market enhancing consumer surplus.

Catering for Muslim investors’ tastesCatering for Muslim investors’ tastes New products promise to conform to religious New products promise to conform to religious

norms ensuring Muslim investors’ purity in financial norms ensuring Muslim investors’ purity in financial life.life.

What are the basic What are the basic objections?objections?

1.1. Islam prohibits interest, in every Islam prohibits interest, in every form. Prohibition came both in the form. Prohibition came both in the Quran and the Hadith.Quran and the Hadith.

2.2. Islam does not allow investments in Islam does not allow investments in projects which are not legitimate projects which are not legitimate themselves in the eye of Islam. themselves in the eye of Islam.

3.3. While efficiency is important, the While efficiency is important, the need for equity has also been need for equity has also been emphasizedemphasized. .

What to do then?What to do then?

There is nothing wrong in the There is nothing wrong in the business of banking. A modern business of banking. A modern society can not do without it.society can not do without it.

All we have to do is to change the All we have to do is to change the business as to make it acceptable in business as to make it acceptable in Islamic framework.Islamic framework.

Islam not only stresses on Islam not only stresses on acceptability of acceptability of whatwhat we do (The we do (The Ends), it also emphasizes on Ends), it also emphasizes on howhow we we do ( The Means) certain things. do ( The Means) certain things.

How to change it?How to change it?

First, we simply remove those aspects of First, we simply remove those aspects of banking that contradict Islamic standards.banking that contradict Islamic standards.

But, we can keep those elements of But, we can keep those elements of banking that don't violate Islamic norms.banking that don't violate Islamic norms.

While making these changes, we refer to While making these changes, we refer to a set of Islamic norms, collectively known a set of Islamic norms, collectively known as as ShariahShariah, which is based on the Quran , which is based on the Quran and The Sunnah (the Prophet’s tradition).and The Sunnah (the Prophet’s tradition).

The Major Objection: The The Major Objection: The RibaRiba

RibaRiba, the Arabic equivalent of interest, , the Arabic equivalent of interest, is the amount of money (or anything is the amount of money (or anything else) that the borrower is obligated to else) that the borrower is obligated to pay to lender in excess to the principle pay to lender in excess to the principle amount.amount.

Conventional banks pay interest on Conventional banks pay interest on deposits and receive interest on loans.deposits and receive interest on loans.

This is the prime reason why This is the prime reason why conventional banks do not conform to conventional banks do not conform to the norms of the norms of ShariahShariah..

Prohibition of RibaProhibition of Riba People who indulge in riba shall be raised like People who indulge in riba shall be raised like

those who have been driven to madness by those who have been driven to madness by the touch of Devil. That is because they say the touch of Devil. That is because they say that a riba-based transaction is like trading, that a riba-based transaction is like trading, while God has permitted trade and prohibited while God has permitted trade and prohibited riba riba (al-Baqarah 2:275)(al-Baqarah 2:275) ..

O believers! Fear God and give up outstanding O believers! Fear God and give up outstanding riba if you are true believers. Watch out! If you riba if you are true believers. Watch out! If you do not obey this commandment, then God do not obey this commandment, then God declares war against you from Himself and declares war against you from Himself and from His Prophet. . But, if you give up your from His Prophet. . But, if you give up your outstanding riba, then you can claim your outstanding riba, then you can claim your principals.principals. (al-Baqarah 2:278-279) (al-Baqarah 2:278-279) ..

What is Riba or interest?What is Riba or interest?

Before moving to an easier definition Before moving to an easier definition of riba, for a definition of interest we of riba, for a definition of interest we can refer to the work of J M Keynes:can refer to the work of J M Keynes:

Interest in economics denotes the Interest in economics denotes the price paid on money in exchange price paid on money in exchange for the use of a sum of money, the for the use of a sum of money, the premium, obtained on current cash premium, obtained on current cash over deferred cash. (Keynes, 1937)over deferred cash. (Keynes, 1937)

A comprehensive Definition of A comprehensive Definition of Riba Riba

The International Institute of Islamic The International Institute of Islamic Economics (IIIE), defines interest in Economics (IIIE), defines interest in ‘the Blueprint of Islamic Financial ‘the Blueprint of Islamic Financial System’ in 1999 as follows:System’ in 1999 as follows: ‘‘Riba is a discrepancy, which Riba is a discrepancy, which

results from the contractual results from the contractual obligation of a party in the obligation of a party in the context of a direct exchange of context of a direct exchange of money between two parties.’money between two parties.’

Interest Vs. Rent, Profit Interest Vs. Rent, Profit and Feesand Fees

Not every known income is interest.Not every known income is interest. Rent is a known payment to use a leased item.Rent is a known payment to use a leased item. Fees are a known payment to buy services.Fees are a known payment to buy services. Interest is a known payment to use Interest is a known payment to use moneymoney.. Profit is the difference between revenue and Profit is the difference between revenue and

costs. It is, however, not known in advance. It is costs. It is, however, not known in advance. It is

therefore not fixed, but variable.therefore not fixed, but variable. Interest forms part of production costs. Profits Interest forms part of production costs. Profits

are the difference between revenues and costs.are the difference between revenues and costs.

So “Loan” can’t be a So “Loan” can’t be a business tool!business tool!

Islam does not allow anyone to give and Islam does not allow anyone to give and take anything extra on a loan. take anything extra on a loan.

But, today banks make money from the But, today banks make money from the loan business.loan business.

Depositors receive interest on their loan Depositors receive interest on their loan to banks. Banks receive interest on their to banks. Banks receive interest on their loans to Entrepreneurs (Finance-seekers).loans to Entrepreneurs (Finance-seekers).

Islamic banks cant make use of such Islamic banks cant make use of such loans.loans.

Where to strike, then?Where to strike, then?

Basic Business Contracts Basic Business Contracts AvailableAvailable

PartnershipPartnership Mudharaba (Profit-Sharing agreement)Mudharaba (Profit-Sharing agreement) Musharaka (Profit and Loss Sharing Musharaka (Profit and Loss Sharing

agreement)agreement) Trade / SaleTrade / Sale

Murabaha ( Cost-plus Sale)Murabaha ( Cost-plus Sale) Bai Muajjal (Cost-plus sale with deferred Bai Muajjal (Cost-plus sale with deferred

payment)payment) Leasing Leasing

Ijara (Operating lease)Ijara (Operating lease)

Initial or Classical ModelInitial or Classical Model

Two-Tier Mudharaba or PartnershipTwo-Tier Mudharaba or Partnership On the Liability side, banks (i.e. On the Liability side, banks (i.e.

shareholders) form a partnership with shareholders) form a partnership with depositors to invest funds. They agree on the depositors to invest funds. They agree on the profit sharing ratio.profit sharing ratio.

On the Asset side, banks form partnership On the Asset side, banks form partnership with entrepreneurs or finance-seekers. They with entrepreneurs or finance-seekers. They agree on a profit sharing ratio as well.agree on a profit sharing ratio as well.

The difference between two ratios The difference between two ratios contributes towards bank profits after contributes towards bank profits after deducting costs. deducting costs.

Deposit ProductsDeposit Products

1. Current Account 1. Current Account

It is organized as It is organized as wadiah or safe-keeping. wadiah or safe-keeping.

The deposits are held in trust and utilized The deposits are held in trust and utilized

by the bank at its own risk. by the bank at its own risk. There is no big difference here between There is no big difference here between

conventional and Islamic banks, as conventional and Islamic banks, as

normally no interest is paid on such normally no interest is paid on such

account.account.

2. Savings Account2. Savings Account

This account is based on This account is based on MudharabaMudharaba

principle. principle.

Depositors are owners of funds and the bank Depositors are owners of funds and the bank

is owner of labor. is owner of labor.

Profits are shared by both parties as per pre-Profits are shared by both parties as per pre-

agreed ratio fixed through negotiation. agreed ratio fixed through negotiation.

If loss occurs, it is borne by depositor only as If loss occurs, it is borne by depositor only as

owners of fund. The bank loses its effort. owners of fund. The bank loses its effort.

3. Investment Account3. Investment Account

Core deposits of an Islamic bank. Based on the Core deposits of an Islamic bank. Based on the

concept of concept of MudharabaMudharaba. Islamic counterpart of . Islamic counterpart of

the conventional fixed deposit products.the conventional fixed deposit products.

1. General Investment Deposits: 1. General Investment Deposits: Open to any Open to any

project as selected by the bank.project as selected by the bank.

2. Special Investment Deposit: 2. Special Investment Deposit: Tied to any Tied to any

specific project agreed upon by both parties.specific project agreed upon by both parties.

Financing Products (Variable Financing Products (Variable Income)Income)

11 . .Trustee Partnership (Trustee Partnership (MudharabaMudharaba))

The bank provides capital finance for a specific The bank provides capital finance for a specific

venture indicated by the customer. venture indicated by the customer.

The bank is the owner of the capital and the The bank is the owner of the capital and the

customer-entrepreneur provides labor. customer-entrepreneur provides labor.

Profit is shared according to a pre-agreed ratio. Profit is shared according to a pre-agreed ratio.

Losses, if any, are entirely absorbed by the bank.Losses, if any, are entirely absorbed by the bank.

2. Joint Venture (2. Joint Venture (MusharakaMusharaka))

Both the bank and its customer-client contribute to Both the bank and its customer-client contribute to

entrepreneurship and capital. entrepreneurship and capital.

The customer and the bank agree to combine The customer and the bank agree to combine

financial resources to undertake any type of business financial resources to undertake any type of business

venture, and agree to manage it together. venture, and agree to manage it together.

Profits are shared between the bank and the Profits are shared between the bank and the

customer in the pre-agreed ratio. Losses are shared customer in the pre-agreed ratio. Losses are shared

in proportion to their respective capital share. in proportion to their respective capital share.

2A. Declining 2A. Declining MusharakaMusharaka: An Innovation: An Innovation

A declining A declining Musharaka Musharaka is a recent phenomenon. is a recent phenomenon.

In it, the bank's share in the equity is diminished In it, the bank's share in the equity is diminished

each year through partial return of capital. each year through partial return of capital.

The bank receives periodic profits based on its The bank receives periodic profits based on its

reduced equity share that remains invested during reduced equity share that remains invested during

the period. the period.

The share of the client in the capital increases over The share of the client in the capital increases over

time, resulting in complete ownership of the venture.time, resulting in complete ownership of the venture.

Areas of ApplicationAreas of Application

Mudharaba Mudharaba is useful for financing projects, is useful for financing projects,

such as, real estate, construction of such as, real estate, construction of

buildings, corporate plants etc. buildings, corporate plants etc.

Musharaka Musharaka is suitable for financing any kind is suitable for financing any kind

of business venture, where the bank is of business venture, where the bank is

willing to act as partner.willing to act as partner.

Diminishing Diminishing Musharaka Musharaka is used primarily in is used primarily in

the area of housing finance.the area of housing finance.

Financing Products (Predictable Financing Products (Predictable Income)Income)

Early models of Islamic banks are based Early models of Islamic banks are based

on a two-tier on a two-tier Mudharaba Mudharaba or partnership or partnership

structure. structure.

Subsequent models of Islamic banks use Subsequent models of Islamic banks use

an expanded framework of debt-based an expanded framework of debt-based

mechanisms, e.g. , mechanisms, e.g. , Murabaha, Bai MuajjalMurabaha, Bai Muajjal

and and Ijara, Ijara, where income can be predicted. where income can be predicted.

3. Deferred Payment (3. Deferred Payment (Bai MuajjalBai Muajjal) or Cost-) or Cost-Plus Sale (Plus Sale (MurabahaMurabaha))

Bai Muajjal Bai Muajjal is a sale where payment of is a sale where payment of price is deferred to a future date. Often it price is deferred to a future date. Often it includes features of a includes features of a MurabahaMurabaha, which , which implies a sale on a cost-plus basis. implies a sale on a cost-plus basis.

As a financing product, As a financing product, Bai Muajjal and Bai Muajjal and Murabaha Murabaha is a very popular, and perhaps is a very popular, and perhaps the most popular Islamic financing the most popular Islamic financing product. product. Bai Muajjal Bai Muajjal is a is a Shariah Shariah approved approved mechanism. So is mechanism. So is Murabaha.Murabaha.

A Simple model of A Simple model of MurabahaMurabaha

1. Client identifies supplier of the commodity that he/ she needs, collects all relevant information;

2. Client approaches Bank for Murabaha finance and promises to buy the commodity from the Bank at a marked-up price;

3. Bank makes payment of base price to supplier;

4. Supplier transfers ownership of commodity to Bank;

5. Bank sells it to the Client at marked-up price;

6. Client pays marked-up price in full or in parts over future (known) time period(s).

4. Leasing (4. Leasing (IjaraIjara))

Ijara Ijara in simple terms, implies leasing or in simple terms, implies leasing or hiring of a physical asset. hiring of a physical asset.

It is a popular product in which the bank It is a popular product in which the bank assumes the role of a lessor and allows its assumes the role of a lessor and allows its client to use a particular asset that it client to use a particular asset that it owns. owns.

The client or lessee, is in need of the The client or lessee, is in need of the asset. asset.

Through Through ijaraijara, it has chance to generate , it has chance to generate income using the asset against payment income using the asset against payment of predetermined rentals. of predetermined rentals.

A Simple model of A Simple model of IjaraIjara

1. Client identifies supplier of the asset that 1. Client identifies supplier of the asset that he/she needs, collects all relevant he/she needs, collects all relevant information;information;

2. Client approaches Bank for 2. Client approaches Bank for ijara ijara of the asset of the asset and promises to take the asset on lease;and promises to take the asset on lease;

3. Bank makes payment of price to supplier;3. Bank makes payment of price to supplier;4. Supplier transfers ownership of asset to 4. Supplier transfers ownership of asset to

Bank;Bank;5. Bank leases the asset, transfers possession 5. Bank leases the asset, transfers possession

and right of use to Client;and right of use to Client;6. Client pays 6. Client pays ijara ijara rentals over future (known) rentals over future (known)

time period(s).time period(s).