What is Islamic Banking?
Islamic banking refers to a
system of banking or banking activity that is consistent with the principles of
the Shari'ah (Islamic rulings) and its practical application through the
development of Islamic economics.
Islamic banking has the
same purpose as conventional banking except that it operates in accordance with
the rules of Shari’ah, known as Fiqh al-Muamalat(Islamic rules on
transactions).
Islamic banking activities
must be practiced consistent with the Shari’ah and its practical application
through the development of Islamic economics.
The principle source of the
Shari’ah is The Qur’an followed by the recorded sayings and actions of Prophet
Muhammad (pbuh) – the Hadith. Where solutions to problems cannot be found in
these two sources, rulings are made based on the consensus of a community
leaned scholars, independent reasoning of an Islamic scholar and custom, so
long as such rulings do not deviate from the fundamental teachings in The
Qur’an.
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.
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 banking.
How Islamic Banks Operate
One
of common questions on Islamic banking is how Islamic banks are operating
without interest. Where the normal banking practices do not clash with the
Islamic principles, the Islamic banks have adopted the current banking tools
and procedures. Where any clash arises, the Islamic banks have devised their
own tools and procedures to accomplish their banking activities. Such tools and
procedures that have been devised so far are enumerated below:
A. Deposits
Islamic Banks receive
two types of deposits:
a.
deposits not committed
for investment which take the form of current accounts or savings accounts, and
b.
deposits committed for
investment which are called Investment Accounts.
Whereas Current Account is operated in the same way as it is operated in the
conventional banking system, the Savings Accounts and Investment Accounts are
operated differently as discussed below:
Savings Accounts
This is an account
where the customers can deposit their savings. Though these depositors allow
the banks to use their money, they get a guarantee of getting their full amount
bank from the bank. In this case, the Bank guarantees their savings but is not
obliged to pay any rewards to the savers. However, most of the banks are still
paying either a cash reward from their profits at the end of their financial
year or are giving some privileges to the holders of these accounts, e.g.
providing financial support for small projects, sale of consumer durables or
producers goods by instalments, distributing gifts etc. These rewards are
discretionary and not obligatory and are paid only in case the bank is earning
substantial profits. On accounts that have no risks, this much profit is not
understandable. Without facing any risk of loss, how can they share in the
profit? The Savings Accounts share the net profit of the bank according to some
agreed proportion.
Investment Accounts
These Investment
Accounts can be of two types:
a.
Accounts with
authorisation, and
b.
Accounts without
authorisation.
In the accounts with
authorisation, the account holder authorises the bank to invest this money in
any one of its projects. After the expiry of a specified period, the account
holder will get the profit. In case of investment accounts without authorisation,
the account holder may choose any particular project for investment of his
deposited money. (The account holder, may or may not specify the period of
deposit.) The bank will give share to the account holder from the profit of
that particular project which has been chosen by him according to agreed
percentage. If the investment accounts are opened for a fixed period, the
customer is not allowed to withdraw his money before the lapse of the specified
period. If he does so, the customer either is not entitled to the share in
profit at all or may be entitled to receive some discounted profit depending
upon the duration of the deposit with the bank.
Investment accounts
are generally popular in these banks. Savings Accounts are equally popular only
in those banks where these accounts are entitled to share the profits of the
bank. Where the Savings Accounts are not entitled to share the profits, the
deposits in these accounts are negligible.
B. Investment Activities
As the bank cannot
earn interest by lending the money, therefore, the Islamic banks have to
undertake investment to earn profit not only for the bank itself but also for
the depositors in the investment account. The investment procedures based on
the Islamic principles are given below:
Musharkah (Equity
Participation)
The banks and their
clients agree to join in a temporary participation (not quite different from
the joint venture concept) for effecting a certain operation within an agreed
period of time. Both parties contribute to the capital of the operation (taken
to mean, assets, technical and managerial expertise working capital etc.) in
varying degrees and agree to divide the net profit in proportions agreed upon
in advance. There is no set formula for profit-sharing and each case is dealt
with on its own merits. Operations carried, according to this mode, can vary
from weeks to years. In medium- and long-term operations, a self- liquidating
form of participation can be agreed upon; whereby the ownership of the whole
project or operation may pass to the partner (customer). The bank would have
retrieved, in the meantime, an agreed share of profits. The bank may also
permanently participate in any establishment or building or factory or agriculture
till the liquidation of the firm, or may participate temporarily promising to
with- draw its share by selling the same to the partners (and partners also
promising the same) by paying the bank’s amounts at once or on instalments as
per mutual agreement among them. This procedure is also being applied to a few
activities other than the investment project. Some of these activities are:
i.
Letter of Credit. If
the importer fails to pay the full amount of the letter of credit at the time
of the delivery of goods, the bank will not charge him any interest on
postponing the payment and will instead, share in the profits of the importer
at a ratio agreed upon in advance. Some of the Islamic banks, however, charge
nothing if the amount is paid in full at the time of the delivery.
ii.
Purchase of Property
or Real Estate. The bank may provide loans for such purchases on the basis of
musharkah. The bank will assess the rent or annual income from the property or
real estate and will share it according to the extent to which he is financing
and according to the terms agreed in advance. As the client pays up the
instalments of the loan, the bank’s share in the income will be reduced till
the whole property is transferred to the client.
Mudarabah or Qiradh
(Agencies)
In this procedure of
investment, bank contributes all the financing (and the customer contributes
only his managerial efforts or labour) and gets again an agreed proportion of
the profit actually realized. In both mudarabah and musharkah, both sides stand
to incur any profit depending on the actual performance of the operation. In
the mudarabah contract, however, the mudarabah (the partner offering his
effort) will lose nothing but his labour (as the principal capital is not his)
in case of financial loss resulting from normal business conditions. The bank
who has financed the capital bears all the finance risks. This finance risk
justifies the bank to claim his share in the profit. The client is, however,
held responsible for the loss of capital, should this be the result of his
negligence or wilful act. To guard against this, the bank may require a
security from the customer.
Murabaha
This is a procedure
where a partner approaches the bank that certain items (be it a commodity or
otherwise) be bought for him and he agrees to pay the bank later on, upon the
fulfilment of the actual buying, din agreed percentage of profit. In order to
avoid any riba element one of the banks provides that the agreement of the bank
and the actual execution of buying do not contribute any legal obligation
(according to Shari'ah) on the partner to buy. Hence the risk is still that of
the bank’s. Until the partner fulfils his original promise of “rebuying” the
commodity, the risk remains with the bank which justifies the profit. There is,
however, also the practice of financing a mark-up with the binding on the buyer
to buy the goods. This type of operation is most commonly being used in foreign
trade and short-term transactions for purchasing raw materials etc. for the
industrial establishments.
Bai Salam (Post
Delivery Sale)
The bank buys certain
goods on post-delivery and pays the cost immediately or sells certain goods on post-delivery
and receives its cost immediately. In this sale, cost of goods is fixed and
paid in advance but the delivery of the sold item is postponed or delayed up to
a certain period. Similarly, the place of delivery, its expenses and quantities
of the sold goods should also be fixed and defined as they are conditions for
such a sale.
Leasing or Renting the
Physical Capital/Equipment
The bank, in this
case, purchases a physical capital/equipment and rents it to his client. This
procedure can be converted into a reduced renting procedure whereby the
customer, by paying every year an instalment of the value of equipment/physical
capital, reduces the rent, till the whole equipment is owned by him and the
rent is eliminated.
These tools of
investments have theoretically been designed to apply to all sectors of the
economy but in practice the investment activities have been found to be
concentrating only to real-estate and trade sectors. Islamic Bank described
their operational strategy as “to prefer for projects which give quick
returns”.
C. Bonds and
Securities
Al-Muqardha Bonds
This tool is utilized
when a large amount is needed for a big project. The bonds carry shares in the
profits of the project. An amount of the bond may be decreased in the same way
as the participation is reduced in the case of Mudarabah or Musharkah or
Renting. These bonds differ from the normal bonds in that they do not pay any
guaranteed or fixed return to investors. The holders of the bond will take a
percentage of the profits of the project that the bonds are financing. The
basis of this bond is a participation contract through which one or more
partners with their money (the beneficial owners) and another with his efforts
(participant) get together to earn profit in a Halal trade. Profits will be
divided between them on an agreed upon proportion.
Islamic Securities
(Al-Mudarabah Certificates)
This is similar to the
Islamic Bonds in nature and have the same basis as illustrated above. The
Islamic Securities, however, are not issued for any specified project. Instead
a Mudarabah (participation) company is established. This company issues a
certificate which is a receipt for the money received and a guarantee by the
Mudarabah Company to reimburse the proceeds of the company, if any, to the
bearer of the certificate at the date of maturity and according to the amount
with which he participated. These certificates, of course, bear the element of
risk of losses, if any.
The Mudarabah Company
will then invest all the money it receives in local or international
enterprizes, in which it is conditioned that it must in -no way contradict with
the rulings of Islamic Shari'ah.
D. Loans
Loan Certificates
These are the
certificates through which a Mudarabah Company receives Islamic Loans whose
maturity is defined but which do not entail, in any way, share in the profits
or losses. The Certificate is meant for such Muslims who do not want to take
risk of investment but are willing to allow the use of their money for the
benefit of and investment in the Islamic Community. Here the Muslim lender is
shunning riba and is positively participating in a collective Islamic task
aiming at spreading Islamic economy and above all the spreading of Allah’s
words.
The reimbursement of
these loans, however, have a priority and their amount is guaranteed.
The public investors
have the option to combine both the portfolio (Mudarabah Certificate and Loan
Certificate) according to their desire for investment and their preference for
risk.
Benevolent Loans
These loans are
provided by banks and the objective of these loans is to produce benefits
either for the general public or for charity. There is no interest or return on
these loans. Though there is, a provision for a service charge to cover the
cost of providing the loan, yet no bank is applying this charge except the
Islamic Development Bank in Jeddah. All the commercial banks provide loans free
of any charge if they have any provision of such loans.
The serivce charge,
whenever applied to a loan, is claimed to be different from interest on the
ground that it is not a fixed percentage of loan, but it is an absolute amount
calculated by working out actual costs in providing the loan.
So far, the Islamic
Banks are not inclined to provide these loans. Only the Islamic Development
Banks are providing such loans for the social and infra-structural projects.
The commercial banks have, however, shown willingness to provide personal non-productive
loans without any charge after they get properly established and have
accumulated enough funds. The criterion for the advancement of such loans will
be based on:
a.
The nature of the need
for which the loan is required.
b.
The credit of the
client with the bank.
Thus an old client of
the bank requiring loan for his son’s education will have a priority over the
new client requiring loan to buy an air- conditioner.
1.
Short-term Loans
To meet short-term
loan/credit requirement of the enterprises, the banks do have the provision to
provide such loans without interest or any other charge. However, this too has
not been very much in practice. The criterion for advancing such loans
theoretically, is:
1.
Specific credit needs
of the firm.
2.
Social priority
attaching to the enterprise.
3.
Nature of the security
against loan.
4.
Whether the credit
seeker has also obtained term advances from the bank for the same enterprise.
5.
Annual, monthly or
weekly average of the applicant’s balance in current account with the same
bank.
Generally, the banks
do not encourage the customers to overdraw. In special cases, this may be
allowed with the fixation of the maximum date to adjust the said drawn amount.
No interest or expenses are charged on such loans. This is treated as
qard-hasanah.
Bills of Exchange
Bills of exchange are
also treated under the mudarabah principles. Cash is provided against the bill
on the condition of a claim in the profits from the. sale of merchandise. An
interest-free loan may also be advanced. No discounts are allowed in either
case.
E. Insurance and
Underwriting
Cooperative Insurance
Some of the banks are
undertaking insurance as a subsidiary business of their organisation. This
insurance is a sort of cooperative insurance. The principle is that all the
losses have to be borne by the participants on cooperative basis. The
participants will, however, share the profit arising out of the investment of
the premium. This principle is being applied to life insurance too. The
procedure is that all the participants (policy holders) at the maturity of
their policy get all the amount that they had paid as premium plus the share in
profit. If a policy holder dies before the maturity of his policy, he gets all
the amount that he paid as premium plus the share in profits plus the remaining
amount of the policy to be contributed by all the other participants. The
participants contribute not only as part of their social obligation but also
because they will get the same treatment.
F. Relationship with
other Banks
Islamic banks are
doing business with other banks also in their countries strictly on Islamic
principles. The working of Islamic banks has impressed the other banks even in
non-Muslim countries particularly those in Europe which are now devising ways
and means to do business with Islamic banks.
