Accounting Article

Instruments of Islamic Banking in Operation

by Dr Shahid Hasan Siddiqui | Published on 4/21/2008


Riba is prohibited in Islam in all forms and manifestations. This prohibition, which is based on the Divine Authority and not on an economic theory, is strict, absolute and unambiguous. The holy Qur’an says “O ye who believe! Fear Allah and give up what remains of your demand for riba; if you are indeed believers” (2:278). The next verse says “If you do it not, take notice of war from Allah and His Messenger. But if ye turn back, ye shall have your capital sums. Deal not unjustly and you shall not be dealt with unjustly.” (2:279). In the light of these guidelines, riba can be defined as “Any amount, big or small, over the principal, in a contract of loan or debt is Riba, prohibited by the Holy Qur’an regardless of whether the loan is taken for the purpose of consumption or for some productive activity.”

It is important to note that in money lending transactions, any thing recovered, paid or received, in excess of the principal amount, as per agreed arrangements is riba. It does not make any difference by whatever name it is called, riba, usury, interest, profit, biyaj, mark-up or service charge etc. It must also be clearly understood that riba is prohibited as it may lead to injustices (zulm) and Islam is against all forms of injustices and exploitations and pleads an economic system that aims to secure extensive, socio-economic justice. It therefore, follows that any system designed and adopted under the banner of Islamic banking system, as an alternate of interest-based banking system, must have the following three ingredients:

(i) It must not contain any element of riba usury or interest, by whatever name it is called.

(ii) It must remove the injustices of the interest-based system in all spheres of operations.

(iii) It must contribute to the achievement of the socio-economic objectives of the Islamic economic system.

There is consensus among Islamic scholars that to replace interest, the ideal mode of financing under Islamic banking system is financing on profit and loss sharing (PLS) basis. It therefore, follows that in case an entrepreneur availing finance from an Islamic bank earns profit, it must be shared between the bank and the entrepreneur. The Islamic bank, on the other hand, must share its profit with depositors/ investors. This would ensure justice between all the stake-holders namely, depositors/ investors, entrepreneurs availing finance from the bank and the bank itself.

While designing modes of financing under Islamic banking system, it soon became clear that large scale resorting to PLS system would pose serious risks and hazards to Islamic banks in many Islamic countries due to wide-spread tendency to adopt unethical accounting practices to conceal true profits, high rate of illiteracy and host of other reasons. It was therefore, considered necessary to devise various other modes of financing in addition to musharakah and mudarabah based on PLS system and of course, Qard-e-Hasan. It was however, initially laid down that some other modes of financing based on second-line pre-determined fixed rate of return techniques should also be designed for Islamic banks for transitory period with the proviso that gradual shift to PLS system will take place.

The two parallel systems

Although interest-based banks and Islamic banks are now operating parallel to each other in many Muslim countries but the interest-based banks are obviously the market leaders and probably will remain so for a long time though Islamic banks and Islamic windows are fast spreading in many Muslim and non-Muslim countries.

There is, however, no denying of the fact that under the interest-based system of banking or in a system not strictly based on the principles and spirit of Shariah, depositors as well as borrowers are being exploited in one form or the other. It is however, significant to note that, as in the case of conventional banking, the depositors are being exploited most by banks and financial institutions operating in many Muslim countries under the banner of Islamic banking. The main reason for this is that Islamic banks are following the bench-marks of interest-based system.

The fact of the matter however, is that Islamic banks, in the present circumstances can not, even if they want to, possibly eliminate the injustices melted out to depositors / investors by the interest-based banks. For payment of real positive rates of return (rates of return less rate of inflation) Islamic banks, in most cases, in addition to reducing their spreads, would have to first enhance rates of return on their financings. This enhancement would not be acceptable to many entrepreneurs availing finance from Islamic banks as alternate avenues are available to them for securing advances at lower rates of interest from conventional banks.

It is therefore, crystal clear that the policy adopted by Central Banks of most Islamic countries to allow, for an indefinite or unduly long periods, the conventional and Islamic banks to run parallel to each other is not correct and is giving bad name to the Islamic system of banking notwithstanding that the fault lies with us and not with the system.

The objective of elimination of the injustices of the interest-based system cannot be achieved if the Islamic banks and conventional banks in Muslim countries continue to operate parallel to each other. These injustices can however, be eliminated to some extent if Islamic banks become market leaders even in the parallel system. This would be possible only when the market share of Islamic banks in a Muslim country is raised to about 50 percent of the total volume of the banking sector in that country. This does not seem to be a possibility even in the next decade in most Islamic countries unless of course, these countries change their existing policies and strategies. The Governor of Central Bank of Pakistan has recently emphasised that Islamic banks in Pakistan will need to grow at least by 40 – 50 percent annually to be able to raise it’s share from the present 3.5 percent to 15 percent.

Modes of financing

The modes of financing in an Islamic frame-work can be divided into following four main categories:

(a) Lending

(b) Shirkah based/profit/loss sharing modes

(c) Debt-creating modes:

(i) Financing by way of trade

(ii) Financing by way of lease

(d) Service / agency based modes

These categories are briefly discussed as under:

(a) Lending

Lending has to be a virtuous act as per the principles of Shariah. The principle that holy Qur’an has given in Verses 2:278 and 2:279 is that in both cases of loans and debts the creditor has the right to the principal amount only; in former case, exactly the amount given as loan, and in latter case, the amount of debt generated from the credit transactions etc. At the most, they can recover from the debtors a service charge not exceeding the actual proportionate cost of the operations, excluding the cost of funds or opportunity cost in the conventional sense. As Islamic banks are commercial organisations, lending is not their major activity.

(b) Shirkah-based / PLS modes

Shirkah can be defined as an arrangement where two or more persons combine either their capital or labour or credit-worthiness together, having similar rights and liabilities, to share the profits or a yield or appreciation in value and to share the loss, if any, according to their proportionate ownership.

Shirkah can be divided into two broad types of Shirkatul Milk (partnership through ownership) and Shirkatul Aqd (through contract) with Shirkatul ‘Inan. The latter, that is more relevant to the general partnership business and generally termed as commercial partnership, is divided into further three types i.e. Shirkah al Amwal (Capital), Shirkah al A‘amal (work) and Shirkah al Wajooh (based on credit worthiness).

Shirkatul Milk is the mixing of ownership mandatory or by choice. It is not for any commercial business or sharing of profit. The co-owners may use the property jointly or individually or share in its appreciation / depreciation when disposed off. If joint property is used by one partner, other partner may demand rent for his part of the property. The distribution of the revenue of Shirkatul Milk is always subject to the proportion of ownership.

Shirkatul ‘Inan is a valid form of contractual partnership in the eyes of all schools of thought. It means a joint enterprise formed for conducting any business with the condition that all partners shall share the profit according to agreed ratio while the loss will be borne according to the ratio of contribution to the joint business. Each partner is an agent to other partners. It is most suitable for joint businesses, adaptable to any situation and applicable in the present day’s commercial practices. Normally every partner can take part in management of the partnership business but it is not necessary that all partners take part in management/work; any one of them may opt not to work. They may distribute among themselves their responsibilities, duties and jobs by a mutual agreement. Below we discuss the commonly used terms of musharakah and mudarabah.

(i) Musharakah

Musharakah is a term used by the contemporary scholars which technically means a contractual relationship established under a contract by the mutual consent of the parties for sharing of profits and losses arising from a joint enterprise or venture. The partners may contribute funds, not necessarily equally according to the arrangements covered under Shirkatul ‘Inan. Capital to be invested by the partners can be unequal but may be in the form of equal units representing currency called shares and the intended partners may buy these shares disproportionately. All assets of musharakah are jointly owned in proportion to the contribution of each partner.

Profit can be divisible unequally and un-proportionate to the capital invested - the ratio of profit distribution may differ from ratio of investment in the total capital, but the loss must be borne exactly in accordance with the ratio of capital invested by each of the partners. If one or more partners choose to become non-working or sleeping partners, the ratio of their profit cannot exceed the ratio which their capital investment bears to the total capital. It is not allowed to fix a lump sum amount for any of the partners, or any rate of profit tied up with his investment.

A partner in a commercial partnership cannot guarantee the capital of the other partners. Any third party that is independent from the musharakah can guarantee to make up loss of the capital, but the guarantee should neither be provided for any consideration nor linked in any manner to the musharakah contract. In the case of musharakah agreements with clients, banks can obtain a pledge of security or guarantee to ensure safety and proper handling of the joint assets and business. Such security can be utilised in case the damage or loss to the principal amount/profit was due to sheer negligence or unwillingness of the client.

The musharakah mode of financing based mainly on the above basis is being used by Islamic banks. Profit projections can play an important role in the musharakah operations. The client can be required to provide periodically the results of operations of the business to the bank. Scholars have approved the concept of ‘projected profit’ subject to final settlement at the end of the term, meaning that any amount so drawn by any partner shall be treated as ‘on account payment’ and will be adjusted against the actual profit due to each partner at the end of the term. The disputes can be resolved through a ‘Review Committee’ comprising of persons to be named in the musharakah agreement with mutual understanding of the parties.

While there is unanimity of thought amongst Muslim jurists that losses are to be shared by the parties according to the ratio of their capital, there is however, difference of opinion among Muslim jurists on the issue of the ratios of the profit to be shared. According to Imam Malik and Imam Shafi’i, the profits must be shared exactly in the ratio of capital provided by the partners.

The view of Imam Ahmad bin Hanbal is that the ratio of profit can be fixed by mutual consent of the parties and could, therefore, differ from the ratio of capital employed in the project. Imam Abu Hanifah’s school of thought is that the ratio of profit may differ from the ratio of capital injected in the project. If however, a partner puts an explicit condition that he would remain a sleeping partner throughout the term of musharakah, his share of profit cannot be more than the share of his investment.

(I) Trade based modes

(i) Murabaha-Muajjal: murabaha means mutually stipulated margin of profit in a sale transaction where the cost of the commodity is made known to the buyer. The parties negotiate the profit margin on the known cost. If payment of the sale price is deferred, it becomes murabaha-muajjal. Credit sale is allowed by the texts of the Shariah. The installments sale with price higher than the cash market price is also permitted as a normal reflection of market-based commercial activities. The price and the due date of payment must be fixed in an unambiguous manner. Other terms used for similar transactions are installments sale, cost-plus/mark-up based sale, etc.

Murabaha, as in vogue in Islamic banking, is used with a prior promise to buy or a request made by a person interested in acquiring goods on credit from a bank. The customer is normally appointed as agent of the bank for purchase of the item on it’s behalf. As such, it is called ‘murabaha to Purchase Orderer’ (MPO) which normally comprises three separate agreements including promise to buy or to sell, agency contract and the actual murabaha contract.

According to contemporary Shariah scholars, murabaha is legitimate provided the risk of the asset being sold is borne by the bank until the possession is passed on to the murabaha customer. For such a transaction to be legal, the bank must purchase a commodity through a contract and sell it to the customer under a separate contract. Murabaha can be used only where a commodity is intended to be purchased by the customer. Banks can promise to sell something that is not yet owned or possessed by them. However, the actual sale will have to be effected through offer and acceptance after the commodity comes into the physical or constructive possession of the seller (bank).

The ideal way of conducting murabaha is that the bank itself purchases the commodity directly form the supplier and after taking it’s delivery, re-sells it on murabaha basis. Alternatively, bank may take the services of a third party for the acquisition of goods. Keeping in view the problems involved in purchasing directly or through third party agent, the Shariah experts have allowed that a bank makes the customer his agent to buy the commodity on it’s behalf. Whatever the procedure for Shariah compliance, the commodity before selling it to the client must remain at the risk of the bank, the seller in this finance-cum-trade transaction. The appointment of customer as bank’s agent is not however, considered desirable.

Banks should make sure that the client really intends to purchase the commodity. The buy-back arrangement is not allowed. The purchase price should be paid directly to the supplier instead of giving funds to the customer. The client should not be made dual agent doing every thing himself and purchase by the bank should be evidenced by invoices or similar other documents to ensure that all conditions of valid murabaha are fulfilled. The commodity must come into the possession of the bank, whether physical or constructive, in the sense that it must be at bank’s risk. The bank should arrange for physical inspection on random basis of the purchased commodities so that the supplier and the client may not end up in any under-hand dealing.

In case of default, murabaha contract cannot be rolled over because the goods once sold by the bank are property of the client and hence cannot be resold by the bank. As the murabaha is basically a sale, all the necessary ingredients of sale acceptable to Shariah must be duly observed otherwise it may involve an element of riba. The fuqha have accordingly laid down strict parameters for its permissibility. The following requirements should therefore, be strictly observed by Islamic banks:

(a) The commodity being sold must be in existence at the time of sale.

(b) Seller must have a good title to the commodity and should be competent to sell it.

(c) The commodity must be in physical or constructive possession of the seller. The constructive possession means that although physical delivery of the commodity has not been taken, it has come into bank’s control that has also assumed the risk of it’s loss or destruction even though for a very short period.

(ii) Musawamah (Bargaining on Price)

Musawamah is a general and regular kind of sale in which price of the commodity to be traded is bargained between seller and the buyer without any reference to the price paid or cost incurred by the former. Thus, it is different from murabaha in respect of pricing formula. Unlike murabaha, seller in musawamah is not obliged to reveal his cost. Both the parties negotiate on the price. All other conditions relevant to murabaha are valid for musawamah as well. Musawamah can be used where the seller is not in a position to ascertain precisely the costs of commodities that he is offering to sell.

Musawamah can be both cash and credit sale but, when used by banks, it will generally be a deferred payment sale in which they will bargain with clients on the price of the goods/assets. Islamic banks may sometimes get a discount from the supplier over the normal retail price. If the purchase price or the actual profit is not brought into the notice of the customer, such sale should be conducted through musawamah and not murabaha.

(iii) Salam

Salam is a forward sale contract for future delivery of specified goods with up-front payment of price. It is also called Salaf or Taslif meaning a sale by advance payment. Salam has been permitted by the holy Prophet (PBUH) notwithstanding the general principle of the Shariah that the sale of a commodity which is not in possession of the seller is not permitted. People in Madinah used to pay in advance the price of fruits (or dates) to be delivered within one, two or three years. But such a sale was carried out without specifying the measure, weight and the date of delivery.

The holy Prophet ordained: Whoever pays money in advance (for dates) should pay it for a known specified measure, weight and time. The list of items covered by salam included wheat, barley, dates and grapes. The conquest of Syria added new items like olive and dried large grape. The jurists have now expanded the list to cover all homogeneous (mithly) commodities that can be precisely determined in terms of quality and quantity. Monetary units, wherein exchange has to be simultaneous, are excluded.

Salam can be applied in those commodities only that are normally available in the market and whose quality and quantity can be specified exactly. It may include any marketable goods with definable features, trade marks, etc. like raw materials, agricultural produce or manufactured goods. The seller in salam need not necessarily be a producer of the goods. He can enter into a salam contract for supply of goods in future against full pre-payment.

Banks should not set-off their receivables for payment of salam price as salam sale cannot be contracted against a loan, or partly cash and partly loan, in which case the contract will be valid only to the extent of cash payment.

If the seller does not deliver the goods at agreed date, the buyer shall have the options to wait until the commodity is available, to cancel the contract and recover the paid price or to agree to a replacement with mutual consent and subject to the relevant rules of exchange. It is pertinent to observe here that the bank has a right to take the goods that it has purchased, it can purchase from the proceeds of the security / pledge, but if it decides to get cash from the customer, it has the right to get only the price given in advance at the time of the contract.

For disposal of goods purchased under salam, Islamic banks have a number of options including: i) enter into a parallel salam contract, ii) agency contract with any third party or with the customer (seller) to sell the goods on behalf of the bank and / or iii) sale in the open market by the bank itself by entering into a promise with any third party or direct selling upon taking the delivery. In case of agency, the salam agreement and agency agreement should be separate and independent from each other. The purchased goods cannot be sold back to the salam seller. Hence, parallel salam cannot be entered into with the original seller – prohibited due to being a buy-back. Bank may take promise from any third party which would purchase the goods of stipulated specifications at any stipulated price.

(iv) Istisna´a

Istisna´a, like salam, is a special kind of sale where sale of a commodity is executed before it comes into existence. It is an agreement culminating into a sale at an agreed price whereby the purchaser places an order to manufacture, assemble, construct, or cause so to do, anything to be delivered at a future date. Al-Saani (manufacturer) would arrange both the raw material and the labour. If material is supplied by the purchaser, it will be the contract of Ujrah (Service contract).

The seller may enter into a parallel contract with a manufacturer to provide the subject matter of istisna´a. On this basis, the banks may undertake financing by getting the subject of istisna´a manufactured through parallel istisna´a contracts.

Istisna´a contract must state the type, dimensions and specifications of the asset / property being manufactured, and time and place of delivery, whether the asset has to be manufactured by any specific manufacturer, or by use of specific materials, as may be agreed between the two parties.

It is not necessary in istisna´a that the price is paid in advance. Payments can be made in installments within a fixed time period. Against the general rule set out for salam, the jurists have legalised it on the basis of analogy and istihsan as istisna´a involves personal labour, effort and commitment of the seller. The price should be known in advance, which once settled, cannot be unilaterally increased or decreased. However, as manufacturing of huge assets may involve longer time, sometimes necessitating many changes, price can be readjusted by the mutual consent of the contracting parties because of making material modification in the commodity or due to unforeseen contingencies or changes in prices of inputs.

Istisna´a contract may also contain a penalty clause stipulating an agreed amount of money for compensating the purchaser adequately if the manufacturer is late in delivering the asset. Such compensation is permissible only if the delay is not caused by intervening contingencies (force majeure). In Fiqh, this principle is termed as Shart-e-Jaz?i or the condition of decreasing the price on account of delay in delivery of the subject matter of istisna´a.

The Parallel istisna´a contract should be without any condition or linkage with the original istisna´a contract. The two contracts cannot be tied up in a manner that the rights and obligations of one contract are dependant on the rights and obligations of the other contract. Further, Parallel istisna´a is allowed with a third party only.

The bank working as a manufacturer must assume liability for ownership risk, maintenance and Takaful expenses prior to delivering the subject-matter to the purchaser as well as the risk of theft or any damage.

(II) Ijarah based modes

Ijarah is a contract under which one party obtains the right of usufruct of an asset owned by another party for an agreed period against an agreed consideration namely rent. The term Ijarah is very much similar to the ‘leasing’. The rules of Ijarah in the sense of leasing are similar to the rules of sales because both cases involve transfer of some property to another. The only distinctive feature is that in the case of sale, the corpus of property is transferred to the purchaser while in the case of Ijarah, the corpus of the property remains in the ownership of the lessor and only its usufruct is transferred. The following are two basic differences between leasing by conventional banks and the Ijarah financing by Islamic banks.

(i) In leasing, the lessee’s liability to pay rent starts from the date the payment has been made by the conventional bank to the supplier and not from the date the delivery of the asset is taken by the lessee. The Islamic bank however, charges rent only from the date the delivery of the asset in working condition is taken by the lessee and not from the date the price has been paid to the supplier.

(ii) In case of Ijarah, Islamic bank, being owner of the asset, assumes full risk of the corpus of the leased asset. If the asset is destroyed during the period of Ijarah contract or the asset looses it’s usufruct without misuse or negligence on the part of the lessee, the Islamic bank cannot claim rent while interest-based banks are entitled to receive interest in such cases also, unless there is a contract to the contrary.

In its origin, leasing is one of the normal real sector business activities like sale and not a mode of financing. Like conventional banks, Islamic banks are extensively using leasing not only for the tax benefits available in case of leasing but also for the reason that it has a number of flexibilities and wider potential for promoting Islamic finance that is essentially real assets-based.

Ijarah is valid for things which possess Manafa´ah and which can be utilised but their corpus or substance (‘Ayn) is not consumed. The goods like candles, yarn, cotton, food or fuel are suitable for sale, not for leasing or hiring. Hence Dirhams, Dinars, any other currencies, bullions etc that are ‘Ain, not usufruct and all those goods taking benefit from which is not possible without consuming them cannot be given on lease. Any form of perishable item may not also be a subject of lease.

Rentals in Ijarah can be fixed for the whole lease period or floating / variable subject to mutual understanding. It can be agreed upon that the rent shall be increased after a specified period like a year or so. Contemporary scholars have also allowed to tie up the rent with a well-defined reference rate or benchmark or to enhance the rent periodically according to a mutually stipulated proportion (e.g. 7.5 percent per year) subject to the condition that other requirements of Shariah for a valid lease are duly fulfilled.

Islamic banks do not purchase / maintain the assets for leasing as in the case of operating lease; they normally purchase the asset in response to specific requests from customers to get the asset on lease that ends with purchase after the lease term expires. This transfer of ownership takes place through gift by lessor at the end of the lease period or at a token consideration or for other amount(s) specified in the lease agreement. The Shariah scholars recommend that lease agreement should not contain a pre-condition of sale or gift after the lease period. The principle, according to them, is that a unilateral promise to enter into a sale contract at a future date is allowed whereby the promisor is bound to fulfill the promise, but the promisee is not bound to enter into actual purchase contract.

It is important to note that the best terminology for normal ijarah operations by Islamic banks is ijarah muntahia bittamleek and not ijarah wa iqtina. Accounting and Auditing Organisation of Islamic Financial Institutions (AAOIFI) has also used this terminology for leasing operations under Islamic banking system.

It implies that mainly the transaction is only one whereby the lessor leases the asset and fixes the rental in the way that during the lease period its total cost as also rent is duly received. The second part is only a unilateral promise not binding on the promisee and as such it is not a transaction until actually entered into by the parties. AAOIFI Standard on Ijarah provides for promise by the lessor, while many Islamic banks, as in the case of Pakistan, take undertaking from the lessee and deem it binding on him. Abiding by AAOIFI’s standard in this regard seems to be justifiable and nearer to the spirit of the Shariah.

Ownership in Ijarah contract, and therefore the risks and expenses relating to ownership, must remain with the lessor. Operating expenses related to use of the asset have to be borne by the lessee. Banks may take the Takaful cover in order to mitigate the risks, but it should be at the expense of the banks. They can, however increase, with the consent of the lessee, the lease rent to recover the Takaful cost. If the Takaful company does not compensate the entire amount in case of loss / damage, banks have to bear the risk of Takaful claim settlement. This is the key difference between the conventional leases and Islamic banks’ Ijarah contracts culminating into transfer of ownership to the lessee under the separate contracts.

The terminology of operating, finance and other leases does not make any difference; If all essential elements relating to contracting party, subject matter, consideration and the period in ijarah are taken care of, ijarah can be used as the mode of financing by the financial institutions in the form of ijarah muntahia bittamleek. The deciding factors in this regard are: i) the risk relating to ownership that must remain with the lessor; and ii) sale should be separate from the lease.

(D) Service / Agency based modes

Islamic banks may provide a number of services to their clients and charge fee / service charge. These may include: Underwriting, letters of credits, letters of guarantees, remittances and correspondence services etc. It is pertinent to indicate in this regard that no charge can be taken against financial guarantees per se. Only management or agency charges can be taken.

Fixed return techniques: some observations

As murabaha and ijarah modes of financing are now being extensively used by Islamic banks worldwide for bulk of their financing, it is proposed to have a look at some of the views expressed regarding these modes.

(i) The Council of Islamic Ideology, Pakistan observes: (a) “It is, therefore, imperative that the use of these methods (financings on fixed return techniques) should be kept to the minimum extent that may be unavoidably necessary under the given conditions and that their use as general techniques of financing must never be allowed.” (b) “It would not be advisable to use it (Bai’ Muajjal) widely or indiscriminately in view of the danger attached to it of opening a back door for dealing on the basis of interest.”

(ii) The council also observed: “The fact of the matter is that “mark-up” is a crude trading practice which has been permitted by certain religious scholars under specified conditions. Its permissibility is questioned by other scholars. In any case, it is a device, which is relevant in the contract of transactions between a seller and buyer of goods. Banks are not trading organisations. They are essentially financial institutions which mobilise funds from the general public and make them available to productive undertakings”

(iii) Justice Usmani observes: (a) The Islamic banks are using the instruments of murabaha and ijarah within the framework of the conventional bench-marks like London Inter-bank offered rate (LIBOR) etc. where the net result does not materially differ much from the interest-based transactions.

(b) By not even gradually enhancing the financing on PLS basis, the basic philosophy of Islamic banking seems to be totally neglected by the Islamic banks. (c) In some cases even murabaha and ijarah are not affected according to the procedures required by Shariah.

(iv) Justice Usmani also observes: (a) Murabaha is only a device to escape from “interest”. The murabaha is a border-line transaction and a slight departure from the prescribed procedure makes it step in the area of interest-based financing. (b) Murabaha is not an ideal instrument for achieving economic objectives of Islam. (c) Murabaha should be used as a transitory step. (d) Murabaha’s use should be restricted only to those modes where mudarabah or Musharakah are not applicable. (e) It should never be over-looked that originally murabaha is a particular type of sale and not a mode of financing.

(v) Prof. Nijatullah Siddiqui says: “The payment obligations of the firms operating with murabaha – financed goods and services are independent of the profitability of the enterprise, unlike Profit-Sharing, thus exposing it to the charge of being inequitable, as in the case of debt financing.” He had also earlier observed: “I would prefer that Bai’ Mu’ajjal is removed from the list of permissible methods altogether. Even if we concede its permissibility in legal form, we have the over-riding legal maxim that anything leading to something prohibited stands prohibited. It will be advisable to apply this maxim to Bai’ Mu’ajjal in order to save interest-free banking from being sabotaged from within.”

(vi) Dr. Hasanuzzaman says: “___ ghost of interest is haunting banks to calculate a fixed rate percent per annum in many modes of financing including Murabaha (Bai-Mu'ajjal, Mark-up) etc. The spirit behind all these contracts seems to make a sure earning comparable with prevalent rate of interest and as far as possible, avoid losses which other wise could occur.” He also adds: “They (Second line techniques), have failed to do away with undesirable aspects of interest thereby they have retained what an Islamic bank should eliminate.”

(vii) Maulana Maududi observed: “Islam says in clear terms that the lender is not justified in earning a fixed rate of profit, irrespective of the operational results of the business.”

(viii) The Shariat Appellate Bench of Supreme Court of Pakistan in it’s historic judgment observed: “We are conscious of the fact that the transaction of a sale of murahaba based on mark-up, even after fulfilling its necessary conditions is not an ideal mode for the extensive use of Islamic banks, Still, the banks will have to resort to this transaction in certain cases, especially in the initial phase of transformation.”

(ix) Henry and Wilson say: (a) “And indeed a principal form of credit extended by an Islamic bank, the murabaha, involves a simple mark-up on a sales price. The bank buys you a car for $30,000/- and you owe the bank $33,000/- a year from now, for example. This arrangement is perfectly acceptable from the standpoint of Islamic financial theory but looks to the outsider like a simple loan at 10 percent. Repaying by five yearly installments of $7913.92 would be equally acceptable and also implies an interest rate of 10 percent”.

They also add that financial transactions modelled on the murabaha constitute well over half of the assets of Islamic banks and since any fixed return can be understood as implied interest, there seems little to differentiate Islamic from conventional banks.

(x) In some Muslim countries interest-based banks are now being converted into Islamic banks. This process includes conversion of existing advances into financing on the basis of trade and lease financing etc., change of security and execution of fresh sets of documents. This type of conversion does not appear to be according to the spirit of Shariah. The right approach would therefore, be to sanction a fresh limit under Islamic Banking system only after the previous advance has been fully adjusted.

Points to ponder

Maulana Maududi while recounting the evils of interest-based banking observed that a financier who advances money at fixed rate of profit is selfish as he is not concerned with the operational result of the business. He adds that the depositors of Islamic banks would hope to get unspecified but unlimited profit instead of fixed rate of interest. It is therefore, obvious that MaAulana Maududi visualised large scale financing only on PLS basis and not on fixed rate of returns (like in murabaha and ijarah etc.,) which in any case is not dependent on the operational results of the entrepreneur.

Maulana Mufti Muhammad Shafi (Late), Grand Mufti of Pakistan while referring to conventional banks observed:

“A person whose own worth is Rs.100,000/- engages in business employing Rs. 1 million. Of the hefty profit earned through such business, a small portion is paid to the bank by way of interest and the rest is pocketed by the businessman. The bank, in turn, distributes an even lesser amount to the depositors.”

Justice Taqi Usmani while referring to modern conventional banks and repeating the above points observes:

“---- our banks are really acting as the blood banks from which forum these capitalists are sucking the blood of the entire nation and the entire nation is rendered half dead economically.”

The position now is that bulk of financing by Islamic banks is being made on fixed rates of profit and that too on the bench-marks of interest-based banks. The rates of returns being paid by Islamic banks to their depositors are also on the bench-marks of conventional banks. The number of persons availing financing from Islamic banks is also a small percentage of total number of depositors of these banks.

For example, in Pakistan, the total number of advances accounts of all conventional banks is 20.7 percent of total deposits accounts whereas in the case of Islamic banks, the total number of financing accounts is only 9.4 percent of total deposits accounts. The conventional banks in Pakistan have been paying real negative rates of returns to their depositors (rates of returns on deposits less inflation rate in the country). The Islamic banks in Pakistan have also accordingly been paying real negative rates of returns to their depositors notwithstanding that some of these banks have been enhancing their profitability. It was in 1993 that the then Governor, Central Bank of Pakistan in the context of interest-based banks said “A banking system that gives a rate of returns to small savers which is negative in real terms is exploitative one.”

It was only in the initial stages of the transformation of the conventional banking system into Islamic banking system that the second line fixed return techniques could have been adopted by Islamic banks with a proviso that gradual shift to PLS system would take place. Unfortunately the modes on fixed rate techniques have been allowed to be perpetuated by Islamic banks and financing on PLS basis is not gaining momentum. The fact of the matter is that Islamic banks have deviated to a great extent from the philosophical basis. There have been no visible differences between Islamic banking and the conventional banking. This is harmful to the cause of Islamic banking.

The position can improve only when bulk of financing is made by Islamic banks on the basis of musharakah, the profit between the bank and the entrepreneur is shared in the ratio of respective capital employed and financing policies of these banks are designed keeping in view the objectives of Islamic economic system.

In view of the difficulties in allowing large scale financing on PLS basis, it is suggested that a Model Islamic Bank should be established in some Muslim countries. The proposed Model Bank should undertake all normal banking business and allow financing only on PLS basis according to true spirit of Shariah. These Model Banks would hopefully pay much higher rates of returns to depositors as compared to the rates being paid by existing Islamic banks.

This proposal was also made before the Shariat Appellate Bench of Supreme Court of Pakistan (SAB). The judgment of SAB says that Dr. Shahid Hasan Siddiqui, an economic expert and Chairman of the Karachi-based Research Institute of Islamic Banking and Finance appeared to state that a model Islamic bank should be established in Pakistan which should operate 100 percent on PLS basis. The establishment of Model Islamic Banks in some Muslim countries would motivate other Islamic banks to enhance their share of financing on PLS basis.

If Islamic banks in Muslim countries succeed in demonstrating a practical example of socio-economic justice by rapidly enhancing their share of financing on PLS basis and achieve satisfactory operational results, with the blessings of Almighty Allah, the dawn of an era of justice would be witnessed where the fruits of Islamic system would be available to large number of people leading to over-all social and economic prosperity.

This is a research-based article dealing with various aspects of Islamic finance and its wider application in today’s banking environment.

Dr. Shahid Hasan Siddiqui is a banker of International repute and an eminent economist from Pakistan. Currently, he is Chairman & Chief Executive of the Research Institute of Islamic Banking & Finance, Karachi. He is Fellow, Institute of Bankers, Pakistan and Institute of Islamic Banking & Insurance, London.

Article originally published in The News. Republished with permission.

Article courtesy of Dr Shahid Hasan Siddiqui


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