Islamic Banking

 

 

Introduction  

In a world where the complexities of modern finance often clash with spiritual principles, sincere Muslims face a daunting challenge: obtaining capital for major purchases and business ventures without violating the sacred prohibition against riba (interest). As we discussed in the previous chapter, the simplicity of transactions during the time of the Prophet Muhammad stands in stark contrast to today's multifaceted economic landscape. Back then, finances were rooted in charity or community-based trading, where profit and risk were shared, fostering a sense of collaboration and fairness.

Yet today, as our societies become increasingly entangled in profit-driven financial systems, finding ethical alternatives can feel like an uphill battle. The necessity of navigating these intricate waters while remaining true to one's faith is not just a challenge—it's a quest for creative solutions that honor Islamic values. This chapter invites you to explore the innovative pathways emerging in Islamic finance, shedding light on how they harmonize with contemporary needs while preserving the integrity of spiritual teachings. Join us as we uncover the possibilities that lie at the intersection of faith and finance, ensuring that Muslims can pursue their aspirations without compromising their principles.

During the period of European colonization, most Muslim countries were encouraged by their colonial rulers to adopt banking and financial systems modeled after European practices. Little serious consideration was given to establishing Islamic banks and economic systems grounded in Shariah until well into the 20th century. It was during this time that a resurgence of Islamic thought and identity prompted a critical reevaluation of interest-based banking systems, which were increasingly viewed as inappropriate and undesirable for Muslim nations.

Given that Islam prohibits interest but permits trade, Muslim economists harnessed their creativity to develop a banking system centered around trade, wherein banks actively participated in the ventures of their customers by sharing in their profits and losses. With no historical precedent for the modern commercial bank in Islamic tradition, the structures of conventional banks were adapted to serve the needs of Islamic banking. Consequently, where standard banking practices do not conflict with Islamic principles, Islamic banks have been able to implement conventional banking procedures effectively.

In some countries, like the Islamic Republic of Pakistan, Islamic banks operate under general banking laws as specialized institutions, while in others, such as Turkey and Malaysia, specific regulatory frameworks have been established to govern their operations. This adaptability not only allows for compliance with Islamic laws but also facilitates growth and innovation within the financial sector, reflecting the evolving relationship between tradition and modernity in Islamic finance.

Principles of Islamic banking 

• The giving and taking of interest is prohibited in all transactions. In principle, interest-based transactions are seen as leading to a transfer of wealth from the economically weak in society to the rich, encouraging social inequality. Islamic banks are part of the economic system of Islam and should be actively concerned with promoting the social benefits of an Islamic economy. Thus they should look beyond mere interest-free banking transactions to promote the greater good of society.?
• Business and trade activities should be undertaken on the basis of halal profit. Not only should interest-based transactions be avoided, but banks should offer finance and/or participation only to businesses that are engaged in activities that are legal under the Shariah.
• Transactions should be free from gharar (unreasonable uncertainty or speculation). There is an element of risk in every business transaction, but risk should not be so excessive as to amount to speculation.
• Making money from money is not acceptable to Islam. Money has no value in itself. It is not acceptable that money should be hoarded or left in a bank without productive investment.

According to one Muslim scholar: Money is primarily a means and a measure, a servant not a master: a system in which money does not beget money but is rather used as a facilitator for the greater production of goods and services resulting not merely in increasing the number of billionaires but producing real well-being for the people in the context of a developing, conserving and sustaining economy. 

• Financial transactions should be in line with Islamic principles of discouraging hoarding and encouraging social justice.
• Islamic banks have religious committees to advise them on the propriety of their activities under Shariah.
• Prohibited in all transactions are seen as economically weak in equality. Islamic banks and should be actively benefits of an Islamic and mere interest-free ater good of society?

• It seems like you're aiming to express a concept related to Islamic finance, particularly regarding activities that are deemed uncertain or excessively risky, and how these are viewed in the context of productive investment. 

• In Islamic finance, transactions and activities must avoid excessive uncertainty (gharar) and risk, as these elements are considered inconsistent with Islamic principles. Activities that involve unreasonable risk or speculative practices are deemed impermissible, as they do not contribute to productive investment or societal welfare. 

• According to Islamic teachings, money should be employed in ventures that are ethical, transparent, and beneficial to the community, fostering economic growth while ensuring that financial engagements adhere to Shariah principles.

• Zakat (the annual charity tax) is to be paid by the bank. Like any Muslim individual, the bank has an obligation to contribute to the assistance of the poor and disadvantaged in society.

Financing structures used by Islamic banks

Mudarabah

• This is a contract whereby one party (rabb al-mal) contributes capital while the other (mudarib) provides work and management skills.
• The bank lends money to a customer for a business venture and in return receives a specified percentage of the venture's profits for a predetermined period of time. The share of the profit covers repayment of the principal of the loan plus a profit for the bank. If the venture incurs a loss, the loss is shared by the bank. The bank is not liable for losses beyond the amount of money loaned, and the mudarib can lose only his or her time and effort.
• Musharakah
• This is a partnership, usually for a short period of time, to carry out a specific project. It is similar in nature to a joint venture.
• Musharakah can be either permanent - without a specified period
• - where the bank participates in the equity and receives an annual share of the profit, or it can be minishing/decreasing partnership in which additional payments can be made over and above the bank's share of the profits so that the bank's equity gradually reduces to nothing, at which point it ceases to be a partner.

Murabahah

• In this case, commodities are purchased by the bank and sold to the customer at cost plus an agreed profit. Normally the customer may pay by instalments. The use of murabahah by Islamic banks has ben criticised since the bank is able to finance the buyer withus taking any risk itself. It is simply a cost plus profit sale which tas the appearance of just being a device to circumvent the prohibition of interest. 

Bay bithaman ajil

• Bay bitaman ail (BA) is similar to muaaha. In modern practice BBA is used for longer-term fina foing of asses such as buildings and machinery, while murabahah is for shorten finance needs such as working capital. BBA is a deferred payment by instalments, while murabahah is a deferred payment by lump sum.

Bay' al-salam

• This is a contract of sale of a specified commodity in which the price in aid in pie rance for ode to be dised e termed
• working capital before he can deliver. 

 Ijara

• This is direct lease financing. The bank purchases an asset and leases it to the customer for a term, the bank receiving an agreed charge or
• rent. 

Bai' al-takjiri

• This is a lease ending with ownership (hire purchase finance). It is the same as jara except that the bank and the customer agree that the customer will eventually purchase the asset at an agreed price, with all lease rentals previously paid forming part of the price.

 Istisna

• This is the giving of an order to a worker to make something, with agreement to pay a definite price on completion. This method of financing can be used for a house under construction. The financier can contract with a customer who wishes to purchase a house. financier then contracts with a builder to copstruct it. Payment of instalments can begin before the house is completed or on completion. 

Qard ul-Hasan

• This is a benevolent loan. The borrower is obliged to repay only the amount of the loan, but Shariah encourages the borrower to pay comething beyond theirinainal ase this without demand from the hank. In practice, flamie banks as this method only for harithe purposes or for buying government investment certificates

Al-wadiah

• This is a contract of trust or safe-keeping. The bank accepts deposits from customers and guarantees the safety and return of the funds.
• The bank can use money deposited for commercial transactions. It does not pay interest but may reward the depositor with a payment representing a share of the bank's profits.

 Rahn (pledge)

• Islamic banks are able to take security for loans by this method. This is somewhat similar to pawnbroking but instead of interest being paid on the loan, a charge is made for the transaction.  

Sukuk (Islamic bond)

• 
  These are asset-based, Shariah-compliant trust certificates which are usually associated with an ijara (lease) structure where the lease rental income provides a return for the holders, or a musharakah structure where the profit share provides a return. ° It differs from an ordinary bond in that the holder obtains a beneficial interest in the underlying asset and assumes rights and obligations for the maintenance of the asset.

  The first Islamic banks

• The first Islamic bank was set up as an experiment at Mit Gham, a rural area outside Cairo, Egypt, in 1963. The aim of its founders was to encourage local people to save, invest in local enterprises, and undertake small development projects, and so raise the scandard of iving in the community. Emphasis was placed on understa easily local conditions, providing simple facilities which could bathip y understood and used by customers, and developing a relationship of trust between the bank anuston villagers .The Bank introduced three types of accounts:

• Freinon of deposit and with saval Rem lar saver in thi type of account were entitled to advice providens for producine ventures, with free technical advice provided by the bank.
• Investment fund: people who tinvesto invest in profiable enterprises could use this fund charas elither directly or indi. rectly through entrepreneurs. Withdrawal could be restricted in accordance with the nature of the investment and is liquidiry requirements.
• Social Service fund: money for this fund was provided from zakat and other donations. Its purpose was to assist savers who fell into financial difficulties as a result of misfortune.
• The bank participated in the losses suffered by its customers ventures as well as in their profits, and provided technical assistance free of charge where needed.
• Following the success of this first experiment in Islamic banking by 1967 eight other banks had been set up in Egypt, including one in Cairo with 250,000 depositors. However, apparently for political reasons,' the experiment was brought to an end in 1967.  

• Evaluations of the performance of the bank demonstrated that the bank had been influential in promoting social change in the areas in which it oper-ated, by mobilising the savings of small depositors, changing attitudes of villagers from passive acceptance of their lot towards active concern for the community, and checking the trend for villagers to migrate to the city by encouraging local industry. 

• In 1973, the Amanah Bank was set up in the Philippines to cater for that country's Muslim minority. It did not last long and its failure has been blamed on the possibility that it was only a propaganda gimmick for the Marcos regime, rather than a genuine attempt at Islamic banking 13 Another Islamic bank, the Amanah Islamic Investment Bank, was set up in 1990.
• Islamic banks or 'finance houses' (some Muslims wish to avoid the connotations of the word "bank'), were set up in Dubai in 1975, Kuwai in 1977, Bahrain in 1979 and Qatar in 1981. In Sudan and Egypt, the Faisal Islamic banks (named after rince Muhammad In Paisal of Saudi Arabia, a leading proponent of Islamic banking) opened ther doors in 1977. Islamic banks have also been set up in Jordan, Turkey,Malaysia, Indonesia, Russia, Sudan of Lanka, Nigeria and move recently in the former Russian republic of KazakhWan.

Typical services offered by Islamic banks

           Savings accounts

• The bank guarantees savings deposited on an al-wadiah basis, but is not obliged to pay any rewards to the savers. The bank may, at its discretion, pay cash rewards from their profits at the end of the financial year.

Investment

• Depositors authorise the bank to invest their money in any of its projects on the basis that after the expiry of the specified period, the account holder will get an agreed share of the profits. These are usually operated on the mudarabah principle.

Current account

• This is operated in the same way as in conventional banking systems but on the principle of al-wadiah and no interest is paid. The bank uses these funds to generate a profit and provides the customer with services such as cheque books and other current account facilities.

Trade finance 

Methods of trade finance are:Letter of credit under the principle of al-wakala. The bank may require the customer to deposit the full amount of the value of goods to be acquired under the principle of al-wadiah.

• The bank charges fees and commissions for its services.
• Letter of credit under the principle of al-musharakah. The customer places with the bank a deposit for his or her share of the goods under al-wadiah principles. The bank issues the letter of credit and uses the customer's deposit and its own share of the finance. The customeomeries pod uses goods as per agreement. Profit is divided between bank and customer as per their agreement.

1. Letter of credit under the principles of al-murabahah. The Customer requests the bank to acquire goods using its olus financing. The bank sells the goods to the customer at cost plus. 
2. Letter of guarantee. The  customer to place a certain amount of deposit with the bank under al. wadiah principle. The bank charges a tee for its service.
   
3. Working capital under the principle of al-murabahah. The bank purchases or appoints the customer as its agent to purchase the goods required and the bank pays from its own funds.The bank sells the goods to the customer on price plus cost basis. The customer may settle the sale price on a deferred basis, usually 30, 60 or 90 days
4.  Investment services
5. Stockbroking and unit trusts are now offered by Islamic banks. For example, stockbrocking is provided by Bank Islam through its sub-sidiary, BIMB Securities, which commenced operations in 1994. It is a brokerage facility which avoids short selling and does not deal in non-halal stocks. BIMB Unit Trust Management Bhd is a wholly-owned subsidiary of Bank Islam which also commenced operations in 1994. It manages Amanah Saham Bank Islam (ASBI) Tabung Pertama, a unit trust fund established by the bank with a fund of RM 150 million

  Other services

Islamic banks may also provide services such as;

• internet banking, safe deposit, credit cards, bank drafts, travellers cheques, clearance trustee fee. In 2010 Bank Sand orer is a bunind isies, on ly forta the Islamic pawnbroking market, in this way providing micro-finance for small business operators and stall holders.

 An evaluation of the success of Islamic Banks

• Some people have queried whether Islamic banks like Bank Islam Malaysia represent a proper approach to Islamisation. It has been argued that a proper approach would be first to adopt an Islamic constitution for the country so that all development would proceed in an Islamic framework. However, Islamic banks have been sur-cessful in countries where there is no overall policy of Islamisation, for example, in Turkey, But in Islamic tores the dinancial viability of bank is not itself sufficient; the bank should be an instrument for establishing a just and efficient economic order.
• The banks have an over-dependence on 'second-line techniques, that is, murabaha, bai bi-thamin ajil and ijara. These are considered y some to be interest under another guise. Mark-ups are about the same as the interest charged by commercial banks. To help achieve the ultimate objective of Islamic banking - alleviation of economic mustice as manifested by inequitable distribution of income and excessive concentration of wealth - the banks should actively promote the first-line techniques' such as mudarabah and musharakah. The banks have been accused of being concerned only with profits and negecting welfare. However, the counter-argument is that the banks are commercial organisations and have a duty to protect the interests of depositors and shareholders.
• Additionally there are differences of opinion among Islamic scholars and Shariah advisers on some aspects of Islamic banking, tor example, whether it is permissible to invest in companies which Induct a range of businesses, some of which might not meet strict hamic guidelines or which might have some interest- based deans.
• Some argue that the pricies of eesity and public interest would ay such investments provided that the non-balal portion of the business is small; others disagree.
• Tabung Haji: a unique Islamic financial institution At an insistin, Tabung Hai the Pilgrims Management and Fund Bond unique Tradional the Malays were agricu.