Project Report - Islamic Finance

 

Islamic  Financing   AN  ALTERNATE  FINANCING  TECHNIQUE   SAHEEBA  SABAKKA  

ISLAMIC FINANCING AN ALTERNATE FINANCING TECHNIQUE

A PROJECT REPORT Under the guidance Of

Mrs. Neena P. G

Submitted By

SAHEEBA SABAKKA Roll No. 510915516

In partial fulfillment of the requirement For the award of the degree

Of MBA in FINANCE DEC 2010

 

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ACKNOWLEDGEMENT

I express our deepest gratitude to our Advisor and Counselor Mrs. Roshini P. K, for her invaluable guidance and blessings. I am very grateful to our Principal and Head of Department Mr. Vinod C. T for providing with an environment to complete this project successfully. I especially thank Project Coordinator Ms. Neena for all the support she had extended to complete the project. I express our sincere thanks to Mr. H. Abdul Raqeeb Jeneral Secretary ICIF, for his constant encouragement and support throughout the course of the project. I am immensely grateful to Mr. Abdussalam K. M Trustee ICIF, for his unwavering support throughout the entire course of the project. I would also like to thank all the staff at ICIF who have co-operated with me for the completion of this project. I would also like to thank Ms. Gopika and all other staff at Mercy Institute of Technology who have extended their help and support throughout the project. Finally, I take this opportunity to extend our deep appreciation to our family and friends, for all that they meant to us during the crucial times of the completion of our project.

 

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    BONAFIDE CERTIFICATE

Certified that this project report titled “ISLAMIC FINANCE” is the bonafide work of “SAHEEBA SABAKKA” who carried out the project work under my supervision.

SIGNATURE

SIGNATURE

Vinod C. T

Neena P. G

HEAD OF THE DEPARTMENT

FACULTY IN CHARGE

MBA

MBA

Mercy Institute of Technology

Mercy Institute of Technology

Punnathoor Rd.

Punnathoor Rd.

Puthanpally (P. O)

Puthanpally (P. O)

Guruvayur – Thrissur

Guruvayur - Thrissur

 

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EXECUTIVE SUMMARY

Uncontrolled capitalism has caused the global economy into a plunge into an unprecedented crisis. Adding to the distress, economists worldwide are expecting the global economy to experience a double dip in the near future. This calls in for a need for eradicating huge bubbles of fiat money and assets brought in by capitalism and build up a real and stable economy. In this project, we try to study Islamic banking and financing as an alternate mode of financing as a remedy. In the wake of crisis, world has slowly started to shifting to this alternate financing model which offers a wide range of complexly engineered tools viz., Mudaraba, Murabaha, Musharaka, Istisna, Musaqat, Ijara and a lot more as has been discussed in the upcoming chapters.

Salient features of each have also been

studied. Though Islamic financing has been creating waves in the global economy, it is yet to unveil in our much potential Indian economy, owing to its non-consonance with the prevailing provisions of Banking Regulations Act. Even though remedies are available as has been studied in the project, our Central Bank is yet to sanction this model of financing which promises a new era of bright future for Indian economy.

 

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  TABLE OF CONTENTS

1. INTRODUCTION 1. 1 An Introduction to financial system 1.1.1 Importance of financial system 2.1 Islamic financial system 2.1.1 Need for Islamic banking

2. ISLAMIC FINANCE 2.1

Basic Tenets of Islamic Banking and Finance 2.1.1 Riba 2.1.2 Gharar 2.1.3 Zakaat 2.1.4 Haram

2.2 Principles of Islamic Banking 2.2.1 Prohibition against the payment and receipt of a fixed or pre- determined rate of interest 2.2.2 Sharing risks and rewards 2.2.3 Permissible forms of businesses

 

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2.2.4 Making money from money is not acceptable 2.3 Islamic Financial Institutions

2.3.1 Islamic Banking 2.3.2 Islamic Insurance (Takaful Institutions) 2.3.3 Investment Banking and Mutual Funds 2.4 Tools and Techniques of Islamic Financing 2.4.1 Murabaha (Cost plus Finance) 2.4.1.1 Steps in Murabaha 2.4.1. 2 Subject of Murabaha 2.4.1.3 Specification of price 2.4.2 Mudaraba (Trustee Finance Contract) 2.4.1 Participatory Financing 2.4.2 Preconditions of Mudaraba Contract 2.4.3 Restricted and Unrestricted Mudaraba 2.4.4 Two tier Mudaraba 2.4.5 Termination of Mudaraba 2.4.3 Musharaka (Joint Venture) 2.4.3.1 Different types of Musharaka 2.4.3.2 Diminishing Musharaka 2.4.3.3 Management of Musharaka 2.4.3.4 Termination of Musharaka

 

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2.4.4 Muzara’at and Musaqat (Agricultural Partnership) 2.4.4.1 Contracting Musaqat 2.4.4.2 Conditions of Musaqat 2.4.4.3 Termination of Musaqat 2.4.5 Ijara (Islamic Lease) 2.4.5.1 Basic Rules governing leasing 2.4.5.2 Types of Ijara 2.4.6 Qard Hassan (Benevolent Loan) 2.4.6.1 Objectives of Qard Hassan 2.4.6.2 Conditions of Qard Hassan Transaction 2.4.6.3 Application of Qard Hassan 2.4.7 Salam or Bai’ Salam (Forward Contracts) 2.4.7.1 Conditions of Salam 2.4.8 Takaful (Islamic Insurance) 2.4.8.1 Principles of Takaful 2.4.8.2 Modules under Takaful 2.4.8.3 Tabarru’ to eliminate Uncertainity 2.4.8.4 Issues in conventional Insurance 2.4.8.5 Distinguishing features of Takaful 2.4.9 Istisna

 

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2.4.9.1 Ways of effecting Istisna Sale Contract 2.4.9.2 Termination of Istisna 2.4.9.3 Istisna as a Deferred Payment Scheme 2.4.9.4 Application of Istisna 2.4.10 Sukuk (Islamic Bonds) 2.4.10.1 Difference between Sukuk and Conventional Bonds 2.4.10.1 Features of Sukuk 2.4.10.2 Uses of Sukuk Funds 2.4.10.3 Types of Sukuk 2.5 Functioning of Islamic Banks 2.5.1 Current Accounts 2.5.2 Savings Accounts 2.5.3 Investment Accounts 2.5.3.1 Equity Fund 2.5.3.2 Ijara Fund 2.5.3.3 Commodity Fund 2.5.3.4 Murabaha Fund 2.5.3.5 Mixed Fund 2.6 Rise and Scope of Islamic Banking 2.6.1 History of Islamic Banking 2.6.2 Growth of Islamic Banking 2.6.3 Reasons for popularity of Islamic Banking 2.7 Viability of Islamic Finance in India

 

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2.7.1 Hurdles on the way of introducing Islamic Banking in India 2.7.2 Risks inherent in Islamic Banking 3. CONCLUSION

 

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LIST OF TABLES

Table 1 : Financing Options for Capital Holders Table 2 : Financing Options for Entrepreneurs Table 3 : An Example of Payment Schedule under Musharaka

 

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LIST OF FIGURES

Figure 1 : Working of Mudaraba Figure 2 : Bar Diagram showing Banking reach in India

 

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LIST OF ABBREVIATIONS AND NOMENCLATURE

SYMBOLS 1. Rs.

Rupees

2. &

And

3. %

Percent

4. @

at the rate

5. $

Dollar

6. i.e

that is

7. viz

namely/ that is to say

ABBREVIATIONS

 

8. SRI

Socially Responsible Investments

9. SSB

Sharia’ Supervisory Board

10. QIB

Qualified Institutional Buyers

11. LIBOR

London Inter Bank Offer Rate

12. P/L

Profit and/or Loss

13. ROSCA

Rotating Savings and Credit Association

14. UK

United Kingdom

15. PLS

Profit Loss Sharing

16. IDB

Islamic Development Bank

17. GCC

Gulf Cooperation Council

18. OPEC

Organization of Petroleum Exporting Countries

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19. USA

United States of America

20. BRA

Banking Regulation Act

21. RBI

Reserve Bank of India

22. IPO

Initial Public Offering

NOMENCLATURE 1. Sharia’ (shariah/sharia) Islamic Rules and Regulations 2. Riba

Interest

3. Gharaar

Uncertainity

4. Zakat

Islamic tax

5. Haram

Prohibitted/ Unethical

6. bai' bithaman ajil

Sales wih advance Payment

7. nisab

basic amount excepted out of tax or zakat

8. halal

permitted/ encouraged

9. israf wa traf

luxurious activity

10. Maisir

gambling

11. Murabaha

Cost-plus Financing

12. Mudaraba

Trustee Finance Contract

13. Rabb ul Mal

Owner of the capital

14. Mudarib

Fund Manager

15. Mudaraba Al-Mutlaqa Restricted Mudararaba 16. Al-Muqayyada

Restricted

17. Musharaka

Joint Venture

18. Shirkat-ul-milk

Partnership based on joint ownership

19. Shirkat-ul-‘aqd

Partnership based on contractual

relationship 20. Shirkat-ul-Mufawadah full authority and obligation partnership

 

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21. Shirkat-ul-Inan

restricted authority and obligation

partnership 22. Shirkat-ul-Wujuh

goodwill/ credit worthiness partnership

23. Shirkat-ul-Abdan

labor, skill and management partnership

24. Mazara'at and musaqat Agricultural partnership 25. Baligh

Major/ Mature

26. Ijara

Islamic lease

27. Ijara Thumma Al- Baai Hire Purchase

 

28. Ijara Wa Iqtina

A form of Islamic lease

29. Qard Hassan

Benevolent Loan

30. Aqil

person with sound mind

31. Rashid

person capable of sound judgment

32. Ijab

offer

33. Qabul

acceptance

34. Sanduq

Box

35. Amana/Wadia

Pure Deposit

36. Salam

Forward Contract

37. Bai’ Salam

Forward Contract

38. Takaful

Islamic Insurace

39. Ra’s ul Mal

Islamic Insurance Contributions

40. Retakaful

Reinsurance

41. Wakala

Islamic Agency Insurance

42. Tabarru’

Contract in writing in Takaful

43. Istisna

Manufacture Financing

44. Suku k

Islamic Bonds

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AN INTRODUCTION TO FINANCIAL SYSTEM

A financial system is a system that allows transfer of money between savers and borrowers. It normally comprises of a set of closely interconnected financial institutions, markets, instruments, savers, practices, transactions etc. Financial system in the modern day serve as a channel through which household savings are distributed to corporate sector for productive utilization for the ultimate good, consequently, of the economy at large. It allocates investment funds among firms, and allows inter temporal smoothing consumption by household and expenditure by firms. In effect, an efficient financial system is a tool of running the economy smoothly, ensuring stability and growth.

Importance of financial system • Provides framework for carrying out economic transactions and monetary policies • Helps efficiently channel savings to investments • Sound financial system is essential for promoting economic growth.

 

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Sound financial system can be considered as the back bone of a prospering economy. A defective one could reduce effectiveness of monetary policy and deepen or prolong economic downturn. It creates a capital flight ( or large fiscal costs related to rescuing troubled institution) on a large scale. To add to it, in the modern liberal world scenario, weakness of one country can rapidly spill over across national borders and result in a global economic slump as we’ve seen in the recent past. That is to say, a sound financial system is essential for the domestic as well as the countries those that have trade or financial linkages with the country concerned.

Thinkers of the recent and ancient past have devised several forms of financial system to keep large economies on its heels. The most popular of them are capitalistic and communist system of finance, both of which in the present scenario have proven to fail on account the unprecedented economic crisis that the planet plunged into.

This situation calls out for a need for alternative financial system for a healthy and sustainable global economy. Islamic finance is an answer to that quest.

 

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ISLAMIC FINANCIAL SYSTEM

Islamic finance is based on principles of shariah, or “Islamic law.” Major principles of shariah are a ban on interest, a ban on uncertainty, adherence to risk- sharing and profit sharing, promotion of ethical investments that enhance society, and asset backing. The international market for Islamic finance has grown between 10% to 15% annually in recent years. Islamic finance historically has been concentrated in the Persian Gulf countries, but has expanded globally to both Muslim and non-Muslim countries. There is huge and growing market potential for Islamic finance in the India. Through international and domestic regulatory bodies, there has been effort to standardize regulations in Islamic finance across different countries and financial institutions, although challenges remain.

Islamic banking is essentially banking in consonance with the ethos and value system of Islam and governed in addition to the conventional good governance and risk management rules, by principles laid down by Islamic law, Shariah. It is, however, not confined to interest free banking, which is a narrow concept. In addition to non-acceptance of interestbased transactions, the fundamental tenet is that of fairness. It envisages ethical practices, contributions towards a more equitable distribution of income and wealth and active participation in achieving the goals and objectives of an Islamic economy.

 

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The history of non-interest banking in its present day incarnation is of recent origin. In the second half of the 20th century, efforts were made to adopt Islamic finance in Egypt. It slowly spread to Middle East and then to other parts of the world. Today approximately 700 registered Islamic finance institutions are said to exist covering 51 countries. The annual growth rate of Shariah compliant assets is more than 15% on year-to-year basis. At this rate, it is the world’s fastest growing financial sector and is becoming an increasingly important component of the international financial system.

Need for Islamic Banking The collapse of major Wall Street institutions, notably Lehman Brothers, and the subsequent global financial crisis and economic recession, Islamic banking is seriously being considered and has emerged as a possible alternative to the conventional banking because of the following reasons: • It is based on Ethical and Socially Responsible Investments (SRI) • It aims at Equity and Justice and leads to poverty alleviation • It acts to new imension to assets andactual projects aiming to support real economic growth instead of financial engineering • It provides services to under banked populations ignored by conventional banks

   

 

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BASIC TENETS OF ISLAMIC BANKING AND FINANCE

The basic tenets of Islamic banking and finance can be put down as under; 1. Prohibition of interest-based (riba) transactions; 2. Ban on speculation and excessive risk taking (gharar); 3. Islamic tax system (zakat); 4. Discouragement of the production of goods and services which contradict the value pattern of Islam (haram) Riba Perhaps the most far reaching of these is the prohibition of interest (riba). The payment and acceptance of riba, which are the fundamentals of conventional banking system is explicitly prohibited in Islamic

banking

and thus investors must be compensated by other means. Technically, riba refers to the addition in the amount of the principal of a loan according to the time for which it is loaned and the amount of the loan. While earlier there was a debate as to whether riba relates to interest or usury, there now appears to be consensus of opinion among Islamic scholars that the term extends to all forms of interest. In banning riba, Islam seeks to establish a society based upon fairness and justice. A loan provides the lender with a fixed return irrespective of the outcome of the borrower's venture. It is much fairer to share the profits and losses. Fairness in this context has two dimensions: the supplier of capital possesses a right to reward, but this reward should be

 

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commensurate with the risk and effort involved and thus be governed by the return on the individual project for which funds are supplied. Hence, what is forbidden in Islamic precepts is a predetermined return. The sharing of profit is legitimate and that practice has provided the foundation for Islamic banking. Gharar Another feature condemned by Islamic banking is economic transactions involving elements of speculation, gharar. Buying goods or shares at low price and selling them for higher price in the future is considered to be illicit. Similarly an immediate sale in order to avoid a loss in the future is condemned. The reason is that speculators generate their private gains at the expense of society at large. Under this prohibition any transaction entered into should be free from uncertainty, risk and speculation. Contracting parties should have perfect knowledge of the counter values intended to be exchanged as a result of their transactions. Also, parties cannot predetermine a guaranteed profit. This is based on the principle of 'uncertain gains' which, on a strict interpretation, does not even allow an undertaking from the customer to repay the borrowed principal plus an amount to take into account inflation. The rationale behind the prohibition is the wish to protect the weak from exploitation. Therefore, options and futures are considered as un-Islamic and so are forward foreign exchange transactions because rates are determined by interest differentials. A number of transactions are treated as exceptions to the principle of gharar: sales with advanced payment (bai' bithaman ajil); contract to  

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manufacture (lstisna); and hire contract (jIara). However, there are legal requirements for the conclusion of these contracts to be organized in a way, which minimizes risk. Zakat A mechanism for the redistribution of income and wealth is inherent is Islam, so that every Muslim is guaranteed a fair standard of living, nisab. An Islamic tax, Zakat (a term derived from the Arabic zaka, meaning "pure") is the most important instrument for the redistribution of wealth. This tax is a compulsory levy, one of the five basic tenets of Islam and the generally accepted amount of the zakat is one fortieth (2.5 per cent) of Muslim's annual income in cash or kind from all forms of assessed wealth exceeding nisab. Every Islamic bank has to establish a zakat fund for collecting the tax and distributing it exclusively to the poor directly or through other religious institutions. This tax is imposed on the initial capital of the bank, on the reserves, and on the profits as described in the Handbook of Islamic Banking. Haram A strict code of 'ethical investment' is prescribed and hence it is forbidden for Islamic banks to finance activities or items forbidden in Islam, haram, such as trade of alcoholic beverage and pork meat. Investments should only support practices or products that are not forbidden or even discouraged by Islam. Islamic banks are required to give priority to the production of essential goods which satisfy the needs of the majority of the Muslim community,  

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while the production and marketing of luxury activities, israf wa traf is considered as unacceptable from a religious viewpoint. In order to ensure that the practices and activities of Islamic banks do not contradict the Islamic ethical standards, Islamic banks are expected to establish

a

Sharia

Supervisory

Board,

consisting

of

Muslim

jurisprudence, who act as advisers to the banks.                                          

 

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PRINCIPLES OF ISLAMIC BANKING Islamic banking has its own unique principles that clearly distinguish it from the rest of the financial system. Principles of Islamic banking and finance are largely value based and as per the guidelines prescribed by the sharia law. These principles form the basis for the tools and techniques of Islamic financing. Prohibition against the payment and receipt of a fixed or predetermined rate of interest The essential feature of Islamic banking is that it is interest free. Islam prohibits Muslims from taking or giving interest regardless of the purpose for which such loans are made and regardless of the rates at which interest is charged. However, the Islamic ban on interest does not mean that capital is costless in an Islamic system. Islam recognizes capital as a factor of production, but does not allow the factor to make a prior or predetermined claim on the productive surplus in the form of interest. Islam allows the owners of capital a share in the surplus, which is uncertain. Profit sharing permissible in Islam, while interest is not, as in the case of the former, it is only the profit sharing ratio, not the rate of return itself that is pre-determined. Profit- making is acceptable in Islamic society as long as these profits are not unrestricted or driven by the activities of a monopoly or cartel. Islam deems profit, rather than interest, to be closer to its sense of morality and equity because earning profits inherently involves sharing risks and rewards. Profit making addresses the Islamic ideals of social justice because both the entrepreneur and the lender bear the risk of investment.  

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Thus the interest is replaced by profit and loss sharing arrangements, where the rate of return on financial assets held in banks is not known and not fixed prior to the undertaking of the transaction. The actual rate of return can be determined only ex-post, on the basis of actual profits accrued from real sector activities that are made possible through productive use of financial assets. Sharing risks and rewards The prohibition of a risk free return and permission of trading makes the financial activities in an Islamic set-up real asset-backed with ability to cause 'value addition'. Islamic banking system is based oh risk­ sharing, owning and handling of physical goods, involvement in. the process of trading, leasing and construction contracts using various Islamic modes of finance. As such, Islamic banks deal with asset management for the purpose of income generation. They will have to prudently handle the unique risks involved in management of assets by adherence to best practices of corporate governance. Once the banks have stable stream of Halal income, depositors will also receive stable and Halal income. Permissible forms of businesses The forms of businesses allowed under Islamic banking include joint ventures based on sharing of risks 8 profits and provision of services through trading, both cash and credit, and leasing activities. Though the apparent similarity between trade profit in credit sale and Riba in loaning is not denied in literature, trade has been permitted and Riba is prohibited. Profit has been recognised as 'reward' for (use of)  

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capital and Islam permits gainful deployment of surplus resources for enhancement of their value. However, alongwith the entitlement of profit, the liability of risk of loss on capital rests with the capital itself; no other factor can be made to bear the burden of the risk of loss. Financial transactions, in order to be permissible, should be associated with goods, services or benefits. Besides trading, Islam allows leasing of assets and getting rentals against the usufruct taken by the lessee. All such things/assets corpus of which is not consumed with their use can be leased out against fixed rentals. The ownership in leased assets remains with the lessor who assumes risks and gets rewards of his ownership. Making money from money is not acceptable Money is only a medium of exchange, a way of defining the value of a thing; it has no value in itself, and therefore should not be allowed to give rise to more money, via fixed interest payments, simply by being put in a bank or lent to someone else. The human effort, initiative, and risk involved in a productive venture are more important than the money used to finance it. Muslim jurists consider money as potential capital rather than capital, meaning that money becomes capital only when it is invested in business. Accordingly, money advanced to a business as a loan is regarded as a debt of the business and not capital and, as such, it is not entitled to any return (i.e. interest). Muslims are encouraged to purchase and are discouraged from keeping money idle so that, for instance, hoarding money is regarded as being  

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unacceptable. In Islam, money represents purchasing power which is considered to be the only proper use of money. This purchasing power (money) cannot be used to make more purchasing power (money) without undergoing the intermediate step of conversion into kind; i.e. by acquisition of goods and services.                                                

 

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ISLAMIC FINANCIAL INSTITUTIONS

While the Islamic financial institutions started almost fifty years back, the growth was slow in the early stages and it is a system, which is still young, evolving and expanding in terms of innovation and geographical location. It is estimated that as of now there are more than three hundred Islamic financial institutions spread across both the Islamic and nonIslamic countries. Some of the major forms of Islamic financial institutions are; a) Islamic Banking Islamic banking is the most popular form of financial institution and it is estimated to be into several hundred billion dollars. There are different models of Islamic banking;  wherein the Islamic banking is a private institution with a traditional conventional economy  a nationalized Islamic banking and third is the existence of both the Islamic and conventional banking system running parallel Many commercial banks have innovated and engineered new products, which have led to their impressive growth. In traditional system, stress is on efficiency and productivity, the basic thrust of an Islamic financial system is ethical code of conduct with an underlying idea of equitable and just distribution of resources to achieve an equitable society. The concept of efficiency and productivity of resource comes later in this  

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system. The islamic banking is currently undertake through two channels; • Islamic banks and ; • Islamic windows. Islamic banks are purely based on Islamic principle and all their operations are in conformity with sharia. Islamic windows are services provided by the traditional commercial banks to Muslim customers who engage in Islamic banking through exclusive window. b) Islamic Insurance (Takaful Institutions) Risk sharing and management is an important constituent of any financial system. There are scholars who believe that insurance can never find place in an Islamic financial system as a Muslim should be dependent upon God and getting insured amounts to challenging the will of Allah. But there is another school of thought, which believes that a Muslim should take all precautions to mitigate the risk and then not worry about the outcome and leave it to the wilt of Allah. The traditional concept of insurance is considered to be Maisir (gambling) and a contract, which has lot of gharar (uncertainty), Islamic insurance is based on takaful wherein every person participating gives a donation or tabarru, all these donations together constitute the fund from which any participant that suffers a loss or damage gets reimbursement. The balance amount, if any, left in the fund is returned back to the participants. c) Investment Banking and Mutual Funds The conventional investment banking deals with raising capital for a business either through sale of shares to the public or allotting the shares to certain Qualified institutional Buyers (QIB). Investment banks also  

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create venture capital funds wherein they provide seed capital for the start-up business growth stages of the business. An investment banker raises money through equity, debt and other investments like derivatives. An islamic investment banker cannot deal in debt instruments and derivatives. In case of equity and preference shares, the majority of islamic scholars permit it on the ground that it involves pro­ rata ownership of assets of the company. But the investment bankers must deal with only those companies, which are engaged in sharia compliant business. Venture capital financing by investment bankers should be after fully appraising and evaluating the venture, which will eliminate uncertainty (gharaar) and therefore permissible. Investment in

the

form

of

venture capital without analyzing the business proposition is outside the preview of an Islamic investment banker as it has lot of uncertainty involved in it. Dealings in the secondary market by fund managers, which are purely speculative in nature, are un-Islamic. The pre-condition for Islamic mutual funds is that there can be no assured profits and the profits and losses from the investment of the pooled funds will have to shared on a pro rata basis. Though this type of fund resembles a

traditional mutual fund but the

funds have to be invested in a company

only

if

it

fulfills

certain

conditions prescribed in the sharia laws. One of these conditions for the company is that its principal business  

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must be halal that is, it should not be dealing in business like pork selling, liquor, gambling. Secondly, the company should not be using debt, in other words having no borrowed money on which it is paying interest and it should not be keeping its money in a bank, which pays interest on these deposits. These two conditions, especially the second one about interest on deposits and borrowings make it almost impossible for the followers of Islam to invest their money in stock markets through pooled funds. However, certain scholars have advocated that if the business of the company is halaal and it is a zero debt company and it receives a small amount from its deposits with banks, then if an investor who receives dividends, gives away that part of the dividend which is attributable to the interest on deposits, then such income will be considered ha1al. Thirdly, the shares of company can be purchased only if the company holds a combination of liquid and illiquid assets. If all the assets are in money then the shares will have to be purchased at par. There has been a huge growth in Islamic equity funds and there are islamic indexes, one of the popular ones is the Dow Jones islamic index. Even though a fund may be tracking an Islamic index, this by itself does not make the profits fully sharia compliant.

 

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TOOLS AND TECHNIQES OF ISLAMIC FINANCING In order to cater to the needs of the modern world, Islamic financing puts forwards a wider range of tools and techniques of financing. These while ensuring to meet the needs of the financial world, also takes care to adhere to rules of sharia, which is primarily staying off interest system. As per the rules of sharia, any addition to the principal amount which adds up without creation of real wealth amounts to riba. That is to say, the amount earned without sharing of risks or losses would in effect amount to riba. Engineers of Islamic financing tools have been careful enough to meet up the requirements of its tenets and basic principles. In effect, what they put forward to us is a wide range of new techniques of financing which are complex in its very own nature and application. At the same time, there’s ease and simplicity at the side of the customer of the banker. Islamic financial tools function basically on; 1. Profit sharing (mudaraba) 2. Buy and sell back (murabaha) 3. Venture Capital (musharaka) Many tools might resemble the conventional tools of financing as they might look, but might differ in it simply because it don’t cater to riba. A wide range of tools and techniques of Islamic financing has been listed in the upcoming chapters.    

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MURABAHA (Cost Plus Finance)   Murabaha is a form of cost plus or mark up financing where an asset id acquired by the bank and sold to the customer. No money is loaned to the client. Rather, the financing party purchases the goods himself, based on the requirement of the client. This ensured that financing is always assetbased. In effect, this type of financing creates real assets and inventories. It is understood that most of the financing operations in Islamic banking are based on Murabaha.

Steps in Murabaha 1. The client indicates an interest in purchasing a particular asset from the bank for a certain price (a combination of cost price plus profit) at a certain time (the utilization date). 2. The client identifies the vendor, selects the goods and advises its particulars, including the vendor's name and its cost price to the bank in writing. Often the bank will appoint the client as its wakil (agent) to acquire the asset on the bank's behalf. 3. The bank acquires the asset and offers to sell it to the client. The vendor will typically make delivery of the asset to the client (as the bank's agent). Delivery need not be physical; it can also be constructive (i.e. evidenced by delivery of documents of title). 4. The agency contract comes to an end. The client accepts the offer and the bank immediately sells the asset to the client through a

 

33  

valid sale contract, with payment due on the agreed date in the future.

Fig 1: Working of Murabaha

Subject of Murabaha The assets (mal), which are the subject of the sale, must fulfill the following requirements: • The subject of sale must exist and be in the ownership (physical or constructive) of the bank at the time of sale. In other words, the second contract must "follow" the first contract. This risk- bearing by the bank - even if for a short or fleeting time period - legitimizes banks' profits under Shari'ah as distinct from prohibited riba. • They must be something of value that is classified as property in fiqh (Islamic jurisprudence) and must not be forbidden commodities, such as alcohol, pork etc.

 

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Specification of price The sale price and payment terms must be known. The price is fixed at the time of contracting, as is the mode of payment, e.g. frequency and quantum of installment payments. This is to avoid any gharar or uncertainty. Where the sale price includes a known profit or mark-up, the profit rate can be determined or expressed in relation to the market interest rate such as LIBOR. The price may not always be specified in the main murabaha documentation but can often be the subject of side letters/agreements between the parties.

     

 

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MUDARABA (Trustee Finance Contract)

Mudaraba is essentially an agreement between a financier and an entrepreneur — the principals. It is a contract whereby one side the investor or Rabb ul Mal contributes money and the other side work, being the manager or Mudarib. The Rabb ul Mal bears all losses, and the Mudarib earns a profit share. Mudaraba is a concept to provide capital to somebody undertaking the work. It could be understood as being similar to the function of an asset manager or employed manager of a company.

Participatory Financing The central idea in the concept of mudaraba is that two parties, one with capital and the other with know- how, get together to carry out a project. The financier provides the capital and plays no further part in the project; specifically, he does not interfere in its execution, which is the exclusive province of the entrepreneur. If the project ends in profit they share the profit in a pre-arranged proportion. If it results in loss the entire loss is borne by the financier, and the entrepreneur gains no benefit out of his effort, which was his part of the

investment.

However,

in

cases

of

proven

negligence

or

mismanagement by the entrepreneurs, they may be held responsible for the financial loss incurred.

 

36  

Mudaraba is usually translated as profit-and-loss-sharing but, as far as the financier is concerned, it is in fact profit-sharing-and-loss-absorbing.

Preconditions of Mudaraba contract 1. The financial risk is entirely and exclusively born by the banker, and as such there’s no scope for reducing credit risk by requesting collateral security. 2. The rate of profit should be determined strictly as a percentage and not as a lumpsum. 3. The entrepreneur has absolute freedom to manage the business.

Restricted and Unrestricted Mudaraba Where the capital is provided as being unrestricted for any purpose the manager deems fitting is called Unrestricted Mudaraba or ‘al-mudaraba al-mutlaqah’. The banker may also grant it upon conditions what has to be made with it which would then constitute what is called Restricted Mudaraba (Mudaraba al Muqayyadah), e.g. all investment funds.

Two -Tier Mudaraba The structure of Mudaraba transactions is such that the banker is involved in two different mudaraba transactions, and hence the name two-tier mudaraba. The first Mudaraba is between the bank and the client with surplus capital (depositors) and the second one is between the bank and the clients who require financing.  

37  

The first tier Mudaraba between depositors and the Islamic has those depositors acting as Rabb ul Mal and the bank acting as the Mudarib. The depositors place their funds with the bank with no guarantee of principal and a return based on the profitability of the investments made by the bank on their behalf. As with other Mudaraba, the depositors bear any losses and share profits with the Islamic bank according to a pre-agreed ratio. The second tier Mudaraba between the Islamic bank and those receiving financing has the bank acting as Rabb ul Mal and the customers acting as Mudarib. The bank bears all losses except in cases of fraud by the Mudarib and share profits with the customer according to a pre-agreed ratio.

Table No. 1 Investment options of capital- holders Type of

Mode of

Type of return on

Investment

Investment

Capital

Active

In own

Profit or Loss from the

investment

enterprise

enterprise

Shares in a

Dividend (P/L) from the

Company

company

Passive investment

Bonds/ securities

Rule

Allowed

Allowed

Fixed positive return (riba) Prohibitted

Bank deposit Fixed positive return (riba) Prohibitted

 

38  

Table No. 2 Financing options for entrepreneurs Type of

Mode of

Type of return on

financing

financing

Capital

Active finance

Own funds

Share Capital

Profit or Loss from the enterprise Dividend (P/L) from the company

Passive

Bonds/

Fixed positive return

finance

securities

(riba)

Bank loans

Fixed positive return (riba)

Rule

Allowed

Allowed

Prohibitted

Prohibitted

Termination of Mudaraba The contract of Mudaraba can be terminated at any time by either of the parties. The only condition is to give a notice to the other party. If at the time of termination, assets of the mudaraba are not in cash form, the mudarib shall be given an opportunity to liquidate them so as to determine the amount of profit, which shall then be divided as per the agreed ratio.

         

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MUSHARAKA (Joint Venture)

Musharaka is a contract whereby the bank and a customer agree to combine their financial resources for the establishment or running of a business or project, or for undertaking any type of business activities. The two parties agree to manage the project in accordance with the terms of the contract. The profit or loss will be apportioned between the parties, according to a mutually agreed proportion, which need not coincide with the ratio of amount of capital invested. Losses are shared by all parties in proportion to their investment. Banks have a legal authority to participate in the management of the project, including representation on the Board of Directors.

Different types of Musharka There are two basic types of Musharaka; 1. Shirkat-ul-milk (Partnership based on joint ownership) – This a voluntary Musharaka, which come into existence at the option of the participants. 2. Shirkat-ul-‘aqd (Partnership based on contractual relationship) – This partnership is based on contractual relationship. They are further divided into 5;

 

40  

1. Shirkat-ul-Mufawadah (full authority and obligation) – This is a limited partnership with equal capital contributions, responsibility, full authority on behalf of others, along with responsibility for liabilities incurred through the normal course of business. 2. Shirkat-ul-Inan (restricted authority and obligation) – This too is a limited form of partnership, but with unequal capital contributions. They do not share equal responsibility, and this reflects their share of profits. 3. Shirkat-ul-Wujuh (goodwill/ credit worthiness) – This is a kind of partnership entered into with companies based on reputations of one of both parties, typically small scale business. 4. Shirkat-ul-Abdan (labour, skill and management) – Partnership with a company based on the contribution of human efforts with no capital contributions. These are again typically small scale business. 5. Shirkat-ul-Mudaraba – This is a partnership for a Mudaraba contract.

Diminishing Musharakah This is a derived form of Musharakah and was developed in the near past. According to this concept, the financier-and the client participate either in the joint ownership of a property or an equipment, or in a joint commercial enterprise, on a diminishing share basis. The share of the financier would be divided into a number of units and the contract is on a condition that the client purchases the units of the share of the banker one by one periodically, thus increasing his own share till all the units of the financier are purchased by him so as to make him the sole owner of the property, or the commercial enterprise, as the case may be. At the same  

41  

time, the share of ownership of the financier in the property keeps diminishing and hence the name ‘Diminishing Musharaka’.

Table No. 3 An example of Payment Schedule under Musharaka

Month

Rent (Rs.)

Extra

Total Fixed

Bank’s

Payment

Payments

ownership

(Rs.)

(Rs.)

(Rs)

opening

120000

1

800

347

1147

119653

2

789

349

1147

119304

….

…..

…..

1147

…

176

37

1110

1147

4439

177

30

1117

1147

3322

178

22

1125

1147

2197

179

15

1132

1147

1065

180

7

1065

1072

0

Management of the Musharaka Every partner has a right to take part in the management and to work for it. However, the partners may agree upon a condition that the management shall be carried out by one of the and not by other partners. In that case, the sleeping partner should be entitled to the profit only to the extent of his investment, and the ratio of the profit allocated to him should not exceed the ratio of his investment.

 

42  

Termination of Musharaka Every partner has a right to terminate the Musharaka at anytime after giving his partner a notice to this effect, whereby the Musharaka with come to an end. Termination of one partner need not terminate the whole agreement and others may purchase the terminating partners share and continue the business.

                                         

 

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MAZARA'AT AND MUSAQAT (Agricultural Partnership)

Mazara'at and musaqat are two types of partnership. They are similar to mudarabah, in that they are both types of partnerships between capital and labour. The difference is that mudarabah is relevant to trading whereas muzara'at is for farming. If a person leaves his trees with someone for a specified period of time, so that he cares, tends and waters them, and in return, that person will take an agreed quantity of fruits, this transaction is called Musaqat. In partnerships between capital and labour, whether mardarabah agreements or mazara'at or musaqat, any kind of harm or loss the capital is subject to is born by the owner of the capital, the investor. And, as such, there is also no certainty of making a profit on the capital. The only profit that is returned to the owner of the capital is in accordance to the profit made by the partnerships and to his specified proportion of those profits. Here it is that the financer, just like the worker, might make no profit, and it is even possible that he may lose his capital and even become bankrupt. Contracting Musaqat While concluding a transaction of Musaqat, the prescribed formula can be recited in any language, or without reciting the formula, if the owner of trees hands over them, with the intention of Musaqat, to the person who  

44  

has agreed to take care of them, and he also receives them with the same intention, the transaction will be in order. (Of course, the necessary talks about the duration and the conditions, etc. should have taken place earlier). The following points need to be considered; 1. If a clear agreement, in respect of melon, cucumber vines etc., in which the number of times of picking and the share of each one are specified, is made. 2. Trees that need not be irrigated and benefit from rainwater or the moisture of the earth, but need other work to be done for them, like turning up with a spade, fertilizing and spraying which will make their fruits or their quality to be increased, it will be in order. 3. The work to be done by each of the parties involved should be specified in advance, like, repairing the subterranean canals, or the water well engine, also the supply of the manure, spray equipments, etc., and if there is a local practice and rule in this respect, that will suffice. 4. It is possible that the other party in Musaqat be more than one, that is, the owner of the trees may leave them in the hands of several people, and conclude the contract of Musaqat with them.

Conditions for Musaqat 1. The owner of the trees and the person who undertakes to tend and care for them, should be Baligh and sane. 2. No one should have compelled them to do so. 3. They should not have been banned from having discretion over

 

45  

their own property. 4. The period of Musaqat should be specified, and if the beginning of it is specified, and its end is fixed to be the time when fruits for that year become available, the contract is in order. 5. It is necessary that the share of each one of them be fixed as 1/2 or 1/3 etc. of the crop. 6. It is necessary that the contract of Musaqat be concluded before the appearance of the crop. And if the contract is made after the appearance of the fruits and before they are ripe, the contract will be in order, provided that some work like, watering and spraying which are required for increasing the crop and protecting the trees, still remain to be done. And if the work required to be done, is merely plucking the fruits and looking after them, the contract is in order but it is not Musaqat.

Termination of Musaqat The parties involved can cancel the transaction of Musaqat with mutual consent, and also if, when concluding the contract, they had agreed that one or both of them would have the right to cancel it, then, he can do so according to the agreement. And if in the contract of Musaqat, they had laid a condition and that condition is not fulfilled, and if the person who benefits from the condition is not able to compel the other party to fulfill it, then, he can cancel the transaction. The Musaqat transaction will not terminate with the death of the owner of the orchard, and his heirs will act on his behalf. However, if the person who has undertaken to look after the trees, dies and if they had agreed

 

46  

that he himself would do the job, the contract will become cancelled, but if they have not laid such a condition, his heirs will take his place.

 

47  

IJARA (ISLAMIC LEASE)

Ijara is an agreement wherein the Bank leases movable and immovable assets to its customers, with the option that the customer may or may not own the leased asset at the end of the term of the lease as per the agreement singed between the two parties. Ijara means lease, rent or wage.

Basic rules governing Leasing 1. Contract should be for an agreed period, at an agreed consideration; determined at the time of contract. 2. The consideration should in monetary form. 3. The object being leased must have a valuable use; and it should not be perishable. 4. The leased asset should remain in the ownership of the lesser; only its usage is transferred to the lessee 5. All the liabilities arising out of the ownership shall be borne by the lesser, but the liabilities arising from the use of the property shall be borne by the lessee. 6. The lessee cannot use the leased asset for any other purpose than specified in the agreement. 7. Damages to the asset owing to misuse or negligence shall be borne by the lessee asset caused by any misuse or negligence on the part of the lessee; whereas that which is beyond the control of lessee

 

48  

shall be borne by the lesser. 8. A property under joint ownership can be leased out and the lease amount distributed between the owners In proportion to their shares in the property. 9. The leased asset should be fully identified by all the parties. 10. If variable rentals are fixed different phases, the particulars should be agreed upon at the time of the lease; else the agreement would not be valid. 11. The lease period commences on the delivery of the asset. 12. If the leased asset loses the function for it was leased, provided it can’t be repaired and it didn’t occur due to negligence on part of the lessee, the lease is terminated.

Types of Ijara Ijara Thumma Al- Baai’ (Hire Purchase) These are variations on a theme of purchase and lease back transactions. There are two contracts involved in this concept. The first contract, an Ijarah contract (leasing/renting), and the second contract, a Bai contract (purchase) are undertaken one after the other. For example, in a car financing facility, a customer enters into the first contract and leases the car from the owner (bank) at an agreed rental over a specific period. When the lease period expires, the second contract comes into effect, which enables the customer to purchase the car at an agreed price. In effect, the bank sells the product to the debtor, at an above market-price profit margin, in return for agreeing to receive the payment over a period of time; the profit margin on the lease is equivalent to interest earned at a fixed rate of return.  

49  

Ijara- Wal- Iqtina A contract under which an Islamic bank provides equipment, building or other assets to the client against an agreed rental together with a unilateral undertaking by the bank or the client that at the end of the lease period, the ownership in the asset would be transferred to the lessee. The undertaking or the promise does not become an integral part of the lease contract to make it conditional. The rentals as well as the purchase price are fixed in such manner that the bank gets back its principal sum along with profit over the period of lease.

                           

 

50  

   

QARD HASSAN (Benevolent Loan)

Islam allows loan as a form of social service among the rich to help the poor and those who are in need of financial assistance. Loan in Islam may be obtained in two ways: (i) Loan with condition of repayment, and (ii) gratuitous loan without any compensation or gift. However, Islam does not recognize any loan with interest for the benefit of the debtor. It only recognizes gratuitous loan or better known as al-qard al-hasan. M. Umer Chapra has given the definition of qard al hasan as: "Qard alhasan is a loan which is returned at the end of the agreed period without any interest or share in the profit or loss of the business." Therefore, qard al- hasan is a kind of gratuitous loan given to the needy people for a fixed period without requiring the payment of interest or profit. The receiver of qard al-hasan is only required to repay the original amount of the loan.

Objectives of Qard Hassan 1. To help the needy fellow people. 2. To establish better relationship among poor and the rich. 3. The mobilization of wealth among all people in the society. 4. To strengthen the national economy. 5. To facilitate the poor to create new jobs market and business ventures by using their merits, skills and expertise. 6. To establish a caring society.  

51  

7. It can remove social and economical discrimination from the society. 8. To eradicate unemployment problem from the society.

Conditions of Qard Hassan Transaction 1. Both parties should be legally (shari'ah) capable to enter into the qard contract It is unanimously agreed by the four schools of law that to enter into a contract, parties should be baligh, 'aqil and rashid (major with sound judgment). The age of marriage and the sound judgment is the age of majority, and thereby a major person is capable to enter into any transaction validly. A person, who has not attained the age of puberty , may not be a responsible party for al-qard al- hasan transaction.

2. Ijab (offer) and qabul (acceptance) of the qard must be clearly made before entering into the loan contract Ijab and qabul should be clearly indicated in the contract, otherwise, the loan contract may create dispute in future. In the loan agreement, there should have clear expression, collation and conjunction of the ijab and qabul between the parties.

3. The date of payment must be specified The date of payment should be mentioned in the loan agreement. If no date is specified, the transaction may lead to ambiguity and dispute in future between the lender and the borrower.

 

52  

4. The loan contract should be written down In order to avoid chances of any future dispute, it is necessary that the contract be made in writing. However, some opine that it is not obligatory but strongly recommended. The reason given by them is that if both parties agree not to write, then it is no longer an obligation upon them to write down. The reason behind the writing down is to avoid future dispute. On the contrary, a minority of the scholars are of the opinion that it is obligatory upon the parties to write down the contract.

5. Getting two witnesses There must be two male witnesses to make any contract valid. Witnesses are of great importance in sharia compliant contracts. If two men are not available, then one man and two women will suffice. This will help avoid any chance of future disputes which disrupt the whole functionality of Qard Hassan.

6. Administrative fee / Service charge To obtain some compensation for offering al-qard al-hasan facilities, the banks demand some charges and fees. These expenses incurred by banks on providing al-qard al- hasan are collected from the borrowers, and the basis for the calculation of these expenses is laid down by the central bank. If any bank or other institutions give al-qard al-hasan, they may require service charge or administrative fee. However, there is no scope for an  

53  

individual lender to demand this charge unless any amount incurred due to procedural requirements of the loan agreement, such as lawyer's fee, stamp duty etc.

7. Extra Payment It is very clear that in the loan agreement, there will be no condition for extra payment, otherwise, it will be riba . It is however, permissible for the debtor to give some sort of gift to the creditor as a sign of appreciation of his voluntary deed. It is exclusively up to the borrower whether to pay extra or not, regardless the loan was for consumption or commercial purpose and the lender cannot demand it, as it is only a virtue on part of the borrower on repayment and not a right of the lender. Added, there should not be any stipulation for extra benefit in the loan agreement.

8. Early demand to pay back Loan is a voluntary act by the creditor. However, it is not encouraged for early demand to pay back the loan from the debtor. The creditor should not demand the loan amount from the debtor before the agreement matures or lapses.

9. Guarantors: In the case of the al-qard al-hasan, there can be guarantors. The guarantors of the borrower may be any person or the property of the borrower that is collateral security, such as, mortgage, charge etc. In case of the borrower's failure to pay back the loan after the expiration of the  

54  

time specified, his guarantor has to pay or the collateral security is to be valued for the repayment of the loan. But, Muslims should remember that a true believer should not delay to pay back his obligations.

Application of Qard Hassan 1. Friends and Families The application for interest free loans is relevant especially among larger families, which may put in place a private “box” called Sanduq among them where needy family members could draw out an interest free credit. Wealthy member may draw out a finance facility against profit/loss sharing explained later on.

2. Qard Hassan for Deposit Taking Islamic banks to provide finance do not use the instrument of Qard Hassan widely, rather it is used to accept deposits. Such a deposit loan is permissible and could be used to be invested in other projects of the bank, while a pure deposit (Amanah / Wadiah) is cannot be used in the same way.

3. ROSCA - Rotating Credit and Saving Associations Another potential application for the Qard Hassan technique is the savings/lending model. The loan depositor receives instead of interest, saving points for the size and duration of the funds provided. After achieving a sufficient number of those points, he should able to take out a

 

55  

loan himself. The administration of such a model could be subject to fees which are not bound by time and size of the credit. Another positive factor to be seen is the effect of a stress test for the borrower – having savings over a period time is a good way to know the own repayment capacity. Further a credit history is no longer an absolute must. It is a called in the conventional sector a rotating savings and credit association (ROSCA ), and reported to be practiced in the informal sector even in UK and Australia but not on a professional basis.                                        

 

56  

 

SALAM or BAI’ SALAM (Forward Contracts)

Salam or Bai'Salaam as it is also called, is a sale whereby the seller undertakes to supply some specific goods to the buyer at a future date in exchange for a price fully paid in advance. It is similar to a forward contract with the buyer paying the seller, the negotiated price of a product that the seller promises to deliver at a future date. The quality and quantity of the products involved in this type of transaction must be capable of being specified at the time of the contract.

Condition of Salam • The buyer should pay the price in full to the seller at the time of effecting the sale. Else, it will be tantamount to a sale of debt against debt, which is expressly prohibited. Moreover, the basic wisdom behind the permissibility of Salam is to fulfill the instant needs of the seller. If the price is not paid to him in full, the basic purpose of the transaction will be defeated. • Salam can be effected in those commodities only whose quality and quantity can be specified exactly. For example, the precious stones cannot be sold on the basis of Salam, because every piece of precious stones is normally different from the other and their specifications need to drawn differently.

 

57  

• Salam cannot be effected on a particular commodity or on a product of a particular field or farm. Because it is possible that field is destroyed before the delivery, and in the presence of this possibility the delivery remains uncertain. • The same rule is applicable to every commodity whose supply is not certain. It is necessary that the quality of the commodity be fully specified leaving no ambiguity that may lead to dispute. • It is a necessary that the quantity of the commodity be agreed upon in unequivocal terms. • The exact date of delivery must be specified in the contract. • Salam cannot be affected in respect of those commodities that must be delivered at the spot. For example, if gold is purchased in exchange for silver, it is necessary, according to Shariah, that the delivery of both be simultaneous. Here, Salam cannot work. • Salam sale is not permissible on existing commodities because damage and deterioration cannot be assured before delivery on the due date. • Salam is permissible on a commodity of a specific locality, if it is assured that it is almost always available in that locality and it rarely becomes unavailable. • The place of delivery must be stated in the contract, if the commodity needs loading or transportation expenses.  

58  

• It is not permissible for the buyer of a Salam commodity to sell it before receiving it because that is similar to the prohibited sale of debts before holding. • Salam sale is suitable for the finance of agriculture operations, where the bank can transact with farmers who are expected to have the commodity in plenty during harvest either from their own crops or crops of others, which they can buy and deliver in case their crops fail. • Salam sale is also used to finance commercial and industrial activities, especially phases prior to production and export of commodities and that is by purchasing them on Salam and marketing them for lucrative prices.                              

59  

 

TAKAFUL (Islamic Insurance)

Takaful is an Arabic word which means “guaranteeing each other” or joint guarantee as against guarantee or mutual security. Takaful or Islamic Insurance is basically based on the concept of mutual or cooperative insurance and it takes care of all the Shariah related concerns including ensuring investment to be made in Shariah compliant instruments. The concept of Takaful as such is not new in Islamic Commercial Law. Islam accepts the principle of reciprocal compensation and joint responsibility. The system of Takaful insurance tends to achieve selfreliance through a self-sustaining insurance system based on community pooling, solidarity and joint guarantee for the well being of community and individuals in need, the entire system and operation being based on Islamic principle. Principles of Takaful • Policyholders cooperate among themselves for their common good. • Every policyholder pays his subscription to help those that need assistance. • Losses are divided and liabilities spread according to the community pooling system. • Uncertainty is eliminated in respect of subscription and compensation. • It does not derive advantage at the cost of others.

 

60  

Modules under Takaful 1. Mudaraba - By this principle, the entrepreneur or al-Mudharib (takaful operator) will accept payment of the takaful installments or takaful contributions (premium) termed as Ra's-ul-Mal from investors or providers of capital or fund (takaful participants) acting as Sahib-ul-Mal. The contract specifies how the profit (surplus) from the operations of takaful managed by the takaful operator is to be shared, in accordance with the principle of alMudharabah, between the participants as the providers of capital and the takaful operator as the entrepreneur. 2. Wakala - Here the Takaful provider act as an agent for the participants and manages the Takaful/Retakaful (Reinsurance) fund for a fee. This model is generally used in middle-east region. 3. A combination of both Mudaraba and Wakala

Tabarru’ to eliminate uncertainity Takaful companies normally divide the contributions into two parts, 1. Donations for meeting mortality liability or losses of the fellow policyholders. 2. Investment fund to be invested in halaal business on a non-interest basis. Accordingly, the clause of Tabarrú is incorporated in the contract. How much of the contribution is meant for mortality liability and how much for investment account is based on a sound technical basis of mortality tables and other actuarial requirements. Both the accounts are invested  

61  

and returns thereof distributed on Mudarabah principle between the participants and the Takaful operators. The profit attributable to the participants is credited into the two accounts separately.

Issues in Conventional Insurance 1. Riba (interest) – Conventional life insurance schemes can be considered to contain riba in that the claim is much higher than the premium amount paid. As about general insurance, the fund is invested in instruments that are interest based. 2. Maisir (gambling) – There can be cases where there’s no claim and the policy holder loses all money, and where there’s claim, its much higher than the amount contributed and hence gambling. Life insurance as such is a contract of wager on the death of the policy holder. 3. Gharaar (uncertainty) – The benefits on insurance are dependent upon the outcome of a future event, which is uncertain. Conventional insurance in itself is a game of uncertainty.

Distinguishing features of Takaful 1. The policyholders are the participants to the Takaful / Retakaful fund 2. The contribution so received are not aimed at making profit per se but are more in the nature of pooling the risk and risk management rather than risk taking. 3. The Takaful operator is not the owner of the fund but merely its custodian.

 

62  

4. The

surplus

generated

belongs

to

the

contributor

(i.e.

policyholders) solely under wakala model and to both i.e. policyholder and Takaful Company under mudarba model. This is a unique feature of Takaful insurance 5. Since the surplus goes back to the participants in proportion to their contribution, there is an inbuilt check on over-pricing. 6. Funds are invested in Shariah compliant instruments / avenues. 7. Incidentally, Reliance Life has come out with a plan called RSIP where the investment is made in non-banking sector excluding liquor, cigarette, tobacco, entertainment, gambling, etc.

                       

 

63  

ISTISNA

Istisna is an Islamic form of financing used to finance construction and industrial projects, such as the construction of buildings and so on. The unique feature of Istisna'a is that it allows the selling of an asset, which does not exist at time of the contract. The payment can be in immediate cash or may be in the form of deferred payments. Ways of effecting Istisna sale contract 1. It is permissible for the bank to buy a commodity on Istisna contract then sell it after receipt for cash or deferred payment. 2. It is also permissible for the bank to enter into a lstisna contract in the capacity of seller to those who demand a purchase of a particular commodity and then draw a parallel istisna contract in the capacity of a buyer with another party to manufacture the commodity agreed upon in the first contract. Each transaction is deemed a separate contract with payment being made in cash either immediately or on a deferred basis. Any disagreements that may arise are settled under each contract separately according to the provisions therein. Istisna is, thus, an exceptional mode of sale, at an agreed price, whereby the buyer places an order to manufacture, assemble or construct, or cause so to do anything to be delivered at a future date. It means to place an order with a manufacturer to manufacture a specific commodity for the

 

64  

purchaser. If the

manufacturer undertakes to manufacture the goods

for him, the transaction of Istisna comes into existence. But it is necessary for the validity of Istisna that the price is fixed with the consent of the parties and that necessary specification of the commodity (intended to be manufactured) is fully settled between them. Termination of Istisna The contract of Istisna creates a moral obligation on the manufacturer to manufacture the goods, but before he starts the work, any one of the parties may cancel the contract after giving notice to the other. But after the manufacturer has started the work, the contract cannot be cancelled unilaterally. However, the party placing the order has the right to retract, if the commodity does not conform to the specifications demanded.. Istisna as a Deferred Payment Scheme Since it is not necessary in Istisna that the price is paid in advance, nor is it necessary that it is paid at the time of the delivery, rather, it may be deferred to any time according to the agreement of the parties, therefore, the time of payment may be fixed in whatever manner they wish. The payment may also be in installments. Application of Istisna Istisna contracts are applied in high technology intensive industries such as the aircraft industry, locomotive and ship building industries. In addition, this type of business transaction is also used in the production of large machinery and equipment manufactured in factories and workshops. Finally, the istisna contract is also applied in the construction industry  

65  

such as apartment buildings, hospitals, schools, and universities to whatever that makes the network for modern life. The Istisna contract is best used in those transactions in which the product being purchased can easily be measured in terms of the specified criteria of the contract.                                                

 

66  

 

SUKUK (Islamic Bonds)

Sukuk in general may be understood as a shariah compliant ‘Bond’. In its simplest form sukuk represents ownership of an asset or its usufruct. The claim embodied in sukuk is not simply a claim to cash flow but an ownership claim. This also differentiates sukuk from conventional bonds as the latter proceed over interest bearing securities, whereas sukuk are basically investment certificates consisting of ownership claims in a pool of assets. Sukuk (plural of word sak) were extensively used by Muslims in the Middle Ages as papers representing financial obligations originating from trade and other commercial activities. However, the present structure of sukuk are different from the sukuk originally used and are akin to the conventional concept of securitization, a process in which ownership of the underlying assets is transferred to a large number of investors through certificates representing proportionate value of the relevant assets.

Distinction between Sukuk and conventional Bond •

A bond is a contractual debt obligation whereby the issuer is contractually obliged to pay to bondholders, on certain specified dates, interest and principal, whereas, the sukuk holders claims an undivided

beneficial

ownership

in

the

underlying

assets.

Consequently, sukuk holders are entitled to share in the revenues generated by the sukuk assets as well as being entitled to share in

 

67  

the proceeds of the realization of the sukuk assets. • A distinguishing feature of a sukuk is that in instances where the certificate represents a debt to the holder, the certificate will not be tradable on the secondary market and instead is held until maturity or sold at par.

Features of Sukuk •

Tradable shariah-compliant capital market product providing medium to long-term fixed or variable rates of return. Assessed and rated by international rating agencies, which investors use as a guideline to assess risk/return parameters of a sukuk issue.

•

Regular periodic income streams during the investment period with easy and efficient settlement and a possibility of capital appreciation of the sukuk.

• Liquid instruments, tradable in secondary market.

Uses of Sukuk Funds The most common uses of sukuk can be named as project specific, assetspecific, and balance sheet specific. 1. Project-specific Sukuk Under this category money is raised through sukuk for specific project. 2. Assets-specific Sukuk Under this arrangement, the resources are mobilized by selling the beneficiary right of the assets to the investors.

 

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3. Balance Sheet-specific Sukuk This is an arrangement wherein the Islamic bank mobilizes funds by issuing sukuk and these funds are used to finance various projects of the member countries.

Types of Sukuk: Sukuk takes several innovative Shariah compliant forms that combine various particles of Islamic forms of finance together. 1. Ijarah Sukuk Ijarah Sukuk are related to leased properties and assets, they carry equal values, and are issued by the owner of the leased property or his agent. The aim of the transaction at the end is to sell the leased property through issuing Sukuk, accordingly, the holders of the certificates or Ijarah Sukuk own the asset and its charges during the rental period, each in proportion to the certificates of Sukuk held in the leased asset. 2. Usufructs of Existing Assets: Usufructs of existing assets' Sukuk certificates carry equal values and are issued by the owner for an existing asset or by sublease at the consent of the owner or by both. The certificates represent the rights on the service or usufruct of an asset that could either be directly or indirectly hired to a second or a third party. A house could either be rented by its owner or agent to a second party or sub rented by the second party to a third party. In both cases the lessee owns the right to enjoy the service of the asset during the lease period while not owning the asset itself.

 

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3. Usufructs of Future Assets: The usufruct could also be futuristic for a specified period of time for a specified asset which would not be ready at the time of issuing the Sukuk certificates but, it could be under construction or contracted for construction and delivery at a future time. This is analogous to the Salam contract. 4. Contractor's Sukuk: A contractor's or a supplier's Sukuk can be issued by a contactor or a supplier of a good or a service. The Sukuk could be for existing commodities or those, which would be offered during a contracted time in future. These sukuk carries equal values issued by a covenanter to provide or sell services described in the security, such services are to be sold in a form of sukuk, so that the holders of the same shall to be the owners of such services and shall gain the proceeds from selling the same in the markets. 5. Potential Services Sukuk: These Sukuk carries equal values issued by a contractor (or a supplier) or an agent having a saleable services to Sukuk holders and such holders shall have the right to sell the same in the stock market. 6. Salam Sukuk Sukuk or certificates of Salam carry equal values for mobilizing the capital necessary to produce some specified commodities contracted for deliverance at specified periods of time in future while their value prices are fully paid in advance. A separate parallel Salam contract could be signed by the Salam item buyer with a third party, without linking it to the first contract. Ethically, the contractors should be committed towards  

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their contract parties, and should not transfer their own responsibilities in a contract to their parties in another one. 7. Istisna Sukuk Sukuk or certificates of Istisna carry equal values for mobilizing capital necessary to produce some specified commodities. Such commodities could be sold with partial advance payments according to Istisna contracts in order to be delivered at a specified period of time in future. Istisna is applicable on building and establishing ships, airplanes, bridges, roads, power generation stations, water supply stations and the alike according to a specific specifications stipulated in the contract and according to a pre-stated delivery date and value. It is possible to synthesize another formula with the same to respond to the requisites of the process and finance. This type is amongst the most active instruments in world of Sukuk. A separate parallel Istisna contract could be signed by the Istisna item buyer, with a third party, without linking it to the first contract, as it is the case with the parallel Salam contracts. Wherein the supplier enters into a contract with an entity to manufacture a specified merchandise for them, then the supplier enters into a contract with a third party to manufacture the product to deliver the same for the demanding party on the stipulated time. 8. Murabaha Sukuk These Sukuk carry equal values and are issued by the merchant or his agent in order to finance the purchasing a commodity then to sell the same at a known Murabaha as for equipments required within an Istisna’a contract weher the equipments shall be purchased on a known Murabaha  

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and the holders of Sukuk will be the owners of such equipments and of the sales income from the same. 9. Musharakah Sukuk These Sukuk carry equal values and are issued by the supplier (entrepreneur or a covenanter )or his agent, to finance a project or projects where the holders of Sukuk will be the owners of such projects, this is far similar to partnership companies although they might differ if the Sukuk issuer is authorized to select the projects which are transferred and constructed. 10. Mudarabah Sukuk This type of Sukuk, carry equal values issued by the contractor to provide the entrepreneurship and to manage the proposed project, for the purpose of financing such project or a combination of projects which are specified or those in which he is authorized to act upon. Thereby, the Sukuk holders shall be the owners of the capital of the project and the project shall remain a partnership between them and between the entrepreneur at an agreed portion of the profits and shall bear the expected losses in capital. 11. Muzaraa Sukuk: These Sukuk carry equal values issued by the owner of the agricultural land in order to finance the agricultural costs according to a Muzaraa contract where the holders of Sukuk become partners in the produced crops as per the terms stipulated in the contract. 12. Musaqat Sukuk: These Sukuk carry equal values, issued by the owner of the plants, the  

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subject of the contract, in order to finance the processes of irrigation and cultivation, where the holders of Sukuk become partners in the produced crops as per the terms stipulated in the Musaqat contract. 13. Musharakah Sukuk in Investment Agency: These Sukuk carry equal values and are issued by an investment agent. They represent projects and activities, where the investment agent shall be appointed as a mediator who manages the investment on behalf of the Sukuk holders in consideration of a percentage out of the profits. 14. Mugharasah Sukuk (Planting): These Sukuk carry equal values and are issued by the owner of the land subject of the contract for financing the costs of plantation under Mugharasa contract. The holders of the Sukuk shall jointly share the ownership of the trees planted together with the ownership of the land on which such trees were planted according to the contract. 15. Sukuk of Reducing Ownership: These Sukuk carry equal values issued by the owner of the innovated idea, the subject of the contract, in order to finance a project pursuant to the establishment contract ending by transferring the ownership of the assets or services to the owners of the idea or to the founding after a specified period of time. The owners of the innovated idea shall be partners in the project either by employment (work), by capital or both together. i.e, the partner shall be an employee who entitles a wage against his work, or a partner by business who shall start paying for the value of the project to the holders of Sukuk out of his share in the profit in a manner reducing the number of Sukuk holders making him a partner with an increasing share, the more he is able to pay out of his share. Thus the  

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shares of Sukuk holders diminishes, while the shares of the working partners increases ending to stage where the ownership of the assets and its associated services, the asset alone or the services alone in favor of the partners. This formula combines the limited period lease Sukuk for assets and services. The above could be summarized as, funds would be mobilized for establishing companies that could be partially owned by the holders of the Sukuk certificates. Gradually, the Sukuk holders can buy the capital share of their partners in the company so that they entirely own the company, as per the agreed contractual conditions.

The market for sukuk is now maturing and there is an increasing momentum in the wake of interest from issuers and investors. sukuk have confirmed their viability as an alternative means to mobilise medium to long-term savings and investments from a huge investor base.

Different sukuk structures have been emerging over the years but most of the sukuk issuance to date have been ijara sukuk, since they are based on the undivided pro-rata ownership of the underlying leased asset, it is freely tradable at par, premium or discount. Tradability of the sukuk in the secondary market makes them more attractive. Although less common than Ijara sukuk, other types of sukuk are also playing significant role in emerging markets to help issuers and investors alike to participate in major projects, including airports, bridges, power plants etc.  

 

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FUNCTIONING OF ISLAMIC BANKS

It can be seen that in any banking business, there exist two aspects - at the one end is the deposit aspect and at the other end is the lending or investment aspect. At the deposit end of the scale, Islamic banks normally operate three broad categories of accounts, namely, current, savings, and investment accounts.

1. Current accounts Current accounts are based on the principle of al-wadiah, whereby the depositors are guaranteed repayment of their funds. At the same time, the depositor does not receive remuneration for depositing funds in a current account, because the guaranteed funds will not be used for PLS ventures. Rather, the funds accumulating in these accounts. can only be used to balance the liquidity needs of the bank and for short­ term transactions on the bank's responsibility. 2. Savings accounts Savings accounts also operate under the al-wadiah principle. Savings accounts differ from current deposits in that they earn the depositors income: depending upon financial results, the Islamic bank may decide to pay a premium, riba, at its discretion, to the holders of savings accounts. 3. Investment accounts An investment account operates under the  

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principle, in which the mudarib (active partner) must have absolute freedom in the management of the investment of the subscribed capital. The conditions of this account differ from those of the savings accounts by virtue of: a) a higher fixed minimum amount, b) a longer duration of deposits, and c) the depositor may lose some of or all his funds in the event of the bank making losses; ie, the principal or the rate of return on the deposits is not guaranteed. The only contractual agreement between investment depositors and banks is the proportion according to which profits or losses are to be distributed between the parties of the deposit contract. The amounts so pooled are invested in a business acceptable to Shariah. The investment funds so created may be invested in varied forms: a. Equity Fund • In an equity fund the amounts are invested in the shares of joint stock companies. The profits are mainly derived through the capital gains and dividends earned on the equity shares. • Dealing in shares or acquisition of shares of companies can be acceptable under Shariah, subject to the following conditions: • The main business of the company is not violative of Shari'ah. • If the main business of the companies is ha/al, like automobiles, textile, etc. but they deposit their surplus amounts in an interest­ bearing account or borrow money on interest, the shareholder must express his disapproval against such dealings, preferably by raising his voice against such activities in the annual general meeting of the company. • If some income from interest-bearing accounts is included in the income of the company, the proportion of such income in the  

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dividend paid to the shareholder must be given in charity, and must not be retained by him. • The shares of a company are negotiable only if the company owns some illiquid assets. The subscribers to the fund will be treated in Shari'ah as partners’ interest. All the subscription amounts will form a joint pool and will be invested in purchasing the shares of different companies. The profits can accrue either through dividend distributed by the relevant companies or through the appreciation in the prices of the shares. In the first case i.e. where the profits are earned through dividends, a certain proportion of the dividend, which corresponds to the proportion of interest earned by the company, must be given in charity. The contemporary Islamic Funds have termed this process as 'purification'. The management of the fund may be carried out in two alternative ways. The managers of the Fund may act as mudaribs for the subscribers. In this case a certain percentage of the annual profit accrued to the fund may be determined as the reward of the management. The second option for the management is to act as an agent for the subscribers. In this case, the management may be given a pre-agreed fee for its services. This fee may be fixed in a lump sum or as a monthly or annual remuneration. According to the contemporary Shari'ah scholars, the fee can also be based on a percentage of the net asset value of the fund. b. Ijarah Fund In this fund the subscription amounts are used to purchase assets like real estate, motor vehicles or other equipments for the purpose of leasing them out to their ultimate users. The ownership of these assets remains  

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with the Fund and the rentals are charged from the users. These rentals are the source of income for the fund which is distributed pro rata to the subscribers. Each subscriber is given a certificate to evidence his proportionate ownership in the leased assets and to ensure his entitlement to the pro rata share in income. These certificates may preferably be called 'sukuk' -a term recognized in the traditional Islamic jurisprudence. Since these sukuk represent the pro rata ownership of their holders in the tangible assets of the fund, and not the liquid amounts or debts, they are fully negotiable and can be sold and purchased in the secondary market. Anyone who purchases these sukuk replaces the sellers in the pro rata ownership of the relevant assets and all the rights and obligations of the original subscriber are passed on to him. The price of these sukuk will be determined on the basis of market forces, and are normally based on their profitability. c. Commodity Fund Another possible type of Islamic Funds may be a commodity fund. In the fund of this type the subscription amounts are used in purchasing different commodities for the purpose of their resale. d. Murabaha Fund If a fund is created to undertake Murabaha, it should be a closed-end fund and its units cannot be negotiable in a secondary market. The reason is that in the case of murabaha, as undertaken by the present financial institutions, the commodities are sold tothe clients immediately after their purchase from the original supplier, while the price being on deferred payment basis becomes a debt payment payable by the client. Therefore, the portfolio of murabaha does not own any tangible assets. It comprises either cash or the receivable debts, therefore, the units of the fund  

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represent either the money or the received debts are not negotiable. If they are exchanged for money, it must be at par value. e. Mixed Fund Another type of Islamic Fund may be of a

nature

where

the

subscription amounts are employed in different types of investments, like equities, leasing, commodities, etc. This may be called a Mixed Islamic Fund. In this case if the tangible assets of the Fund are more than 51% while the liquidity and debts are less than 50%, the, units of the fund may be negotiable. However, if the proportion of liquid assets and debts exceeds 50%, its units cannot be traded according to the majority of the contemporary scholars. In this case the Fund must be a closed-end fund.

                           

 

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RISE AND SCOPE OF ISLAMIC BANKING

Since the early 1980s, Islamic banking has developed into a multi-billion dollar business. The Western world is realizing that, even in its own cities, it is no longer a ‘fringe’ business.

History of Islamic Banking The creation of the Islamic Development Bank (IDB) in Jeddah in 1975 was a landmark for Islamic banking. The IDB was the first development institution dedicated to the financial requirements of Muslim countries. The bank's articles of association stipulate that all its business should be conducted in accordance with Islamic Shari'a law. Its success can be measured by the Saudi government's decision in 1992 to double the subscribed capital of the IDB to $5.7bn, making it the largest inter government agency in the Muslim world.

Commercial Islamic banking took off in the 1970s when a number of new institutions were established in the Gulf, including the Dubai Islamic Bank (1975), the Kuwait Finance House (1977) and the Bahrain Islamic Bank (1979). However, the most significant developments took place in Saudi Arabia, aided by its huge economic infrastructure. One of the prime movers of such developments was Prince Mohammad Al-Faisal, whose ambition was to create a network of Islamic banks across the Muslim world - a process which saw the founding of the Faisal Islamic Bank in  

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Egypt in 1977 and the Faisal Islamic Bank in Sudan in 1978. But it was Prince Al Faisal's Geneva-based Dar Al Mal Al Islami, founded in 1981 that brought Islamic banking to the attention of those Western bankers who, previously, had little or no knowledge of Islam or Middle Eastern countries. The Geneva office of Dar Al Mal is now the centre of a network of 43 branches in 20 countries with assets under management in excess of $3bn.

The assets of Islamic banks incorporated in the Middle East rose from $4.4bn in 1985 to $15.7bn in 1994, although total assets controlled by Islamic financial institutions, including assets under management and the activities of banks based outside the Middle East, are estimated to be in the order of $80-$100bn. Compared with conventional banking this is a relatively small sum, but the overall demand for Islamic banking products is probably much greater than banks have so far been able to tap.

Growth of Islamic Banking In recent times, Islamic banking and financing services have increased phenomenally around the world. There now exist 150 such banks spread over most countries of the world. Yet, the same trend in financing with a concentration around murabaha (trade financing) is found to intensify. Equity participation and profit sharing have remained distant minimum in the total allocation of resources. Secondary financial instruments in accordance with Shari’ah could not be developed so as to give rise to a viable Islamic capital market. Islamic financial instruments are therefore traded in conventional stock markets. As a result, neither the developmental aspects of Islamic banking in favor of realizing an Islamic  

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economy nor the distributive goals for the poor and marginal enterprises could be attained.

Reasons for the popularity of Islamic Banking Some possible reasons of the popularity and acceptability of the Islamic Banking are as under: 1. Evils of interest based system Interest based economic and financial system of the world has caused havoc and that Islamic system has the ability to prevent the recurrence of the global financial crisis and resolve all related issues. But the world is not ready to do away with the system it is following. The truth is that the Islamic system has not been fully and effectively introduced, presented and popularized in the world to merit any worthwhile attention towards it. 2. Attractive performance of Islamic banking Islamic banking has not yet been fully implemented anywhere in the world, except as a system complementary to the conventional interestbased system. However, where this alternative system has been implemented successfully has proven the unthinkable to the modern financial system. Such attractive performance has in effect popularized Islamic banking, so much that they accommodate 3. Extended reach of Banking activity The reach of banking activity in many of the non-Muslim countries like that in the Muslim countries is very poor and a vast majority of population is not bankable. For example it is estimated that not more than

 

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15 per cent of Indians have any bank account. In other words the overwhelming majority of Indians, say 85 per cent, are outside the net of banking activities – they are not bankable. This is a precarious situation for any country because normally when a person becomes bankable he also brings his savings in the main stream of economy. As Islamic Banking is genuinely expected to attract savings of Muslims living in non-Muslim countries it will increase the bankability in a country and will have direct positive effect on the economy of the countries. 4. Invites Petrodollar It is said that introduction of Islamic Banking in any country will serve as the drain through which petrodollar will flow through. As the economy of the members of Gulf Cooperation Council (GCC) countries in particular and other members of Organisation of Petrol Exporting Countries (OPEC) in general is rentier based the fund saved in these countries are mostly invested outside their own respective countries. Till 9/11 a major portion of those savings were being invested in the USA and other Western countries. But now the situation has changed and the Arab investors have started looking around for other possible opportunities. If Islamic banks are opened in non-Muslim countries, including India, such funds will be attracted and this will ultimately give a boost to economy and a fillip to the overall welfare of the states.

         

 

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VIABILITY OF ISLAMIC FINANCE IN INDIA

Like how the emerging Islamic finance world has shown us, it is clear that banking without interest can take care of any kind of financing which the conventional banks are indulged in. This may also save thousands of needy people to come forward to borrow from the banks and can free the banks from the clutch of Non-Performing Assets to a large extend; ultimately resulting in complacency amongst the customers of the bank as well as for the banks themselves. It is reported that in India, thousands of crores earned in interest is kept in suspended accounts, as believers do not claim it. The assets controlled by Muslims are estimated to be $1.5 trillion and growing at 15% a year.' In Kerala alone, it is reported that this money could be above Rs. 40,000 crore. Research reveals that a handsome bulk of money in. India owned by the believers is lying idle, which if invested in profit sharing basis and utilized properly, can have a major impact on the Indian economy.

 

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Southern  Region   Western  Region   Central  Region  

Rate  of  @inancial  Inclusion   Rate  of  @inancial  exlusion  

Eastern  Region   North  Eastern  Region   Northern  Region   0%   20%   40%   60%   80%   100%  

Fig : Bar diagram showing extend of banking reach in India Data Source: www.rbi.org

There are several moral and religious arguments on the concept of Islamic Banking and its introduction in India. However, the economic argument, which has been welcomed across the globe, has also set its foot in India. Hurdles on the way of introducing Islamic Banking in India 1. Islamic Banking does not adhere to BRA, 1949 Many a critical issues emerge in introducing islamic Banking in india since the concept of Islamic Banking is not in consonance with the provisions of the Banking Regulation Act, 1949, which is the prevailing Act over the banks in the country. 2. Role of RBI as the Central Bank Issues also emerge as to the role of the Reserve Bank of India as the

 

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Central Banker the context of Islamic Banking. Though the basic functions of a modern Central Bank may be relevant also for an Islamic monetary system, the mechanisms may have to be different. For instance, in terms of Central banking functions the bank rate Instrument cannot be used as it entails interest. In this regard the Scholars in the field of Islamic Banking' has suggested that adjustments in profit-sharing ratios can be substituted for bank rate manipulations by the Central Bank. 3. Issue of Credit According to Scholars, credit can be tightened by reducing the share accruing to the businessmen and eased by increasing it. It is also proposed that the Central Bank should acquire an equity stake in commercial banking by holding, say, 25 per cent of the capital stock of the commercial banks which would give-the Central Bank access to a permanent source of income so that it effectively act as lender of last resort could. 4. Inability to maintain interest-based Reserves Another issue is that the Islamic banks if set up cannot maintain cash reserve and SLR since these involve interest. 5. Inability to maintain capital adequacy The other constraints may be their inability to maintain capital adequacy and would be unable to interact with interest based banks and money market in India.

 

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The problems of liquidity shortage or surplus would have to be handled differently in Islamic banking, since the ban on interest rules out resort to the money market and the Central Bank. However, Scholars have suggested a solution in such cases i.e. arrangement for reciprocal accommodation among banks without interest payments and creation of a common fund at the Central Bank into which surpluses would flow and from which shortages could be met without any interest charges.

                       

 

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RISKS INHERENT IN ISLAMIC BANKING

There are some unique risks in Islamic banking in additional to the risks faced by conventional banks: 1. Credit risk While the profit — loss sharing modes of financing may shift the direct credit risk of these banks to their investment depositors, they-may also increase the overall risk on the asset side of the balance sheet. This significantly increases the potential for moral hazard and creates an incentive for risk taking and operating financial institution without adequate capital. This risk arises when the bank is under pressure to pay a rate that exceeds the return that has been earned on assets financed by their investment depositors. The breach of the investment contract for management of investor's funds may also lead to fiduciary risk. 2. Market risk Owing to the Sharia's prohibition against interest-based instruments, interest rate risk affects Islamic banks only indirectly through the markup price of deferred sale and lease-based transactions. This risk arises from exposures to the price volatility of the underlying "real" assets inherent in some financing modes, which are in the form of trading and real investment. Similarly, the bank has to share any increase in earnings with investment depositors, but cannot, at the same time, re-price its receivables on the asset side at higher rates. The bank, is therefore, exposed to mark-up price risk due to this pricing mismatch.

 

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These banks are directly exposed to commodity price risk because, unlike conventional banks, they typically carry, inventory items on their books. They are exposed to a greater extent than conventional banks to equity price risk as the very nature of Islamic banking is equity financing through the PLS modes. 3. Operational risk The unique activities that these banks perform like administration of profit loss sharing modes of financing — which includes determination of profit and loss sharing ratios in investment projects in various sectors of the economy, as well as on-going auditing of financed projects to ensure proper governance and appropriate valuation, is more complex and these activities that are not normally performed by conventional banks. This is compounded by the non-standard nature of some Islamic financial products and lack of an efficient and reliable Sharia litigation system to enforce financial contracts. 4. Shariah compliance risk This risk arises from non-compliance with Shariah principles in conducting the Islamic banking business, which may lead to reputation risk. The interpretation of Shariah also differs across countries.

       

 

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CONCLUSION

Global finance today dominates the world economy. Western economies are characterized with financial sectors which generate billions for the economy. Stock Markets, multinationals, companies raising billions, initial public offerings (IPO) and so on, all symbolize the apparent success of Capitalism. Over a period of 300 hundred years the emergence of fiat currencies (i.e. currency without an intrinsic value), the role of compound interest and the development of limited liability company structures have shaped western finance.

Such developments have also been the sole reason why the West has come to be characterized with regular financial crises. This is because the financial sector moved away from raising finance to fund business startups and projects to speculating on company share prices and the movement of currencies. In this way trading in the financial sector ceased to be about purchasing currency or buying shares in the hope of receiving a dividend to purchasing financial commodities in the hope they could be sold for a higher price. The financial economy that doesn't produce anything has become so sophisticated that various products have been created which allow an investment in a paper with no real asset represented.

 

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The problems that the world economy faced caused hues and cries about an alternative financial system for smoother and healthier economy. The answer to this human quest was Islamic Banking and Finance. With its peculiar features of being interest-free primarily, rationally ensures “real” economic activities. Its various unique forms of trade, once unfolded to the world under crisis opened a brand new way of more stable economy. All tools of it viz., Mudaraba, Murabaha, Musharaka, Ijara etc. all form the discussion of world economies. Its basis laid down centuries ago, and practiced for once at the time it was opened to the world, it was soon forgotten for the greed of money and sheer selfish ends. Now that on the verge of crisis, some entities practically reminded the world of this wonderful system of finance, lets hope that the world will receive it a warm welcome, like it apparently does now. However, introduction of this complex, yet rational system of financing and banking, is still at the doorstep of our Indian economy. Even after proving its viability and scope, our own financial conservatism is allowing us to neither shift on to nor to leave little room for this new system. For better health and stability of our economy, we do need an alternative, and lets hope that the Indian government soon resolves the current issues and receive Islamic banking into our economy.

 

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REFERENCES/ BIBLIOGRAPHY

1. Bernard Lietar

“Future of Money”

2. Bindu Vasu

“Islamic Banking- Banking for a Change”

(RBI Legal News and Reviews- Jounal Section) 3. Mufti Barkatulla

“Ethical Fusion”, Islamic Banking and

Finance Vol.7 Issue 3 No.23 4. Niladri Bhattacharya “Islamic funds likely to invest $1 bn”, Business Standard (2008. 10th Jan) 5. Rodney Wilson

“Islamic Finance and Ethical Investment”

6. Syed Zahid Ahmed, “Economics of Islamic Banking in India”, RGE Monitor (2008, 11th Sept) 7. Report of the Working Group to examine financial instruments used in Islamic Banking, RBI 8. Report on the Committee on Financial Sector Reforms, Planning Commision, Govt. of India, “A hundred Small Steps” 9. www.icif.in 10. www.rbi.org 11. http://www. newhorizon-islamicbanking.com/index.cfm 12. www.islamic-finance.com 13. en.wikipedia.org/wiki/Islamic_banking 14. www.islamicfinance.de 15. www.islamicfinancenews.com  

 

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