RIGA TECHNICAL UNIVERSITY

THE MANAGEMENT OF FINACIAL OPERATIONS

IN ISLAMIC BANKING Sardorbek Mirzaev

Riga

5/27/2014

Abstract

The globalization of finance has allowed Islamic finance to thrive and there has been in

recent years a fusion of sorts between Islamic and conventional banking. My task includes to

provide the apprehensible and intelligible description for Islamic financial terms, specifications

and peculiarities of financial transactions; to explain the non-interest system in Islamic banks

and the substitutions and alternatives of them. At last but not least, to analyze the interactions of

Islamic and conventional banks in modern society, pertaining to corporate finance; to

distinguish the advantages and cons in financial operations; elicit the competitive prevailing

advantages of techniques and methods of allocation of assets and liquids both in Islamic and

conventional banking system. Primarily, to proper analysis of the issue in details I have divided

my paper into two main parts: Analytical (Theoretical) Part and Practical Part. In analytical

part I have covered main theories and definitions related to Islamic banking and Islamic

financial operations, transactions. Also it covers existing methods and techniques of Islamic

financial operating system and gives information about results and success of the management of

financial operations in Islamic banking system in early stages, before and after the world crisis,

interaction between Islamic banks and conventional ones, their current status quo in

contemporary economic and financial world, respectively. The second main part is about Islamic

banks and financial institutions operating throughout the world, their annual financial reports

and statistical data. To investigate their efficacious performance and amelioration of their

reputation in the financial market I’ve researched apposite data from a few Islamic financial

institutions. In addition to it, I’ve exampled a typical leasing situation in both Islamic and

conventional banks. Prioritizing the benefit from client-costumer side, I have proved the possible

outcomes depending on client’s decision on which of the financial institutions are suitably meets

his expectations. The examples create pictures of the ordinary banks’ credit-borrowing

transparent procedures and distinct conditions in Islamic banking and conventional financial

institutions, respectively.This paper includes 7 formulas, 16 figures and 7 tables. The total

volume of it is 65 pages.

1

CONTENT

INTRODUCTION……………………..………………………………………………….2

1. ANALITICAL PART…………………………………………….…………………4

1.1. Uzbekistan banking overview……………………………………………….4

1.2. The Principles and Characteristics of an Islamic Economy………..……....10

1.2.1. Principles of Islamic Economy………………………………...………..10

1.2.2. The Elements and Superstructure of Islamic Financial System………...12

1.2.3. The Role of Islamic Banking and Finance: a Global View and Trend…16

1.3. The Role Non-interest Philosophy of Islamic Finance……...……..………19

1.4. Islam, Economics and Finance…………………………..…………………20

1.4.1. Historical and Religious Background…….…………………………….20

1.4.2. Islamic Economics……………………………...………………………22

1.4.3. Reconciling Islam and Finance..………………………………………..23

1.5. The Ethical Framework of Islam …………………………………………..24

1.5.1. Riba and Gharar……………………………………………………….24

1.5.2. The Moral Economy of Islam…………………………………………25

1.6. Financial Products and Instruments in Islamic Banking and Their

Conformity with Conventional Banks………………………………………27

1.6.1. Murabaha………………………………………………………………27

1.6.2. Leasing ………………………………………………………………...30

1.6.3. Profit and loss Sharing………………………………..............................31

1.6.4. Sukuk – Islamic Bonds………………………………………………...33

1.6.5. Islamic Mutual Funds…….……………………………………………36

1.6.6. Mircro-lending or Mirco-finance………………………………………37

1.7. The management and Control, the Islamic Moral Hazard………………….37

2. PRACTICAL PART……………………………………………………………….40

2.1. Uzbekistani Leasing Market……………………………………………..…40

2.2. Leasing Procedures in Conventional Banks………………………………44

2.3. The Leasing in Islamic Banks………………………………………………49

2.4. The Comparison of the Systems: Leasing and Ijarah in Conventional and

Islamic Banks Respectively…………………………………………………52

CONCLUSION………………………………………………………………………….…55

BIBLIOGRAGHY….…………………………………………………………………...…57

2

INTRODUCTION

Nowadays, due to the various types of financial crises and mistrust to modern banking

system it is quite popular and well-known such terms as “Islamic economy”, “Islamic banking

system”. But, what is it? What it has been built on? What does it underlie? Certainly, it would be

impossible to explicate in a brief description, since Islamic economy is the whole science based

on Islamic jurisprudence. Therefore, I try to reveal this curtain of fundamentally different

system, touching with expository theory such aspects as: principles of Islamic economic theory,

its ethical principles, prohibited trade deals and reasons for these forbiddances and et al. Islamic

banking services.

Islamic finance and banking system have been growing rapidly in recent years. Motivated

by a heightened interest in financial instruments that emphasize risk sharing, it has been

attracting greater attention in the wake of the recent financial crisis. Today, as a consequence of

broad changes in the political-economic environment, a new generation of Islamic financial

institutions, more diverse and innovative, is emerging as the doctrine is undergoing a new –

aggiornamento-update. Perhaps the most important development has been the growing

integration of Islamic finance into global economy.

The Islamic banking industry is based on the prohibition of interests, and it promotes just

distribution of wealth whereby all levels of the society would benefit. The Western World, in

particular the Europe has been using and developing the conventional banking system which has

brought a lot of economic instability for many people living there. The conventional banking

system which basically operates on the basis of interest has created social problems because it is

simply not sustainable. Many have written about the conventional banking system which

produced capitalistic society and the financial crisis. Therefore, the existing conventional

banking system is definitely not suitable and the sound of alternative should be sought. Islamic

banking system could be that alternative everywhere in the world because it is an ethical

financing which promotes welfare for everyone [21].

In my thesis I’ve tried to reach the objective of presenting the core principles of Islam

finance, that place great emphasis on social justice, inclusion, and sharing of resources between

the haves and the have-nots. Islamic finance addresses the issue of financial inclusion from two

directions: one by promoting risk-sharing contracts that provide a viable alternative to

conventional debt-based financing; and the other through specific instruments of redistribution of

wealth in society; to improve understanding of the perspective of Islamic finance on economic

development, social and economic justice, human welfare, and economic growth.

The author has analyzed the structural difference in management of financial instruments

between Islamic finance and conventional financial institutions. The purpose of the paper is to

3

identify and analyze the affinity for financial operations and tools in two banking financial

institutions, disparate from one another. There have been a great number of discussions

pertaining Islamic finance and its possible future prospective. For this reason I’ve decided to

analyze that differences, fluctuations and performances of both financial institutes as my subject

in my work.

In consideration of these prospects and objectives, this research tends to accomplish the

following tasks:

Discuss the banking sector in Uzbekistan, especially it for Islamic finance in the nearest

future

Analyze the theoretical background of Islamic banking and finance instruments

Describe the positioning of Islamic banking in global financial market and its role

Study the elements of Islamic financial products and the possible corresponding products

in conventional banking sectors

Explain the problematic issues concerning expansion of Islamic banking in Europe

Overview the implications of regulatory standards on bank capital adequacy, stress

testing and market liquidity risk, and related Islamic baking indices

Define pros and cons of leasing in Islamic and conventional banking sectors.

The paper itself is divided into two major parts. Analytical part reviews the Uzbekistan’s

banking sector in brief, including an analysis of them. Moreover, in the first part the reader can

discover the origin and foundation of Islamic financial system, its technics, products, and

regulations. The second part is about the calculations and practical analysis; opportunities for

leasing operation are analyzed in conventional banks of Uzbekistan, also, in Islamic banks in

example of Turkish participation bank “BankAsya”.

The author used in his work the methods of grouping, processing statistical data related to

the theme of the thesis. The author confined by analyzing leasing operation procedures in

Uzbekistan as well its alternative transaction in participation bank “BankAsya” based on Islamic

non-interest principle. The author does not consider the features and problems of value added tax

(VAT) describing formulas and solutions in his calculations. In design of this work, the writer

uses internship experience gained in “BankAsya”, Istanbul, Turkey in 2013. The paper ends

with brief concluding remarks and appendix after the second part.

4

1. ANALYTICAL PART

1.1. Uzbekistan banking system overview Uzbekistan has traditional two level banking systems, headed by the Central Bank of the

Republic of Uzbekistan (CB). Main functions and objectives of the Central Bank are defined in

the Law on Central Bank, issued in December 1995. At present, the CB is fulfilling functions of

central monetary-lending institution. Main goal of the Bank is to maintain stability of the

national currency. The priority objectives of the Bank are as follows:

development / maintaining monetary-lending, credit and currency policy of the

country;

introduction of efficient payment system in Uzbekistan;

licensing and regulation of banking and financial activity;

management of cash flow of the state budget and performance of commercial

activities on behalf of the Government (together with the Ministry of Finance);

Management of state reserves of the Republic of Uzbekistan (currencies,

precious metals and etc.).

Aggregate capital of commercial banks of Uzbekistan in 2010 increased by 44% versus

2009 and reached 4.1 trillion Soums (about US 18 billion) by the 1 January.

The domestic financial sector was not directly affected due to the isolated and

underdeveloped nature of the financial system. The banking sector and capital market in

Uzbekistan is not yet well developed. The government has taken a gradual approach in economic

reform. Similarly, reforms in the banking sector and capital market are slowly undertaken. The

deposit base and penetration (ratio of loans and assets to GDP) are one of the lowest in CIS

countries. Credit to economy/GDP and broad money /GDP are quite low. Credit to economy was

about 38% of GDP in 2001, however, it declined to around 14% in 2007, which was low

compared to other CIS countries. The state-owned banks are predominant in the banking system .

Over half of the assets, capital, and loan portfolio in the Uzbek banking are possessed by state

banks. The banking system is concentrated in Uzbekistan since the five largest banks own 70%

of assets. Government guaranteed loans are still significant, albeit they are declining every year

22].

Uzbekistan’s state-dominated banking sector has promoted industrial development by

channeling public investment to strategic industries and increasing total bank lending, while

keeping banks sound. At the end of 2013, the sector’s capital adequacy ratio reached 24.3%.

Aggregate capital in the banking sector rose by 25%, helping expand total credit by 31%.

In August 2013, Moody’s Investors Service issued a stable outlook for the country’s banking

5

Source: based on information from[33]

2009 2010 2011 2012 2013

GDP 8.1 8.5 8.3 8.2 7.4

Inflation (%) 7.8 7.2 7.3 7 7.2

Investment FDI(%) 2.5 4.2 3.6 1.7 1.7

Labor remittances (%) of GDP 3.9 4.5 6 6.8 6.5

Debt (%)of GDP 15 14.8 13.4 13 13

02468

1012141618

Uzbekistan Key Economic Indicators

sector, citing healthy bank profits, improvements in asset quality, stable liquidity, limited

reliance on wholesale funding, and few problem loans, averaging less than 10% of total lending.

The government reported a budget surplus of 0.3% of GDP in 2013, though the surplus in the

augmented budget, which includes the FRD, is estimated to have narrowed to 1.8% of GDP from

the 4.7% recorded in 2012 Budget revenues (including the FRD’s estimated revenues) are

estimated to have declined slightly, from 38.6% of GDP in 2012 to 35.8% in 2013, in line with

declining international prices for key export commodities (Figure 1.1). Rising government

spending, particularly for health and education, helped slightly raise budget expenditures

(including the FRD’s estimated expenditures) from 33.9% of GDP in 2012 to 34.0% in 2013.

The government adopted a new budget code in 2013, streamlining legislation on public finance

management and strengthening the enforcement framework [3].

The government raised public sector wages and pensions by 21% in 2013 and

maintained large-scale public investment in industry and housing. State investment spending

grew by 11.0% to $11.3 billion, enabling gross fixed capital formation to rise by 19.8%,

following 11.1% growth in 2012. An increasing share of investment is financed by the Fund for

Reconstruction and Development (FRD), a sovereign wealth fund with assets exceeding $15

billion [33].

Figure 1.1 Key economic indicators of Uzbekistan

There are following banking system and insurance market in Uzbekistan:

I. Commercial banks - 30:

3 state-owned banks

13 joint stock banks

6

NBU

31%

Asaka Bank

12%

AgroBank

7%

UzPSB

8%

Ipotekaban

k

4%

Microcredit

bank

7%

People'sBan

k

6%

Others

25%

Capital

NBU

32%

Asaka

Bank

11% Agrobank

10%

UzPSB

11%

IpotekBa

nk

5%

Microcre

ditbank

3%

People's

Bank

6%

Others

22%

Assets

5 banks with foreign capital

9 private banks

Over 4600 branches and retail offices all over the country

II. Nonbank financial Institutions:

110 Credit Unions

82 Microfinance Entities

III. Fund for Reconstruction and Development

Since the Uzbek government saw the banking sector’s role as an important instrument in

the implementation of the country’s import substitution policies, the sector was dominated by

state- 9 owned and state-controlled banks. The assets of the three banks that are directly owned

by the government comprised 65 to 80 per cent of the assets of the banking sector over the period

1996 to 2005. Among these three, the National Bank of Uzbekistan stands out. Since 1996, this

giant bank has controlled over 50 per cent of assets of the banking system. Thus, since 2004 the

National Bank has shown positive dynamics of development and strengthened its position in the

Republican financial market. The consolidated balance of the National Bank in terms of US

dollars comprised 2,929 million. However, nowadays the tendency of private banks, for instance,

Hamkorbank, Trastbank, et al. have shown escalating progress in financial operations in both

medium and large scales of banking economic sector of Uzbekistan.

Figure 1.2 Assets and capital of Uzbekistan banking system according to Fund for

Reconstruction and Development of Uzbekistan

The following Figure 1.2 illustrates the distribution of assets and capital of Uzbekistan

banking system among national and commercial banks [5710].

Source: based on information from [10]

7

1386

4904 1181

934

0

1000

2000

3000

4000

5000

6000

7000

2005 2011

Domistic sources External Debt

Stable banking and financial system are in strict compliance with the Basel Core

principles of banking supervision sustaining the stability of banking system in Uzbekistan. The

one of the fundamental rations as bank capital adequacy ratio is over 23%, which indicates the

positive efficiency of banks and being almost 3 times higher than international standards. The

banks’ total assets of banks are more than 2 times higher than the total balance of the population

and legal entities deposits, insuring complete protection and guarantee of timely payments.

For the last 10 years domestic sources channeled to financing the real sector of the

economy )increased by 25 times Total current liquidity of the banking system is 10 times higher

than external payments due (Figure 1.3).

Figure 1.3 Credit portfolio of commercial banks (USD mln)

The Islamic Development Bank (IDB) is an international financial institution established

in pursuance of the Declaration of Intent issued by the Conference of Finance Ministers of

Muslim Countries held in Jeddah in Dhul Q'adah1 1393H, corresponding to December 1973. The

Inaugural Meeting of the Board of Governors took place in Rajab 1395H, corresponding to July

1975, and the Bank was formally opened on 15 Shawwal 1395H corresponding to 20 October of

1975.

The purpose of the Bank is to foster the economic development and social progress of

member countries and Muslim communities individually as well as jointly in accordance with

the principles of Shariah i.e., Islamic Law.

1 Dhu al-Qi'dah is the eleventh month in the Islamic calendar. It is one of the four sacred months in Islam

during which warfare is prohibited, hence the name ‘Master of Truce’.

Source: The authors idea based on information from[10].

8

Uzbekistan became an IDB member in 2003; an exemplary step in this direction is the

recent IDB’s US$37 million 14-year financing that will be used to purchase medical equipment

for the modernization of oncological institutions in the country. The project, whose total amount

is US$83 million, is one of the 15 projects currently jointly implemented by the Uzbek

government and the IDB in the fields of health, education, agriculture, energy and transport, with

a total value exceeding US$400 million.

In the past three years, IDB has sponsored several important projects and signed many

significant treaties:

• US$30 million in loan financing, co-financed with the Asian Development

Bank, to improve water supply to major cities around the country, including Bukhara and

Samarkand.

• US$54 million grant: Of this amount US$15 million will go the National Bank

for Foreign Economic Activity to finance small business projects; US$12.5 million will

be spent on modernizing an asphalt factory, constructing roads and buying equipment for

these purposes; US$25 million will be spent on the construction of an electricity line

from two existing power stations; and US$143,000 will be spent on preparing a project

on setting up an investment company.

• In 2005, the Islamic Corporation for the Development of the Private Sector, a

member of the IDB Group, and the National Bank of Uzbekistan signed an agreement of

cooperation to further develop the Uzbek private sector.

In the three years following Uzbekistan’s induction into the IDB, the IDB has already

established a strong presence within the country providing the Uzbek government with

considerable financing and sponsorship of numerous projects. This trend will likely continue in

the future.

In just over a decade, Uzbekistan has proven to be prime candidates for the establishment

of Islamic banking and finance. Although primarily landlocked, the countries of this region for

the first time are being linked to a greater network of commerce and trade throughout the Muslim

world with the help of not only the IDB but also the just-flourishing Islamic banks . Not only

has an organization like the IDB effectively demonstrated its support for socio-economic

development, but it has also provided the six Muslim republics of this study with a means to

remain Islamic-compliant when running various banking and finance projects that promote

national development. [11].

On the other side, the private-owned bank – Hamkor Bank – is gearing up to provide

Islamic banking services across the country leveraging on the bank’s wide network.Hamkor

Bank is open joint-stock commercial bank, was established in 1991. Since its inception, Hamkor

9

Bank is focused on private and corporate customers. The bank's customers are companies who

are attracted to sound banking philosophy, which allows ensuring the stability, efficiency and

security of financial transactions.

Hamkor Bank, being a universal financial organization provides services to customers

regardless of their activity and size of business. Current customers are representatives of large

and small businesses, leading manufacturers of consumer goods and construction companies,

telecommunication and transportation companies, trading organizations and representative

offices. In previous years, Hamkor Bank was looking to collaborate with selected international

organizations to become the first entity to provide Islamic banking solutions to the country’s 29

million Muslims to develop its human capital base to ensure that its Islamic banking initiatives

and, to a greater extent, Uzbekistan’s Islamic banking and finance aspirations, can be kick-

started with "sound foundations". He added that the bank, which focuses mainly on SMEs, is the

only bank in Uzbekistan which is looking to collaborate with international financial institutions,

such as the World Bank, Islamic Development Bank and Asian Bank for this purpose.

In May 2010 the International Finance Corporation (IFC) acquired a 14.5% stake in

Hamkor Bank, at US$0.09 cents per share, for US$3 million. The stake was then diluted to

12.59% in 2012 when the bank issued additional equity worth US$3.4 million.

In February 2013 the Chief Executive Officer of Al Huda Centre of Islamic Banking and

Economics – Muhammad Zubair Mughal – recently has met with Ikram Ibragimov, the chairman

of supervisory board of Hamkor Bank in Uzbekistan's capital, Tashkent. There was a detailed

discussion on affairs of their mutual interest for the advancement of Islamic banking in

Uzbekistan. Unfortunately, Hamkor Bank is the only bank is Uzbekistan which is working in

collaboration with international organization e.g. World Bank, Islamic Development Bank, Asian

Development Bank, European Bank, KFW, Triple Jump and others Hamkor Bank will cooperate

and be supervised by Al Huda CIBE Pakistan, especially advising and consulting in Islamic

Banking; Shariah advisory; and Human Capital Development in this field. Consequently, Islamic

banking can be initiated in Uzbekistan with sound foundations. Furthermore, Hamkor Bank,

though not as big as leading banks in Uzbekistan, has a wide network in the country through

which they wish to render the services of Islamic Banking.

Shariah compliance and Islamic human capital development will be privileged so

that Islamic banking can be initiated in Uzbekistan with sound foundations [15]. Uzbekistan is

not the only country in the region to have realized the opportunities offered by Islamic finance

and competition is rife between countries to conquer the Islamic finance pole position in central

and north Asia [2].

10

It should be noted that Hamkor Bank is a part of a large financial group of Uzbekistan.

The group comprises of a bank, insurance company, 4 leasing companies and other institutions.

1.2. The principles and characteristics of an Islamic economy

1.2.1. Principles of Islamic economy

The Islamic economy is an economic, social and political model based on the theological

doctrines and values promoted by the Quran and Sunnah1. In other words, as “Islamic economy is

an approach to, and progress of, interpreting and solving the economic problems of human

beings based on the values, norms, and institutions found in, and derived from sources of

islam”.2 While the Quran is considered prescriptive, the Sunnah and hadith literature is

considered descriptive. These two textual sources serve as the foundation of Islamic law.

There are no compete economic or financial systems described in Islam. If to locate

economics and finance in Islam, one could visualize the connection as seen in Figure 1.4.

Figure 1.4 Economics and Finance in Islam

Another useful definition is following: Islamic financial institutions are those that are

based, in their objectives and operations, on Koranic Principles [Ibrahim Wade, Edinburgh

University Press, 2001]. They are thus set apart from ‘conventional’ institutions, which have no

much preoccupation. This definition goes beyond simply equating Islamic finance with ‘interest-

Islam

Faith and Belief Practices and Activities Morality and Ethics

Worship to God Social Interaction

Political

Activities

Economic Activities Social Activities

Banking and Financial Activities Other Activities

Source: Designed based on the ideas of the author

11

free’ banking. It allows to take into account operations that may or may not be interest-free, but

are nonetheless imbued with certain Islamic principles: the avoidance of riba (in the board sense

of unjustified increase) and gharar (uncertainty, risk, speculation); the focus on halal (religiously

permissible) activities; and more generally the quest for justice, and other ethical and religious

goals. Two aspects of Islamic finance must be signed out. Fist is risky-sharing philosophy: the

lender must share in the borrower’s risk. Since fixed, predetermined interest rates guarantee a

return to the lender and fall disproportionately on the borrower, they are seen as exploitative,

socially unproductive and economically wasteful. They preferred mode of financing is profit-

and-loss sharing (PLS). Second is the promotion of economic and social development through

specific business practices and through zakat (almsgiving).

Figure 1.5 Islamic Concepts of a Market Economy between Economics and Law

Source: Designed based on information from[25]. .

Most but not all Islamic institutions have a Shariah board- a committee of religious

advisers whose opinion is sought on the acceptability of new instruments, and which conduct a

religious audit of the bank’s activities – as well as other features reflecting their religious status.

In sum, the defining difference is that while ‘conventional’ finance usually seeks profit-

maximization within a given regulatory framework, Islamic finance is also guided by other,

religiously-inspired goals.

Secular Economics

Koran Sunna

Fiqh (jurisprudence) Islamic Economics

Shariah

(Islamic law)

Concept of market Economy

Principles Rules

Systems

Design Isla

mic

Syst

em

Sec

ula

r L

aw

12

Islamic banking also involves more than banking more than banking. It includes mutual

funds, securities firms, insurance companies and other non-banks. Where once - in the mid-

seventies – Islamic banks were few numbers and easily identifiable, the phenomenon has become

quite amorphous with the proliferation of Islamic institutions and the blurring of the lines

between traditional banking and other forms of finance (Figure 1.5). Another complicating factor

is that growing number of conventional institutions, inside and outside the Islamic world, have in

recent years created Islamic subsidiaries or have been offering Islamic ‘windows’ or products in

addition to conventional ones.

For the outside observe, the inevitable question is: how can a financial system operate

without interest rate? The answer is that it can through the development of profit-and-loss

sharing mechanisms, or through alternatives such as imposing fixed service charges or acting as

young agents for clients.

1.2.2. Elements and Superstructure of Islamic system

Over the past decade, public duties (both of society and the state) have broadened to

include safeguarding sustainable economic activity and protecting the environment. Finally, the

state should create favorable framework conditions for a private economy consistent with the

requirements of Islam, something which can have particular implications [25].

Essentially, this list contains all the elements that constitute a social market economy,

which have been summarized in the Konrad-Adenauer-Stiftung’s publication entitled

“Guidelines for Prosperity, Social Justice and Sustainable Economic Activity”. The prevalent

doctrine of Islamic economics today can be summarized as follows:

Islam conveys a positive outlook on this life in general and provides a supportive value

system for economic activities in particular

Islamic economic ethics exhibits considerable overlap with Western-Christian

perceptions in the field of individual ethics. Great importance is ascribed to personal

achievement.

Individuals are expected to earn their living through their own work. A person’s own

achievement (physical and intellectual work) is the most important basis for legitimately

obtaining material goods and wealth. Neither individual human skills nor natural

resources should lie idle unnecessarily, and it is forbidden to waste or wantonly abuse

resources.

Legitimately acquired wealth should not be used to maximize the pursuit of a person’s

own wants (in this life): luxury is frowned upon; Islam preaches moderation; and the use

of surpluses for social aims is meritorious.

13

The needy have their own claim to solidarity from the community, which is

institutionally protected and based on the Quran: Muslims are required to pay zakat, i.e. a

two and a half percent levy on assets or a five or ten percent levy on agricultural produce,

which is used for specific (social) purposes. This is an obligation for the individual, and

the claims of the needy should be satisfied by the community or the society (and only

then by the state); this is very similar to the principle of subsidiarity.

The needy have their own claim to solidarity from the community, which is

institutionally protected and based on the Quran: Muslims are required to pay zakat, i.e. a

two and a half percent levy on assets or a five or ten percent levy on agricultural produce,

which is used for specific (social) purposes. This is an obligation for the individual, and

the claims of the needy should be satisfied by the community or the society (and only

then by the state); this is very similar to the principle of subsidiarity.

Since Allah has made the goods of this world available to all human beings, inequalities

in the distribution of income and wealth must not be allowed to become too great. If

needs be, the state must intervene with corrective measures to fight poverty.

Humans, as God’s custodians of the earth, only have the right to use creation. They must

not inflict lasting damage on it and must consider the legitimate claims of future

generations in what they do. This principle gives rise, among other things, to a collective

ownership of non- renewable resources (natural resources, but also water) and, more

recently, a duty to protect the environment.

Islamic law recognizes private ownership of the means of production. Nationalization and

state control of the economy are only permissible in exceptional circumstances.

Land and capital become productive only as factors of production when combined with

labor. Therefore, income may not be derived from merely owning land or capital. Financing,

lease, and other contracts, which allocate returns and risks to the owners of factors of production,

must meet particular criteria of justice. [4].

For the outside observe, the inevitable question is: how can a financial system operate

without interest rate? The answer is that it can through the development of profit-and-loss

sharing mechanisms, or through alternatives such as imposing fixed service charges or acting as

young agents for clients. By this means of information, a following chart can be structured to

properly understand the Islamic economic system (Figure 1.6.).

Legal framework

Law and the rule of law are important: linking government action to a superior law –

Shariah (which only contains some directly applicable economic content) and Shariah compliant

secular law (the formulation of which gives great creative leeway). Concepts of an Islamic

14

Source: Designed based on information from [25]

economic system are compatible with different forms of government (democracy, monarchy,

etc.).

Figure 1.6. Elements and Superstructure of an Islamic Economic System

Competition as a basis

Justice is important: price fairness; state protection of competition against

monopolization; occasional state intervention in the case of “sensitive” prices.

Solidarity and social security

Poverty reduction is as a primary economic objective. Zakat at the core of a social

security system that is independent of the family (claim of the needy in respect of society – state

is subsidiary).

Sustainability

Allah is the ultimate owner, human beings are merely custodians, and duty extends to

future generations (idea of sustainability).

Open markets

Science Ideology Religion

Prescriptiveness Mobilization

Open and Competitive Markets, Competition Policy

Financial and Monetary Economy Prohibition of riba

Stable money ( gold, 100%,…)

Individual social Security Zakat (social security contributions)

Takaful (mutual insurance)

State and the Public Sector Economy Legal Framework

Infrastructure, environment

Legitimacy Functionality

15

In principle, for all open goods, services, and labor markets, but reservations with capital

markets (issue of interest, speculative transactions).

Therefore, the special regulations in Islamic economy lead to sustain development of the

social market and life of the nations. For that reason there were the formal restrictions, which

stem from the requirements for Shariah-conformity, do not prevent the construction of a

sophisticated and efficient financial system and capital market – without which the social market

economy could not function. In view of the current global financial crisis, such a strong link

between the financial sector and the real economy, and a limit to the development and

application of synthetic financial products for speculative and high-risk purposes is, perhaps,

more beneficial than detrimental for a social market economy. Against the backdrop of

replications of problematic, conventional techniques and products that conform to Shariah law,

the calls by Islamic economists – which perhaps go a little too far – for every financial

transaction to be based on a real economy transaction, can also be understood in some respects as

self-criticism, or at least a warning to Islamic financial engineers.

The Islamic economic systems are indeed compatible with the concept of the social

market economy, and that Islamic economics can act as an advocate of such a concept transfer.

Nevertheless, this alone would not bring much benefit as the political effectiveness and the

practical relevance of Islamic economics as an academic discipline is relatively weak at a

systems level, and this influence has tended to wane rather than wax over the past twenty years.

It is an obvious fact that the social market economy is a concept that was created for

highly developed and structurally differentiated economies only in the twentieth century in the

Western world, where it has proved itself. In Islamic countries, most of which only gained their

independence in the middle of the twentieth century, this concept was rather unknown.

In the light of the lasting development problems of many countries of the Muslim world

– stretching from North Africa, across the Middle East to Southeast Asia – these states have by

no means ruled out the search for economic concepts that promote development. Not least as a

result of disappointment with the results of the capitalist and socialist economic systems, since

the mid-1970s people have been progressively formulating ideas about an Islamic economic

system, propagating them as an alternative to the unsatisfactory status quo. Against this

backdrop, therefore, it is worth investigating the general principles of the social market economy

and their compatibility with such economic systems in order to share the experiences of our own

economic system as part of the dialog surrounding development policy.

16

1.2.3. The Role of Islamic Banking and Finance: a Global View and Trend

Over the last three decades, the concepts of Islamic Finance and Islamic economics have

captured the attention of researches. The growing market for transactions compatible with

Islamic law (Shari’ah) is further evidence of growing interest in this mode of finance. Although

Islamic finance is one of the fastest growing segments of emerging global financial markets, it is

often stated that the market is far below its true potential. At the same time, the concept of

Islamic finance are not fully explained and exploited – especially in the areas of economic

development, inclusion, access to finance, and public policy. Over the last two decades, by some

estimates, the total volume of Islamic financial assets has grown by 15-20 percent a year and

now exceeds $1.3 trillion [7].

There are more 267 Islamic financial institutions (IFI) worldwide with capitalization in

excess of $13 billion. This includes banks, mutual funds, mortgage companies & Takaful

Shariah-compliant financial products estimated to exceed $250 billion with annual

growth rate of 23.5%over the past 5 years

There is approx. $1.5 trillion of GCC funds held in investment assets worldwide

(Treasuries/corporate bonds/equities/funds etc). Of this $1.5 trillion, $250 billion

constitutes of High Net Worth Individuals

The potential is huge. By 2020, there will be 2.5 billion of Muslim population worldwide

from the current 1.5 billion level

Islamic banks are expected to manage 40%-50% of total savings of Muslim

Population in 8 to 10 years. Therefore, potential for Islamic financial services is

estimated at $4 trillion by 2020

It is crucial these huge amounts of funds are channeled towards productive use –into

GCC infrastructure/economic sectors and other emerging economies.

Following on from the significant developments that have occurred in what we view as

the core area for this market – the predominantly Muslim countries – we are now witnessing the

globalization if Islamic finance. In recent years, significant interest in Islamic finance has

merged in the world’s leading financial centers, including London, New York, and Hong Kong,

and Western investors are increasingly considering investment in Islamic financial products. The

growth of this market has been driven by the high demand for Shari’ah-compliant products, as

well as increasing liquidity of Gulf States. The table 1.1 shows the growth trend in Islamic

finance for banking sectors by different regions, with estimates of total Islamic banking assets

reaching $1.8 trillion by the end of 2013 [7].

17

19

9

34

20

25

42

22.5

8 5

18

13 15

31

14

0

10

20

30

40

Malaysia Indonesia Turkey Saudi Arabia United ArabEmirates

Qatar Median

Islamic banking Conventional Banking

Table 1.1.

Total Islamic Banking Assets (in $ billion)

Global Islamic banking assets 1.334

Growth estimates by the region through 2013

Southeast Asia 89

Gulf Cooperation council (GCC) countries 131

Rest of the world 257

Global Islamic Banking assets (2013, est.) 1.811

In the following figure 1.7 we can see trends promoting the growth of the Islamic

financial sector in the 2006-2010 periods surpassed the growth of the conventional financial

sector in all segments of the market, ranging from commercial banking, investment banking, and

fund management to insurance in several Muslim-majority countries [6].

Islamic banking continues to be an exciting growth story characterized by robust macro

outlook of core Islamic finance markets and increasing share of system assets. It is increasingly

gaining acceptance, especially in high-growth emerging markets, as an effective means to build

an inclusive financial system and replace the shadow economy. Figure 1.8 illustrates the global

distribution of Islamic assets in world’s financial market.

One of the recent developments in Islamic finance is the introduction of Islamic bonds, or

sukuk, which are structured as a securitized product. The key feature of sukuk is that they are

structured following principle of linking the financial return to the real sector activity. We will

Figure 1.7 Growth of Islamic Banking and Conventional Banking Assets in Selected

Countries (in percent)

Source: based on information from [3,33]

18

Saudia Arabia 16%

Malaysia 8%

UAE 5%

Kuwait 4% Qatar

3% Turkey 2%

Indonesia 1%

Bahrain 1%

Rest of the world(inc. Iran) 60%

50 50 100

180

300

370 420

685

831 794

825

0

100

200

300

400

500

600

700

800

900

2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012

Volume ($ billion) Number of issues

describe more explanatory about this special financial product later on, however there is a room

to mention about important value of the introduction of sukuk escalated the financial stability of

Islamic liquidityin world market. Figure 1.9 shows the total number of sukuk and their volume

over the last ten years, which is testimony to the rapid growth of this market, and its quick

recovery during global downturn. The sukuk market has been used by both the public sector and

corporate sector to mobilize finance [21].

Figure 1.8 The Global Distribution of Islamic Assets

Source: based on information from[3,33]

Figure 1.9 Total Sukuk Issuance 2002-2012

Source: based on information from[29]

19

1.3. The Role non-interest philosophy of is Islamic Finance

Most definitions reduce Islamic banking to ‘interest-free’ banking. Islam prohibits

interest but it does not means, that it prohibits all gains on capital. The only increase stipulated or

sought over the principle loan or debt is prohibited in Islamic shariah law. Islamic principles

simply require that performance of capital should also be considered while rewarding the capital.

The prohibition of a risk free return and permission of trading, as enshrined in the Holy Quran,

makes the financial activities in an Islamic set-up real asset-backed with ability to cause ‘value

addition’.

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. Islam encourages shearing

of risk among lender and borrower, Islamic financing system is based on this principle, it has

also another character of owing and handing of real assets, its involvement in trading,

construction and leasing using Islamic mode of financing. 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. Profit has been recognized as ‘reward’ for (use of) capital and Islam

permits gainful deployment of surplus resources for enhancement of their value. However, along

with 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. At macro level, this feature

of Islamic finance can be helpful in creating better discipline in conductive of fiscal and

monetary policies [30].

The most important prohibition is riba (usury/ interest). The subject of riba is a difficult

for many scholars. There is huge number of literature discussing the topic of riba in accordance

to Islamic teachings.

Islam, however, strongly and precisely prohibits interest, but permits trade. Doing interest

business is viewed equal to rebel against God and His prophets. In Koran2 it states: “Those who

take riba (increased amount, i.e. usury / interest) will not stand but as stands the one whom the

devil has driven to madness. That is because they say: ‘Trade is like usury’, but Allah has

permitted trade and forbidden riba. Those who after receiving direction from their Lord, desist

(from indulging riba), shall be pardoned for the past; their case for Allah to judge; but those who

repeat (the offence) are companions of the Fire: They will abide therein (forever)” [17]. “Allah

2 Koran (Quran) is the scripture, the holly book of Muslims and was verbally revealed from God to his

prophet Muhammad.

20

will deprive usury of all blessing, but will give increase for deeds of charity: for He loves not

creatures impious and sinning”.[17]. “O you, who believe, do not eat up the amounts acquired

through Riba, doubled and multiplied. Observe your duty to Allah, that you may be

successful”.[17].

At the same time, there is a notable number of hadith explicitly pointing of the

prohibition of interest, e.g. the Prophet Muhammad (BPH) cursed “the one who accepted

interest, the one who paid it and the one who recorded it and the one who witnessed it, and said

that they are all alike (i.e. they are equal partners to the sins)”.[5].

Trade on the other hand is permitted, furthermore, encouraged. It says as follows in

relevant verses: “There is no sin on you that you seek the grace of your Lord (by trading)” [17].

Despite numerous proofs and easily accessible information presented, the question of

whether interest is prohibited in Islam seems to be the most frequently asked question in regard

to Islamic finance. The main reason Islam has delivered such a harsh rulings against interest that

it is set to establish economic system in which all forms of exploitation are eliminated, and

particularly the injustice in the form of financier being assured of a positive return without doing

any work or sharing risk, while entrepreneur, in spite of his management and hard work, is not

assured such a positive return. In this regard, Islam wishes to establish justice between the

financier and the entrepreneur. The difficulty to understand the prohibition comes from lack

appreciation of the whole complex of Islamic values, and particularly its emphasis on socio-

economic justice and equal distribution of income and wealth. [20].

1.4. Islam, Economics and Finance 1.4.1. Historical and Religious Background

Any successful belief system, whether religious or secular, has seemingly contradictory

characteristics: it is malleable enough to adopt to a variety of geographical settings and survive

the test of the time, yet it must be able to maintain its specificity, or else it would disappear or

become fused with competing belief systems; it is idealistic, sometimes even utopian, yet

capable of adjusting to human imperfection and making the kinds of compromises that are

endemic to political and economic life. With this in mind we can better understand hoe a system

rooted in the Middle Ages could survive, and thrive, in the global economy [14].

Following, a board of overview of the parallel evolution of religion and history we can

now deepen into the mechanisms by which Islam adapted to changing circumstances, and

explains how Islam could accommodate itself with modern economic and finance.

The tenets of the Islamic religion can be conceived as a pyramid. At the top stands Koran,

considered by Muslims to be God’s word as conveyed to the Prophet Mohammed. Below it are

21

the Hadith and the Sunna. Often interchangeably, the first actually refers to the words and deeds.

In other words, the Hadith, in the form of a large and ill-defined number of short texts, relates

stories about and sayings (specific pronouncements, deeds, or approvals of other people’s

actions) of the Prophet, whereas the Sunna consists of the practices and rulings deduced from

such narratives.

In order to examine the impact of Islamic banking it is important to understand the

historical origins of the banking system in predominantly Muslim countries and the evolving

divergences from conventional banks. The modern conventional banking system in Islamic

countries is a product of colonizers using the support of financial institutions for mining,

agriculture, and manufacturing. The initial banks were predominantly used for the funds of

foreigners and as a means to increase foreign-owned industries that spread through imperial rule.

These institutions were used to finance the expansion of the public sector in the Middle East and

North Africa, huge portions of the population made up of devout Muslims [23].

Throughout its golden age (roughly the seventh to tenth centuries in the Middle East, and

the eleventh to fourteenth centuries in North Africa and Spain), the Islamic world did not fit the

imagine of a narrow-minded theocracy. Great libraries and translation centers were established

where great works of philosophy, literature, medicine and science from East and West were

collected and translated. Such knowledge was improved upon and formed a necessary link to

later advances in the West.

So where does the persistent image of an Islam incapable of separating mosque and state

– indeed incapable of dealing with the modernity and change – come from? The answer lies in

the parallel evolutions of Islam and the West, starting with the end of the golden age.

However, due to the industrial revolution in the West countries in the late nineteenth

centuries, most countries followed a path of Westernization and secularization that led to adopt,

under foreign tutelage, Western models in politics, economics, law, and education. Muslims

were divided. While some did not see a necessary contradiction between Islam and

Westernization, a number of political and religious movements emerged throughout the Islamic

world, calling for a return to Islamic values and traditions. There was no clear consensus, insofar

as some wanted a return to the past while others called for an update of Islamic doctrine. Islamic

modernists shared with traditional Islamist groups the belief that the ills of the society were

caused by the betrayal of Islamic ideals. While they shared with secularists the embrace of the

reason, science and progress, what set Islamic modernists apart their belief that political

liberalization and intellectual reawakening could be, indeed had to be, rooted in a return to Islam

[14].

22

In sum, modernity – undertaking a radical reinterpretation of Islam to suit modern

conditions – is not easy to dissociate from a quest for authenticity. And traditional

fundamentalism – if defined as the effort to return to the fundamentals of the religion – is not

necessarily the same as literalism.

1.4.2. Islamic Economics

The commerce is central to the Islamic tradition. The Prophet Mohammed was himself a

merchant. In his day, the economic system was quite simple. Mecca, at the time wealthiest

Arabian city, depended heavily on trade. The continuous spread of Islam soon brought the

region’s lucrative trade routes, previously controlled by Byzantium and Sassanid Persia, under

Islamic control. As the expansion of trade in Islamic world, the economy became increasingly

complex institutional innovation occurred, for example with the creation of hisbah, an office in

charge of supervising markets, providing municipal services, and settling petty disputes.

By the time passed, Muslims in the liberal era who had studied Western-style economics

tried to transpose that knowledge to the Islamic world. With decolonization and the nascent tend

toward a return to Islam, religious scholars attempted to rethink economics and the social

sciences in the light of their religious training, with the goal of creating an ‘authentic’ or at least

indigenous brand of economics. It is usually agreed that the most original work in Islamic

economy is that of Mohammed Baqer as-Sadr, whose book Iktisaduna (‘our economy’) is an

attempt to develop an Islamic approach to economics.

With the newfound wealth of oil-producing countries and the rise of Islamic militancy,

the need to promote further thinking on economic matters gained new urgency. A number of

fiqh3 academies sprouted throughout the Islamic World, have settled a majority based decision

making processes. Gathering in convocations, scholars deliberate collectively and decide

questions by the majority vote.

First time the Islamic economics conference was held in 1976, in Mecca, where the

conference dealt exclusively with economic matters. King Abdul Aziz University established

the International Center for Research in Islamic Economics in 1979. Starting with Pakistan in

1977, a growing number of countries sought to Islamicize their economic systems. Islam would

typically be presented as offering a ‘third way’ between capitalism and socialism that would be

not only different, but also superior to, and no less efficient than, the two others.

In Islam, strict definitions have typically prevailed. But as its economy grew more

complex, the Islamic world was able to find proper substitutes, justifications, or subterfuges.

3 Fiqh is Islamic jurisprudence, based on the expansion and interpretation of Shariahh; deals with the

observance of rituals, morals and social legislation in Islam

23

1.4.3. Reconciling Islam and Finance

Muslims’ Holy book – Koran states that despite superficial resemblance, profits from

commerce are fundamentally different from profits from money-lending [Surah Al-Baqarah,

275]. Muslims, unlike other nations, have traditionally looked favorably at commerce, while

being suspicious towards finance. While the reconciling between other religious representatives

and finance was long-drawn and fraught with theological and philosophical disputes, in Islam

however, riba would occasionally be interpreted not as interest [14], but the usury or excessive

interest, severe and accurate descriptions have, in common, as a rule dominated. The early years

of Islam, jurists devised an impressive array of contracts designed to circumvent interest-riba, the

most important ones being profit-and loss contracts (mudarraba or qirad).

Modern finance entered the Islamic world alongside wit Western colonial expansion.

Foreign banks financed trade and development, and in due course Islamic governments, strapped

for cash, had become debtors, therefore paying interest to foreign creditors. For example, the

Ottoman Empire in the middles of 19 century had been issuing interest-bearing treasury bonds

[28]. In Egypt foreign banks played a crucial role: in 1920 Banque Misr was established, the first

ever to be formed exclusively with local capital. Egypt’s thriving stock-market made it a favorite

among early twentieth-century ‘emerging markets’, which promoted to be a third largest stock

market in the world after World War 2. Perhaps most importantly, it is in Egypt that interest was

legitimated by religious authorities in 1904.

The riba controversy was temporarily ignored but not to rest. Many legal codes adopted

by Islamic countries observed an ‘eloquent silence’ – on the issue of interest-bearing loans.

The world finance took a new tern with the end of colonialism: newly independent states

established national monetary authorities and central banks, issuing local currencies.

Thus, until resent attempts at ‘Islamicizing’ economic systems, all countries regardless of

ideological learnings, learned to live with interest and with modern finance. With the advent of

Islamic finance, prevailing consensus among Islamic scholars was that dealing with conventional

banks was acceptable if Islamic institutions were not accessible to them. The transformation of

modern finance that has taken place since 1980s has also reopened the debate about the

acceptability of new financial instruments. But rather than a wholesale rejection, the trend has

been towards a now ijtihad designed to separate those products that are acceptable from those

that are not, and to create financial instruments adapted to the need of Islamic societies [9].

24

1.5. The Ethical Framework of Islam

1.5.1. Riba and Gharar

Most definitions reduce Islamic banking to ‘interest-free’ banking. While the injunctions

against riba are indeed the cornerstone of Islamic finance, debates persist as to the exact

significance of the word. Since the early days of Islam, the majority of scholars have adopted a

restrictive definition: any form of interest constitutes riba. The debate is nonetheless still keeps

actual topicality in modern world. The most common way of financing throughout recorded

history is where the owner of money loans it to someone in need and receives the principal plus

an agreed upon amount of interest after an agreed upon time.

The riba debate has been approached from many angles. One set of discussions contrasts

‘interest’, a moderate economically justified remuneration of capital, with ‘usury’, an excessive,

sometimes extraordinary rate. A few scholars have argued that only latter constitutes rib,

however the majority of Islamic scholars still consider that any increase in the amount of money

returned by a borrower constitutes riba and is therefore prohibited.

Another angle is the requirements of modern economy. As one of the Islamic modernist –

Fazlur Rahman says: “As long as our society has not been reconstructed on the Islamic pattern, it

would be suicidal for the economic welfare of the society and the financial system of the country

and would also be contrary to the spirit and intentions of the Koran and Sunna to abolish bank-

interest [16]. Despite argues and long debates; in 1986 the Fiqh (jurisprudence) Academy of

Islamic Conference supported the restrictive interpretation of early jurists, condemning all

interest-bearing transactions as void. But in 1989, while an economic and rhetorical debate

between Islamic financial institutions and conventional banks was raging, the mufti (religious

scholar) of Egypt A. Tan2tawi, issued what he considers fatwa (code), one legitimizing

‘capitalization certificates’, which are interest-bearing government bonds underwritten by

Egyptian banks. There is little difference between Western-style bans which offer fixed interest

rates, and Islamic banks in which depositors share the risk of investing projects, for Islam

simply requires financial transactions to be market by clarity and justice.[29]. On the other hand,

the Egyptian fatwas had paradoxical impact on Islamic finance, insofar as they added the

legitimacy to more pragmatic approaches, but the intellectual debate on riba is still raging. It is

all the more inconclusive that unassailable, factual elements about the origin of riba are scarce.

Islamic scholars have insisted that the prohibition of the riba is not an isolated religious

injunction but ‘an integral part of Islamic economic order with its overall ethos, goals and values.

Based on the definitions it comes out the riba is not necessarily about interest rates as

such and it certainly is not exclusively about interest rates. It really refers to any unlawful gain

25

derived from the quantitative inequity of the counter values. Interest or usury would then be only

one from riba.

The meaning of the word ‘Gharar’, however is not mentioned as riba in Koran,

etymologically relates to the words deception or delusion. The principals are the same as

prohibition of riba: unequivocal though the concept itself is somewhat vague. The Gharar in

addition to deception and delusion also connotes peril, risk and hazard. In more financial terms it

can be interpreted as ‘uncertainty, risk or speculation’. Any gain that may result from chance,

from undetermined causes, is here prohibited.

There are some examples to clear up with this definition. It would be wrong to get a

worker to ski an animal by promising to give him half the skin as the reward, or to get him to

grind some grain by promising him the bran separated out by the grinding process. It is

impossible to know for certain whether the skin may not be damaged and lose its value in the

course of the work, or to know how much bran will be produced.

More accurately, Gharar refers to aleatory transactions, that is, transactions conditioned

on uncertain event. Gharar should not be used interchangeably with the broad concept of risk.

Gharar is prohibited yet it would be nonsensical to prohibit risk.

There are Hadith goes much further, extending the concept of commercial transactions

involving uncertainty. The meanings of most significant of them are following:

Do not buy fish in the sea, for it is Gharar.

To sell grapes until they become black, and sale grain until it is strong.

Do not sale what in wombs, contents of the udders, pebble.

1.5.2. The Moral Economy of Islam

The three pre-requisites for an economic system as being a set of rules, an ideology to

justify them, and a conscience in the individual which makes him strive to carry them out [ 27].

The Ethical dimension is not all too often forgotten, though it exists, as well in any society.

Hard work and participation in economically creative activity is obligatory for every

Muslims [17]. Economic activity is not to be confined to earning or producing enough to meet

one’s personal needs only. Muslims are expected to produce more because they cannot

participate in the process of purification through providing security to others (zakat or alms tax)

unless they produce more than what themselves consume. The most recommended use of fairly

earned wealth is to apply it to procuring of all means to fulfill a Muslim’s covenant with Allah

[18].

The broad ethical/economic system emphasizes fairness and productivity, honesty in

trade and fair competition, the prohibition of hoarding wealth and worshipping it, and protection

26

of human beings from their own folly and extravagance. Such a system, although rooted in

ancient tradition, is not, at least in its broad outlines, far moved from many contemporary

approaches to ethical business practices.

As for the ethical/economic justification for the prohibition of riba, it is three-pronged:

riba is unfair, it is exploitative, and it is unproductive. Due to this relation the lender and

borrower are in equalized balance of economic chain. Islam prefers the risks of loss be shared

equitably between the two both lender and borrower. In other words, rather than collecting a

‘fixed, predetermined’ compensation in the form if interest, leaders should be entitled to a share

from any profits from a venture they have helped to finance. The broader argument is that any

point should be morally and economically justified. As in other religions riba was also seen as

exploitative, since it tended to favour the rich, who are were guaranteed a return, at the expense

of the vulnerable who assumed the risk.

A number of economists and philosophers disagreed with the idea of marking capital gain

without any effort and living off other people’s work unethical. The prominent ancient-Greek

philosopher Plato (424-347 BC) pointed out immortality of interest and argued that in an ideal

society interest should be forbidden as it leads to inequity, egoism and egotistical conflicts

among people. Another Greek philosopher Aristotle (384-322 BC) like his teacher did not agree

the idea of exploiting money interest. According to him there was a ‘natural’ and ‘unnatural’ way

of income. Shepherding, fishing, farming, hunting and alike were natural ways. Unnatural ways

on the other hand were those done with the sole purpose of making profit. The worst way of

gaining wealth through unnatural ways was interest. In this regard he recorded: “Very much

disliked also is the practice of charging interest: and the dislike is fully justified for interest is a

yield arising out of money itself, not a product of that for which money was provided. Money

was intended to be a means of exchange; interest represents an increase in the money itself.

Hence of all ways of getting wealth, the most contrary is to nature.” [32].In the early times of

Roman Empire there were laws forbidding interest. Even later under the ‘Law of the Twelve

Tables’ interest rates was fixed, and loan sharking was illegal.

Significantly, the issue of fairness is related to the issue of productivity and efficiency.

Earning a profit is legitimate when one is engaged in an economic venture and thereby

contributes to the economy. By certain accounts, Meccan merchants in the days of the Prophet

routinely engaged (usually in-between arrivals and departures of caravans) in interest-based

lending, speculation and aleatory transactions [13]. This would account for the sharp distinction

drawn in the Koran between profit from trade and profit from riba. While the former benefited

the community and enhanced welfare, the latter diverted resources towards non-productive uses

and contributed to illiquidity and scarcity. The modern-day economy equivalent of that debate

27

contrasts the real, productive economy with the financial, speculative one. Some Islamic

economists have also argued that an interest-based economy was inherently inflationary and

caused unemployment and poverty because of money was not linked to productive investment.

1.6. Financial Products in Islamic Banking and Their Conformity with

Conventional Banks

Most Islamic financial institutions engage in a variety of financial operations. Besides

their range of equity, trade financing and lending operations, Islamic banks worldwide also offer

a wide array of wholesale and retail products including loans, partnership investments, foreign

exchange transactions, fund transfers, letters of credit, securities safe-keeping, investment

management and advice, and other conventional banking services. Many are also in active

derivatives, fund management and insurance. There are favourable investment climate on

liability side in Islamic banks for depositors as well. Current accounts are operated on the

principles of al-wadia (safekeeping) and are not remunerated. In this term, depositors are

provided with the cheque-books and can withdraw their funds at any time without any

restrictions or conditions, unlike in conventional banks. Investment in profit-and-loss (PLS)

deposits linked to bank mudaraba investments are in the theory though not in practice the

principal instruments offered to depositors. Banks usually offer a variety of accounts – PLS

deposit accounts, PLS special notice deposit accounts, etc. (Figure 1.10).

Yet in classical Islamic tradition, the only acceptable loan was the ‘qadr hasan’ (meaning-

good loan) or interest-free loan in the only common form of deposit was ‘al-wadia’

(safekeeping). By creating new products that pose no religion objections, or by invoking custom,

or overriding the general interest to justify the creation of somewhat controversial instruments,

Islamic bankers have been able to devise new products and instruments by updating or

combining contracts that go back to classical Islam. In Appendix, the reader can find more

information about differences of products and techniques in Islamic and conventional banks.

1.6.1. Murabaha

The best-known Islamic banking instrument is murabaha a cost-plus contract in which a

client wishing to purchase the equipment or goods requests the financial provider to purchase the

items and sell them to him at cost plus a declared profit. It is thus a financing-cum-sale the items

and sells them to him at cost plus a declared profit. It is thus a financing-cum-sale: the bank

purchases the required goods directly and sells them on the basis of fixed mark-up profit,

agreeing to defer the receipt of the value of the goods. While the interest-based bank would lend

the money on interest to client, and he would go and purchase the required commodity from the

28

Shariah Sources

Koran

Sunna

Ijtima jurists’consensus)

Qiyas (Analogy)

Ijtihad (Reasoning) Shariahh

Filter islamic

products

transations

Islamic Trade/ Financial

Contracts

Musharaka ( partnership)

Murabaha (purchase-sale)

Ijarahh (lease)

Takaful (insurance)

Salam( forward sale)

market, in Islamic bank, as it does not operates on interest basis, the bank therefore, purchases

the commodity in cash and sells it to the client on an agreed mark up. Thus, the client gets the

commodity on credit for which financing required and the Islamic bank makes profit on the

amount it has spent in acquiring the commodity and selling it to the client on installments. There

are a number of requirements for a murabaha transaction to be a legit transaction and meet

Islamic standards of a legal sale. The whole murabaha transaction is completed in two stages. In

the first stage, the client requests the bank to undertake a murabaha transaction and promises to

buy the specified commodity from the bank. A promise under Shariah, however, is not legally

binding. Which means, if the client goes back on the promise to purchase, the bank risks the loss

of the full or part of amount it has spent to acquire the goods. To eliminate such situations,

Islamic banks sign legally binding agreements with their clients beforehand, which also can

Figure 1.10 Islamic Finance in Ethical and Religious Framework

Banking and financial needs

Asset-backed

transactions with

investments in real

durable assets

Islamic Banking and finance

Prohibition of certain

investments:

- Sectors: (e.g.: alcohol,

armaments, tobacco

pork pornography )

- Instruments(e.g. no

forward transactions,

no derivatives, short

selling

Credit debt

products are not

encouraged

29

Supplier

Financial Institution

Costumer

Sell asset at purchase

price Make upfront payment

Deferred payment

Sell asset at purchase price +

markup

be understood as a promise between the two parties. In the second stage, the client purchases the

good acquired by the bank on a deferred payments basis and agrees to a payment schedule.

Another important requirement of a murabaha sale is that it consists of two sales contracts, and

through which the bank acquires the commodity for the client, and the other through which it

sells the acquired commodity to the client. The two contracts should be separate and real

transactions (Figure 1.11).

Murabaha form of financing is being widely used by the Islamic banks to satisfy various

kinds of financing requirements. It is used to provide finance in various and diverse sectors

such as consumer finance – for the purchase of consumer durables, for example, cars and

household appliances, the real estate – to provide housing finance, the production sector – to

finance the purchase of machinery, equipment and raw materials. Murabaha contracts are also

used to issue letters of credit and to provide financing to import trade at Islamic banks.

A Murabaha transaction has the following characteristics:

The cost price of the asset is known to both the buyer and seller

The buyer pays the seller at a fixed agreed time after receipt of the asset for an agreed

mark-up

The mark-up may be a lump sum or a certain percentage of the purchase price

The mark-up can, and often does, relate to the prevailing LIBOR (or equivalent) rate

Payment default will require the buyer to cover the seller's stated cost of capital for this

period

A Murabaha transaction is a debt based transaction and is therefore not tradable (as

Figure 1.11 Murabaha transaction structure

30

Shariah forbids trading in debt) but can be transferred at par value.

Generalizing the incidental closeness between profit shares and interest rates, which

appear in some periods, and thereby reaching some conclusions will not give correct results. A

conventional bank determines the interest rate it will pay clients at the time of depositing money.

A Islamic banks on the other hand utilizes the money through applicable profit margins, and

shares the money it earns. Event in case that the distributed profit shares are close to the interest

rates of conventional banks, this does not mean that the work done is the same. Important here is

not the rate of interest and profit sharing, but the source of each. While interest steams from a

source forbidden by all theistic religions and condemned by many prominent philosophers and

economics, profit sharing at participation banks is a result from permissible economic activity.

In order for earning yield to be interest, it is necessary that income is known beforehand,

and that money earned in return for lending out money. For instance, a conventional banks

collect money from the depositors in return for a certain interest, and yet again present it in terms

of cash loans to those in need for financing, subject to current interest rates. But on the other

hand, there is neither a promise made for income nor a guarantee for principal capital of the

people under profit sharing.

1.6.2. Leasing

Ijarah4 or leasing is probably the fastest growing activity in Islamic financial institutions.

The principle is well knows and virtually identical to conventional leasing: the bank leases as

asset to a third party in exchange for specified rent[1]. The amounts of payments are knows in

advance and the asset remains the property of the lessor. Only in a few respects do Islamic

contracts differ. A variation of basic principle is ijarah wa iktina, a lease- purchase agreement

whereby at the expiration of the lease, the lessee becomes the owner of the asset (Figure 1.12).

From the standpoint if classical Islamic fiqh, ijarah is understood as the sale of usufruct

(manfaa) and, as such, its rules closely follow those of ordinary sales. In order to avoid the

elements of riba and gharar, there are minor differences between ijarah and commercial leasing.

The law views some benefits and burdens of the property as belonging naturally and

unchangeably to the lessee, others to the lessor. For example, law provides that the duty to repair

the goods always fall on the lessor since the repair benefits him as the owner. Also, the usufruct

is not something existent and tangible, but a stream of the use extending into the future, which is

risky and unstable. Islamic law thus gives broad scope to the lessee to cancel the lease if the

4 “Ijarah” or in various literature “ijara”, which are identical in definition.

31

usufruct proves less valuable than expected. Finally, the price at which the asset may be sold to

the lessee at the expiration date of the contract cannot be predetermined.

Main characteristics of Ijarah:

It is necessary that the lessor own the asset and holds valid title to it.

Operating lease – the asset is returned to the lessor

Financial lease – the asset is sold to lessee be lessor upon completion of lease term

Lease rent is fixed by parties updating to market competitiveness

Lease will terminate upon total loss of asset or damage

A number of reasons account for the repaid growth of leasing : it is an acceptable

instrument in the eyes of the most scholars; it is an efficient means of financial intermediation;

by financing assets, it is useful tool in the promotion of economic development; because it is a

well-established instrument that lends itself to standardized mechanisms and procedures, and

because the similarity to conventional leasing, it is a flexible mode pf financing that lends itself

to securitization and secondary trading and to collaboration with conventional institutions.

1.6.3. Profit-and-Loss Sharing

The basic principle of profit-and-loss is that instead of lending money at a fixes rate of

return, the banker forms a partnership with the borrower, sharing in a venture’s profits and

losses. The partnership can be one or two types: mudarraba (commenda partnership or finance

trusteeship) and musharaka (long term equity-like arrangements). In both cases, the bank

receives a contractual share of the profits generated by business ventures.

The principle is at the core of the Islamic banking philosophy. It is at once the most

‘authentic’ form of Islamic finance since it replicates transactions that were common in the early

days of Islam, the one that is most consistent with the value system and moral economy of Islam,

and the most ‘modern’ one. Indeed, venture capital and merchant banking – both among the

Bank

(Lessor)

Client

(Lessee)

Asset

Purchases Bank leases

Asset to Client

Client pays rent to Bank

Figure 1.12 Ijarah (Leasing) transaction structure

32

fastest growing segments of contemporary finance – would be conventional equivalents of profit-

and-loss sharing arrangements. The bank, being an investor, as opposed to a lender, has a stake

in the long-term success of the venture. The entrepreneur, rather than being concerned with debt-

servicing, can concentrate on a long-term endeavor that in turn would provide economic and

social benefits to the community.

Mudaraba partnership (entrepreneur based partnership) is a type of partnership where one

party supplies the capital and the other the labor. One party who owns capital – rabb al-mal

(beneficial owner or the sleeping partner) – entrusts money to the other party, called the mudarib

(managing trustee), who is to utilize it in an agreed manner. After the operation is concluded, the

rabb al-mal receives the principal and the pre-agreed share of the profit. The mudarib keeps for

himself the remaining profits. The rab al-mall also shares in the losses, and may be in position of

losing all his principal. Among the other rules od mudaraba are the following: the division of the

profits between the two parties must necessarily be on proportional basis and cannot be lump

sum or guaranteed return; rab al-mal is not liable for losses except for the losses beyond the

capital he has contributed; the mudarib does not share in the losses except the loss of his time

and efforts.

Musharaka is similar in its principle to mudaraba, except for the fact that the financier

takes an equity stake in the venture. It is in effect a joint-venture agreement whereby the bank

enters into a partnership with a client in which both share the equity capital, and sometimes the

management, of the project or the deal. Participation in a musharaka can be either in a new

project or in an existing one. Profits are divided on a pre-determined basis, and any losses shared

in proportion to the capital contribution. Under certain circumstances, for example if the mudarib

has engaged in religiously illicit activities (speculation, production of forbidden goods), or of the

bank has imposed a collateral for its investments, the mudaraba or musharaka contracts can be

considered null and void.

Recent variations of mudaraba (mudaraba mutanaqisa) and musharaka (musharaka

mutanaqisa), where the bank’s capital or the bank’s share increase his share in he projects.

Although many scholars consider profit-and-loss sharing as the most authentic and most

promising form of Islamic contracts, there are a few dissenting voices. In addition, profit- and-

loss sharing arrangements create managerial and regulatory problems that have yet to be fully

mastered.

To finance such arrangements, most Islamic banks offer accounts that act like investment

funds. Depositors can reap profits from a venture’s success, but risk losing money if investments

perform poorly. The return paid on investment accounts is determined by the yield obtained from

all financial activities of the bank. After deducting such administration costs as wages, provision,

33

and capital depreciation, the bank pools the yields obtained from all ventures, and the depositors,

as a group, share the net profits with the bank, according to a predetermined ratio that cannot be

modified for the duration of the contract.

Perhaps the greatest strategic challenge of Islamic financial institutions is to increase their

involvement in PLS activities and overcome the institutional and cultural obstacles that have so

far stood in the way [14].

1.6.4. Sukuk – Islamic Bonds

Sukuk market is one of the fastest growing segments of the Islamic capital market

(“direct funding market”) usually translated as Islamic bond is the most active Islamic debt

market instruments (in addition to Islamic equity market). The development of the sukuk market

has accompanied the transformation of the economy that has now become more diversified and

private sector driven. The market, initially dominated by the Government debt securities, now

reflects the growing demand for the long term financing requirements of the private sector. In

this highly competitive environment, the presence of a deep and liquid of sukuk market thus

contributes towards the stability of the financial system.

Nowadays, sukuk or Islamic fixed-income securities that have emerged over the past 15

years become as an increasingly important asset class. Sukuk may be defined as certificates of

equal value that represent an undivided interest (proportional to the investor’s interest) in the

ownership of an underlying asset (both tangible and intangible), usufruct, services or investments

in particular projects or special investment activities. Through this concept, sukuk enjoy the

benefit of being backed by assets, thereby affording the sukuk holder or investor a level of

protection which may not be available from conventional debt securities. Furthermore, unlike

conventional debt securities that mirror debts or loans on which interest is paid, sukuk can be

structured based on innovative applications of Islamic principles and concepts. Sukuk share some

similarities with conventional debt securities, in that they are similarly structured based on assets

that generate revenue. The underlying revenue from these assets represents the source of income

for the payment of profit on the sukuk [19].

Modern sukuk emerged to fill a gap in the global capital market. Islamic investors want

to balance their equity portfolios with bond-like products. Because sukuk are asset-based

securities — not debt instruments — they fit the bill. Each sukuk has a face value (based on the

value of the underlying asset), and the investor may pay that amount or (as with a conventional

bond) buy it at a premium or discount.

With sukuk, the future cash flow from the underlying asset is transferred into present

cash flow. Sukuk may be issued for existing assets or for assets that will exist in the future.

34

Source: based on information from[8]

Investors who purchase sukuk are rewarded with a share of the profits derived from the asset.

They don’t earn interest payments because doing so would violate Shariah.

As with conventional bonds, sukuk are issued with specific maturity dates. When the

maturity date arrives, the sukuk issuer buys them back. However, with sukuk, the initial

investment isn’t guaranteed; the sukuk holder may or may not get back the entire principal (face

value) amount. That’s because, unlike conventional bond holders, sukuk holders share the risk of

the underlying asset. If the project or business on which sukuk are issued doesn’t perform as well

as expected, the sukuk investor must bear a share of the loss.

Table 1.2.

Most shariah scholars believe that having sukuk managers, partners, or agents promise to

repurchase sukuk for the face value is unlawful. Instead, sukuk are generally repurchased based

on the net value of the underlying assets (each share receiving its portion of that value) or at a

price agreed upon at the time of the sukuk purchase [8].

Distinguishing Sukuk from Conventional Bonds

Conventional Bonds Sukuk

Asset

ownership

Bonds don’t give the investor a share of

ownership in the asset, project, business, or joint

venture they support. They’re a debt obligation

from the issuer to the bond holder.

Sukuk give the investor partial

ownership in the asset on which the

sukuk are based.

Investment

criteria

Generally, bonds can be used to finance

any asset, project, business, or joint venture that

complies with local legislation.

The asset on which sukuk are

based must be shariah-compliant.

Issue unit Each bond represents a share of debt. Each sukuk represents a share of

the underlying asset.

Issue price The face value of a bond price is based on the

issuer’s credit worthiness (including its rating).

The face value of sukuk is based on

the market value of the underlying

asset.

Investment

rewards and

risks

Bond holders receive regularly scheduled (and

often fixed rate) interest payments for the life of

the bond, and their principal is guaranteed to be

returned at the bond’s maturity date.

Sukuk holders receive a share of

profits from the underlying asset

(and accept a share of any loss

incurred).

Effects of

costs

Bond holders generally aren’t affected by costs

related to the asset, project, business, or joint

venture they support. The performance of the

underlying asset doesn’t affect investor rewards.

Sukuk holders are affected by costs

related to the underlying asset.

Higher costs may translate to lower

investor profits and vice versa.

35

In practice, some sukuk are issued with repurchase guarantees just as conventional bonds

are. Although not all shariah scholars agree that this arrangement complies with Islamic law, a

product called sukuk ijarah may come with a repurchase guarantee.

The key characteristic of sukuk — the fact that they grant partial ownership in the

underlying asset — is considered shariah-compliant. This ruling means that Islamic investors

have the right to receive a share of profits from the sukuk’s underlying asset.

When you have the basics about how conventional bonds and sukuk work, it’s time to put

them next to each other. Table 1.2 offers a quick look at the key ways in which these investment

products compare. The sukuk bonds can be applied to all other Islamic transactions and

agreements, and therefore, potentially gain the profit of invested capital.

In a mudaraba sukuk, the sukuk holders are the silent partners, who don’t participate in

the management of the underlying asset, business, or project. The working partner is the sukuk

obligator. The sukuk obligator, as the working partner, is generally entitled to a fee and/or share

of the profit, which is spelled out in the initial contract with investors.

With sukuk that are based on the murabaha contract, the SPV (Special Purpose Vehicle)

can use the investors’ capital to purchase an asset and sell it to the obligator on a cost-plus-profit-

margin basis. The obligator (the buyer) makes deferred payments to the investors (the sellers).

This setup is a fixed-income type of sukuk, and the SPV facilitates the transaction between the

sukuk holders and the obligator. The murabaha contract process begins with the obligator (who

needs an asset but can’t pay for it right now) signing an agreement with the SPV to purchase the

asset on a deferred-payment schedule. This agreement describes the cost-plus margin and

deferred payments (Figure 1.13).

The basic idea of ijarah sukuk is that the sukuk holders (investors) are the owners of the

asset and are entitled to receive a return when that asset is leased. The ijarah contract process

begins when a company that needs an asset but can’t afford to purchase it outright contracts with

an SPV, which agrees to purchase the asset and rent it to the company for a fixed period of time.

In this scenario, the SPV receives the sukuk proceeds from the investors; in return, each

investor gets a portion of ownership in the asset to be leased. The SPV buys the title of the asset

from the same company that is going to lease the asset. In turn, the company pays a rental fee to

the SPV.

Istisna is a contract between a buyer and a manufacturer in which the manufacturer

agrees to complete a construction project by a future date. The contract requires a fixed price and

product specifications that both parties agree to. If the end product doesn’t meet contract

specifications, the buyer can withdraw from the contract. Istisna sukuk are based on this type of

contract. The sukuk holders are the buyers of the project, and the obligator is the manufacturer.

36

The obligator agrees to manufacture the project in the future and deliver it to the buyer, who

(based on a separate ijarah contract) will lease the asset to another party for regular payments.

The process of issuing istisna sukuk begins when the obligator (manufacturer or contractor) and

the SPV sign an istisna contract.

Another innovative type of sukuk is hybrid sukuk which has new complicated structures.

Based on various demands of investors, a more diversified kind of hybrid sukuk or mixed sukuk

emerged in the market. The assets can comprise of istisna, murabaha as well as ijarah. Islamic

Development Bank issued the first Hybrid Sukuk for US$400 million. The assets comprised 66%

ijarah sukuk, 31% murabaha and 3% istisna sukuk. The hybrid sukuk structure represents the

potential of new structures and benefits to the investors.

Sukuk has now become the strongest segment in Islamic finance, are involved in the

international market and generate significant cross-border flow of funds as may be achieved

beyond domestic markets. Along with hard work, growth and balanced development agenda, all

countries have the potential to expand the role of Islamic finance is increasing in contributing to

global growth and financial stability. Investment sukuk are the ideal investment for investors

requiring a fixed investment return with low risk and the Shariah Compliant.

1.6.5. Islamic Mutual Funds

Islamic investment funds are similar to socially responsible mutual funds n that they

select their placements bot in bases of profitability alone, but on non-economic criteria – in this

Investor (seller)

SPV Asset or commodity

supplier

Obligator (Buyer)

1. Cash proceeding 2. Sukuk

certificate

issuance

4.Delivery of

asset

3.Purchase of asset

for spot

payment and delivery

5. Differed payments on

installment or lump sum

(cost+profit)

6. Periodic distribution

of deferred payments

Figure 1.13 Murabaha sukuk structure

Source: Designed based on the ideas of the author

37

case, compatibility with Islamic values. Driven by abundant liquidity and the boom in financial

markets, thousands of investments funds were started in recent years. In addition to Islamic

financial institution, virtually every major Western financial institution – such as Merrill Lynch,

Goldman Sachs, Flemings, etc. – now offers Islamic investment funds. In 1990, Dow Jones and

Company has created the Dow Jones Islamic Market Index or DJIM, which track 600 companies

whose products and services do not violate Islamic law.

An Islamic mutual fund is similar to conventional mutual fund in many ways. However,

unlike its conventional counterpart, an Islamic mutual fund must confirm to shariah investment

precepts. The Shariah encourages the use of profit and loss sharing and partnership schemes, and

forbids riba (interest), gambling and gharar (selling something that is not owned or cannot be

described in accurate detail in terms of size, type and amount). Shariah guides and supervises the

several aspects of Islamic mutual funds, including its asset allocation (portfolio screening),

investment and trading practices, and income distribution.

Any Mutual Fund falls roughly into the following two sub-groups:

Income Funds. The investor receives a regular income (monthly/quarterly) by investing

in securities that provide income (e.g. dividend paying stocks, etc.).

Growth Funds. The main aim of this type of fund is to grow the capital invested by

appreciation of the underlying securities, and not to provide any annual/quarterly income.

The following Mutual Funds presented below are ones of best prospective funds advertise that

they operate according to Islamic Shariah principle. Most have a Shariah Advisory board that

oversees its compliance with Islamic teachings:

Azzad Asset Management is a financial services firm specialized in providing ethical

(halal only) financial solutions. The company offers the Azzad Funds as well as an

ethical (halal) separately managed program using asset allocation. Clients can choose

from a variety of retirement, college savings, and managed investment accounts. In

addition, the company assists affluent investors with their estate planning needs.

Businesses and individuals depend on Azzad to help them turn their wealth into their

goals by using only halal investing.

Amana Mutual Funds. They offer two Mutual Funds (Growth and Income) operating

according to Islamic Principles, with an Islamic Advisory Board.

Allied Asset Advisors. These are an Islamic Mutual Fund that tracks the Dow Jones

Islamic Markets USA (DJIM-US).

Wright Islamic Equity Investment. Their objective is to "provide competitive Shariah

compliant investment returns utilizing a globally diversified portfolio of high quality

equity investments rigorously screened for Shariah compliance.

38

1.6.6. Micro-lending or Micro-financing

Most micro-lending or micro-finance institutions (MFI) are not, technically, Islamic

banks. Yet they may be closer to the moral of economy of Islam than many self-styled Islamic

banks, and will no doubt be a source of ideas and concepts for Islamic finance in the future. The

micro-financing idea has gained a number of adherents, in particular among governments and

international organizations in recent years.

Micro-finance purports to provide a market-based solution to one of capitalism’s

thorniest problems: integrating the poor into the economy. This finance scheme focuses on

moving people off the dole and into productive enterprise. Self-helped and self-reliance are at the

center of the system. The scheme turns the conventional banking logic on its head: rather than

looking for creditworthy customers and basing lending decisions on credit history and collateral,

MFIs lend small amounts of money to people – principally women – with no resources, as means

of integrating them in the productive economy.

The best known experience in micro-financing is Muhammed Yunus’s Grameen Bank,

which was initially started in Bangladesh and has since been replicated in more than 50

countries. Although interest-based and devoid of explicit references to Islam, Grameen Bank

concept – not to mention the fact that it was created in an overwhelmingly Islamic country by a

Muslim – is based on a central tenet of the moral economy of Islam.

The MFIs are in the process of destroying several very old myths: the poor are not

creditworthy; they are not reliable borrowers; they are not successful enough to make saving;

they are bad investors and even worse entrepreneurs. Grameen Bank boasts that 98 per cent if its

loans are repaid on time [14].

The main objection of Islamic scholars to micro-lending banks is that they lend at

interest.

1.7. The Management and Control, and ‘Islamic Moral Hazard’

The notion of moral hazard is commonly use in the connection with financial regulation.

It refers to policies that many encourage reckless behavior. For many, it is axiomatic that bank

and their customers are people of virtue, who act at all times in a righteous manner. While it is

undeniable that religious fervor was for many people a reason to work for an Islamic bank, or to

conduct business with it, it was soon discovered that religion could be a double-edged sword. In

the Koran there are numerous references to hypocrisy [17]. Since time immemorial, con artists

have used the cover of religion as a means of rapid enrichment. Even when the overwhelming

majority of people are honest, all it takes is a few bad ‘apples’ – a few dishonest customers or

employees – for banks to incur serious difficulties.

39

There are four factors of special importance in this regard. One is the assumption of

righteous behavior on the part of employees and customers, which sometimes turns certain

institutions into magnet for dubious characters [14]. The second is the use of religion as a shield

against scrutiny. The third is the religious and legal ambiguity that often allows borrowers to

escape their obligations with impunity. The fourth involves conflicts of interest involving the

bank and its clients.

In the early years, Islamic bankers failed to act prudently and exercise the kind of due

diligence expected of bankers, because implicit assumptions about the virtue of their employees,

and customers Internal control has also been a problem for the same reasons. A number of failure

in management of banking was seen in Dubai, the world’s centre of Islamic commercial banks

and regulations in last decade of twentieth century.

A Second type of Islamic moral hazard occurs when financial activities of certain Islamic

institutions or group become immune to scrutiny or criticism, whether for political or religious

reasons. A more subtle but equally pervasive form of Islamic moral hazard is the advantage that

can be taken from ambiguity. Unlike specular systems, the legal system of Islam incorporates

both an economic and religious logic. In the religious law of Islam, equitable considerations of

the individual conscience in matters of profit and loss override the technicalities of commercial

dealings. It is harmonization of these two very different approaches which poses the real

challenge for developing Islamic law today [24].

Islamic banks face serious problems with late payments, not to mention outright defaults,

since some people take advantage of every dilatory legal and religious device. However, it

should be notes that same problems often hurt conventional banks in Islamic countries. In Saudi

Arabia, problems of late payment are endemic, and banks receive little help from juridical

system. In Pakistan, many borrowers took advantage of the ambiguity of a multilayered legal

system to avoid repaying much of their debt.

The last type of Islamic moral hazard is related to the bank’s relation with its depositors.

Islamic banks share their profits with those of their customers who hold investment deposits. For

example, 80 per cent of the net profits may be distributed to the depositors, and 20 per cent to the

shareholders. Empirical surveys have shown that banks often arbitrarily change distribution

ratios.

Perhaps the most vexing managerial issue is the lack of qualified personnel. Bank

officers at once management skills appropriate to conventional institution and religious training.

40

2. PRACTICAL PART

2.1 Uzbekistani Leasing Market

The leasing and housing finance sectors have been developed in line with international

best practices, with the value of lease financing increasing from US$265 million in 2007 to over

US$890 million in 2012.

Analyzing the leasing market of Uzbekistan in 2012, we can identify the following

trends. Factor outpacing GDP growth, despite a significant increase in the volume of leasing

transactions the share of leasing in GDP for the previous year has not increased and amounted to

0.6 %. However, the leasing market has huge potential for growth. Every year the lessors’

competition in the market is growing, which means an increase in the level of provided leasing

services. Also, it should be noted, the role of public-private cooperation in the leasing sector,

which contributes to the development of diversified and specialized companies in leasing market

of the country, such as “Uzkishlokhuzhalikmashlizing”, “Taiba leasing”, “O`zavtosanoat-

Leasing”, and et al.One of the determining factors in the development of the leasing sector is

lessors’ access to the source of financing [26].

The total volume of leasing operations in Uzbekistan in 2013 increased by 36 percent

compared to 2012, up to 805.2 billion soums and the volume of the leasing market rose by 16.5

percent, up to 1.511 trillion soums, the Uzbekistan Lessors Association told Trend on Feb .13

(Figure 2.1).

In late 2013, the share of leasing in the country's GDP was 0.7 percent compared to 0.6

percent a year earlier, the specific weight of the leasing portfolio in GDP remained at the

previous year's level of 1.3 percent and the specific weight of leasing transactions in investments

to the main capital increased by 0.1 percent to 2.8 percent.

In total, last year Uzbek lessors concluded 6700 transactions versus 7000 transactions a

year earlier. The Table 2.1 shows the snapshot for Uzbekistani leasing environment for last year.

In 2013 agricultural equipment prevailed amongst the leased property. The agricultural

equipment's share in total transactions stood at 37.5 percent compared to 33.1 percent in 2012.

Among all the leased properties, motor vehicle leasing deals stood at 24.8 percent,

technological equipment at 21.4 percent and the real estate and property complex was at 16.3

percent.

In all the leasing deals on technological equipment in 2013, the major place belonged to

construction machinery and equipment for building material manufacturing (35.4 percent), land

reclamation equipment (22.9 percent) and equipment for light industry (12.8 percent).

41

37 45

149

245

337

818

1122 1135

1258 1297

1511

2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013

In 2013, some 99 lessors operated in the country's leasing market, including 24

commercial banks and 75 leasing companies.

The major leasing companies on the market last year were: Uzselhozmashlizing (271.5

billion soums), Uzavtopromlizing (65.9 billion soums), Uzmeliomashlizing (38.5 billion soums),

Uzbek Leasing International J.V. (36.2 billion soums) and the Artum Leasing Group (20.9

billion soums).

The most active commercial banks in leasing services included the State joint-stock

commercial bank Asaka (65 billion soums), joint-stock commercial bank Ipoteka (32.3 billion

soums), the Rural Construction Bank (20.3 billion soums), open joint-stock commercial bank

Mikrocreditbank (16.2 billion soums) and Uzpromstroybank (15.9 billion soums).

Uzbekistan abolished customs duties during the import of modern technological

equipment on leasing terms and the lease payments are exempt from VAT with the lessees

released from taxes on leased property.

Moreover the recent foundation of leasing company with Islamic financing related basics,

has escalated the improvement of leasing possibilities in the country. The TAIBA LEASING

LLC was established in 2010 as the 100% subsidiary of The Islamic Corporation for the

2006 2007 2008 2009 2010 2011 2012 2013

No. of lessors 28 33 49 64 86 83 84 99*

*Banks - 24, Leasing Companies - 75

Figure 2.1 Leasing market in Uzbekistan

Source: based on information from[26].

42

Development of the Private Sector (ICD), Member of the Islamic Development Group. FC

TAIBA LEASING LLC was incorporated in line with ICD’s vision to set up Islamic leasing

companies across its member countries. Aim of TAIBA LEASING is to support private SME

companies in Uzbekistan.

Table 2.1.

Leasing performance in Uzbekistan

Number of operations to date 54

Net cumulative Bank Investment €709.8 million

Cumulative disbursements Portfolio €503.7 million

Portfolio €34.3 million

Number of active portfolio operations 11

Operating assets €34.0 million

Private share of portfolio 49%

Equity share of portfolio 2%

Leasing portfolio of the company is formed in areas such as light industry, medical

equipment, transportation, and manufacturing. The average estimated cost of leasing object

varies from $ 50 to $ 400 thousand credit portfolio “TAIBA LEASING” for the year 2012

amounted to more than 3 billion soums ( about USD 1.32*106). Presently held by the transaction

currency and leasing contracts, also are working to increase the leasing contracts in national

currency.

Leasing companies and banks provide leasing services exclusively to legal entities of

different forms of ownership. In addition, banks prefer to customer's current account is in the

same bank as the companies’ one. Some private companies provide leasing and individual

entrepreneurs as well.

The timing of leasing services has no special distinction, and are provided to 1 year to 5

years, except such as leasing companies " Uzkishlokhuzhalikmashlizing ", " Uzmeliomashlizing

" and " Uztranslizing " whose lease term can be up to 120 months . In the banking sector to

provide long-term conditions may differ from leasing banks such as "Asaka " OJSCB "

Microcredit " OJSCB "Hamkorbank" whose period can last up to 7-8 years. Interest rates leasing

companies and banks do not have specific differences in size. And their range varies from 8% to

30% in SLE, and from 5 to 30 % of sums. The magnitude of the interest rate also affects the

requirement for size and type of collateral. Companies that do not require collateral, interest rates

are significantly higher than those companies that have requirements for collateral . Advance

Source: Review of leasing operations in Uzbekistan, 2013

43

payment, in % of the value of the lease is an average of 20% and above. Lessors mainly finance

in domestic currency amounting to an average of 500 million sum for leasing transactions.

The share of leasing in investment to fixed capital by the end of 2012 was 2.67%. Also,

there is stability of GDP per share of leasing 0.61%. The indicator leasing share of GDP portfolio

tends to decline, and by the end of 2012 was 1.34%.

The growth rate of the volume of leasing on the basis of 2012 amounted to 22%. If in

2011 the volume of leasing amounted to 484.5 billion sums, by the end 2012, it rose to 106.1

billion sums to $ 590.6 bln and was observed a significant increase in the number of leasing

transactions, more than 12% (Figure 2.2).

Figure 2.2 Dynamics of property transferred to the leasing (millions of UZS)

Source: based on information from[26].

There a number of banks and leasing companies providing services in medical equipment

agriculture transport building and construction etc. More than half of the leasing market by the

end of 2012 owned by leasing companies - 64.5%, however, this figure decreased by 2.6%

compared to the previous year. The total amount of transactions of leasing companies in 2012

amounted to more than 381 billion sums, and the remaining amount of 209.6 billion sums are

owned by banks.(Figure 2.3).

In conclusion, it should be noted that in our country the leasing sector is gaining

momentum and there is great potential for growth. In the near future leasing, ensuring an orderly

and secure relationship between all participants of the chain of financial investment,

modernization of industries and regional infrastructure, may be one of the most promising tools

351.66

401.65 430.33

484.51

590.63

0

100

200

300

400

500

600

700

2008 2009 2010 2011 2012

44

for sustainable development and the development of innovative economy of the Republic of

Uzbekistan.

Figure 2.3 The share of “players” in leasing market

Source: based on information from[26].

2.2 The leasing procedures in commercial banks

For better understanding of the procedures of financial leasing transaction we assume

hypothetical model of leasing example.

The private dental clinic is willing to buy new equipment for their renovated building. It

is located in the center of the city and enjoys a great success among the clients. In order to step

aside to the innovations the clinic decided to order the medical equipment from Switzerland. The

goods are following:

Dental chairs: KaVo Primus 1058 CLEO II (AIR)

Stools: Estro L Stool

Multimedia: SOPRO 617 INTRAORAL TELECAMERA

Accessories: VITALI PORTABLE NEGATIVOSCOPE

Operatory Lights: The Marus

KaVo dental instrument

Descriptions:

KaVo Primus 1058 is designed for specialty and available space.

Treatment unit is perfectly designed for both specific treatment protocols and surgeries – with:

63.20% 66.70% 67.70% 67.10%

64.50%

35.20% 33.10% 32.40% 32.90%

36%

2008 2009 2010 2011 2012

Leasing companies Banks

45

Hanging tubing

Continental Style

Knee Break

Cart System

Benefits that are tailored to requirements:

Eerything directly to hand: The workplace adapts to the dentist and not vice versa

Use of proven KaVo technology (Progress backrest, one-hand system, stability through floor

mounting)

Ease of operation

Compact: Also fits into smaller surgeries

Optimal for treatment of children through height adjustable chair base

Fully multimedia-prepared

Outstanding ergonomics

CLEO II (AIR). Treatment Centre facilitates multiple working methods and a variety of

dental procedures. Cleo II Chair Features include:

Unique Knee Brake chair design

Twin-articulating headrest

2 preset positions

Last-position memory (LP) and auto-return

Automatic extendable leg rest with manual override and auto safety stop

Foldaway, detachable armrest

Integral service centre with air and water regulators and pressure indicators

4 handpiece outlets and 3 in 1 syringe

Stools. Estro L Stool sliding on a polished aluminum 5-spoke base, equipped with 5 swiveling

and self-braking casters. Wrapping polyurethane backrest with upholstered central insert. Gas

shock-absorber ranging of 200 mm. Handle available on the right or left side.

Multimedia. SOPRO 617 INTRAORAL TELECAMERA DSP is digital technology, electronics

integrated in the hand-piece with reduced overall dimensions, extreme manageability (weight of

hand-piece: 50 g), automatic adjustments, LED lighting without fibre optics, 80° field of vision,

no upside-down image and depth of field of 5 to 30 mm, automatic focus, possibility of stopping

1 to 4 framings by foot, easy mounting both on the instrument table and nurse's console.

Accessories VITALI PORTABLE NEGATIVOSCOPE Accessory completely independent of

the unit that backlights radiographic photographs, thus allowing for their easier visualization.

The radiating surface (85x75mm) is lit by led diodes, thus obtaining a cold light, low

46

consumptions and high reliability. The device, of small dimensions (about 165x115x65 mm), is

battery operated.

Operatory Lights The Marus Compact, yet powerful, two intensity settings with a color

temperature of 4400°K.

KaVo dental instrument Dental turbines, surgical instruments, straight and contra-angles

headpieces.

The clinic researches the market of leasing in the country and decides to apply for the

leasing in “XX Leasing Group”. According to legal acts and code of leasing operations, “XX

Leasing Group” offers the following option:

At the final year or date of the leading contract the object of leasing becomes the

property of the lessee ;

Terms of leasing contract exceeds 80 percent of useful life of the lease or

residual value of the leased object at the end of the lease is less than 20 percent of

its original value ;

the lessee has the option to purchase the leased object at a fixed price or price

determined at the end of the lease ;

total amount of payments for the period of the leasing contract exceeds 90 percent

of the cost leasing object.

The lessor is obliged to acquire the property under the lease agreement and pass it into

possession and use to the lessee; notify the seller that property intended for leasing a particular

person acquiring the property for the lessee; timely and fully perform its obligations to the lessee

on the content of the object of leasing, repairs and maintenance service if such conditions are

required by the treaty [31].

Calculation

The Clinic company have been acknowledged with the regulations of the leasing procedures now

is presenting the dentistry equipment they would like to buy (Table 2.2).

The “XX Leasing Group” is interested in the project of financing and make decision to offer the

leasing transaction in following terms:

Advance payment in amount of two monthly payments at signing leasing contract;

Interest rate of 6.5 % , within the period of 36 month;

Frequency of payment is 12/year;

Residual value of equipment equals $10000;

The lessee is obliged to buy the equipment at the end of the leasing contract.

47

Table 2.2.

The clinic required medical equipment

At the beginning we don’t know the monthly payments’ amount. The principle of value

additivety states that the present value (lease amount) is equal to the present value of the monthly

payments (an annuity) plus the present value of the residual value (a lump sum). Therefore, we

have the following formula (2.1) as starting point:

[

]

Where

PV – present value, in our case is the lease amount;

Pmt – is monthly payments;

FV – future value, residual value in our case;

i – is (nominal) interest rate;

N – is number of month due to payment.

According to this formula (2.2) we can get the equation of monthly payment:

[

]

However, we are still challenged with the advance payment that makes a minor trouble in

our calculations. The advance payment serves to reduce the effective lease amount and also

reduces the number of monthly payments to be made by the number of advance payments. This

insight makes it relatively simple to solve the problem using a variant of our PV equation above.

In the equation below (2.3), A is the number of advanced payments:

Name of equipment Production Condition Quantity Price Total

KaVo Primus 1058 KaVo(Germany) new 2 21,430.47 42860.94

CLEO II (AIR) Belmont (USA) new 1 27,769.03 27769.03

Estro L Stool Vitali(Italy) new 3 587 1761

SOPRO 617

INTRAORAL

TELECAMERA Vitali(Italy) new 3

2,421.86

7265.58

VITALI PORTABLE

NEGATIVOSCOPE Vitali(Italy) new 2 5,074.48 10148.96

The Marus Lights Marus(USA) new 4 1,749.87 6999.48

KaVo dental instrument KaVo(Germany) new 20 480 9600

Total

needed

$

106,404.99

48

[

]

So, we are simply subtracting the number of advance payments from the lease amount (because

they are both at period 0), and reducing the number of payments from N to N – A. Now, we

simply need to solve the equation for the monthly payment. After some algebraic manipulation,

we get the following formula (2.4):

Let’s apply these formulas to our data. According to terms from “XX Leasing Group” and the

information from the dental clinic we have the following:

PV- (leasing amount) is $106,404.99;

i – (Nominal) interest rate is 6.5%;

A5 – 2 advance payments;

FV- Residual value6 is $10000.

Converting the annual rate to a monthly rate (0.065/12 = 0.0054) with monthly payment

frequency, we can calculate the monthly payment amount as follows (2.5):

As it is shown in the table 2.3, the dental clinic has to pay following installments to the

“XX Leasing Group” within 34 month:

$ 5670.18 first payment at closing – signing the leasing contract

$ 2835.09 monthly regular payment

$ 10000 for buying out the goods (dental tools) at the end of contract

5 A – Advance payment, In calculation the two-monthly-payment is subtracted from 36 payments as it is

considered as payment at close date of contract. 6 Residual value the value of the goods is estimated by bank, defining how much it is worth at the end of its

lease, or at the end of its useful life, ensuring the client to purchase it.

49

Table 2.3.

Leasing payment schedule in conventional bank

Number

of

payments

Payment

date

Leasing

amount Installments Interest Principal Balance Residual

0

$(106404.99) $ 5670.24

$

100734.8

1 1/1/2014

$ 2835.12 $ 545.68 $ 2,289.44 $ 98,445.31

2 2/1/2014

$ 2835.12 $ 533.28 $ 2,301.84 $ 96,143.47

3 3/1/2014

$ 2835.12 $ 520.81 $ 2,314.31 $ 93,829.16

… … …. … … … …

34 10/1/2016

$ 2835.12 $ 98.88 $ 2,736.24 $ 15,516.88

35 11/1/2016

$ 2835.12 $ 84.05 $ 2,751.07 $ 12,765.81

36 12/1/2016

$ 2835.12 $ 69.15 $ 2,765.97 $ 9,999.85 $ 100000

Totals $ 102064.32 $ 11329.42 $ 90,734.90

The dental clinic agrees to sing for the conditions of the leasing contract of “XX Leasing

Group” or decides to know the other alternatives for purchasing the dental instruments and

machines via Islamic bank.

2.3 Leasing in Islamic bank

As described in the first part of the paper, we now that in Islamic banking most of the

transactions are based on interest-free or partnership conditions. Consecutively, there is an

alternative of leasing transaction in Islamic banking system. It is ijarah. The term ijarah literally

means rent, the Shariah process is known as ijarah-wal- iqtina , rent with an acquisition or rent to

own. The process of ijarah can be used for equipment as well as property. This Islamic

finance process is very simple. A single asset trust is created whereby the bank purchases the

property, and then leases the property to the customer. A portion of each monthly payment goes

towards ownership, until the customer owns 100%.

The following basic principles are to be followed in order to fulfill the requirements of

ijarah transaction:

Parties of contract – what they can and cannot do

Subject of the matter – what can be used as basis of valued ijarah contract

Consideration/rent – the rent that will be payable

Period/termination – when the ijarah will be valued and ruled regarding its termination

The basic difference between a Shariah ijarah-wal-iqtina Islamic loan process and a

conventional lease is the ijarah process obligates the bank (seller) to sell the property to customer

under a promise to purchase. While the same contract entitles the customer to purchase the

property, the customer is not obligated to do so.

50

The conditions for an ijarah contract to be valid are that the asset to be leased should have

a tangible presence, be visible, and capable of being transferred back to the lessor after the

termination of the contract. Furthermore, the asset should have some usage value. From here it

follows that the lessor should transfer the asset to the lessee, for use only, in a condition that

enables it to be used to achieve its stated objectives. In this context, it is worth mentioning that

lessee should put to use the asset only in the way specified in the ijarah contract.

The purchase price agreed in contract is equal to the original purchase price less the down

payment made by the customer plus $1.00. For example, if the value of the property is $200,000

and the customer makes a $40,000 down payment (advance payment), the initial amount the

customer has to pay the investor for 100% ownership is $160,001. As the customer makes more

payments, this amount reduces, until the final ownership payment of $1.00 is reached.

For dental clinic type of ijarah as ijarah-thumma-al-bay(lease-sale or financial lease) is

suited. This is one of the most commonly entered-into of all ijarah, which is preferred by

businesses. These form of ijarah contract shares many points of similarity with the conventional

form of the financial lease agreement, however the differences are present.

The clinic – lessee – has the option to buy the asset or the piece of property for which he

had been paying a specified amount of rent, at the end of the contractual period, at a pre-fixed

price. This type of contract presents a convenient situation for both parties and hence is one of

the most popular of all ijarah contracts. Although the bank basically funds the buy of the asset or

the property, it still gets to earn some money out of this contract, by way of the rent. The client

or lessee, on the other hand, is not only able to use the asset without having to pay its full price

all at once or bear the risks during the leasing period, but also can become its owner after the

contract terminates.

The initial ijarah Islamic finance amount financed by the customer earns profit for the

investor through monthly rental payments7. The calculation of the ijara is based on amortization

principles as the mathematical formulas are acceptable as there are no Shariah issues with

calculations. The major difference between a traditional amortization and an ijarah transaction is

that the ijarah transaction is based upon a reverse amortization calculation.

The Islamic bank purchases the property at the agreed-upon purchase price. The customer

gives the down payment – which serves as an advance rent payment – to the bank. The customer

pays a percentage of the price every month as rent until they have paid off the purchase price (if

they do not sell the property before then). Therefore the customer’s percentage of ownership

increases each month.

7 The rental payments are also commonly considered as profit rate in bureaus of statistical calculation

agencies.

51

Although conventional amortization schedules are used to calculate the amount of rent,

the process is really a reverse mortgage. With a conventional leasing the customer is paying off

the amount owed until the contract is finished. With an ijarah loan, the customer is basically

saving up to take over ownership; so with each payment, their share of ownership increases.

When they have paid the entire amount, the customers can buy the property for $1.00. The bank

collects the insurance and property taxes as part of the rent payments.

Calculation of the ijarah

Assuming the same situation as in conventional bank, we need to calculate the ijarah

scenario for the dental clinic as Islamic financial instrument providing the services. As above

mentioned the calculation of the ijarah is conceptually the same as reverse amortization. First we

find out the monthly payment. The formula for calculating the payment amount is shown

below(2.6):

Where

Pmt = payment Amount per period;

P = initial Principal (loan amount);

i = rate of rental payments;

n = total number of payments or periods.

monthly payment frequency 12/year

Thus, it comes out after converting the annual rate to a monthly rate (0.065/12 = 0.0054)

with, payment for dental clinic is calculated (2.7):

From the Islamic banks side this calculation can be interpreted as following. The banks

has amount of 106404.99 and purchase the machine and other instruments for the clinic. The

dental clinic, meanwhile, pays for usufruct of the goods monthly rental payments. The bank after

generating the rent payments gains the profit from the transaction.

As the table 2.4 shows us the declining of the financed capital, it can be whereby stated

the lessee ownership of the commodity increases ascending the end of the contract the full

acquirement of property. Nonetheless, the question may arise as if the bank charges the rates it

isn’t an interest? Then, the answer is approved both logically and methodically; it is clearly it is

52

rental payments on property since it is based upon a business transaction. From a Shariah

perspective it is acceptable to describe the profit on an Islamic ijarah transaction as a percentage;

any profit earned on a rental ijarah finance transaction should be described as a percentage so a

customer can clearly understand what the overall cost of the financial transaction is.

Figure 2.4.

Ijarah payment schedule8

Date Principal Installments Rental rate

per month Balance

(0.0054) $ (106,404.99)

1/1/2014 $ 3,834.83 $ 3,260.24 $ (574.59) $ 102,570.16

2/1/2014 $ 3,814.12 $ 3,260.24 $ (553.88) $ 99,309.92

3/1/2014 $ 3,796.51 $ 3,260.24 $ (536.27) $ 96,049.68

… … … … …

10/1/2016 $ 3,303.57 $ 3,260.24 $ (43.33) $ 4,762.96

11/1/2016 $ 3,285.96 $ 3,260.24 $ (25.72) $ 1,502.72

12/1/2016 $ 3,268.35 $ 3,260.24 $ (8.11) $ 00.00

Where

Rental rate = 0.0054 × previous balance;

Principal = monthly payments – rental rate;

Balance = Principal – previous balance.

The above practical applications of ijarah make it clear how this mode of Islamic

financing aids both cash-strapped start-ups find their footing and establish them in an

increasingly competitive business environment. The dental clinic can whereby buy the

equipment in more convenient way in payments:

Monthly payment: $ 3,260.24

Total of 36 payments: $ 116,943.49

Payoff date: Dec. 2016

And preferability and increase their ownership of the property, ignoring the buying them

for a quite different price $1.00 or alike, at the end of the contract.

2.4 The Comparison of the systems: leasing and ijarah in conventional and

Islamic banks respectively

The comparisons between ijarah and conventional operating lease contracts throw up

several points of similarities. With regard to ownership of the asset, the lessor retains the right to

own in both ijarah and conventional operating lease contracts. The lessor bears the risks and

8 The author used the calculations that have no advance payment in conditions of the contract

53

liabilities and the costs of maintenance of the asset in both forms of contracts. This responsibility

also pertains to instances where the asset has been damaged due to factors that were beyond the

control of the lessee. Comparisons between ijarah and conventional operating lease contract

sprovide an interesting insight into the working principles of ijarah in particular and reiterate the

soundness of this mode of Islamic financial agreement arising out of its adherence to the basic

tenets of Shariah. For instance, in a conventional operating lease contract, the lessor is entitled to

penalize the lessee for delaying or defaulting on payments. The ijarah contract also states the

same but modifies it to include the condition that the lessor can use the amount received as

penalty only for charitable causes, thereby avoiding interest-riba (Table 2.6).

Table 2.5.

Comparison of leasing transactions in two systems

Conventional Leasing Ijarah

In conventional lease agreement the lease

commences on the very next day on which the price

is paid by the lessor whether the lessee has taken the

delivery of the assets or not

Where as in ijarah rent should be charged after the

delivery of asset.

In conventional bank’s lease the lessor does not bear

all the expenses incurred on the purchase of assets

e.g. freight charges, custom duty etc.

In Ijarah lessor is the owner of the assets therefor he

bear all the expenses incurred on the purchase of

assets and include them in the cost of assets

In Conventional lease if the lessee makes late

payment then penalty will be charged and added to

lessors account that is not allowed in Shariah

But in case of Islamic Lease penalty on late

payment will be charged but given to some charity

account and in no case it will be a part of lessor’s

income.

At the expiry of conventional lease the leased asset

is normally transferred to the lessee because the

lessor has recovers his cost along with an additional

profit. Asset is transferred free of cost or nominal

token price

In Islamic lease as the asset is the sole property of

the lessor and after the expiry of leased period the

lessor is at liberty to renew the lease agreement or

take the asset back and lease it out to another party

or sell it to the lessee.

Advantages of ijarah for financial institutions must be studied from two varying

perspectives – the ethical angle that harps on the Shariah roots of these Islamic financial products

and the commercial angle that harps on the ease-of-use and administration of these loans.

The Ethical Perspective

The priorities of ijarah for financial institutions from the ethical perspective stem from

the fact that the working principles of these loans are deeply ingrained in the guidelines laid

down by the Shariah. Shariah is an Islamic body of law containing rules and regulations that

govern the private and professional lives of Muslims all around the world. This brings on

dual benefits of ijarah loans for financial institutions.

54

One of the most integral benefits of ijarah loans for financial institutions can be

understood after analyzing the Shariah laws that govern financial transactions. Here are the

principal rules:

Financial institutions are barred from charging and receiving interest.

Financial institutions cannot engage in any speculative or risky behavior.

Banks and other Islamic financial institutions that offer ijarah loans must draw up

transparent and detailed contracts that explicitly mention the terms, conditions, rights,

duties, obligations, and/or promises binding on each party that has entered into the

contract.

Compliance to these rules of the Shariah imparts a considerable degree of transparency,

integrity, and consistency to ijarah loans, thereby making them lucrative even in times of

recession. Thus by offering ijarah loans, many financial institutions have been able to do

business even when people around the world turned away from conventional loan agendas. One

of the crucial and most noticeable benefits of ijarah loans for financial institutions is that by dint

of these loans, many financial institutions have been saved from downing their shutters during

those turbulent financial times.

Secondly, many Islamic financial institutions are able to reap the afore-mentioned

benefits of ijarah loans for financial institutions without having to violate their religious

affinities.

The Commercial Perspective

There are dual benefits of ijarah for financial institutions from the commercial viewpoint.

Firstly, the ease-of-comprehension and execution of these types of loans make them far more

time-saving and cost-efficient than conventional types of loans. The efforts thus spared on the

resources fronts translate into greater revenues for banks and other Islamic financial institutions

that offer ijarah loans.

Ijarah incorporates a provision whereby the lessee can exercise his right to purchase the

leased asset at the end of the rental period or after making all the payments. The dental clinic can

make use of this right. The benefits of ijarah for financial institutions arise from the fact that

financial institutions are not only saddled with the responsibility of owning an asset for which

they have no use in many instances, but they are also able to accumulate some profits by leasing

out the asset.

The benefits of ijarah loans for financial institutions that have been highlighted above are

only some in a list of many. But they suffice to prove the role these loans have played in

furthering the interests of Islamic financial institutions.

55

CONCLUSIONS

Islamic banking is continuing to grow as a viable financial institution in areas with

Muslim populations across the world, yet its effect on economic growth and the deepening of

financial systems was previously undetermined. In the process of the work the author has

analyzed the allocations of Islamic financial instruments and their alternatives and similarities

with conventional banks and has come up conclusions.

The early stages of formation banking system in Uzbekistan had particular difficulties but

favourable climate for flourishing of the country with its reforms and reorganizations of financial

sector of the country after post-soviet regulation. The rapid grow and development of the

banking sector were positively affected the economy and financial investment opportunities for

investors and other foreign direct investments. Moreover, on the scene of these reforms the

Islamic banks and Islamic (ISDB) non-profit organizations such as Islamic Development Bank

International Monetary Fund (IMF) have been integrating into Uzbekistani. The promotion of

Islamic banking in the state is being operated in the system of introduction as first initiative to

launch Islamic bank is the Hamkor Bank, which tends to create a new reliable system of banking

services. That will be supervised by the board of Shariah compliant advisers to preserve in sound

interest-free regulation.

We have also analyzed the origin of Islamic finance from simple trade relations to

advanced modern Islamic financial instruments. The soundless, ethical and moral principles are

the fundamental basics of the Islamic finance and therefore we have acknowledged with the

regulatory mechanisms of Islamic banking and finance. Also the study shows the performance if

Islamic banks, or conventional banks with Islamic financing windows in non-Muslim and

Muslim countries. We have found out that the religion is not only the way of belief, but the way

of life: in economic relations, social interactions and political statutes.

Since, the Islamic finance has begun to compete with conventional banks in roughly last

decades there are immense prospective development that will probably achieve a one of the

dominant role in providing financial operations in different states. The study shows that a variety

of Islamic instruments such as murabaha, mudaraba, ijara, salam, etc. have cardinal different

attitude and method of gaining profit and sustain the generation of adequate leverage in the

banks.

The work reviewed the leasing operations in conventional and Islamic banks, assessed

the advantages and bottle necks of the systems. The essence of the bank regulation in

Uzbekistan, clearly stating the codes and articles has been presented; also, the leasing reforms to

enhance the middle oriented business in the country.

56

Any objective assessment of Islamic finance can only be mixed. Islamic fiancé is a

success, considering that it is no longer an uncertain experiment, but a reality. This work has

attempted to unveil a more completing picture of Islamic finance by presenting its many facets,

by exploring it from empirical, comparative and historical perspectives. The agenda for the

future research is daunting and includes topics that many analysts, steeped in literal and legalistic

interpretations, have shunned [14]. Yet identifying the moral economy, and addressing issues of

culture, Islamic moral hazard, etc., is more useful than parsing medieval contracts, or engaging

in irrelevant apologetics. We tried to introduce the reader to Islamic finance and banking

regulations in order to widen and enlighten his acknowledgement and we hope that this modest

work will stimulate the readers and researches in relevant areas of Islamic finance.

57

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59

APPENDIX

60

APPENDIX Comparison of Islamic and Conventional banking systems

Conventional

banking system

Islamic banking system

Charge interest on loans. Do not charge interest. Riba (interest) is an unjust return. interest or

usury. The term applies to any financial gain by the lender as a

condition of a loan and in a commodity trade. It also applies to any

disparity in quantity or time of delivery. as such transactions are

illegal under Islamic Zero-return loans. Prohibits the charging or

receiving of interest. A unique feature of Islamic banking is its

profit-and-loss sharing (PLS) paradigm. which is based mainly on

the mudarabah (profit-sharing) and musharaka (joint venture)

concepts of Islamic contracting

Principal stakeholders are

shareholders.

The principal stakeholder is God. The aim is to sen/e God. while

the stakeholders are the clients and the general public. Clients are

partners and the decisions are in the interest of society.

Support arms industries and

industries that pollute the

environment and exploit children.

Shariah law places restrictions on business activities. The law

further prohibits trading in alcohol. tobacco. products that contain

pork. defense and weapon production and certain entertainment

activities like gambling and pornography

Gives loans to whoever has a

guarantor or collateral.

Gives loans to those who need loans. Do not need collateral to get a

loan.

Decisions are made in the interest

of shareholders.

Islamic principles advocate for an economic system in which all

forms of exploitation are eliminated. The other principle is

Mudaraba (trust financing). a profit-sharing agreement between

two parties in which one provides the finance and the other

provides entrepreneurial and management skills. Profits are divided

according to a predetermined ratio. Losses are borne by the

provider of capital.

Designed for those who have

money and who do not care what

it is used for. Consumers have no

opportunity to choose where

money is invested. Provides no

information about what it does

with depositors’ money.

Islamic banks have an interest in how the money borrowed is used.

The Islamic banks have a stake in the financial activities so that

money is not used for economic activities that are injurious to

society. Those who lend to the Islamic banks expect the banks not

to invest their money in business activities that are not Shariah-

compliant. Islamic banks invest only in business activities that are

Shariah-compliant.

Its investment rewards

companies even if they act

irresponsibly.

Islamic banks share profits and losses. Murabaha (cost-plus

financing) is a contract sale between the bank and its client for the

sale of goods at a price that includes a profit margin for both

parties. As a financing technique. it involves the purchase of goods

by the bank as requested by its client.

Seeks to satisfy demand.

Conventional banks open

branches in those areas that have

sufficient demand but not needs.

They open accounts for

individuals whose income levels

can create demand for banking

services and not for those that

might be in need of such

accounts.

Seeks to satisfy need