1.WHAT IS Islamic BANKING? Concept, Instruments Issues, Theory and Practice AUSAF AHMAD Azerbaijan State Economics University Baku April 7-11, 2008

2. In the name of Allah, themost Beneficent, the MostMerciful. 3. This presentation includes:

What is Islamic banking?

Basic function: Financial Intermediation

An Introduction to Islamic financing techniques.

Practices of Islamic Banking and Finance

Observations on some common misconceptions.

4. Clarification on Nomenclature

Islamic Banking is known by several names:

• • Interest free banking (Iran)

• • PLS Banking (Pakistan)

• • Islamic Banking (Gulf)

• • Special Finance Houses (Turkey)

All expressions are used interchangeably.

Is it a contradiction in terms?

5. Clarification on Nomenclature contd.

Some people prefer Islamic Finance House instead of Islamic bank. (Beit ul tamweel)

It is argued that banking is purely Western Phenomenon

Islamic banking and Islamic finance are also used interchangeably.

6. Common interface between Islamic and contemporary banks

Same purpose: Financial intermediation

Same Objective: Profit

Successful Operation of Islamic banks has shown that financial intermediation is possible even without interest.

7. FINANCIAL INTERMEDIATION

DEFICIT

HOUSEHOLDS

[Firms}

SURPLUS HOUSEHOLDS FINANCIAL INTERMEDIATION FINANCIAL INTERMEDIARIES Financial Flow Financial Flow Goods Real Flow 8. THE FIRM FINANCIAL MARKET FINANCIAL INTERMEDIARIES INDIVIDUALSIndirect financing Indirect financing 9. DIRECT FINANCING Households Businesses Flow of Real goods Financial Flow 10. Indirect Financing Business Financial Institutions Households Financial Resources Financial Resources Return on Investment Return on Investment Goods Goods goods 11. STRUCTURE OF FINANCIAL MARKETS Supervisory Bodies Direct Finance Indirect Finance Bonds Equities Primary Markets Secondary Markets Investment Banks Dealers and Brokers Stock Exchanges Over-the-Counter Exchange Depository Institutions Contractual Savings Institutions Investment I ntermediaries Commercial Banks Saving & Loan Associations Cooperatives Insurance Companies MutualFunds Pension Funds Finance Companies 12. Islamic Banks and Other businesses ALL BUSINESSES Financial Institutions All Banks Islami Banks 13. Theoretical considerations 14. Social and Moral Norms

Should not indulge inRiba

Should not involveGharar

Should not indulge in fraudulent behavior

Should not coerce

Should assure fairness to all parties.

No financing of socially undesirable goods such as alcohol, drugs, pornography.

Should not resort to morally reprehensible practices such as cheating, bribing, fraudulent practices.

15. The Views on Bank Interest

No distinction is made between usury and interest.

No distinction is madebetween consumption loans and productive loans.

No distinction between constant and variable interest rates.

No distinction is made between individual and institutional rate of interest.

16. AVOIDANCE OF GHARAR

Definition ofGharar

Uncertainty / Ambiguity

Ambiguity of Quantity [Gharar fil Miqdar]

Ambiguity of Attributes [ Gharar fis sifah ] such as

• • Ambiguity in time or place of delivery

• • Ambiguity in price etc.

17. DEBT FINANCE Vs.Islamic FINANCE

Islamic finance, in comparison, to debt finance is:

• More just [Treats creditor and borrowers equally]

• More equitable [ Interest rate is exploitative ]

• More efficient [ allocates resources on the basis of profitability ]

• More growth oriented. [ Increases productive Capacity of the society ]

18. Practices of Islamic banking 19. PRESENT SCENE

Islamic Banks in the Government Sector

• Pakistan, Sudan, Iran

Islamic Banks in the Mixed Sector

• - Malaysia

Islamic Banks in the Private Sector

• Gulf

Non Banking Financial Institutions

• Al Ameen [ Bangalore, India]

Islamic Financing by standard Commercial Banks in the Domestic Sector

• Saudi British, NCB, Saudi American, Misr Bank

• Islamic financing by Commercial banks in the foreign sector.

Islamic Banks established by multinational Banks

• • Citibank, HSBC Amanah Bank,

20. TYPES OF ISLAMIC BANKS

Predominantly social banks such as Nasser Social Bank

Predominantly international development banks such as Islamic Development Bank

Predominantly financial investment bank such as Kuwait Finance House

Completely government owned bankssuch as Nasser Social Bank

Banks owned by several Islamic governments such as Islamic Development Bank

Multipurpose non government banks such as Dubai Islamic Bank [1]

[1]Al Hawary,Ma Mana Bunk Islami ( Arabic) Cairo: International Association of Islamic Banks, 1982 p. 49

21. Other Classifications

Islamic Banks in the Government Sector

• • Pakistan, Sudan, Iran

Islamic Banks in the Mixed Sector

Malaysia

Islamic Banks in the Private Sector

Gulf

Non Banking Financial Institutions

Islamic Financing by standard Commercial Banks

22. Elementary Observations

EMERGENCE O F ISLAMIC BANKS

WHAT IS AN ISLAMIC BANK?

THE DIFFERENCE BETWEEN AN ISLAMIC BANK AND AN ISLAMIC FINANCIAL INSTITUTION.

EVOLUTION OF ISLAMIC BANKING.

PRESENT SCENE.

23. A TYPICAL BALANCE SHEET

Sources of Funds

Current Account

Saving Accounts

Investment Acc

Special Invest. Acc

Uses of Funds

Murabaha

Musharakah

Mudarabah

Ijarah

Qard Hasan

24. Business Practices : Sources of Funds

Current Accounts

Saving Accounts

• Saving a/c without authorization

• Saving a/c withauthorization toinvest

Investment Accounts

• General Investment accounts

• Limited Period Investment accounts

• Specified Investment accounts

25. Current Deposits[sources of funds]

Very Similar to standard commercial banks

No return paid back to depositors

Checking facilities

Are Current deposits a loan to the bank from depositors ?

Are Current deposits a trust by depositors to banks ?

Use of Current deposits by the banks on their own risk .

26. Saving Deposits [Sources of Funds]

Saving depositswithout authorization to invest

Saving deposits with authorization to invest

Return to depositors who provide authorization to invest.

Saving deposits as a part of trust accounts.

Saving deposit as Notice account

27. Investment Deposits [Sources of Funds]

Islamic Banking counterpart of Fixed Deposits.

Withdrawal allowed only in special cases

Investment deposits as Mudarabah Accounts.

Depositor: Rabbal Mal; Bank: Aamil

Share profit on agreed basis, bear full loss.

Investment pool

Distribution of profits on pro rata basis.

28. Special Investment Deposits [Sources of Funds]

Concept of Wakalah

The bank acts as a wakeel. Implements the instruction of the Mawakkil.

Special purpose investment, Specify, purpose, sector, industry, or even project.

The bank gets a fee for the services rendered.

Full profit or loss goes to the depositor. The bank will share in loss only in case of proven neglect.

29. USES OF FUNDS

MUDARABAH

MUSHARAKAH

MURABAHAH

IJARAH (Leasing)

IJARAH WA IQTINA (Lease Purchase)

MUSHARAKAHMUTANAQISAH

LOAN ON SERVICE CHARGE

INTEREST FREE LOANS.

30. TYPES OF CONTRCTS Contracts MuawadatContracts against Payment MusharakatContracts of Partnerships Tabarruat Contracts of Charity 31. TYPES OF CONTRCTS

Contracts of Sale / Lease are Muawadat.Ghararis not allowed in such contracts.

MudarabahandMusharakahare contracts of Partnerships.Some amount ofghararmay be tolerated in such contracts.

Sadaqat and Hadaya areTabarruat.No objection toGhararin these type of contracts.

32. Financing Techniques

These techniques were devised intheclassical period for the commodity trade

Their application to financial sector is an innovation of the modern era.

The application of these techniques requires new documentation which was not required in the early period.

33. MURABAHAH [USES OF FUNDS] - I

The word MURABAHAis derived from the wordRibh,meaning profit in Arabic.

Sale with a profit.

Cost-plus financing.

Examples of Murabahah.

Two contracts: A contact of intent to conduct a Murabaha Sale and another contact to buy the good ordered in previous contract.

Promise is not a legal binding. It introduces an element of risk in the transaction.

The element of risk justifies the profit in Murabaha sale : Fiqhi principle :Al Kharaj bi Daman.

34. MURABAHAH [USES OF FUNDS] - II

Applications of Muraqbaha:

• In domestic trade

• In foreign trade

• In financing consumer durables

• In financing real estaes

• ABUSES OF MURABAHA

• MURABAH AND BAY EINA.

35. MURABAHAH [USES OF FUNDS] - II

Applications of Muraqbaha:

• In domestic trade

• In foreign trade

• In financing consumer durables

• In financing real estaes

• ABUSES OF MURABAHA

• MURABAH AND BAY EINA.

36. MUSHARAKAH [USES OF FUNDS]

Musharakah is from the word Sharikah.

More than one partners: Partnership in capital proportion and project supervision.

A partner may waive his right of supervision or delegate it to another partner.

Arrangements: Sharing of Profit and loss in accordance with capital proportion agreed proportion.

Variant: Share of profit in agreed proportion, share of loss in capital proportion.

Applications of Musharakah:

i. in Import trade

Ii. In Agriculture

37. MUDARABAH [USES OF FUNDS]

Mudarabah existing from pre-Islamic times.

Permitted on the Cannon of Necessicity.

Profit and loss sharing is a wrong translation.

Arrangement: Profit is shared on an agreed basis, loss is borne by the Rabbal Mal.

Bank: Rabbal Mal, Entrepreneur : Aamil

Double tier Mudarabah.

Requirements for a successful Mudarabah

38. Other Financing Techniques

Loans on Service Charge

Qard Hasan [interest free loans]

Service Charge is to be equal to actual administrative expenditure

Qard Hasan is limited to social purposes only.

39. IJARAH [USES OF FUNDS]

Ijarah is emerging as a popular technique of financing amongst the Islamic banks

Elements of a lease contact: Lessor, Lessee, instrument and period of lease,

The asset remains in the ownership of the lessor. Maintenance is the responsibility of the owner.

Ijarah muntahi bit tamlik

40. Other Financing Techniques

Diminishing Musharakah

Loan of Service Charges. Only administrative expenses can be charged.

Interest free loans are provided as a social service

41. A TYPICAL BALANCE SHEET

Sources of Funds

Current Account

Saving Accounts

Investment Acc

Special Invest. Acc

Uses of Funds

Murabaha

Musharakah

Mudarabah

Ijarah

Qard Hasan

42. MAIN QUESTIONS

How Islamic Banks use these techniques?

What is the incidence of their use?

Are some techniques more amenable to certain sectors?

Which techniques are easier to use?

Which techniques have lesser documentation requirements?

These are all empirical issues !

43. Salient features of the Survey

Results based on a Sample survey

Period: April October 1985

IV and V Meetings of the Directors of Islamic Banks

30 Banks approached, 8 Banks responded

55 questions asked.

Information to be supplemented by other sources.

44. Responding Islamic Banks

Jordan Islamic Bank (1979)

Faisal Islamic Bank, Egypt (1977)

Islamic Bank for Western Sudan (1981)

Tadamon Islamic Bank, Sudan (1981)

Qatar Islamic Bank (1983)

Islamic Bank International Denmark (1983)

Islamic Bank, Bangladesh (1983)

Sudanese Islamic Bank, Sudan (1983)

45. Financial Operations of Islamic Banks [Financing Techniques]

Mudarabah

Musharakah

Bay al ajal

Murabaha

Ijarah

Lease purchase financing

Qard Hasan

46. FINANCING TECHNIQUES[CONTD. ]

These techniques were devised in the classical period for the commodity trade

Their application to financial sector is an innovation of the modern era.

The application of these techniques requires new documentation which was not required in the early period.

47. Relative Significance of Islamic Financing Techniques

Dominance of Murabaha in 1984

• • Jordan Islamic Bank 72%

• • Bangladesh Islamic Bank 65%

• • Sudanese Islamic Bank 53%

• • Tadamon Islamic Bank 61%

• • Qatar Islamic Bank 97%

• • Significance of Musharakah

• • Hybrid Techniques

48. Financing By Modes for 10 Islamic Banks 1994-96 12.61 11.2 Other 3.73 4.84 Ijarah 8.17 7.29 Mudarabah 9.83 6.49 Musharakah 65.66 70.19 Murabaha Weighted Average Simple Average Modes 49. Mode wise Finance of Islamic Bank, Bangladesh 4.32 3.56 Qard Hasan 3.18 3.87 Musharaka 7.22 7.18 Purchase and Negotiation 16.66 14.57 Hire purchase 18.34 17.28 Deffered sale 50.28 53.54 Murabah 1996 1995 Mode 50. Sector Wise Distribution of Finance 1984 73.01 - - 26.10 0.83 Islamic Bank Bangladesh 90.34 9.35 - - - Qatar Islamic Bank 32.79 25.67 1.00 39.79 0.53 Jordan Islamic Bank Trade Real estate SSI Mfg. Agriculture Name Of the Bank 51. Sectoral Financing by Nine Islamic Banks, 1994-96 19.4 19.1 Other 14.8 12.9 Real Estate 19.7 11.2 Services 9.2 11.0 Industry 2.7 2.4 Agriculture 34.1 42.4 Trade Weighted Average Simple average Sector 52. Relative Significance of Islamic Financing Techniques

Dominance of Murabaha in 1984

• • Jordan Islamic Bank 72%

• • Bangladesh Islamic Bank 65%

• • Sudanese Islamic Bank 53%

• • Tadamon Islamic Bank 61%

• • Qatar Islamic Bank 97%

• • Significance of Musharakah

• • Hybrid Techniques

53. Financing By Modes for 10 Islamic Banks 1994-96 12.61 11.2 Other 3.73 4.84 Ijarah 8.17 7.29 Mudarabah 9.83 6.49 Musharakah 65.66 70.19 Murabaha Weighted Average Simple Average Modes 54. Mode wise Finance of Islamic Bank, Bangladesh 4.32 3.56 Qard Hasan 3.18 3.87 Musharaka 7.22 7.18 Purchase and Negotiation 16.66 14.57 Hire purchase 18.34 17.28 Deffered sale 50.28 53.54 Murabah 1996 1995 Mode 55. Sector Wise Distribution of Finance 1984 73.01 - - 26.10 0.83 Islamic Bank Bangladesh 90.34 9.35 - - - Qatar Islamic Bank 32.79 25.67 1.00 39.79 0.53 Jordan Islamic Bank Trade Real estate SSI Mfg. Agriculture Name Of the Bank 56. Sectoral Financing by Nine Islamic Banks, 1994-96 19.4 19.1 Other 14.8 12.9 Real Estate 19.7 11.2 Services 9.2 11.0 Industry 2.7 2.4 Agriculture 34.1 42.4 Trade Weighted Average Simple average Sector 57. TERM STRUCTURE OF FINANCE

Term structure means temporal distribution of finance

Significance of term structure

Heavy dominance of short term finance

Reasons for this dominance: asymmetry between term structure of deposits and term structure of finance.

58. Latest Trends in Islamic Financial Markets

Derivatives and secondary market

Evolution of Financial Instruments and Financial Papers

Securitization

Musharakah bonds

Ijarah bonds

59. SOME MISCONCEPTIONS

ISLAMIC BANKING IS RELIGION BASED.

ISLAMIC BANKING IS FOR A SPECIFIC COMMUNITY

ISLAMIC BANKING REPLACES INTEREST RATE WITH PROFIT AND THAT IS ALL.