Islamic Banking or Shariah Compliant Banking

ISLAMIC BANKING OR SHARIAH COMPLIANT BANKING <!--[if gte mso 10]> ISLAMIC BANKING OR SHARIAH COMPLIANT BANKING By M. Mahmood Anees Qureshi, Advocate, High Court, Lahore Introduction: Allah Taa'ala says:-‑ "O you have believed, when the call is made to the prayer on Friday, hasten to the remembrance of Allah and leave off your trading. This is better for you if you know. "Then when the prayer is over, disperse in the land and seek Allah's bounty, and Allah's much: may be you achieve success." It is therefore Muslims are bound to see His bounty in the limits of Shariah. The Ulemas have classified Shariah's limits into major three categories:-‑ (i) Agaid(faith and belief) (ii) Shariah (iii) Akhlak Further Shariah may be classified into various kinds of activities:-‑ (i) Social activities (ii) Political activities (iii) Economic activities (a) General economic activities (b) Banking and finance activities Objectives of Islamic Banking 1. To provide shariah compliant and prudent (practical) banking opportunities; hence providing an opportunity to Muslims to do their banking transactions in a HALAL way. 2. Achieving the goal and objective of an Islamic economic system. Main Theme of Islamic Economic System 1. Equality of wealth 2. Human dignity 3. Simplicity, economy, and austerity in expenses 4. Ethics and value system 5. Competitive price mechanism 6. Transparency and disclosures 7. Closer linkage with real economy and finance. Imposition of Certain Restrictions Islam has prohibited some economic activities that are not allowed at any time and at any place like interest/ riba, gambling, hoarding etc. History of Islamic Banking In the early history of Islam, the injunctions against interest were strictly observed, but with the decadence of moral values, financial practices based on interest (Riba) began to permeate. In the period of colonial domination, the interest based system infused into Muslim society rapidly. Thus after attainment of freedom from foreign powers the elimination of Riba became the biggest challenge faced by the Muslims. Modern Development Establishment of Three Institutions 1. Islamic Development Bank 2. Islamic Research Institute (Makkah) 3. Islamic Financial Services Board (Kualalampur) Holding of Three International Conferences 1. Ministry of Finance, Indonesia (2003) 2. Ministry of Finance, Indonesia (2003) 3. Karachi (2005) The International Islamic Financial Market shall start its working by 2010. Islamic Banking Pakistan Perspective The Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI) was established in 1990 and has compiled Shariah standards under the supervision of Mufti Muhammad Taqi Usmani. Islamisation of Financial Transaction Ordinance, 2002 The promulgation of Islamisation of Financial Transaction Ordinance, 2002 is a very significant move in this direction. The preamble of the law states categorically that it is convenient to take such measures as may be necessary to restructure the national economy on the basis of Islamic Injunctions as laid down in the Holy Quran and Sunnah in pursuance of Clause (f) of Article 38 of the Constitution, 1973 and to bring all financial laws and financial transactions in conformity with the injunctions of Islam. Prohibition of Riba Ordinance, 2002 The said Ordinance established a Shariah Board. Section 2(ii) of part I defines the mechanism to implement the Islamic Financial System through the said Shariah Board. Recognition of Certain Conventional Banking Rules and Regulations Islamic Banking provides equal opportunities by using conventional banking Rules and Regulations like CIB, Anti-money Laundering, Know your customer (KYC), Prudential Regulations, Code banking etc. Two Major Concepts Of Islamic Banking (i) Ownership of product on which finance facility has been extended. (ii) Conveyed purpose in reality with the user. Loan /Debt in Islamic Finance (i) Qard (Loan).--to give anything in ownership of other by way of virtue- same or similar amount of that thing would be paid back on demand or at the settled time. (ii) Dayn (Debt).--incurred by way of rent or trade ought to be returned at the settled time without any profit. (iii) Ariyva.--to give any commodity to other for use without taking any return for its use-Ghazwa Hunain; camels and iron chest plates. Prohibitions in Islamic Banking (1) Riba/lnterest (1) Allah Taa'ala Says: "If you do not do so then be sure of being at war with Allah and His Prophet. And if you repent then you have your principal." "And if you repent then you have your principal. Wrong not, and you shall not be wronged." What implies from above verdict that anything sought to be received over and above the principal of loans and debts is Riba. What is Riba? (i) Surplus value without counterpart/consideration. (ii) All benefits accruing to a person without any labour, risk or expertise. (iii) Earning returns from loan or debt contract. (iv) Compensation-based restructuring of debt. Types of Riba (i) Riba Al-Fadl-Sale/Exchange Transactions: Exchange of low quality goods with better quality of goods of same kind is prohibited e.g., dates for dates and wheat for wheat. (ii) Riba Al-Nasia-Loan/credit Transactions: Involved in credit/delay; modern banking transactions fall under it. Riba in Sale/Exchange Transactions Islamic banking allows exchange of six (6) commodities i.e., Gold, Silver, Wheat, Barley, Dates and Salt. 2. Gharar: Excessive uncertainty in contracts in respect of the respect of the subject matter or the price like gambling. Salam is the only exception. 3. Zara: 4. Qimar: It includes every form of gain or money: acquisition of which depends purely on the basis of luck and chance. 5. Maysir: Getting something too easily or getting a profit without working for it. Example.--lottery based prize schemes covered under the definition of gambling and maysor. Basic Difference Between Islamic Banking and Conventional Banking Allah Taa'ala Says: "Those who protested and argued that lending on interest was like an act of trade were admonished through revelation that while 'trade' was permitted, 'Riba' was forbidden and in loan transactions they were entitled to their principal sums only." Conventional Banking Islamic Banking 1. Borrowing on interest 1. Trading Shariah Rules 2. Lending on interest 2. Leasing 3. Money- the subject matter 3. Doing other real sector businesses through sole proprietorship or shirkah 4. Service against wages or commissions. 4. Same 5. The relationship between conventional bank and customer is that of debtor and creditor. 5. The relation between Islamic bank and customer is one of participation in risks and rewards 6. There is pre-agreed fixed return on funds either provided by the bank or invested by the customer. 6. There is no previously fixed return on the funds invested with the bank and the same is case when bank provides funds. 7. The conventional banks pool together all the funds. 7. An Islamic bank keeps capital funds and investor's funds aggregated in order not to mix up the profit earned on its own funds. 8. The conventional banks provide finance totally by offering cash loans. 8. Islamic banks do not provide finance by offering cash loans but through Musharaka, etc. 9. The conventional system as a whole is interest based. 9. Islamic banking is primarily equity-based. 10. The system is value neutral. 10. The Islamic system is value‑oriented. 11. Conventional Banks borrow funds from the depositors paying interest on the liability side of its balance-sheet. 11. There is a partnership (Mudaraba) or profit and loss sharing arrangement between the bank and the depositors. 12. There is an iron wall between the depositors and the bank. 12. Islamic bank entitles the depositors to be informed what the bank does with their money. 13. Transactions are financial asset based. 13. Transactions are real asset based. Islamic Banking-Points of Encouragement (i) Benevolence (ii) Transparency and Disclosures (iii) Participation of income (iv) Comprehensive and universal ethical approach (v) Documentation. Shariah Compliant Modes of Financing 1. Musharikah (Joint Venture): (i) Relationship established under a contract (ii) Contract by mutual consent of parties (iii) Contract of profits and losses in joint business (iv) Mechanism (a) Islamic bank provides funds. (b) Such funds are mixed with funds of business enterprise and others. (v) All parties are entitled to participate in management. (vi) Profits and losses are strictly in proportion to respective capital contribution. 2. Mudarabah (P&L Sharing): (i) An arrangement or agreement (ii) An arrangement or agreement between a capital provider and an entrepreneur (iii) Entrepreneur provides expertise and management and is called Mudarib. (iv) Both parties share in profits according to an agreed ratio. (v) Only capital provider bears losses if occurred. (vi) Profit sharing continues until the loan is repaid. (vii) Bank is compensated for the time value of money (over-head expenses + margin of profit). 3. Equity participation in a Company like Musharikah 4. Salam Two conditions must be fulfilled (i) Pre-payment in full is made in cash. (ii) Delivery of goods is deferred. Salam Modes of Financing (i) Agricultural Finance (ii) Export Finance (iii) Working Capital Finance (iv) Inventory Finance (v) Operational Cost Management (vi) Liquidity Management-Short Term Financing 5. Istisnah (i) Pre-payment not necessary (ii) Deferred delivery Istisnah is a sale transaction where commodity is transacted before it comes into existence like house under construction. 6. Ijara (Lease) Ijarah means a contract by which transfer of usufruct of goods is made against payment/consideration of rent. Two kinds of Ijara: (i) Contract to get service on human capital is Ijara tul Amal (employment). (ii) The contract by which transfer of usufruct of goods is made against payment of rent (Leasing). Essential Elements of Ijara: (i) Parties (ii) Subject matter (iii) Consideration (iv) Period 7. Murabaha (Cost Plus) It is a sale contract known as absolute agreement. It is a trading mode of finance. It is not a financing activity. Mechanism of Murabaha: Step 1: Customer proposes to bank for his needed commodity/goods. Step 2: Bank will purchase in real sense that requisite commodity and sell it to that customer. Step 3: Customer will pay only the agreed cost of that item and profit (time value of money +over head expenses). Practical Examples: (i) Long term financing of fixed assets (ii) Short term financing of working capital on assets (iii) Housing finance (iv) Tawarraq/ Tabarrue (Temporary Transfer of ownership of goods/assets free of any payment) Carelines in Morabaha Contract: (1) Purchase and sale to the same client is banned. (2) Actual goods involved. (3) No over charging on delays is permissible. (4) Ownership finally shifts. (5) Morabaha agreement must be signed on delivery date. 8. Musawamah (i) A general and regular kind of sale. (ii) Price of commodity is negotiated between the seller and the buyer. 9. Qard Hassan/ Tabarrue (Good Loan) It is the temporary transfer of ownership of goods/assets free of any payment. This transaction does not compensate the creditor for the time value of money. 10. Hiba (Gift) It is an agreement by which ownership of assets are transferred permanently free of any payment. 11. Sukuk (Islamic Bonds) These are assets backed by bonds applicable in investment products. Mothods of Shariah/Islamic Banking Approved By SBP SBP has divided Shariah Compliant Products into three (3) categories. 1. Trade Related Modes of Financing: In the Trade Related Modes of Financing six Products are traded in Pakistan. (i) Purchase of goods by banks and their sale to clients at appropriate mark-up in price on deferred payment basis only (Mark-up on Mark-up is banned). (ii) purchase of trade bills (iii) Hire purchase (iv) Leasing (v) Financing for development of property on the basis of development charges (vi) Purchase of movable/immovable properties by banks from their clients with buy-back agreement or otherwise 2. Investment Related Modes of Financing (i) Musharika (Profit and loss Sharing) (ii) Equity participation and purchase of shares (iii) Purchase of Participation Term Certificates/Modaraba Certificates (iv) Rent Sharing. 3. Financing by Lending (i) Financing by lending without interest and service charges (Qard Hassan) (ii) Financing by lending (without interest or cost of funds) on which banks may recover actual service charges to be determined by SBP from time to time. Conclusion Islamic banks and banking institutions that offer Islamic Banking Products and Services are required to establish Shariah Advisory Committees/Consultants to advise them and to ensure that the operations and activities of the bank comply with Shariah Principals. In Malaysia, The National Shariah Advisory Council, which additionally set up at Bank Nigara Malaysia (BNM), advises BNM on the Shariah aspects of the operations of these institutions and on their products and services.