This is the 3 rd of 4 series on the topic Islamic Banking Interest-Free Banking. Read the 1 st, 2 nd and 4 th of the series

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1 This is the 3 rd of 4 series on the topic Islamic Banking Interest-Free Banking Read the 1 st, 2 nd and 4 th of the series 1 / 10

2 The universal functions of all financial systems are the same, differences only arise in how these universal functions are performed and the type of contracts issued. An Islamic bank is just like any other bank in a financial system performing the universal functions of: - Providing financial intermediation services, channeling funds from ultimate savers to ultimate borrowers. - Providing a wide range of financial services quite apart from financial intermediation i.e. payment services, financial advisory services, funds management, foreign exchange, safekeeping, funds transfer, etc. - Creating a wide range of assets and liabilities each of which has different characteristics with respect to liquidity, maturity, the type of returns generated and risk profile. - Creating incentives for an efficient allocation of resources within the economy and allocation of scarce financial and real resources among competing ends. The major distinguishing feature of an Islamic bank however, is its Riba-free (interest-free) operations in accordance with the Islamic tenets prohibiting Riba (interest). Does it then mean Islamic banking is charitable business if it gives loans without interest? How in any case does a bank operate without interest? These are some of the questions that may arise. 2 / 10

3 A concise answer to the above is no, Islamic banking is no charitable business. A bank can certainly operate without interest. The fact that a bank operates without charging a rate of interest on its assets does not mean the bank is not entitled to a rate of return on its assets. In other to address these further, we need to bring to focus the concept of money and the legal critique of interest in Islamic economics. Money, however defined is not a commodity to be traded in, it is a mere medium of exchange with no intrinsic value to be exchanged for profit. For an exchange of money and/or goods to be legitimate and free of riba (interest), neither party should receive an advantage without an appropriate countervalue. On one hand, the profitable exchange of services/goods for money, (as obtains in trade) is licit, because the excess rewards the provision of a service/commodity. On the other hand, the exchange of money for money is legal only if no increase (Riba) occurs, since the equivalent countervalue of one monetary sum is exactly the same sum. The Quran specifies in Q2:279. Allah has permitted trade and forbidden Riba In operating interest-free therefore, all financial transactions in an Islamic bank except Qard Hassan (benevolent loan), are either representation of sales (goods, services or benefits) or ri sk sharing arrangement. Accordingly two major modes are adopted: -Investment / Profit sharing modes -Mark-up modes Investment /Profit sharing modes These are classical Islamic partnership contracts adapted as financing modes. 3 / 10

4 The main investment / profit sharing modes in an Islamic bank are: Mudaraba (Agency partnership) Musharaka (Participative partnership) Mudaraba (Agency partnership) is a profit sharing arrangement between the suppliers of the capital and the users of the capital. In this type of contract, the bank supplies financing to an agent-manager (Mudarib) for trading or industrial purposes and the agent would contribute labour and managerial/entrepreneurial expertise. Profits are shared according to a specified and mutually agreed upon predetermined ratio. In case no profit is realized or a loss occurs from normal business or natural causes, the bank /supplier of funds bears the loss and the Manager (Mudarib) receives no reward for his efforts. Musharaka (Participative partnership) 4 / 10

5 is a share contract whereby the bank and the would-be customer agree to a temporary partnership (not quite different from the joint venture concept) and both contribute financially to carry out a certain operation within an agreed period of time. Profit is shared amongst the partners according to predetermined and agreed ratio and losses are shared according to the ratio of each partner s equity contribution. Mark-up Modes These are basically trade related modes of Islamic finance. The main mark-up modes are: Murabaha Bay -Muajjal Ijarah (leasing) Ijarah wa Iqtina (Hire-purchase) 5 / 10

6 Bay al- Salam Bay al-istisna Murabaha (Sale for mark-up) and Bay-Muajjal (Sale on deferred payment) Both terms are extension over their classical sense and are used synonymously. It involves the sale of a commodity at a price which includes an agreed profit. They are used to refer to an agreement where the bank purchases the goods or property desired by its customer, who is seeking financing for their purchase and then sells them to the customer at an agreed price which yields a specified margin of profit to the bank. The payment being settled by the customer within an agreed time frame either in instalments or lump sum Ijarah (leasing) This is the transfer of a usufruct of a property from one person to another for an agreed period and for an agreed consideration. This is similar to the conventional concept of operating lease. 6 / 10

7 Ijarah wa Iqtina (Hire-Purchase) Lease ending in the partner acquiring the underlying asset. Bay al-salam The salam sale involves advance payment by the buyer for delivery of goods by the seller. This is an exception to the general Shariah rule that you cannot sell what you do not own and possess. This exception itself is based on the Quran, Sunnah and Ijma (Consensus). The Salam contract is generally applicable to all those fungible goods and services whose quality can be precisely specified, whose units are interchangeable and whose price, quantity and the time and value of delivery are clearly stated at the time of agreement so that there is no possibility of any uncertainty, misunderstanding and dispute. It can enable producers of goods and services to have access to financing for different working capital needs. 7 / 10

8 Bay Istisna is a similar mode of financing. It refers to a contract whereby a manufacturer agrees to produce and deliver a certain specified quantity on a given date in the future. The Istisna mode can be used to finance the needs of all sectors of the economy which require goods and services to be produced and delivered at given times in the future in accordance with given specifications. It has the potential of playing a special role in the construction industry. Qard Hassan (Beneficent Loan) Multiple use of Modalities: A number of the above mentioned modalities can be used concurrently to finance one single operation. 8 / 10

9 In the final analysis, Islamic banks/interest-free banks provide all the functions required of any bank but devoid of interest in their operations; They are profit-oriented financial institutions which, amongst other services rendered, are prepared to take calculated risk, going into partnership in business ventures with entrepreneurs (of course after due rigorous and technical analysis) having been truly convinced of viability and profitability; this, with a view to sharing profits or of course bearing losses - depending on the business outcome. Saidat.A.Otiti has an MSc in Islamic Economics, Banking and Finance from 9 / 10

10 Loughborough University, UK. She had worked in Chartered Bank (now StanbicIBTC) and left at a Senior Management Level in She is currently the MD/CEO of Baytuzzeenah Ltd. ytuzzeenah.com 10 / 10

Glossary Of Islamic Finance Terms

January 7, 2008 Glossary Of Islamic Finance Terms Primary Credit Analyst: Mohamed Damak, Paris (33) 1-4420-7322; mohamed_damak@standardandpoors.com Table Of Contents The Five Pillars Of Islamic Finance