IN THE NAME OF ALLAH, THE BENEFICENT, THE MERCIFUL

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1 IN THE NAME OF ALLAH, THE BENEFICENT, THE MERCIFUL O ye who believe Fear God and give up what remains of your demand for usury if ye are indeed believers. If ye do not, take notice of war from God and His Apostle. But if ye turn back ye shall have your capital sums. Deal not unjustly, And ye shall not be dealt with unjustly. SURA AL BAQARA II VERSE The articles published in this Journal contain references from the sacred verses of Holy Qur an and Traditions of the prophet (p.b.u.h) printed for the understanding and the benefit of our readers. Please maintain their due sanctity and ensure that the pages on which these are printed should be disposed of in the proper Islamic manner. Journal of Islamic Banking and Finance Oct Dec

2 Journal Of Islamic Banking and Finance Publication Date: 1984 (Pioneer in field of Islamic Banking & Finance in Pakistan) Frequency: Quarterly (Refereed/Peer Reviewed) Registration: ISSN Index Islamicus (Indexing/Abstracting Service) Circulation: Worldwide include IMF, World Bank, Central Commercial Banks, Universities, Educational Institutions, and Public Libraries in Pakistan/abroad, Individuals, Scholars, Jurists etc. Subscription Rates (Including postage) S u b s c r i p t i o n One year Two years Per single Copy Pakistan Rs Rs Rs Overseas US$ US$ US$ Old Issues of One Year Pakistan Rs Overseas US$ For Students* Pakistan Rs Overseas US$ * Photocopy of the proof of the existing status of the students required Advertisement Rates (per Insertion) Pakistan Ordinary Full Page (Coloured) Rs. 8,500/= ( Minimum 3 Insertions) Inside Front Cover (Coloured) Rs. 9,000/= Inside back Cover (Coloured) Rs. 9,000/= Full Page Back cover(coloured) Rs. 11,000/= Classified (Black and White) Rs. 2,000/= Abroad Ordinary (Coloured) US$. 150/= Full Page Back Cover (Coloured) US$. 200/= For Further Details Please Contact: B-5 (1st Floor), Kehkashan Apartments, Block No. 7, Main Clifton Road, Karachi (Pakistan) Phone: + 92(021) ia_ib@yahoo.com 2 Journal of Islamic Banking and Finance Oct Dec. 2012

3 Journal of Islamic Banking and Finance Founding Chairman Muazzam Ali (Late) Former Chairman * Pakistan Press Foundation (Pak) * Pakistan Press International (Pak) * Institute of Islamic Banking & Insurance (UK) * Former Vice Chairman DAR AL-MAAL AL-ISLAMI TRUST, GENEVA, SWITZERLAND Chairman Basheer Ahmed Chowdry Editor Aftab Ahmad Siddiqi Associate Editor Mazhar Ali Co-ordinator Research & Marketing Mohammad Farhan Business Executive A. N. Haqqani Published by International Association of Islamic Banks Karachi, Pakistan. Ph: Fax: ia _ yahoo.com Registration No Printed at M/S Maaz Prints, Karachi Volume 29 Oct Dec No. 4 Board of Editorial Advisors S. A. Q. Haqqani Dr. Hasan uz Zaman Dr. Mohammad Uzair Altaf Noor Ali (ACA) International Advisory Panel Professor Dr. Md. Ma sum Billah Corporate Advisor & Consultant to Global Islamic Banks & Financial Market. Malaysia. Professor Dr. Rodney Wilson School of Government and International Affairs, Durham University, UK Dr, R. Ibrahim Adebayo Department of Religions, University of Ilorin, Nigeria Prof. Dr. Zubair Hasan The Global University of Islamic Finance, Kuala Lumpur, Malaysia Dr. Waheed Akhtar Assistant Professor, Comsats Institute of Information Technology (CIIT), Lahore, Pakistan Dr. Manzoor Ahmed Al-Azhari, PhD Legal Policy (Shariah & Law) Chair, Department of Islamic Studies Institute of Religious Education & Research (IRER) HITEC University Taxila Cantt, Pakistan Professor Dr. Khawaja Amjad Saeed FCA, FCMA Hailey College of Banking & Finance University of Punjab, Lahore, Pakistan Dr. Mehboob ul Hassan Professor, Department of Business Administration, Sindh Madarsatul Islam University, Karachi, Pakistan Mr. Salman Ahmed Shaikh External Reviewer Bankers Academy USA, Research Associate & Faculty Member IBA, Karachi and also Heads of Islamic Economics Project Prof/ Dr. Habib ur Rahman Head Business Administration Deptt Sarhad University of Science & Information Technology, Peshawar, Pakistan Dr Muhammad Zubair Usmani Jamia Daraluloom, Karachi Journal of Islamic Banking and Finance Oct Dec

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5 Journal of Islamic Banking and Finance Volume 29 Oct Dec No. 4 C O N T E N T S 1. Editor s Note Cooperative Micro-Bond...16 By Prof Dr. Mohd. Masum Billah 3. The Legal Framework for Islamic Banking in Nigeria...20 By Dr. Abdulqadir Ibrahim Abikan 4. The Performance of Insurance Industry in Malaysia:...40 Islamic vis-à-vis Conventional Insurance By Muhamad Abduh, Mohd Azmi Omar and Raudhah Mohd Tarmizi 5. Interest Based Financial Intermediation: Analysis & Solutions...50 By Salman Ahmed Shaikh 6. The Analysis of Shariah Bank Efficiency Level in Indonesia:...65 A Comparison Between the Intermediary Approach and Production Approach By Muhamad Nadratuzzaman Hosen & Muhammad Dadi Sutisna 7. Islamic Financial Product As Alternative to Riba in the Cooperative...81 Sector in Nigeria By Bukhari Sikirullahi 8. Educational Islamic Financing Models:...94 Salam...95 Ijara Development of New Five Years Strategic Plan for Islamic Banking Industry by State Bank of Pakistan BY Kazi Abdul Muktadir 10. Country Model: United Arab Emirates (UAE) Islamic Banking Glossary Note To Contributors of Articles Order Form for Subscription/Ad to the Journal Journal of Islamic Banking and Finance Oct Dec

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9 Editor s Note This is an article on Interest Based Financial Intermediation: Analysis & Solutions by Salman Ahmed Sheikh. It contains a plethora of pro-interest and antiinterest arguments. The article opens with the assertion that not only Islam but all revealed religions prohibited interest. However, the Commandments of God to Muslims in this respect are very strict and couched in threatening language. It is asserted that the violators must be prepared to face wrath of God. Even the famous philosopher Aristotle in his book Politics denounced Riba as being the most un-natural of all modes of getting wealth. Thomas Aquinas in his book Summa Theological condemns it as selling a non-existent thing. It leads to in-equality and is contrary to justice. Even a modern economist Keynes has also opposed it in his treatise General Theory of Income, Employment and Money and also in one of his essays. Some scholars differentiated between interest and usury. According to them high rate of interest charged on consumption loans in olden days was usury and it is this practice which has been banned by the Holy Quran but the Council of Islamic Ideology report and subsequent judgment of the Supreme court on interest held that riba includes interest in any shape, whatsoever. The votaries of interest have brought forth farfetched arguments to justify interest. The lender after giving loan loses every chance of reaping any benefit from the lent money and also incurs cost in the process of lending. These two factors are enough to entitle him to interest as compensation. Further more subtle arguments favoring interest have been adduced but they all stand rebutted. The paper further has enumerated various ills of capitalist system based on Riba and the harm they wreak on the people. The paper outlines the financial architecture sans interest. Under this head the point of view of Islamic economics has been projected and the advantages of Islamic system over the interest based one have been brought out in bold relief. But these have also been critically reviewed and the other point of view has been fully discussed. It is Islamic principle that in case of transactions on credit, the returned article must be identical to the one borrowed. It is argued that the principle should be extended to loans taken during period of inflation and deflation. This proposal has been examined and it is found that it will raise many serious problems and hence it is not practicable. The problems have been identified. Journal of Islamic Banking and Finance Oct Dec

10 Lastly the question of pricing the financial capital in Islamic finance has been focused upon. Two studies by Muslim economists Mirakhor (1996) and Haque & Mirakhor (1998) were undertaken and they derived two formulae. Some other proposals were also considered. It was concluded as under: The merit of these proposals will rest on the criterion that how well they remain close to the actual returns in particular sectors and overall economy. Concluding remarks which carry the crux of the article are reproduced below: Interest as a system of allocation of resources ensures a fixed return for one variable and uncertain for another. In contrast, Islam encourages equity financing in which loss/profit would be shared. This ensures better results from the perspective of redistribution and better cooperative behavior since payoffs for all parties are linked with productive sector of the economy. Consequently, markets will not have to produce speculative surplus output just to service exorbitant amount of debt and that could stabilize business cycles. Islam by prohibiting interest eliminates one important source of distributive injustice (Chapra, 1984). But, it does so in a just manner by allowing all people with capital and labor or one o f these to contribute in productive enterprise and earn the rewards out of actual return on productive enterprise. The article is on The Analysis of Shariah Bank Efficiency Level in Indonesia: A Comparison Between the Intermediary Approach and Production Approach is co-authored by i) Muhamad Nadratuzzaman Hosen and ii) Muhammad Dadi Sutisna. They have undertaken a research to assess the efficiency of Shariah Banks and also to find out the factors which affect the efficiency. The period covered is The Shariah banking in Indonesia has been making good progress as Indonesia has Muslim population in majority and an efficient regulatory authority but in spite of these advantages the market share of Islamic banking is very low and it was this aspect which proved a catalyst for the present research. The article defines efficiency, divides it into three categories and explains their characteristics. The research is however based on alternative efficiency. This article has given a detailed description of research models and methodologies adopted in the process. Their findings in a nut-shell are that efficiency of the Shariah banks using intermediary approach during the period decreased each year, whereas those using production approach during this period fluctuated each year. It has been recommended that the central bank of Indonesia should take suitable action in the matter to improve the efficiency of the Shariah banking system. The article on The Performance of Insurance Industry in Malaysia Islamic visà-vis Conventional Insurance is the output of three authors i) Muhamad Abduh ii) Mohd Azmi Omar and iii) Raudhah Mohd Tarmizi, and its aim is to compare the performance of Takaful, which signifies Islamic insurance, and the conventional insurance. 10 Journal of Islamic Banking and Finance Oct Dec. 2012

11 Islamic insurance owes its origin to the custom prevalent in ancient Arab tribes to maintain a fund to pay compensation to the tribes against whom some offence had been committed by a member of their tribe. Later on this system proliferated to other sectors like losses in sea trade etc. which were covered by contributions. Presently Takaful companies offer general and family Takaful whereas conventional insurance offers general and life insurance. No positive return on policies is guaranteed in Takaful as it may carry the semblance of interest which is banned. In Takaful the policy holders are the joint investors with the Takaful operator as Modarib and share the profit and losses. The aim of this study is to measure and compare the performance of Takaful and conventional insurance for which this research has been conducted employing ratio analysis and data envelopment analysis system. It has included eight tables showing the detailed results of the analysis and each table is followed by a discussion of the result. The sum total of the findings is that conventional insurance is more efficient than Takaful but the difference is only slight. However the study has brought out the performance efficiency and factors that affect the level of the performance efficiency. This will prove beneficial from both private and regulatory point of view and they can take steps to improve their performance and efficiency. This is an article on Cooperative Micro-Bond by Dr. Masum Billah. Most countries of the world these days, excepting only a few, have debt-based economies and they resort to transference of risk. However when recently recession overtook the financial world these economies faltered before its onslaught and they had to be injected huge bail-out sums to prevent their total collapse but the assets-based economies showed resilience in the face of this turmoil. Mostly the third world countries have ensnared themselves in the debt trap. To rescue them from this unenviable position the article proposes a cooperative Micro- Bond Scheme which is a debt-free fund solution. The article further gives the detail of the scheme. Briefly the plan is that the project will be evaluated to find out the total amount needed for its financing. This sum will be divided into shares of small denomination which may be affordable for all strata of society and offered for public subscription. It also carries a flow chart of the organizational plan. The article on The legal Framework for Islamic banking in Nigeria by Dr. Abdulqadir Ibrahim Abikan recounts the hurdles that Islamic banking had to contend with in its quest for being recognized as a category of banking in Nigeria and allowed to operate under this nomenclature un-handicapped from complying with the principles of Shariah in its operation. It has enumerated the difficulties it had to face in the journey towards its destination. The Nigerian Muslims struggled hard for revival of Islamic laws through constitutional amendments in 70 s and 90 s but it was for the first time in 1991 that they made a demand for introduction of Islamic banking system when enabling law was promulgated. However this did not end their travail as the provisions of law, its implementation and interpretation were found to clash with the principles of Shariah which is binding on the Islamic banks. The adoption of the name Islamic Banking Journal of Islamic Banking and Finance Oct Dec

12 was opposed, the charging of interest on transactions and the payment of interest on deposit was made compulsory by authority who prescribed the closure of defaulting banks. Such difficulties continued to raise their heads off and on and cause concern to those working for the establishment of Islamic Banking In conclusion it is suggested that all present laws need to be amended to lay the foundation of a full fledged Islamic banking system immune from frequent change of laws or introduction of practices in banking which militate against Islamic principles. This is an article on Islamic Financial Product As Alternative to Riba in the Cooperative Sector in Nigeria by Bukhari Sikirullahi. The article traces the history of cooperative societies in Nigeria. Originally some farmers established a society in 1904 followed by Agege Planter Union in 1907, and Egba Farmers Associating in It was in 1922 that the Govt blessed them with their patronage. However the Govt enacted two laws on the subject in 1935 and 1951 after regionalization of the country but they were interest-based. Islam bans interest in every form and therefore Muslims formed their own coop-societies on interest-less basis. But it was doubted if the organization would be able to work without interest as it will need funds to run its affairs and also to meet the charges imposed by Govt. However this betrays their unawareness of Islamic products which can bring in more income than that of interest. Details of these Islamic methodologies of business and investment have been incorporated in the article to dispel the doubts lurking in the minds of some votaries of interest. The adoption of these Shariah prescribed methods would overcome the question of shortfall of income sans interest. The article has also discussed in detail the definition of cooperative and also analyzed Riba and quoted Chapra and Al-Qusi. It differed with them for as according to it, they have overlooked Riba-al-Fadl and Riba-un- Nasa. It has agreed with the definition of an Islamic economist as under:- Riba is the excess made in exchange of some specific items as well as the excess charged on a loan for an extention in maturity. It further discusses the various Islamic approved methods of business and investment and quotes the opinion of religious scholars, the sayings of the prophet and the Commandments of God. Concluding the article it asserts that in Nigeria cooperative societies are the only organizations which operate under the Islamic law in a greater part of the country as Islamic bank Jaiz International has only four branches in 36 states. It lastly laments that there would be shortage of personnel trained in Islamic finance and suggests that the staff be trained in this field by the concerned cooperative Union bodies, ministry in charge through scholarship awards and sponsorship of seminaries and workshops. We carry three extracts from SBP Bulletin two of them relating to Islamic Financing on the basis of Ijara and Salam and the third one giving details about the Islamic banking model prevalent in UAE and the development of new five-year strategic plan for Islamic banking industry by State Bank of Pakistan. 12 Journal of Islamic Banking and Finance Oct Dec. 2012

13 Each of the extracts contain crucial information on the relevant subject which will help the uninitiated in the Islamic banking system to understand it. It will provide guidance to the practitioners of Islamic banking and will also raise the level of awareness of the subject among the readers. Disclaimer The authors themselves are responsible for the views and opinions expressed by them in their articles published in this Journal. We invite our readers not to hesitate in communicating to us their opinion which will be welcomed. Please send your comments on our This will help us in improving the standard of the Journal. CORRIGENDUM In the article Analysis of Islamic Mutual Funds Operations in Pakistan published in the July-September 2012 issue of the Journal, there is an error in para 2.1 on page 16 whereby the Mudarabah Companies have inadvertently been mentioned along with the types of investee companies in which investment is not permitted. The criteria developed by Al-Meezan Investment Management Limited and available on their web reads as follows: a. Business of the Investee Company Core business of the company must be halal and in line with the dictates of Shariah. Hence, investment in securities of any company dealing in conventional banking, conventional insurance, alcoholic drinks, tobacco, pork production, arms manufacturing, pornography or related activities is not permissible The Modaraba Companies operate under the Modaraba Companies and Modaraba Ordinance 1980 and are not permitted to undertake any business which is opposed to the injunctions of Islam. A proper Shariah Compliance Mechanism is in place for their operational implementation with effective regulatory monitoring. The readers are requested to please correct the error which is sincerely regretted. The Editor Journal of Islamic Banking and Finance Oct Dec

14 Readers Comments 1. Dr. Waheed Akhtar, Assistant Professor, Department of Management Sciences, Comsats Institute of Information Technology, Lahore. JIBF is a pioneer and one of the leading Journal in the field of Islamic Finance that is contributing and disseminating knowledge in the field of Islamic Finance for the last 27 years that is indeed a great service to the researchers, scholars, and readers of Islamic Finance. 2. Prof. Dr. Zubair Hasan, INCEIF, The Global University in Islamic Finance, Malaysia. I am all praise for it. One it is quarterly yet coming out regularly and on time. In that your score over all the Journals in the area of Islamic Banking and Finance. The Editing is good. Not many typos are left uncorrected. Editorials are sensible and balanced. 3. Dr. Manzoor Ahmed Al-azhari, Ph.D Legal Policy (Shariah Law), Dean Institute of Religious Education & Research (IRER), HITEC University, Texila. Appreciate the standard of articles of the esteemed Journal 4. MD. Atiqur Rahman Khan Khadem, Senior Officer, Islamic Bank Bangladesh Ltd, International Banking Wing, Head Office, 40, Dilkusha C/A Dhaka-1000, Bangladesh. Would take the privilege to avail the opportunity to suggest some recommendations to upgrade the standard of the esteemed Journal in due course. Appreciate your valuable patronage for the cause of Islamic Banking & Finance. 5. Dr. Syed Sikandar Shah Hanif (haneef) Associate Prof. of Fiqh International Islamic University. I was impressed by your reputed scholarly Journal on Islamic Banking and Finance. 6. Dr. R. I. Adebayo, Department of Religions, University of Ilorin, Nigeria I sincerely appreciate the efforts of your organization in reaching out the world on recent developments in Islamic economic system. May Almighty Allah assist the organization to continue waxing stronger and stronger 14 Journal of Islamic Banking and Finance Oct Dec. 2012

15 7. Asif Pasha, Library Officer Pakistan Institute of Management, Karachi. Your Journal, Titled Islamic Banking & Finance, will be very useful for our faculty/students and library. Please continue to send the Journal regularly in future. 8. Syed Zahid Ahmed, Assistant Secretary General All India Council of Muslim Economic Upliftment Ltd Trust Mumbai, India. Your efforts and dedication for Islamic Banking and Finance, through this Journal is really appreciable. Being printer and publisher for AICMEU s Newsletter, I can understand the difficulties your might have been facing for the last 27 years continued publication. May Allah (S.T) reward you suitably Aamen. 9. Dr. Abdulqadir Ibrahim Abikan, Senior Lecturer, Department of Islamic Law, University of Ilorin, Kwara State, Nigeria. May Allah reward you abundantly for your service to Islam and humanity as a whole. 10. Prof. Dr. Abdul Azim Islahi, Islamic Economic Research Center, King Abdul Aziz University, Saudi Arabia. My acquaintance with journal is since long time. Masha Allah it is doing a very good job for dissemination of knowledge in this area of Islamic Economics. 11. Justice (R ) Dr. Ghous Muhammad, Advocate Supreme Court of Pakistan, Former Judge Sindh High Court, Karachi-Pakistan. I deeply appreciate the contribution being made by the management of your esteemed Journal. The standard of articles is excellent. Publication of such valuable material is vital to create more awareness of Islamic banking and Finance. God bless all of you. 12. Shahjehan S. Karim, President, Institute of Business Management, Korangi, Karachi. As Islamic Studies, Banking & Insurance is a part of curricula of Institute of Business Management your publication could be extremely useful to our faculty & Studies, please send the publication regularly for our institution s library. Journal of Islamic Banking and Finance Oct Dec

16 Cooperative Micro-Bond A Debt-free Nation Development Model in the Socio-economic Reality By Prof. Dr. Mohd. Ma sum Billah * ABSTRACT Majority of the countries of the world have debt-based economies with arrangement for transfer of risk. The third world countries are over head and ears in debt. To tide over this difficulty, it is proposed to introduce cooperative Micro Bond. The article gives a flow chart of the organizational plan and minute details for the setting up of the system, its operation and how it will offer greater facilities for meeting financial needs of new projects of small enterprises and cause lesser difficulties than borrowing from the present channels of obtaining loan. Keyword: Cooperative Micro-Bond, a debt-free Nation Development Model in the Socio-Economy Reality. History witnesses that, the World had been dominated by debt-based economy with risk transferring mechanisms. Factually, today the debt-based economy failed to rescue the world with material self-reliance and prosperity. Alternatively, an assetbased economy with risk sharing techniques may be a guaranteed platform to direct the world with economic prosperity ahead. It has been a common culture of every nation particularly among the 3 rd world countries, relying on borrowing habit for any form of development, be it either private or government project, resulting in the life long curse of debt for the nation, which eventually compels the nation and its citizens tying their necks in to paying the price of liability and thus, darken the future of the nation and its ultimate destiny. To rescue the nation and the people of 3 rd world countries, Cooperative Micro-bond is among the right rescuer platforms to discover a way ahead towards creating a debt-free developed nation in the wake of globalization. A Cooperative Micro-bond scheme is also justified under the broad principle of Shari ah as a holistic mechanism based on mutual cooperation, brotherhood and solidarity in view of noble achievement and common good for all humanity and creatures as enshrined in the holy Qur an: cooperate amongst you in righteousness and piety. (5:2). * Author Professor Dr. Mohd. Ma sum Billah is a group Executive Chairman, Middle Eastern Business World (MBW) group of Companies Founder of World class Leading Islamic Finance Site masum2001@ Malaysia yahoo.com 16 Journal of Islamic Banking and Finance Oct Dec. 2012

17 Cooperative Micro-bond is a discovered strategic mechanism, which enables any nation to develop its major sectors by having a debt-free financial power through a holistic cooperative micro-spirit with sharing and caring culture with a view to create a self-reliant, progressive, prosperous and proud nation in this advanced tech-era. The rational outlook of Cooperative Micro-bond is to make a nation enjoy a debt-free fund solution required for any project development within the spirit of mutual cooperation, maturity and common sensitivity towards creating a self-reliant nation envisioning prosperity. This is among the sustainable promising mechanisms, which may ease the nation from undesirable dependency and debt while moving forward to create an enterprising and entrepreneur-ship based nation as the way ahead in today s socio-economic and political reality. In the model and structure of a Cooperative Micro-bond, the government or the private sector shall first identify a sound project which requires financing in its development. The project then shall be listed in the project index with accrual value (justifiably required for project financing). The total project-financing shall be packaged in shares at a minimum par value affordable to all levels of citizen to enable them to participate full-heartedly in the national development plan within the holistic spirit of mutual cooperation, solidarity and brotherhood towards common goal of national prosperity. Such move eventually makes them proud through having the profit oriented micro-stake in the national projects. The shares shall be ultimately opened for public for subscription as per one s ability with affordable equity financing in view of profit making. The shareholders shall hold the opportunity to participate in the secondary market. The flow-chart is the organizational action plan: In the total management with successful outcome in a Cooperative Microbond shall be facilitated by a team force where the government undertake the Journal of Islamic Banking and Finance Oct Dec

18 appropriate policies, securities and effective enforcement. A Project central body shall be positioned in project related decision making. The Project management office, which shall be responsible for the total management and due operation of the project. The central bank shall be assigned in issuance of ordinary bond (profitsharing in equity financing) with limited liability as per the central guidelines while a credible bank shall be authorized to manage the total project funds besides managing the share certificates issued in the name of the central bank as per project directives. An audit and compliance unit shall be established at both central as well as management levels to ensure the total compliance in all aspects of the policies, project, funds and the management. A special unit shall also be established comprising of several experts to advise the project board so as to facilitate them in making appropriate policies and decisions. Other vital units shall be established under the management office, among them are intelligence unit, which shall undertake the total risk management and attractive income oriented business plan of the project. The project management office (PMO) shall be designed under the management office, which shall be responsible for the total development of the project with successful result. For the continuing maintenance of the entire components of the completed project a project maintenance unit shall be established under the management office. In other word, the total discipline, management and operation in a Cooperative Micro-bond arrangement shall be centralized with regulatory action, but with separation of power, assignment and due accountability. The issuer of Cooperative Micro-bond shall be the Central bank in terms of capital guarantee (in its capacity as the fund guarantor) to the subscribers while the fund management bank shall hold the total accountability (in its capacity as the fund manager) to the Central bank for the fund release as per the Central bank s guidelines and subsequently the Project board shall be the end accountable (as the Principal liability) for the right management of the fund. The total investment in the Cooperative Micro-bond scheme shall be treated as conservative Public fund by empowering neither capacity for the government nor any party to influence over or misuse the fund, which shall be strictly regulated by the standard policy and be closely audited by the Audit and Compliance Unit at both Central as well as Micro-levels. To protect the subscribers against any unexpected risk on their fund shall be ensured by a compulsory project Insurance policy to be purchased in the name of the Project board. Among the sectors that may be included for potential development with the funding facilities under the Cooperative Micro-bond scheme are public, private or semi-government projects namely: highways, bridges, power plants, water supplies, gas supply, mono-rail, industrialization, digitalization, refineries, tourism spots and other commercial oriented mega projects. Subscribers in the Cooperative Micro-bond scheme may be any one regardless of one s status, background, gender, nationality or religion so long as one participates with the share price at par value. The par value of shares shall be nominal affordable to all categories of people so as to give an opportunity to 18 Journal of Islamic Banking and Finance Oct Dec. 2012

19 participate in the national development mission besides having the chance to participate in the share market in view of possible legitimate money making. The shares shall be allowed to be traded in both the primary as well as in the secondary markets so to enable the Project to be rated highly with gradual effect. The total net income of the project under Cooperative Micro-bond scheme may be suggested to be distributed as: 60% for the shareholders as dividends; 20% shall be allocated for the continuing maintenance of the project; 10% shall be reserved in a special security fund (SSF) in view of contributing to the settlement of the national debts and; 10% shall be reserved into a project foundation account (PFA) for the possible humanitarian services. Among the general benefits for the government in the Cooperative Microbond scheme are: the sustainable support to the national development scheme, all categories of standard taxes to be imposed over the project income at its all components, creating a nation with utmost cooperation and maturity, political gain through a smart government s policy and internally popular for moving towards a debt-free self-reliant developing nation with smart planning. It is indeed submitted that, a Cooperative Micro-bond scheme is a new dimension designed in view of rescuing the 3 rd world in particular from being hanged with debt, while discovering a way ahead to develop the nation with debt-free cooperative micro-bond based on holistic principles of cooperation, utmost care and concern leading to make the nation self-reliant, peaceful, harmonious, progressive, prosperous and proud in the modern reality. Journal of Islamic Banking and Finance Oct Dec

20 The Legal Framework For Islamic Banking In Nigeria By Abdulqadir Ibrahim Abikan (Ph. D) * Abstract. Islamic banking system cannot operate in Nigeria or in any other country without agreement of its principles and practice with the various extant bank and other financial institutions regulatory laws. The usually adopted option is for the regulatory laws to be amended to accommodate the emerging financial system. This research therefore examines the provisions of the existing banking regulatory laws in Nigeria with a view to determining their amenability or otherwise to the principles and practices of Islamic banking. It finds that although the Banks and other Financial Institutions Act, 1991, amongst other laws, prepared a take-off ground for Islamic banking, its provisions are not sufficient for a smooth operation of Islamic banking system. The recent issuance of regulatory framework for non-interest financial institutions by the Central Bank of Nigeria (CBN) does not satisfy the need for a comprehensive substantive legislation, hence the suggested amendments to the existing laws. Keyword: Substantive Legislation, Monopoly, dichotomy, Promulgate Enabling one Deviant Law. Introduction The first Regulatory instrument introduced to the Nigerian financial system was occasioned by the main factor of monopoly of the pre-colonial banking industry by foreign banks 1 whose main concerns were to serve expatriates and colonial * 1 LL. B., LL.M., Ph.D, B.L., Senior Lecturer and Ag. Dean, Faculty of Law, University of Ilorin-Nigeria, abikan.ia@unilorin.edu.ng The first bank established in Nigeria was the Bank of British West Africa (BBWA), later known as Standard Bank and now First Bank of Nigeria Plc, in The bank was the principal importer of currency from the British Treasury until West Africa Currency Board was established in 1912, when it was yet appointed the sole agent of the Board in Nigeria, see Danjuma, N., The Bankers Liability, (Ibadan: Heinemann Educational Books (Nig.) Plc., 1993), 2 and 20; following it was The Anglo-Africa Bank 20 Journal of Islamic Banking and Finance Oct Dec. 2012

21 interests. 2 The spirited attempt made by the indigenous entrepreneur cum patriots to break the foreign banks monopoly resulted in the establishment of locally-owned banks and it made the country to witness a free for all conventional banking. 3 The few operating indigenous banks were discriminately forced out of business owing to capital suffocation, lack of technical know-how and acute shortage of skilled manpower. 4 The situation caused some reactions from the nationalists and resulted in the enactment of the first Banking Ordinance in 1952, to regulate banking operations. Further agitations against the continued discrimination of the foreign banks resulted in the draft of CBN Ordinance and Banking Acts in The latter Act was repealed by the Banking Act In 1991, Central Bank of Nigeria (CBN) Act No. 24 and Banks and other Financial Institutions Act (BOFIA) No. 25 were promulgated. The thrust of their promulgation was to bring the new banks and other Financial Institutions emerging as a result of 1986 financial liberalization and deregulation under control. More significantly, the Acts recognised Profit and Loss banks as a category of Nigerian Banks for the first time in the history of the nation s financial system. The two Acts were amended by Acts No. 3 & 4 of 1997 respectively; only to remove the limited autonomy granted to CBN by the 1991 Acts. They were further amended by Acts No. 37 & 38 of 1998 and Acts No. 41 and 40 of 1999 respectively. Attempt was made in 2005 to further amend the two Acts, but while the Central Bank Act sailed through the amendment process, BOFIA was not that lucky. The CBN has described the reasons for the non-passage of the amended BOFIA as inexplicable 6 but it is a public knowledge that it is not unconnected with the challenge posed by the National which later became Bank of Nigeria, established in 1899; then, the Colonial bank in 1917, which later became Barclays Bank in 1925 and is now the Union Bank of Nigeria Plc.; and the British and French Bank, now United Bank for Africa, established in Igweke, K. I., Law of Banking and Negotiable Instruments, (Onitsha: Africana-Fep Publishers Ltd., 1991), 1. By 1914, indigenous banks started springing up with the establishment of Industrial and Commercial Bank, Nigerian Merchant Bank in 1931, National Bank of Nigeria in 1933, Agbonmogbe Bank and Nigerian Penny Bank in 1945, African Continental Bank and the Nigerian Farmers and Commercial Bank in 1947, see Danjuma, n. 1 at 3-4; seven and nine other indigenous Banks were established in 1951 and 1952 respectively, see Central Bank of Nigeria Economic and Financial Review, vol. 6, No. 1, (June, 1968). The Industrial and Commercial Bank established in 1929 folded up in 1930; The Nigerian Mercantile Bank established in 1931 failed in 1936; The Nigerian Penny Bank established in 1945 died in 1946; The Nigerian Farmers and Commercial Bank established in 1947 failed in 1953; seven (7) other banks established in 1951 failed in 1954 while another nine (9) established in 1952 failed in 1954, see Central Bank of Nigeria, Annual Report & Accounts, These latter legislations have variously gone through amendments and repeals that crystallised in consolidated statutes, the CBN Act (cap. 47) and Banking Act (cap. 28) both compiled in the Laws of the Federation of Nigeria (LFN) See CBN, A Brief on the Central Bank of Nigeria Act, 2007 an undated memo of the Legal Services Division of the CBN, p. 3 available at OUT/PUBLICATIONS/PRESSRELEASE/GOV/2007/PR PDF accessed on 17 March, Journal of Islamic Banking and Finance Oct Dec

22 Assembly to the CBN banking reform requiring uniform N25 billion capital base for all banks 7 at a time the first Islamic bank was to be issued operating licence. 8 This research therefore examines the provisions of the foregoing financial regulatory laws, amongst others, with a view to determine their amenability to the take-off and operation of Islamic Banking system in Nigeria. The work is presented in seven parts. After this introduction, part two examines the provision of the Banking Act 1969 in relation to Islamic banking. Islamic banking is examined through the lenses of BOFIA 1991 as amended in part three. Part four looks into the operation of Islamic banking under the CBN Act Provisions of the Nigeria Deposit Insurance Corporation Act, 2006 which are relevant to the Islamic banking system are examined in part five while part six looks at the provisions of the Economic and Financial Crime Commission (EFCC) Act The paper rounds-up in part seven with conclusions and suggestions. 2.0 Islamic Banking Under The Banking Act, 1969 All through the struggle of the Nigerian Muslims to fully apply Islamic law in their affairs through the various constitutional amendments in the 70s to 90s, nothing was heard of the specific demand for Islamic banking until 1991, when the enabling law was promulgated. As a result, the Banking Act, 1969 and its two predecessors 9 had no contemplation of Islamic Banking system. This is most probably why their provisions were unfriendly to many of the Islamic banking products. In the first place, no operating license for Islamic Banking would have been obtainable under the Act. This is because of the dichotomy in the underlying philosophy between the banking system it was promulgated to regulate and Islamic banking. The conventional banking system guarantees both the capital and the predetermined rate of return while Islamic banking system, operating under the principle of profit and loss sharing (PLS) does not. This principle of the latter system alone was enough for the Minister of Finance to form an opinion that it would be The Senate did passe the Bill but in a way that reversed the Capitalisation policy of the CBN by categorising banks into Mega, Large, Medium and Community Banks with different capital requirement and thereby restoring the categorisation policy of BOFIA eroded by the reform, see Jamiu, M., Adetutu, F. and Mumeh, P., Senate Dares CBN, Categorizes Banks, Daily Independent, Friday, February 4, 2005, 1 and 2; however, the Executive which sponsored the Bill quickly blocked its concurrent passage at the House of Representative; the author has done a critique of the reform as being illegal in another work: (Il)Legality of the Reform of the Banking Sector in Nigeria, University of Maiduguri Law Journal, (2010), vol. 8, pp Jaiz International had filed its application for operating license in December 2004 and was still waiting for its issuance when the reform was launched in June 2004 and its promoters were asked to comply to get a license, see Jaiz International Plc., Annual Report and Accounts 2004, p. 4; and Abdulqadir I. A., Islamic Banking under the Existing Laws in Nigeria: Problems and Prospects, (Ph. D Thesis submitted to International Islamic University Malaysia (IIUM), 2007), p Banking Ordinance, 1952 and Banking Act, 1958, the latter legislation repealed the former while the latter was also repealed by the Banking Act Journal of Islamic Banking and Finance Oct Dec. 2012

23 undesirable in the public interest to issue an operating licence. 10 Similar opinion had been formed in respect of the banking system vis-à-vis the Bank of England Act 1946 from which this law borrowed a leaf. It has once been declared that the Bank of England was not legally able to authorize Islamic banking under the Banking Act because it is a system which does not take deposit as defined under that Act. According to this view, a central feature of the banking system of the United Kingdom as enshrined in the legal framework was capital certainty for the depositors. It is the most important feature which distinguished the banking sector from the other segments of the financial system. It would therefore amount to misleading and confusing the general public by allowing Islamic banking system, which is an essentially different system to operate in parallel with the conventional banking. It was argued that, Islamic banking could at best be accepted as a perfect mode of financing but does not fall within the definition of what constitutes banking in the United Kingdom. 11 Secondly, some transactions like ijārah (lease) murābaha (cost-plus) and bay bithaman ājil (BBA) (deferred sale) which have become day-to-day ordinary business of Islamic banks were restricted. Each of these transactions was subjected to prior approval of the Central Bank. The Act provides that a licensed bank shall not, without the prior approval of the Central Bank, purchase, acquire, sell, dispose, or lease out any real estate. 12 And where a bank is recognized with the status of a merchant bank, 13 it shall not hold any equity interest acquired in a company while managing an equity issue for more than six months except with the prior approval of See S. 2 (4)(a), Banking Act, Sir Leigh Pemberton, the Governor of the Bank of England (as he then was) in his speech to Arab Bankers Association, Middle East Economic Digest (Meed), 5 October, 1984, 2; this conception has been nullified by the latter statement of Sir, Eddie George, also a former Bank of England Governor after Leigh, who said: Indeed, it seems to me also that as a matter of general principle, a wider range of financial products would benefit the whole of our Community, and that Islamic Products could prove to be attractive beyond the purely Muslim sector. see Parker, M., FSA Authorisation: Challenges to IBB, Islamic Banker, Issue No. 102/103, July/August, 2004, 6; see similar remarks in the keynote address of William L. Rutledge, Executive Vice President of the U.S. Federal Reserve at the 2005 Arab Bankers Association of North America (ABANA) Conference on Islamic Finance: Players, Products and Innovations held in New York City, April, 2005; see also, the keynote address of Callum McCarthy, Chairman, U.K Financial Services Authority at the, Muslim Council of Britain Islamic Finance and Trade Conference, 13 June 2006; in line with these, Islamic Bank Britain was established in 2004; and European Finance House and Gatehouse Bank, in 2008, in addition to the existing HSBC Amanah, the Islamic subsidiary of global giant HSBC which became the 10 th of the top 500 Islamic Financial institutions in the world, see Joe Divanna, Top 500 Islamic Financial Institutions, The Banker, 3 November, 2008 available at < tutions.html>, accessed 14/09/09. See S. 14 (1) (i) and (j), Banking Act, Merchant Bank has been defined to mean any person in Nigeria who is engaged in wholesale banking, medium and long term financing, equipment leasing, debt factoring, investment management, issue and acceptance of bills and the management of Unit Trusts, see S. 43 (1) (e), Banking Act, Journal of Islamic Banking and Finance Oct Dec

24 the Central Bank. 14 These procedures would automatically be cumbersome for an Islamic bank having some of these restricted products constituting about 70 percent of its transactions. 15 By the restrictions, long term mushārakah, which has always been argued to be one of the instruments of a true Islamic banking, was not accommodated. A situation where each such transaction would be subject to the Central Bank approval with all the attendant bureaucracy is better imagined for a prosperous banking business. Lastly, the Act did not anticipate the possibility of any bank operating without charging interest on advances or having to pay interest on deposits. The Act provides that the interest rate charged on advances, loans or credit facilities or paid on deposits by any licensed bank shall be linked to the minimum rediscount rate of the Central Bank. They were subject to stated minimum and maximum rate of interest which when approved shall be the same for all banks. 16 Failure of any bank to pay interest on deposits may amount to its carrying on business in a manner detrimental to the interest of its depositors and other creditors. The resultant effect of this is revocation of the bank s license and requiring its business to be wound-up by the Minister, as may be directed by the National Council of Ministers. 17 There is definitely no way an Islamic bank whose primary object is to eliminate interest from the sector can operate under this law and that may be the reason why when the idea of establishing Islamic Banking was mooted, the very first step taken was to repeal this law and promulgate an enabling one. 3.0 Islamic Banking Under The Banking And Other Financial Institutions Act, 1991 As Amended For the first time in the history of the Nigerian banking law, provisions were made for a banking system which deviates from the conventional banking. The deviant law was the Banks and other Financial Institutions Act (BOFIA) No. 25, In its categorization of banks in Nigeria, BOFIA provides that the President See S. 14 (6) (c), Banking Act, Murabahah and BBA constituted 45 percent -93 percent of ten leading Islamic banks financing in 1993 and percent of that of Bank Islam Malaysia Berhard in 2004, see Parker, M. Islamic Trade Financing, New Horizon, November, 1994, p. 14; see also, Anwar, Muhammad, Islamicity of Banking and Modes of Islamic Banking, (Malaysia: IIUM, 2002), p. 4; see also, Iqbal, Z. Scope of Asset Securitization in Islamic Banking, vol. 14:4, (1997), Journal of Islamic Banking and Finance, 36; and BIMB, Annual Report 2004, p. 34. Banking Act, 1969, S. 15; Minimum Rediscount Rate is the interest rate at which the Central Bank of Nigeria lends money to commercial banks and was reduced from 15 percent to 13 percent on Wednesday, February 2, 2005, see, Mathias Okwe, CBN releases new rules, cuts lending rate, The Guardian, Thursday, 3 February, 2005, 80; it was 14 percent at 9 th August, 2006, see Central Bank of Nigeria Communiqué No. 47 of the Monetary Policy Committee, August 9, 2006 available at < GOVADD PDF> accessed 17 March, See SS. 22(a)(i) and 23(b)(i) Banking Act, BOFIA formerly referred to as BOFIA was promulgated as a Federal Decree No. 25, 1991 by the Supreme Military Council of Nigeria of the Military era, it however automatically became an Act deemed to have been concurrently passed by the National Assembly by virtue of S. 315 of the Constitution of the Federal Republic of Nigeria, It is presently codified in Cap. B3, Laws of the Federation of Nigeria (LFN), Journal of Islamic Banking and Finance Oct Dec. 2012

25 on the recommendation of the Central Bank shall, from time to time, determine, as he may deem appropriate, the minimum paid-up share capital of each category of banks. It then made Profit and Loss Sharing bank a category of the Nigerian banks with minimum paid-up share capital, for the time being, of N50,000,000 (USD 5, ). 19 In recognition of the peculiarities of this new banking system, the law made provisions for a number of exceptions to facilitate its smooth operations. Chief among these exceptions is the non-applicability of the need to display the interest rate in the banking premises of a PLS bank. The law provides: Every bank shall display at its offices its lending and deposit interest rates and shall render to the Bank information on such rates as may be specified, from time to time, by the Bank, provided that the provisions of this subsection shall not apply to Profit and Loss sharing banks. 20 This provision presumes the payment or taking of interest on deposits or loans as a necessary practice of banks and thus mandated the display of the interest rates. Its exemption of PLS banks from the practice therefore sets a solid foundation for Islamic banking system. Similar provisions of the Act empowered the Central Bank Governor to further exempt PLS banks from the general provisions of the Act as he may think fit Islamic banking and the Profit and Loss Sharing (PLS) bank A careful perusal through the Banks and Other Financial Institutions Act would reveal that there is no place where a provision was made in recognition of the establishment of Islamic banking system. Its provisions as above referred and many others only recognised PLS banks as a category of banks in the country. In fact, the Act categorically subjects the registration or incorporation of any bank with a name that might include the words Central, Federal, Federation, National, Nigeria, Reserve, State, Christian, Islamic, Muslim, Quranic or Biblical to a prior written consent of the Governor of the Central Bank. 22 This has however been misunderstood and misrepresented as prohibition of the use of the name Islamic for any bank in Nigeria, even if such bank operates on Islamic principles. 23 This misunderstanding is creeping into documentations of the Central Bank of Nigeria See S. 9(1) and (2) Banks and other Financial Institutions Act(BOFIA), 1991 (No. 25) conversion based on the rate as of year of the enactment of the Act at N9.91 to USD1.00, see, Free Encyclopaedia, Exchange Rate History of Nigeria Naira, < (accessed 24 January, 2006). S. 23(1) BOFIA, 1991; emphasis mine and reference to Bank as opposed to bank in this law relates to the Central Bank of Nigeria and any other bank respectively, see S. 61 thereof. See S. 52 BOFIA, See S. 39 (1) (a), BOFIA 1991 as amended. See Onafowokan, O., Non-interest (Islamic) Banking: Principle and Practice. (Lagos: Kings & Queen Associates, 2003), 72. Journal of Islamic Banking and Finance Oct Dec

26 Relying on Section 39 (1) of BOFIA 1991, the Bank proposed a regulation which seeks to prohibit the use. 24 On the contrary, the Act has not prohibited the use of the name Islamic bank. Rather, it restricts and subjects its usage to a prior consent or approval of the Governor of the Central Bank. Each of such application is expected to be treated on its merit. The approval should be granted if the application is shown to be the aspiration of the majority shareholders of the bank and the bank also satisfies all other prerequisites of a licensed bank. It is a known fact, world over, that the Islamic banking system is the only banking system that stands to avoid payment or taking of interest in its transactions and investment in certain prohibited areas. It operates on the Islamic principles of Profit and Loss sharing summarized in the legal maxims: الغنم بالغرم والخراج بالضمان Benefit goes with damage and revenue follows liability 25 A leading proponent of the above prohibited name admits this much. Yet, he went ahead to state that PLS banking was conceived in Nigeria in line with the current international trend in the provision of banking services whereby major international banks like Citibank of USA, HSBC of UK etc. either set up non-interest or Profit and Loss arm internationally like HSBC Amanah or start new brand banks wholly based on this principle. 26 He stopped short of calling the operational principles of those banks product Islamic principles. The international banks referred to never pretend to make PLS banking their innovation or shy away from at least calling it Islamic window. Islamic Bank of Britain, Bank Islam Malaysia and the like of them proudly bear Islam or Islamic as part of their names in nation that are not less multi-religious than Nigeria. The genuine spirit of the above legislation is to make it possible for any group of Nigerians desirous of naming Islamic or Christian bank, as the case may be, to do so without the legislation being seen as promoting a particular religion. At the same time, it makes it possible for any conventional bank to operate Islamic window without the need to change its name. PLS bank is defined by the law to mean a bank which transacts investment or commercial banking business and maintains profit and loss sharing accounts. 27 This See paragraph 10.1, CBN, Draft Framework for the Regulation and Supervision of Non- Interest Banking in Nigeria, Circular No.: BSD/Dir/Gen/NIB/01/008 published on 4 March, 2009 available at < (accessed: 12 March, 2009). This legal maxim found its root in the hadith of the holy Prophet (pbuh) narrated by Abu Hurairah where the Prophet was reported to have said: The mortgage is not closed on the mortgagor who mortgages it, its benefit is for him as much as its responsibility. see Muhammad Ibn Abdullah al-naisaburi, Al-Mustadrak alā al-sahihain, (Beirut: Dār al- Kitāb al- ilmiyyah, 1990), vol. 2, 58. See Onafowokan, n. 23 at pp. 70 and See S. 61, BOFIA, 1991 as amended, CAP B3, LFN, Journal of Islamic Banking and Finance Oct Dec. 2012

27 definition is in recognition of the nature of Islamic banking which combines the operations of both commercial and merchant banks in its mudārabah, mushārakah, BBA, ijārah and its savings and current deposits practices. No other type of bank can swerve between commercial and merchant banking under the law. 28 This postulation casts a shadow of doubt on the legality of any conventional bank claiming to operate Islamic products. At best, such operations may qualify as a ploy by money lenders to attract non-interests deposits. The law envisages the registration of PLS banks as a specialized category of banks and made all the various exceptions relating thereto as such. 29 Therefore, operation of PLS account is just a unique characteristic of an Islamic bank which has attained the status of being synonymous to the banking system itself. Nonetheless, a careful study of all the relevant provisions of the law leads to an inevitable conclusion that the law was made to pave ways for the establishment of Islamic banking system in Nigeria Hindrances within the Act As an improvement over its predecessor in relation to Islamic banking, the Act made some imputable exceptions from the general restrictions on banks. PLS banks are exempted from restrictions to engage, whether on their own account or on a commission basis, in wholesale or retail, in trade, including export trade and purchase and acquisition or lease of real estate. The exceptions are seen as necessary for the purpose of conduct of the banks business. However, sales or disposal of real estate transactions are still subjected to a written approval of the Central Bank Governor. 30 It is not clear on the face of the Act whether such approval is required for every transaction under the restricting decree. Suffice it is to say, however, that such requirement is capable of hampering a smooth operation of Islamic banking products like direct investment, BBA, ijārah wa iqtinā (hire purchase), and murābahah (cost-plus financing). The reason for singling out this restriction is hardly conceivable and it is most probably an omission, as majority of similar transactions are put within the exempted categories. 31 Meanwhile a number of amendments have been made to the Act in 1997, 1998 and The 1997 amendment 33 deleted section 51 and 52 of the Principal Act. 34 Sections 51 directly exempted funds established under National Provident Fund Act, Nigerian Industrial Development Bank Limited, Federal Mortgage Bank, Nigerian Bank of Commerce and Industry, and the Nigerian Agricultural and Co-operative See S. 22, BOFIA, 1991 as amended, CAP B3, LFN, See SS. 9 (2), 23 (1) and 52, BOFIA, 1991 as amended, CAP B3, LFN, See S. 20 (2) (c) (f) and (g), BOFIA, 1991 as amended, CAP B3, LFN, See S. 20 (2) (c) (f) and (g), BOFIA, 1991 as amended, CAP B3, LFN, The 1999 amendment to the Act, Banks and other Financial Institutions (Amendment) Act, 1999, (No. 40), contains no provision affecting PLS Banking system and is therefore not relevant for consideration here. Banks and other Financial Institutions (Amendment) Act (BOFIA) 1997, (No. 4) as amended, CAP B3, LFN, The phrase principal Act is a common usage in the legal parlance in Nigeria referring to an amended Act in relation to the amendment contained in the new Act. Journal of Islamic Banking and Finance Oct Dec

28 Bank Limited from the provisions of the Act. Section 52 on the other hand empowered the Governor of the Central Bank to exempt PLS banks. 35 The deletion has the implication of bringing all the mentioned banks within the ambit of the Act and withdrawal of the powers of the Governor from making further exceptions for PLS banks than are specifically provided in the Act. However, since the power so withdrawn by the deletion of section 52 of the Principal Act has to do with practice and procedure, its effect is going to be felt much later when the banking system comes into full operation. Hitherto, the Governor would have been able to exempt the bank from some practices directly required of it by the Act thereby amending the law indirectly. This power is only reminiscent of Military rule 36 and would not have been good enough for a law making or amendment process in a democratic dispensation. The Act, by virtue of section 315 of the Constitution of the Federal Republic of Nigeria 1999 has been considered a law properly made by the National Assembly. Its amendment would therefore, expectedly be required to go through the constitutional law making or amendment process. Even then, the powers of the Governor to make regulations to give full effect to the object of the Act were not diminished by a hoot. 37 The 1998 amendment to the Act 38 was dramatic in a way that it eroded the foundation and the first reference ever made to Profit and Loss bank in the Nigerian Banking laws. It substituted section 9 of the Principal Act and in the process removed the former subsection (2) which is the only provision of the Act that categorized banks along their minimum paid-up share capital. The removed subsection of the principal Act provides: Subject to subsection (1) of this section, the minimum paid-up share capital of a bank shall in respect of- (a) a Commercial bank, be N50,000,000; (b) a Profit and Loss sharing bank, be N50,000,000; (c) a Merchant bank, be N40,000,000; (d) a Community bank, be N250,000. This amendment, it may be argued, made a show of poor draftsmanship. This is evidenced as the substitute still makes reference to the categorization it removed and which never appeared in other places in the Act. For the purpose of clarity, the new section 9 provides that the Bank shall, from time to time, determine the minimum paid-up share capital requirement of each category of banks licensed under this Act. The former subsection (3) that made non-compliance with the provisions of the section a ground for revocation of license was merely renumbered as subsection (2) See S. 25 BOFIA, 1997 (No. 4) as amended, CAP B3, LFN, Military rule in Nigeria is the unconstitutional exercise of political powers acquired through coup d état and governance in an undemocratic manner by military personnel, see S. 1 (2), CFRN, 1999; starting on 16 January, 1966, governance in Nigeria through that means took 30 years at various times between 1960 and See S. 55 BOFIA, 1991 as amended, CAP B3, LFN, Banks and Other Financial Institutions (Amendment) Act (BOFIA), 1998 (No. 38) as amended, CAP B3, LFN, Journal of Islamic Banking and Finance Oct Dec. 2012

29 with slight amendment to the time required for compliance to be determined from time to time by the Bank. 39 Still under this amendment, the position of restricted transactions in relation to PLS banking was aggravated. Rather than improving on section 20(2)(g) of the Principal Act shown above to restrict some products of PLS bank, the amended Act merged the former section 20(2)(f) which exempted Islamic bank from restrictions on purchase, acquisition or lease of real estate, with the said section 20(2) (g). 40 The gist of the amendment is that while the principal Act exempted PLS bank from obtaining prior consent of the governor to purchase, acquire or lease real estate as necessary products to its type of business, the amended Act removed the exemption. The implication of this is that it enlarges the scope of the restricted transactions for Islamic banks to also include purchase, acquisition or lease of real property. Permission in writing of the Central Bank first had and obtained is now required in these transactions. No clarification is made still on the frequency of such approval. And as stated earlier, the situation is capable of making terms and trade-related products of Islamic bank cumbersome. What is left of PLS banking in the Act is the Interpretation section and others sections exempting it from interest based operations. The sustainability of these too has therefore become questionable when the establishment section has been removed. On a general note, the Act does not seem to appreciate the need for a fundamental pillar of the banking system for which it made provisions. This is evident in its failure to make provisions for the constitution of Shari ah Advisory Board. It also did not require inclusion in the Memorandum and Articles of Association of the prospective Islamic banks, the establishment; composition and qualification of the members of such Board as it ought to be made in the banking law. 41 Making this a prerequisite to the grant of operating license will go a long way to retain the trust and confidence of the general public and protect the integrity of the new system as one rooted in trust and faith. The powers of the Central Bank Governor to make rules and regulations for the effectuation of the objects of the law contained in Section 57 of the Act are not sufficient for this important requirement 42. Such power can only cover the areas of practice and procedure of banking See S. 7, (No. 38); similar trait was exhibited by the retention since 1997 to date of S. 52(2) of the principal Act despite the deletion of S. 51 to which it relates; Senator Abubakar Maikafi, Vice Chairman of Senate Committee on appropriation and Finance, expressed the belief that the spirit of the law was to retain the categorization and that position remains to date, see Ayodele Aminu N25bn Capital: CBN to Bear the Merger Costs This Day, Wednesday, 11 August, 2004, 3. See S. 11, BOFIA, 1998 as amended, CAP B3, LFN, See Central Bank of Malaysia Guideline on Shariah Advisory Boards and Alaro, A. A. Shariah Supervision as a Challenge for Islamic Banking in Nigeria, in Oloyede I. O. et. al. (eds.) Al-Adl (The Just) Essay of Islam, Islamic Law and Jurisprudence (Ibadan: NAMLAS, 2009) Although Article 4 of the Guidelines on Shariah Governance for Non-Interest Financial Institutions in Nigeria, 2011 establishes the Committee, it is debatable whether such exercise of power is still with the delegated legislative powers to make rules for practice and procedures. Journal of Islamic Banking and Finance Oct Dec

30 The Islamic Banking Act of Malaysia provides a lead on the importance of this requirement to granting of operating license where it provides: (5) The Central Bank shall not recommend the grant of a licence, and the Minister shall not grant a licence, unless the Central Bank or the Minister, as the case may be, is satisfied... (b) that there is, in the articles of association of the bank concerned, provision for the establishment of a Syari ah advisory body, as may be approved by the Central Bank, to advise the bank on the operations of its banking business in order to ensure that they do not involve any element which is not approved by the Religion of Islam. 43 However, stipulation of the roles of the Board, qualification and procedure of their appointment would fall within the powers of the Governor to make regulations. 44 No doubt, Nigeria is blessed with more than enough human resources, most of whom are non-public figures that can fill the position. It is a duty of the promoters to recruit the most qualified personnel through advertisement and critical scrutiny. No effort to ensure this can be too much as the success of the banking system as truly Islamic one or failure may depend on the composition of the Board. 4.0 Islamic Banking Under The Central Bank Of Nigeria (CBN) Act, 2007 This law like many of the ones before it provides for the continuance of the Central Bank of Nigeria. 45 It charges the bank with the responsibility of the overall administration of the monetary and banking policies of the Federal Government both within and outside Nigeria. Specifically, it empowers the Bank to issue legal tender currency; maintain external reserves to safeguard the international value of the legal tender currency; promote monetary stability and sound financial system in Nigeria. It also enjoys the status of the banker and financial adviser to the Federal Government as well the banker of the last resort. 46 The apex bank does all these while regulating, controlling and supervising the banking system and other financial institutions. 47 An Islamic bank in Nigeria cannot but also be under the watchful eyes of the Central Bank. However, as long as the country s economic system and the operations of the Central Bank are still interest oriented, certain difficulties are likely to be posed on the relationship between the two banks by the provisions of the Act which require some exposition See S. 3(5)(b), Islamic Banking Act, 1983 (Act 276 Law of Malaysia) See Chapra M. U. and Tariqullah K., Regulation and Supervision of Islamic Banks, (Jeddah: IRTI, 2000), P. 23; see also Articles 5-7, Guidelines on Shariah Governance for Non-interest Financial Institutions in Nigeria, See S. 1 CBN Act See S. 2(a)-(d), Central Bank of Nigeria (CBN) Act1991 (No. 24) as amended.. See SS and SS BOFIA, 1991 as amended, CAP B3, LFN, Journal of Islamic Banking and Finance Oct Dec. 2012

31 4.1. Interest Based Operations of the CBN Statutorily, the Central Bank is empowered to issue directives requiring every bank operating in Nigeria to maintain, at all times, a ratio of the bank s deposit liabilities in form of cash reserve, as may be prescribed from time to time. Another percentage of the deposit liability is to be maintained with the Central Bank as special deposit. The percentage to be so deposited is specified by the Central Bank in accordance with the increase in such deposit liabilities. 48 These requirements are to ensure that every bank has sufficient assets to cover its liabilities to the public and meet its obligations under the law. A matter of particular interest in this area is the requirement of the law that the Central bank should pay interest on both the cash reserve and the special deposit. 49 In the same manner, the Central Bank is authorized to grant temporary advances to commercial banks in respect of temporary debit balances on their accounts. It does this at an interest rate it may from time to time determine. 50 These provisions are not only inimical but also antithetical to the object of Islamic banking which seeks to avoid interest in all its transactions. Unfortunately, none of the subsequent amendments to this law 51 has touched on this requirement. The provisions of section 23, Banks and Other Financial Institutions Act, 1991, which in itself is a mere technical exemption of PLS banks from interest based transaction, cannot also be extended to this situation. This is because the provisions of the section relates only to the relationship between the PLS bank and its customers. The implication of this is that while an Islamic bank would operate on interest-free transactions with the members of the public, it will be forced to at least pay interest to the Central Bank on its advances. It must pay the interest even if it decides not to take on its own deposits and cash reserve. Since the funds of Islamic bank with the Central Bank are not meant to be kept idle, the proper approach would be that the Central Bank also relate with Islamic banks on the basis of profit and loss sharing system. In respect of the funds of an Islamic bank with the Central Bank, the latter Bank acts as mudārib while the Islamic banks take the position of rabb al-māl. This position becomes reversed when the Central Bank invests in the shares of the Islamic bank and thereby becomes entitled to share in both the profit and loss of the Islamic bank. 52 This relationship would not See S. 39(1) (a) and (c) CBN Decree, 1991 as amended, CAP B3, LFN, See SS. 29(g) and 39(6), CBN Decree, 1991 as amended, CAP B3, LFN, See S.27(1)(v), CBN Decree, 1991 as amended; the bank is also empowered to sell or place by allocation to any bank in open market operation stabilization securities on a mandatory interest rate, see subsection (3)(a) and (4)(a) thereof. Central Bank of Nigeria (Amendment) ActNo. 3, 1997; CBN (Amendment) ActNo. 37, 1998; and CBN (Amendment) ActNo. 41, This situation is accommodated by S. 27 (1) (i) BOFIA 1991 as amended; probably acting under the provision of the repealed S. 52 of the same law, the CBN is said to have exempted Habib Nigeria Bank (HBN) from paying or receiving interest on the latter s non-interest scheme deposits with the former, treating same as the former s treasury and clearing balances maintained with the apex bank but no mudārabah arrangement is in place yet, source: Usman Adam Abubakar, Assistant Manager of HNB, in a telephone interview by thesis writer from IIUM on 2 June, Journal of Islamic Banking and Finance Oct Dec

32 diminish any bit, the role of the Central Bank to come to the aid of the Islamic bank by granting non-interest loan in critical time just as it does for the conventional banks. At this juncture, the need for the establishment of Shari ah Advisory Board for the Central Bank too would seriously be felt. This Board would function in cooperation with the similar Boards in every Islamic bank or conventional banks operating Islamic window. They are to ensure that the depositors who have faithfully submitted to the interest-free banking are not taken advantage of. The Board will also be responsible for advising the Bank on the appropriate business to do with the special deposits and cash reserve of the Islamic banks that best suits their special type of relationship. In addition, it will act as the unit of the Central Bank, responsible for the enforcement of Islamic regulations covering contracts and property rights as they relate to the financial market. Such enforcement function is capable of encouraging lending of funds on the basis of viability and profitability of investment projects. It would also reduce the uncertainties that tend to discourage private investment. 53 This would be a reversal of lending on the basis mainly of solvency, creditworthiness or collateral strength of entrepreneurs obtainable in the conventional banks Supervision and Control of Islamic Banks under the CBN Act Aside from the powers to issue directives on cash reserve and special deposits mentioned above, both the CBN Act and BOFIA sufficiently empowers the Central Bank to exercise supervisory and control function over every bank operating in Nigeria. Among such powers are the powers to issue guidelines, rules and regulations for the operations of banks or any institution engaging in financial services as well as enforcing the rules and regulations. 54 Approval or disapproval annually of the appointment of the auditor by all banks; appoint director of banking supervision and remove ailing bank s manager, staff and directors. He can also order special examination or investigation of any bank if it is in the interest of the public to so do or upon an application of a director, shareholder, depositor or creditor of the bank. 55 Islamic or PLS bank is not and should not in any way be insulated from these supervisory and controlling powers of the central bank for the same reason of maintaining the public confidence in the financial system. 56 Furthermore, one of the distinctive supervisory and controlling powers of the Central Bank is its statutory right to subscribe to the shares of any bank in Nigeria. 57 This provision is double edged. On one hand, it could assist the Islamic bank to generate the statutorily required financial resources for its establishment. On the other hand, the ownership of substantial equity shares of an Islamic bank by the Central Bank would enhance See Iqbal, Z. and Mirakhor, A. Iqbal, M. and Mirakhor, A. Islamic Banking, The Islamic and Comparative Law Quarterly, vol. 4, No. 3, (1987), pp See S. 51, CBN Act, 2007 SS. 31 (1) and (2) 32, 33, 35, 36, and BOFIA, 1991 as amended, CAP B3, LFN, See Chapra M. U. and Tariqullah K., Regulation, n. 44, p. 21 See S. 31 CBN Act, Journal of Islamic Banking and Finance Oct Dec. 2012

33 the control of the former by the latter and by necessary extension, an efficient control of the banking system. The foregoing notwithstanding, a concern has been raised on the issue relating to liquidity requirement and adequacy of capital in the Central Bank supervision and control of Islamic bank. It was opined that a Central Bank would have great difficulty under the regulatory laws in putting a value on the assets of an Islamic financial Institution. This is because, unlike the traditional banking system which has much of its assets in fixed interest investments and instruments and is thus comparatively easy to value, it will be very difficult to value an Islamic asset such as a share in a joint venture. This situation, it is contended, would require the Central Bank to send a team of experienced accountants into every Islamic bank operating in a country to try to put a proper and cautious value on its assets. 58 This and other similar opinions are heavily relied upon to reach the conclusion that Islamic banking system would not be accommodated by the existing laws and procedures. Such accommodation, it is opined, would require serious modification to the existing laws which may not be easy to come by. This view has been more authoritatively contradicted by the immediate past Governor of the Bank of Britain. He has always maintained that there are no impediments under the United Kingdom Banking Act which prevent the authorization of an Islamic bank in the country. 59 This position was later corroborated by the actual authorization of the Islamic bank of Britain by the UK Financial Services Authority (FSA) in August, 2004 and four others operating in UK alone. 60 Under the Nigerian laws, expression of such fear would seem as crying wolf when there is none. BOFIA puts up a requirement that is capable of allaying fears relating to valuation of Islamic banks assets. Section 25 of the Act provides that every bank shall submit a statement in a prescribed form to the Central Bank not later than 28 days after the last day of each month or such other interval as the Bank may specify. The statement is expected to show the assets and liabilities of the bank as well as the analysis of advances and other assets at its head office and branches in and outside Nigeria. 61 This requirement coupled with the Central Bank s power to periodically examine the books of the banks would, unless the Central Bank has reason to suspect falsification, greatly eliminate most of the anticipated problems in assessing the value of Islamic bank assets. This is particularly so as each of its mushārakah projects would have been appropriately evaluated before they are embarked upon See Abdul Gafoor, A. L. M. Interest-free Commercial Banking, (Groningen: Apptec Publications, 1995), 62-63; quoting Steele, F. Islamic Banks Operating in the Western Countries, Paper presented at the Conference on Islamic banking: Its Impact on World Financial and Commercial Practices, London, on 18 September, See Parker, n. 11 at 6. See Sections 49 Finance Act 2005 and Section 95 and 98 Finance Act, 2006 (both of UK) by which the UK amended the existing laws to accommodate Islamic Banking Products referred to in the laws as alternative finance arrangement. See S. 25, BOFIA, 1991 as amended CAP B3 LFN Journal of Islamic Banking and Finance Oct Dec

34 The law does not also treat non-compliance with this requirement or falsification of information in respect thereof with kid glove. Such act is a criminal offence and a culprit bank is liable on conviction to a fine not exceeding N125,000 for each day during which the offence continues. 62 Thus, unlike the case of some country s Central Banks which charge penal rate of interest for non-compliance with their directives or the requirement of the law on banks, 63 the CBN Act would not require a change in the penal system. Its present provisions in such circumstance suit Islamic banking system. The law has always treated non-compliance as crime either of the bank or its officials. It also prescribes appropriate penalty of fine for different offences or imprisonment or both, where a particular officer of the bank is responsible. 64 Meanwhile, the foregoing intends not to reduce the need for continued improvements on development of Islamic accounting standard that will be more suitable to the banking system and ease the process of evaluating its assets. Yet, abandoning the whole developmental process of the banking system because of lack of international accounting standard would be apologetic and would be killing to the nascent banking system. 65 It need be mentioned that the present level of international accounting standard attained by the conventional banks which has always been used as basis for comparison is a product of hundreds of years of practice. The steps already being taken by Accounting and Auditing Organisation of Islamic Financial Institutions (AAOIFI) and INCEIF of issuing yearly, an accounting, auditing and governance standards for Islamic Financial Institutions is a step towards attaining to such standards. The above notwithstanding, the Central Bank in the exercise of its power of supervision and control would still need to be giving special consideration to the nature of the mushārakah contract of an Islamic bank which would make it impracticable for the latter bank to immediately liquidate its particular operation as the Central Bank may direct. This is necessary because the directive, which although is a normal one as part of the Central Bank general credit control policy, is usually impromptu and as such may not have been anticipated by Islamic bank at the time of entering into a mushārakah contract. 66 Otherwise, the banking system would be exposed to an unending chain of litigations for breach of contract See S. 16, BOFIA (Amendment), 1998 (No. 38); this is an increment on the 1991 Act penalty of N5,000 for each day the offence continues, the increment does not seem to indicate a harsher penance to stop a repeated contravention of the law, but most probably represents the value of the amount of the fine at different times. The State Bank of Pakistan is an example in mind in this respect, see Council of Islamic Ideology, Summary of Conclusions and Recommendations on the Elimination of Interest from the Economy, in Readings in Islamic Banking, edited by Hoque, A. (Bangladesh: Islamic Foundation, 1987), pp The above provision is an instance of fine only, see also, SS. 4, 8, 9 and 15(a) BOFIA (Amendment), 1999 (No. 40), for similar fines; and SS. 15(b) and 16 thereof for offences attracting penalties of both fine and terms of imprisonment. See Haqiqi, A. and Pomeranz, F. Accounting Needs of Islamic Bank, January-March, 2004, Journal of Islamic banking and Finance, 76. See Hamdi, A.R. The operation of Faisal Islamic Bank: Sudan, in Hoque, A., Readings in Islamic Banking, (Bangladesh: Islamic Foundation, 1987), p Journal of Islamic Banking and Finance Oct Dec. 2012

35 5.0. Islamic Banking Under The Economic And Financial Crime Commission (Establishment) Act, 2006 This Act established the Economic and Financial Crimes Commission (EFCC) with the object, among others, to coordinate and enforce all economic crimes laws and enforcement functions conferred on any other authority. It is responsible for investigating all financial or economic crimes. 67 On its own, Islamic banking as a faith-based system has an inbuilt safeguard against economic crimes for which, as observed by Jack A. Blum 68, a number of conventional banks are being used as vehicles. Yet, the fact that existence of rogue elements cannot be ruled out in any type of organization would justify the cooperation between the bank and the Commission. 69 The management of an Islamic bank cannot but submit to the investigative, prosecution and account freezing powers of the Commission on both its own activities and that of its customers suspected of economic and financial crime. 70 As a rule, Non-Interest Financial Institutions (NIFIs) are not only required to have effective anti-money laundry policies and procedures but are also to screen shareholders, customers, counterparties, transactions, products and activities against the proceeds of crime, corruption, terrorist financing and other illicit activities using legal and moral filters See SS. 1 and 6 EFCC (Establishment) Act, 2006, generally; Economic crime has been statutorily defined to mean non-violent criminal and illicit activities committed with the objectives of earning wealth illegally either individually or in a group or organized manner thereby violating existing legislation governing the economic activities of government and its administration and includes any form of fraud, narcotic drug trafficking, money laundering, embezzlement, bribery, looting and any form of corrupt malpractices, illegal arms deal, smuggling, human trafficking and child labour, illegal oil bunkering and illegal mining, tax evasion, foreign exchange malpractices including counterfeiting of currency, theft of intellectual property and piracy, open market abuse, dumping of toxic waste and prohibited goods, etc., see S. 46, EFCC (Establishment) Act, An American Attorney specialized in controlling bank fraud, government corruption and money laundering, while testifying on Nigerian debt and corruption situation before the US House of Representative Sub-committee on domestic and International monetary policy on 25 May, 2000; see also Corey, C. W. Past corruption is the Nigeria s Biggest problem (But expert calls for worldwide reforms), The Embassy of the United States of America in Nigeria, Washington File, May 26, 2000, < (accessed 8 February, 2005) 69 Five Nigerian conventional banks: All States Trust Bank, Standard Trust Bank, Diamond Bank, African International Bank and Lion Bank were indicted by Mr. Clark, London Investigating Police Officer, while giving evidence in the case of Federal Republic of Nigeria v Chief Joshua Chibi Dariye & 6 Ors. Suit No. FHC/KD/143c/2004 reported in [2005] 10 NWLR 528, apart from the fact that All States Trust Bank is an accused person in the case involving laundering of millions of Dollars; see also Lanre Oyetade, Money Laundering: Banks shy away from commenting Sunday Independent, Sunday, 30 January, 2005, A4. 70 See SS. 14(1), 31 and 34EFCC (Establishment) Act, See Article 15, Framework for Regulation and Supervision of Institutions Offering Non- Interest Financial Services in Nigeria (FINFSN), Journal of Islamic Banking and Finance Oct Dec

36 6.0 Islamic Banking Under The Nigerian Deposit Insurance Corporation Act, The Nigerian Deposit Insurance Corporation (NDIC) was established by the NDIC Act 2006 as a government-owned Deposit Insurance Corporation. 73 The sole purpose of its establishment is the management of the nation s Deposit Insurance Scheme (DIS). The scheme aims at protecting the banking system and offering financial guarantee to the depositors. Establishment of the commission became necessary in the wake of the deregulation of the banking sector in This policy had a consequential influx of new banks, competitiveness and increase in risk taking and sophistication in the banking operations. It was a major policy shift, from mainly protecting the banks failure to protecting the depositors as well; especially the small ones whose deposits form the bulk of retail banks total deposits. 74 The Act empowered the corporation to insure all deposit liabilities of licensed banks and other financial institutions with the exception of insider deposits counterclaims and deposits held in the off-shore branches of local banks. 75 In promotion and sustenance of public confidence in the banking system, the corporation is empowered to come to the aid of an insured bank in case of imminent or actual financial difficulties which may threaten payment. This may be in form of liquidity support to the banks on agreeable terms, giving guarantee for the banks loans, or even taking over the management of a wobbling bank until its financial position improves. 76 In the event that the corporation exhausts all its protective alternatives and a failing bank still has to postpone payment, the corporation is obliged to pay every insured depositor up to the insurable limit which is presently N2000, The author has done a fairly exhaustive work on the Islamic law point of view of an Islamic bank s participation in the Deposit Insurance Scheme. 78 It therefore suffices to summarise the findings of that research for the purpose of this work as follows: Deposit Insurance Scheme is similar to the Cooperative Insurance permissible و ت ع او ن وا ع ل ى ال ب ر و ال تق و ى under the Islamic law with the backing of the Quran verse This was NDIC Decree, 1988 (No. 22); it was amended in 1997 by NDIC (Amendment) Decree, 1997 (No. 5) and further amended by NDIC (Amendment) Decree, 1998 (No 39). See S. 1, NDIC Act See Umoh, P. N. Bank deposit protection: The Nigerian experience, vol. 13, No. 4, (December 2003) NDIC Quarterly, See SS. 2(1), 15 (1) and 16 NDIC Act, 2006; insider deposit is the deposit of bank staffs while counter-claim is a deposit account used as collateral for a loan account in the same bank, see S. 16 (a) and (b) NDIC Act, See SS. 2(1) (b) and 37 (2) NDIC Act, See SS. 20 (1) NDIC Act See Abdulqadir I. A., Islamic Banks Participation in Deposit Insurance Scheme: A Legal Appraisal, NDIC Quarterly Journal of the Nigeria Deposit Insurance Corporation 2011, Vol. 21 No. 1, pp Journal of Islamic Banking and Finance Oct Dec. 2012

37 Help you one another in righteousness and piety. The hadith 79 in which the Prophet held the Àqilah 80 of a woman who killed another woman in a fight, responsible was also used in its support. Some of the practices of the scheme are not compatible with the principle upon which Islamic banking is based. The practices include: investment of the scheme s fund in interest yielding Federal government security 81 while lateness in paying of premium attracts penal interest, at the prevailing Minimum Rediscount Rate of the Central Bank of Nigeria (CBN). 82 The liquidity support given to an ailing bank also attracts interest 83. All these contradict the very foundation of Islamic banking of zero tolerance to riba (interest). The Malaysian scheme provides a model to avoid these contradictions. 84 Also, the sharing formula for the net operational surplus above 10 times the capital of the deposit insurance fund was observed to be unjust especially as it favours the shareholder, CBN and the Federal Government above the member banks who contributed the major sum Regulations Made Pursuant To The Legislations Pursuant to relevant provisions of the CBN Act, 2007 and BOFIA 1991 as amended 86, empowering the Central Bank Governor to make rules and regulations for the operation and control of all institutions under the supervision of the Bank, the CBN issued regulations for Non-Interest financial institution in Nigeria in January, Although the framework 88 attracted a lot of criticism, particularly from the non-muslim populace on allegation of promoting religious ideals in a secular state, Narrated by Abu Hurairah and reported by Al-Bukhāri, Sahih Al-Bukhāri, vol. 5, 1987 ed.: Àqilah is an Arabic word for a clan which commits itself to paying the wergild for each of its member, see Werh, H., A Dictionary of Modern Written Arabic, (London: MacDonald & Evans Ltd., 1974), 630; the commitment developed to become a popular pre-islamic Arabian custom by which close paternal relations paid blood money to the heirs of the victim of their member, it was adopted by Islam but restricted only to cases of manslaughter, see Ma sum, n. 121 at 3-4; The practice of Àqilah upon which the above hadith was based was also practiced nationally by Khaliph Umar Ibn Khatab, See Gibb, H. Q. R. et. al., Shorter Encyclopaedia of Islam, Leiden: E. J. Brill, 1953), p. 29. See S. 13(1) NDIC Act, 2006 See S. 17(7) NDIC Act, 2006; see also, S. 25 Canada Deposit Insurance Corporation Act, 1985 as amended. See, Umoh, p. 57 and S. 37 (2) NDIC Act, 2006 particularly the proviso thereto. See S. 25(2)(a)(ii) MDIC Act, S. 12 (2) NDIC Act See S. 33(1) (b) CBN Act, 2007 and S. 57(2) BOFIA 1991 as amended CAP B3 LFN See CBN, Circular number FPR/DIR/CIR/GEN/01/010 of January 13, Framework for the Regulation and Supervision of Institutions Offering Non-interest Financial Services in Nigeria (FINFSN), Journal of Islamic Banking and Finance Oct Dec

38 nonetheless, it laid good foundation for a smooth take-off of Islamic financial system in Nigeria. The framework covers operations of full-fledge Islamic bank, Micro Finance Bank, non-interest subsidiary, window or branch of a conventional bank and non-interest mortgage and finance institutions 89. It also established the CBN Shariah Council (SCC) as advisory body on Shariah regulatory matter 90. Two guidelines have also been issued in support of the framework 91. All these regulations and guidelines paved ways for the issuance of the operating license to the first full-fledge Islamic bank in Nigeria in June, Other relevant financial institutions regulatory agencies have also been taking similar steps to accommodate the newly adopted financial system. The Nigeria Deposit Insurance Corporation for instance, issued a draft framework for Non- Interest Deposit Insurance Scheme in August Similarly, the Security and Exchange Commission in the proposed amendment to its rules and regulations made provisions for Rules on Islamic Fund Management 94. The rule recognized Islamic Fund Management as well as the role of Shariah Adviser in relation thereto Conclusions We have considered some provisions of the Nigerian financial regulatory laws relevant to the take-off and operations of Islamic banking. All the banking laws enacted before 1991 did not have Islamic banking in contemplation and there was no way the banking system could have been licensed under them. It was clear on the face of BOFIA 1991 that it was enacted to give foundation for the take off of Islamic banking but its provision were not sufficient for the needs of a full fledge Islamic banking. Its subsequent amendments appeared to be more confused as they partially uprooted what the principal legislation establishes rather than improving it at a time when nations with smaller market for the financial system were paving ways for its establishment. Lack of sufficient framework after this initial legislation in 1991 was responsible for the long delay in the take-off of the banking system See Article 1.0 (i-vii), FINFSN, 2011 as amended. See Article 9.0, FINFSN, 2011 as amended. Guidelines on Shariah Governance for Non-Interest Financial Institutions in Nigeria, 2011; and Guidelines on Non-Interest Window and Branch Operations of Conventional Banks and Other Financial Institutions, 2011, see CBN, Circular number FPR/DIR/CIR/GEN/01/010 of January 13, Kunle Aderinokun and Obinna Chima, CBN Licenses First Islamic Bank in Nigeria This Day, Tuesday, 21 June, 2011, available at visited on 30/3/2012 See NDIC, The Draft Framework for Non-Interest (Islamic) Deposit Insurance Scheme (NIDIS) in Nigeria, 2010 available at visited 30/3/2012. See Security and Exchange Commission, Proposed Amendments of the Rules and Regulations of the Securities and Exchange Commission 2010, available at E&url=http%3A%2F%2Fwww.proshareng.com%2Fnews%2Fdownload.php%3Fitem%3D UNLISTESECURITIEAUG.pdf&ei=UpN2T_aMJcLh0QHD_K2RDQ&usg=AFQjCNEZm 81mofsM36o189PhX4fjVSAe6A&sig2=20LoecBjjGGe1C1nv4ADgQ visited on 25/3/12. Ibid. Articles 1 and Journal of Islamic Banking and Finance Oct Dec. 2012

39 The Central Bank would retain its supervisory role in its relationship with Islamic banks but with slight adjustment to its interest based operations. Essentially, its examination and oversight functions would be continued to be handled by the existing relevant units while Shariah compliance issues will be handled by its Shariah Council. Islamic banks or subsidiary of window operations of conventional banks have no option than to be part of the Deposit Insurance Scheme. However, if the scheme s interest-based operations and sharing formula for the net surplus are not reworked, great disservice would be done to Islamic banking system. The Economic and Financial Crime Commission would also add Islamic banks to her watch list but it is expected that the faith root of the banking system would make the duo a better partner in the fight against economic crime. Apart from the EFCC Act, all other current laws considered in this work would require amendment to their provisions to have a comprehensive legal framework for Islamic banking system in Nigeria. This of course could not be asking for too much when the progenitor of the contemporary Nigerian laws, the Great Britain has deemed such amendments fit. Journal of Islamic Banking and Finance Oct Dec

40 The Performance of Insurance Industry in Malaysia: Islamic vis-à-vis Conventional Insurance Abstract By 1. Muhamad Abduh, 2. Mohd Azmi Omar, 3. Raudhah Mohd Tarmizi * The Islamic financial institutions have been developing tremendously since the last three decades. However, many studies are focused more on the development and performance of banking and financial markets and almost neglecting another specific and important sector, which is insurance. Thus, this study aims to measure the performance of Islamic insurance industry in Malaysia and compare them with their conventional counterpart. This study covers a three-year period, i.e to 2010 and employs ratio analysis and data envelopment analysis to measure the performance of both industries. The findings show that insurance industry is more efficient than Takaful industry in both ratio analysis and data envelopment analysis. Keywords: Insurance, takaful, performance, data envelopment analysis, ratio analysis 1. Introduction The main way for businesses and individuals to reduce the financial impact of a risk occurring is through insurance. Thus, it is a form of risk management primarily used by firms or individuals to protect their financial assets. Today, there are two types of insurance operated in some countries, particularly in Malaysia, which are conventional insurance and Islamic insurance (takaful). Malaysia introduced the first takaful as an alternative to conventional insurance in the year of However, * Corresponding author: 1. Muhamad Abduh is Assistant Professor, IIUM Institute of Islamic Banking and Finance International Islamic University Malaysia. 2.Mohd Azmi Omar, is a Professor and (3) Raudhah Mohd Tarmizi is a Post graduate Student, Department of Finance, Kulliyah of Sciences International Islamic University Malaysia E mail Abduh.114m@gmail. 40 Journal of Islamic Banking and Finance Oct Dec. 2012

41 Malaysia is not the first country in contributing to the establishment of Takaful industry because Sudan and Saudi Arabia introduced the takaful industry in the late 1970s. The origin of takaful comes from the ancient Arab tribes, which was interpreted as a pooled liability that obliged those who committed offences against members of a different tribe to pay compensation to the victims or their heirs. Later on, this principle is extended over many parts of life, including sea trade, in which participants contributed to a fund to cover anyone in a group who suffered misfortune on sea voyages. Takaful operation today is under the cooperative principle and the principle of separation between the funds and operations of shareholders. Hence, it is passing the ownership of the Takaful fund and operations to the policyholders. The policyholders are joint investors with the insurance vendor (Takaful operator), who acts as a mudarib a manager or an entrepreneurial agent for the policyholders. The policyholders share among them the investment pool s profits as well as its losses. A positive return on policies is not legally guaranteed, as any fixed profit guarantee would be akin to receiving interest and offend the prohibition against riba. Muslim jurists conclude that insurance in Islam should be based on principles of mutuality and co-operation, encompassing the elements of shared responsibility, joint indemnity, common interest and solidarity. Takaful companies offer general and family Takaful whereas in conventional insurance industry, they offer general and life insurance. Furthermore, the assets of Takaful funds in Malaysia have recorded a five-year compounded annual growth rate of 16%, and it is double than that of conventional insurers. Meanwhile, assets in the Takaful industry also increased by 17% to RM14.7 billion (US$4.82 billion) in the year of 2010, accounting for 8.7% of the combined asset base of the insurance and Takaful industries (IFN, 2011). Besides that, based on Takaful annual report and insurance statistics, both industries experienced growth in their premium. Thus, it is interesting to study the performance of insurance and Takaful as well as their level of efficiency in their operations. This study is aimed at investigating the performance of Takaful industry and the performance of conventional insurance industry in Malaysia. This paper is organized as follows. Section 2 discusses about the previous researches that have been done on the performance of both Takaful and insurance industry. Section 3 describes the methodology and data employed in order to get the results. Section 4 discusses the findings, and the last section is the conclusion of the paper. 2. Literature Review There are several ways in measuring the performance of Takaful operators and conventional insurance companies. One of it is by looking at the efficiency of both companies. Saad et al (2006) argues that there is an impact upon the efficiency of Takaful operators and insurance companies as the Malaysian financial system has experienced structural changes with several liberalization measures since a decade Journal of Islamic Banking and Finance Oct Dec

42 ago. Therefore, Saad et al (2006) uses Data Envelopment Analysis (DEA) with Malmquist Index in order to investigate the life insurance industry in Malaysia and to compare its performance with Takaful operators from year 2002 to They evidence that scale efficiency has made big contribution rather than pure efficiency to the total factor productivity in the insurance industry in Malaysia. On the other hand, they found that Takaful has performed below than the industry average in pure efficiency, but the Takaful scale efficiency is at the industry average. As a result, they conclude that, Takaful Nasional is competitive in Malaysian insurance industry. On another occasion, Ismail et al (2011) conducts a study on technical efficiency to measure the performance of conventional insurance industry and Takaful industry using DEA. In order to examine the technical efficiency of both industries, Ismail et al (2011) uses constant return to scale and variable return to scale assumptions. By examining the technical efficiency, they also make a comparison for pure technical efficiency and scale efficiency. In the end, Ismail et al (2011) evidences that conventional insurance industry is more efficient than Takaful industry in constant return to scale and variable return to scale assumptions. Besides that, Takaful industry has lower pure technical efficiency and scale efficiency than that of conventional insurance, and this is in line with the previous study done by Saad et al (2006). Rahman (2009) examines the Takaful performance by looking at the growth of the Takaful industry. Based on the study, she finds that the population size and demographic factors play a vital role in contributing to the growth of the Takaful industry. However, in the study, she only used descriptive statistic from a secondary data. Furthermore, Kassim (2008) conducts a study regarding Takaful in Malaysia using qualitative techniques. According to Kassim (2008), it is difficult to compare the performance of Takaful industry and that of the conventional insurance industry as both industries have different products and have different ways in recording their profit. Furthermore, he also concludes that, it is hard to look at the level of capital and solvency margin in comparing the performance of both industries because they have different nature of contracts. 3. Data and Methodology 3.1 Data The sample of this study consists of 7 companies from insurance industry and 5 companies from Takaful industry. Data are collected from the annual report of Takaful and insurance companies from the year of 2008 to In order to conduct this study, return on assets will be calculated as in accordance to Akhter and Zia-ul- Rehman (2011) and Liquid Asset to Total Asset Ratio, premium and reinsurance receivable to total asset ratio, Total Equity to Total Asset ratio will be calculated as in accordance to Ozdemir and Balkanli (2011). Besides that, commission and management expenses are taken as input, while premiums and investment income are taken as output and this is in line with what has been done by Saad et al (2006) and Ismail et al (2011). 3.2 Methodology Following Akhter and Zia-ul-Rehman (2011) and Ozdemir and Balkani (2011), ratio analysis will be employed in order to identify which industries have better performance. The ratio analysis includes; 42 Journal of Islamic Banking and Finance Oct Dec. 2012

43 1. Liquid asset to total asset ratio. This ratio is measured by dividing cash in hand and bank and financial asset with total assets of the firms. This ratio is to identify how much liquid asset is comprised on the total assets of the firm. 2. Premium and reinsurance receivable to total asset ratio. This ratio is calculated by dividing premium and reinsurance receivable with the total assets of the firms. This ratio indicates the performance of the firms in managing their liquidity position. 3. Total Equity to Total Asset ratio. This ratio is calculated by dividing total equity of the firms with the total assets of the firms. This ratio measured how much amount from shareholders equity is used to finance the assets. 4. Return on asset (ROA). This ratio is measured by dividing the return of the firms with the total assets of the firms. This ratio explained the management ability to generate profit from the investment of the assets of the firms. If the ratio is high, it shows that, the management is efficient in their assets utilization. Then, DEA will be used to compute Malmquist index in order to measure the performance of both insurance and Takaful industry in Malaysia. 4. Findings and Discussion 4.1 Ratio Analysis As mentioned in previous section, liquid asset to the total asset ratio is calculated by dividing the liquid asset with the total assets. In this ratio, liquid asset consists of cash, bank and financial assets. Therefore, based on the ratio calculated in the Table 1 below, insurance industry has more liquid assets as compared to Takaful industry. It is because they have invested more in financial assets such as in government securities. Based on the information provided in Table 1, both industries experienced growth in the liquid asset to the total asset ratio. Hence, both industries will be less risky if there is a liquidity crisis. Even that so, in year 2010, there is not much difference in the means of both industries, but the standard deviation for insurance industry is double than that of Takaful industry, which shows that insurance was more volatile in the year of Table 1. Liquid Asset to Total Asset Ratio (%) Takaful Insurance Mean Std. Deviation Mean Std. Deviation In a while, for premium and reinsurance receivable to total asset, it is calculated by using premium and reinsurance receivable and then, dividing it with total assets of the firms. As can be seen at Table 2 below, insurance industry has low Journal of Islamic Banking and Finance Oct Dec

44 premium and reinsurance receivable to total assets ratio as compared to Takaful industry. Thus, it shows that insurance industry has a low impact in liquidity positions if there is any event of default. Nevertheless, it does not mean that Takaful industry will be much affected if there are any events of default as they will use tabarru' (donation) account to cover it. Although insurance industry has high premium and receivable than Takaful industry, the big amount of assets that belongs to insurance industry is indirectly affected by this premium and receivables to total assets ratio. Table 2. Premium and reinsurance receivable to total asset ratio (%) Takaful Insurance Mean Std. Deviation Mean Std. Deviation Table 3 shows the measurement of total equity to the total asset ratio by dividing total equity to the total assets of the firms. It can be seen that Takaful industry has high total equity to the total asset ratio as compared to insurance industry. Nevertheless, Takaful industry shows a downward trend in the ratio, while insurance industry shows an upward trend in the ratio. This total equity to total assets ratio indicates that, the highest the ratio, the less risky to the firms. Nevertheless, it cannot be said that insurance industry is riskier as compared to Takaful industry because the asset of insurance industry is more than tripled from the assets of Takaful industry. Table 3. Total Equity to Total Asset ratio (%) Takaful Insurance Mean Std. Deviation Mean Std. Deviation Finally, Table 4 shows the ratio analysis of the return on assets ratio which is looking at the overall profitability of the industry by dividing the return with the total assets of the firms. Overall, it can be seen that, insurance industry has better performance than Takaful industry even though there is only a slight difference in the ratio. However, Table 4 also depicts that the performance of both industries fluctuated in the 3 years of the analysis. The ROA for Takaful industry is low may be because of Takaful operators does not have many place to invest as they have to invest with the shariah compliant instruments. Besides, the Takaful operators might be less efficient in managing the assets investment. 44 Journal of Islamic Banking and Finance Oct Dec. 2012

45 Table 4. Return on asset (%) - ROA Takaful Insurance Mean Std. Deviation Mean Std. Deviation Data Envelopment Analysis In order to perform data envelopment analysis in this study, input and output for each firm will be used. Input consists of commissions and management expenses, while in output, premiums and investment income will be used. Those inputs and outputs will be used in order to measure the efficiency of both Takaful and insurance industry. There are five Takaful operators (Takaful Ikhlas, Etiqa Takaful, CIMB Aviva Takaful, BSN Takaful, and Hong Leong MSIG Takaful) and seven insurance companies (Etiqa Insurance, CIMB Aviva Insurance, ING Insurance, Prudential, UniAsia Life Insurance, Great Eastern, and Alliance Life Insurance) included in this study. This study is an output oriented in order to identify how much output can be produced by the firms for the given input. Table 5. Statistics of Input-Output for Premiums (RM mill.) OUTPUT Investment income (RM mill.) Commissions (RM mill.) INPUT Mgt expenses (RM mill.) Total 50,449,176 9,375,114 7,534,114 4,714,684 Mean 1,401, , , ,963 Median 771,219 51,110 80,155 84,443 Std. Deviation 1,410, , , ,897 Table 5 depicts the descriptive statistics of variables included in the analysis from the year of 2008 to Overall, this study is covering RM 50,449,176 millions of total premiums and RM 9,375,114 millions of investment income respectively. In a while, for input, it covers RM 7,534,114 millions of commissions and RM 4,714,684 millions of management expenses. For this 3-year period, Great Eastern insurance has maximum value of both input and output in 2010, which are about RM 4,890,825 millions of premiums, RM 1,778,121 millions of investment income, RM 855,344 millions of commissions and RM 313,249 millions of management expenses. On the other hand, Hong Leong MSIG Takaful has the minimum amount of inputs and premiums, which are only about RM 67,450.5 millions of premiums in 2009 and RM 3,171.5 millions of commissions and RM 6,744 millions of management expenses in Journal of Islamic Banking and Finance Oct Dec

46 Table 6. Efficiency in for CRS (Constant Returns to Scale) Takaful/Insurance Company Year Takaful Ikhlas Etiqa Takaful CIMB Aviva Takaful BSN Takaful Hong Leong MSIG Takaful Mean Standard deviation Etiqa Insurance CIMB Aviva Insurance ING Insurance Prudential UniAsia Life Insurance Great Eastern Alliance Life Insurance Mean Standard deviation As Malmquist index is used to measure the efficiency of both industries, the efficiency under constant returns to scale and variable returns to scale will be taken into consideration. Under constant returns to scale, feasible output is achieved when average productivity, which is output divided by input, is maximized (Fare et al, 1994). If the value for constant returns to scale or variable returns to scale is more than 1, it indicates that the firm is efficient, and if the value is less than 1, it indicates that the firm is less efficient. Therefore, based on Table 6 and 7, it can be seen that few operators in both industries are efficient as they are able to produce maximum output for a given input in both constant returns to scale and variable returns to scale. The operators are Etiqa Takaful, Hong Leong MSIG Takaful, Etiqa Insurance, CIMB Aviva Insurance, Great Eastern. However, for UniAsia Life Insurance, it is only efficient under variable returns to scale and the efficiency is fluctuated for the threeyear period of analysis. The reason might impact be the global financial crisis, in the year of Nevertheless, based on geometric means, it can be summarized that, insurance industry is more efficient under both constant returns to scale and variable returns to scale as compared to Takaful industry. 46 Journal of Islamic Banking and Finance Oct Dec. 2012

47 Table 7. Efficiency in for VRS ( Variable Returns to Scale) Takaful/Insurance Company Year Takaful Ikhlas Etiqa Takaful CIMB Aviva Takaful BSN Takaful Hong Leong MSIG Takaful Mean Standard deviation Etiqa Insurance CIMB Aviva Insurance ING Insurance Prudential UniAsia Life Insurance Great Eastern Alliance Life Insurance Mean Standard deviation Table 8 shows the summary of Malmquist index from the year of 2008 to 2010 for all companies. BSN Takaful recorded the highest total productivity growth for Takaful industry, which is about 5.5 percent and UniAsia Life Insurance recorded the highest total productivity growth for insurance industry, which is about 6.3 percent. In contrast, Hong Leong MSIG Takaful and Etiqa Insurance recorded the lowest of total factor productivity growth for Takaful and insurance industry, which is about percent and percent respectively. Overall, the average means in total productivity growth for insurance industry is higher than the Takaful industry, and this is in line with Saad et al (2006). Nevertheless, Takaful industry recorded higher growth in efficiency change compared to insurance industry. Table 8. Malmquist Index Summary of Firm Means ( ) Effch Techch Pech Sech Tfpch Takaful Ikhlas Etiqa Takaful CIMB Aviva Takaful BSN Takaful Hong Leong MSIG Takaful Mean (geometric mean) Journal of Islamic Banking and Finance Oct Dec

48 Etiqa Insurance CIMB Aviva Insurance ING Insurance Prudential UniAsia Life Insurance Great Eastern Alliance Life Insurance Mean (geometric mean) Note: Effch: efficiency change; Techch: technical change; Pech: pure efficiency change; Sech: scale efficiency change; Tfpch: total factor productivity change. 5. Conclusion This study aims to measure the performance and efficiency level of insurance industry in Malaysia, both Takaful and conventional insurance, during the period of 2008 to In order to achieve the objective of this study, ratio analysis and DEA methods are employed. The findings are showing that insurance industry is more efficient than Takaful industry in both ratio analysis and data envelopment analysis. Even that so, there is only a slight difference in the efficiency in both industry. The reason might be because of Takaful industry, even though its products are different from that of the insurance, is operated under the same financial system as insurance industry. There are few limitations that have been discovered throughout this research. Firstly, there are only a few Takaful companies as compared to insurance companies. This is because, Takaful industry is still new even though the industry was established in Secondly, the time frame for this research period is short, i.e to 2010, because few Takaful companies have just been established, and a few insurance companies experienced company merger and restructuring. However, as few studies were done in measuring the performance of Takaful and insurance industry, this study might help the regulators and practitioners to ascertain the performance of takaful and insurance industry as well as the factors that contribute to the performance of the industry. 6. References Akhter, W. and Zia-ur-Rehman, M. (2011). Financial performance of Pakistan insurance industry in global scenario. Far East Journal of Psychology and Business, Vol. 3, No. 2, pp Fare, R., Grosskopf, S., Norris, M. and Zhang, Z. (1994). Productivity growth, technical progress, and efficiency change in industrialized countries. The American Economic Review, Vol. 84, No. 1, pp IFN. (2011). Takaful s Strong Growth. Islamic Finance News, Vol. 8, Issue. 25, p.34. Ismail, N., Alhabshi, S.O., and Bacha, O.I. (2011). Organizational form and efficiency: The coexistence of family Takaful and life insurance in Malaysia. 48 Journal of Islamic Banking and Finance Oct Dec. 2012

49 Paper presented at 2 nd International Conference on Business and Economic Research, March 2011, Langkawi, Malaysia. Kassim, Z.A.M. (2008). Are Takaful models converging?. Paper presented at The 2 nd International Takaful Summit, 15 July 2008, London, United Kingdom. Ozdemir, O. and Balkanli, A. (2011). Liquidity structure of Turkish insurance industry: Ratio analysis. International Research Journal of Finance and Economics, Issue 71, pp Rahman, Z.A. (2009). Takaful: Potential demand and growth. JKAU: Islamic Econ., Vol. 22, No. 1, pp Saad, N.M., Majid, M.S.A., Yusof, R.M., Duasa, J., and Rahman, A.R.A. (2006). Measuring efficiency of insurance and Takaful companies in Malaysia using data envelopment analysis (DEA). Review of Islamic Economics, Vol. 10, No. 2, pp Journal of Islamic Banking and Finance Oct Dec

50 Interest Based Financial Intermediation: Analysis & Solutions By Salman Ahmed Shaikh * Abstract Interest is prohibited in all monotheist religions. Apart from religion, interest is also regarded as unjust price of money capital by pioneer secular philosophers as well as some renowned economists. However, it is argued by some economists that modern day, market driven interest rate in a competitive financial market is different from usury and that the interest based financial intermediation has served a useful purpose in allocation of resources as well as in allocation of risk, given the interpersonal differences in risk preferences that exist in any society. Hence, there is a need to delineate clearly whether Islamic economics distinguishes between usury and interest. Secondly, there is also a need to reassess the economic merits and demerits of modern day competitive financial markets fueled by interest based financial intermediation. This paper tries to serve this need and presents a brief review of literature on the issue and examines the economic rationale usually presented for legitimizing interest as the price of capital. The paper analyzes the impact of interest based financial intermediation on macroeconomic variables as well as on development goals by highlighting few glaring facts and statistics and empirical evidence documented in past studies. The paper concludes with delineating the role of capital in an Islamic economy and how it can be valued in an Islamic economy without compensating it with fixed payoffs and the paper also assesses how economic and financial decisions will be altered in this new interest-free framework. Keywords Interest, Usury, Islamic Finance, Islamic Banking, Financial Intermediation, Economic Justice 1. Introduction Besides Islam, interest is also prohibited in all monotheist religions (See Exodus 22:25, Leviticus 25:35-36, Deuteronomy 23:20, Psalms 15:5, Proverbs 28:8, * Salman Ahmed Shaikh is a Research Associate & Faculty member at IBA, Karachi. He heads Islamic Economics Project. He can be contacted at: salmanashaikh@iba.edu.pk 50 Journal of Islamic Banking and Finance Oct Dec. 2012

51 Nehemiah 5:7 and Ezakhiel 18:8,13,17 & 22:12). Even in secular literature, one finds criticism on interest. Aristotle ( BC) in his book Politics criticized interest in following words Of all modes of getting wealth, this is the most unnatural". Thomas Acquinas in Summa Theologica writes: To take usury for money lent is unjust in itself, because this is to sell what does not exist, and this evidently leads to inequality which is contrary to justice. He further explains that money was invented chiefly for the purpose of exchange and consequently the proper and principal use of money is its consumption or alienation whereby it is sunk in exchange. Hence, it is by its very nature unlawful to take payment for the use of money lent. He reasons that: Just as man is bound to restore ill-gotten goods, so is he bound to restore the money which he has taken in usury. In modern economics too, we find criticism on interest. Keynes (1936, p. 377) in his treatise General Theory of Income, Employment, Interest and Money stated: Interest to-day rewards no genuine sacrifice, any more than does the rent of land. The owner of capital can obtain interest because capital is scarce, just as the owner of land can obtain rent because land is scarce. But whilst there may be intrinsic reasons for the scarcity of land, there are no intrinsic reasons for the scarcity of capital. An intrinsic reason for such scarcity, in the sense of a genuine sacrifice which could only be called forth by the offer of a reward in the shape of interest, would not exist, in the long run, except in the event of the individual propensity to consume proving to be of such a character that net saving in conditions of full employment comes to an end before capital has become sufficiently abundant. But even so, it will still be possible for communal saving through the agency of the State to be maintained at a level which will allow the growth of capital up to the point where it ceases to be scarce. In one of his famous essay, Keynes (1932, p.358) argues: When the accumulation of wealth is no longer of high social importance, there will be great changes in the code of morals. We shall be able to rid ourselves of many of the pseudo-moral principles which have hag-ridden us for two hundred years, by which we have exalted some of the most distasteful of human qualities into the position of the highest virtues... But beware! The time for all this is not yet. For at least another hundred years we must pretend to ourselves and to everyone that fair is foul and foul is fair; for foul is useful and fair is not. Avarice and usury and precaution must be our gods for a little longer still. For only they can lead us out of the tunnel of economic necessity into daylight. Journal of Islamic Banking and Finance Oct Dec

52 2. Definition of Capital in Islamic Economics It will be worthwhile to discuss the difference between physical capital stock and financial and money capital. Physical capital stock includes human-made goods or produced means of production. In classical economics literature, capital takes different forms. A firm s assets are known as its capital, which may include fixed capital (machinery, buildings, and so on) and working capital (stocks of raw materials and part-finished products, as well as money). Financial capital includes money, bonds and shares. In classical economics, investment which increases the capital stock is also priced the same way as physical capital stock. Hence, classical economics considers rent on machine and interest on money as one and the same thing and the classical economics only attributes interest as compensation to all different classifications of capital generally. Money itself has no intrinsic value and is neither a rentable asset nor a tradable commodity as Islamic principles. If capital is combined with labor, it could produce profit, but if money alone is lent, the interest it earns is not permissible. Interest is neither a justifiable reward of money nor capital. Money holder/owner has to convert it in one of the factors of production namely 1) land with natural resource, 2) physical capital stock and/or 3) become an investing entrepreneur to have any justifiable compensation from the production process. Now, we discuss the issue of correct meaning of riba and whether it includes usury only or modern day interest too. In modern times, few scholars argued that there is a difference between interest and usury. Usury refers to the exorbitant rate of interest charged on consumption loans in olden times. Quranic reference to Riba is condemnation of this Usury that existed in those times. They further argue that the interest rate is competitively set price of use of financial capital determined in the market with the consent of buyers and sellers and is different from usury. However, the issue was clarified by the council of Islamic ideology s report in 1980 and later; a historic judgment on interest was issued by the supreme court of Pakistan (Usmani, 2007). The council s report stated: The term riba encompasses interest in all its manifestations irrespective of whether it relates to loans for consumption purposes or for productive purposes, whether the loans are of a personal nature or of a commercial type, whether the borrower is a government, a private individual or a concern, and whether the rate of interest is low or high (Council s Report, 1980, p.1). 3. Critique of Interest Based Financial Architecture 3.1 Critical Analysis of Economic Rationale for Interest Clary (2011) mentions that Scholastics recognized two cases that give title to legitimate interest. The first, cessant gain, represented the failure of the lender to receive what he would have gotten, had he not made the loan. The second, emergent loss, represented the direct costs to the lender when making the loan. Clary (2011) argues that in fractional reserve banking, banks create credit money out of thin air 52 Journal of Islamic Banking and Finance Oct Dec. 2012

53 and hence, they incur no direct cost as such. Briefly, we discuss these two and other reasons and their economic and legal rationale Is interest the price of risk? It is not right to say that lending money involves a risk. Because the lender gets interest in any condition, whereas businesses after taking risk either earn profit or incur a loss. The relevant risk that differentiates entrepreneurship and money lending is the risk of owning and possessing a risky tradable asset and taking the risk related to the asset, including price risk and sale risk Is interest the price of self-forgone needs? A lender lends a portion of his money that he doesn't need immediately. So, he is not forgoing his needs as his needs are already fulfilled. He is only lending the money that is in excess of his needs. The argument of opportunity cost is interesting and merits an explanation. If I have a job paying me $1,000 per month and I decide to leave it and complete my PhD. Then, the opportunity cost of going to do PhD is $1,000 of job income forgone for me. When I am considering the option of doing PhD, I must also bear in mind this opportunity cost along with fees and cost of books (out of pocket costs). Opportunity cost of an activity is the cost of best alternative forgone in its place. If, for example, I had another job option paying $500 per month, then, the opportunity cost of doing PhD will remain to be $1,000. It is because by not doing PhD, I would have taken one of the two jobs and I will have taken the one that pays me $1,000 over the one that pays $500. Then, the opportunity cost of doing PhD is $1,000 of job (best alternative of the two jobs) income forgone plus the out of pocket costs. Just like I cannot ask or force the university to pay me $1,000 each month for me to do PhD, similarly, the owner of capital cannot ask or force the borrower to pay him/her any stipulated increase over the principal amount in a loan transaction. Dempsey (1951, p ) comments on this argument as follows: This is analogous to saying that a workman should be paid for staying away from work because if he does not work, he does not get paid, and therefore, by staying home, he suffers a loss for which he deserves compensation Is interest the share in the profits of the borrower? Interest is not a share in the profit of the borrower because if money is borrowed for fulfilling needs rather than for conducting business, then, there is no question of a profit. But, even if money is lent for commercial purposes, then, how can we say that the business will be profitable. Businesses earn profit and incur losses, but why the investor doesn t share in the loss and what sort of an effort he has put in to demand a profit that is fixed and confirmed irrespective of the profitability of the business of the borrower. Journal of Islamic Banking and Finance Oct Dec

54 3.1.4 Is interest a rent on money? Those things on which rent is charged are used and returned back in the same existing condition like homes, cars etc. While money and other consumption goods are necessarily consumed during their use. When we borrow money, we consume it and regenerate it to repay the borrowed sum. When the money is consumed, the borrower has to regenerate it and the lender without taking any risk is entitled to receive the consumed money with the interest. Can we borrow apples or mangoes on rent? We can borrow hammer but not the nails based on the above classification. Watt (1945) explains this concept by giving an example. He argues that when a piece of bread is sold, the right of use is included in the sale. According to him, any baker would be extortionist who charged a customer a price to buy the bread and who then charged the customer for the right to eat it. 3.2 Problems in Circular Flow Model With Interest As per Islamic principles, within certain bounds, the market forces can operate and will determine which goods should be produced and offered at what price. Through private sector investment and production, resource markets and product markets will function to enable households to obtain purchasing power by providing factors of production like labor or land in the production process and earn compensation in terms of wage and rent, respectively. The difference from capitalistic system is that rather than having a fixed compensation, the capital will only earn share in actual profit/loss out of the production process in which it is used. Hence, the capital has to be used in some production process to earn its reward out of actual net payoffs arising from a production process. This will have positive effects on distribution of income as well as wealth. With no fixed compensation to capital and together with a tax on idle capital, the capital would be directed towards production activities enabling the households to get more employment opportunities rather than to rely on subsidies/poverty reduction grants etc. Redistribution of resources will be always progressive in nature i.e. wealth will flow from rich to the poor. Moreover, any capitalist would only earn profits in a competitive economy after taking part in the production process rather than just loaning out money and earn interest on it. Competitive nature of the economy which is not more than an assumption in a capitalistic system would be present and ensured through banning fixed return on capital, introducing direct tax on idle capital, having only lenient tax on productive income and reduced average cost of capital by disallowing fixed rate of interest on it. With an opportunity to share in profits, households will have an added benefit to not only gain purchasing power through provision of labor and land, but also through provision of capital and they can share in actual profits rather than earn just a fixed rate of interest which is negative in real terms in most developing countries. Since capital will not have fixed interest as compensation, the compensation to each factor would be linked with payoffs from the production process. Hence, the policy making will only have to look at boosting production. 54 Journal of Islamic Banking and Finance Oct Dec. 2012

55 Capital use in productive activities would increase rather than remaining idle and out of production process. Unlike in a capitalistic system, capital will not add a burden factor of interest on the production process. It will get compensation from the actual profits earned rather than adding to the cost of productive activities. Through the above features, efficiency as well as equity can both be adequately addressed and obtained without having to rely on force, exorbitant taxes, and unnecessary government intervention or to rely on unorthodox policies. 3.3 Distributional Inequity in Interest Based Finance Capitalism, the way it is practiced as an economic system, has largely allowed and provided legal cover to certain exploitative institutions and their operations based on free market philosophy. Such institutions have been chiefly responsible for much of the distributional inequity in the world today. Interest based financial system has resulted in increased concentration of wealth in the world. To put the matters in right perspective, income inequality even in OECD (Organization for Economic Cooperation & Development) countries is at its highest level for the past half century. The average income of the richest 10% of the population is about nine times that of the poorest 10% across the OECD, up from seven times 25 years ago. OECD countries represent developed world with sophisticated financial markets. High income inequality in OECD countries shows that more sophisticated the interest based financial system, more disturbed the income distribution will be and as various reports suggest, the high economic growth even in long term does not and has not improved income distribution and rather it has worsened income distribution. Past growth experience of Japan and USA or even recent growth experience of India and China has resulted in increased income inequality in these countries. Growth not only has failed to improve income distribution, but when it is obtained in presence of interest based financial system, the income distribution has worsened as the empirical evidence shows for these countries. Indeed, even in free market philosophy, we do not allow certain institutions which bring harm to the society and individual liberty. But, so far, we have turned limited attention towards critically evaluating the ever more intricate system of interest based financial intermediation in practice today and its negative externalities including pecuniary and otherwise. Having perfect markets leads to efficiency and economic welfare, but the institution of interest hampers potential investment by arbitrarily making capital scarce. It encourages concentration of wealth and creates a barrier in the way of use of funds in productive enterprise. Positive economics says that given an interest based investment opportunity; consider productive enterprise only if rate of return exceeds the market interest rate, but positive economics does not consider negative externalities, e.g. increased income inequality, poverty and below full employment use of real scarce resources resulting by artificially making capital scarce. No matter whatever is the initial distribution of wealth in society, interest based financial intermediation brings concentration of wealth eventually in every society by granting private right of fiat money creation to central bank and allowing fractional reserve system which gives right to private banks to create credit money. Journal of Islamic Banking and Finance Oct Dec

56 The disincentive to enter in entrepreneurial pursuits because of lack of willingness of capitalists to risk capital while having the opportunity to earn fixed interest income brings down investment in the economy. Decline in the potential investment in productive pursuits reduces real sector economic growth, keeps unemployment high and it adds burden on fiscal position of government to expend on transfer payments. Then, if more money is printed, it increases indebtedness and which can eventually result in a country paying major portion of its gross national income every year in the form of interest, which is the price of intrinsically valueless fiat money in a loan transaction. Furthermore, in terms of economic organization, interest based system also decreases competitiveness in the markets, resulting potentially in the loss of welfare, allocative and productive efficiency and by creating other ills associated with market imperfections. Chapra (2007) mentions another aspect that in an interest based relationship, the lender may tend to take risks which are not worthwhile if the arrangement was based on risk sharing basis. The fixed contractual compensation encourages less prudence, carelessness, unsound risk analysis and hence may contribute to losses and macroeconomic imbalances and crisis. Indeed, the frequency of the crises in recent past has increased alongside more sophisticated and complicated interest based financial architecture Negative Effects of Interest Based Loans on Development Most developing countries are going through a perpetual debt trap which takes away resources that could have been used on development, but instead are used to service compounded debt. Continent of Africa seems to be most affected by the debt crisis. Africa s debt stock in 1970 was $11 billion and Africa s debt stock in 2008 stood at $215 billion. Furthermore, Sub Saharan Africa receives $10 billion in aid but loses $14 billion in debt payments per year (Africa Action, 2008). Currently, Africa s total external debt stands at $300 billion. Many African countries spend more on debt than either on health or education. For example, Cameroon, Ethiopia, Gambia, Guinea, Madagascar, Malawi, Mauritania, Senegal, Uganda and Zambia all spent more on debt than on health in GNP per capita in Sub-Saharan Africa is $308 while external debt per capita stands at $365. Just to cite one example, Nigeria borrowed around $5 billion and has paid about $16 billion, but still owes $28 billion. Regrettably, 7 million children die each year as a result of the debt crisis. Ajayi & Oke (2012) found in an empirical study for Nigeria that external debt burden had an adverse effect on the per capita income and led to devaluation of the currency, increase in unemployment, social strife and poor educational system. Easterly (2002) presented the similar empirical evidence which shows a negative effect of indebtedness on growth. Explaining the evidence, he stated that the paradox of debt is that heavily indebted poor countries (HIPCs) became more heavily 56 Journal of Islamic Banking and Finance Oct Dec. 2012

57 indebted after two decades of debt relief efforts. He stated that even concessional financing, a form of debt relief also failed to reduce net present value of debt. According to him, the record is not encouraging for the success of current debt relief efforts. Cunningham (1993) collecting evidence for the period from 16 HIPCs found a significant negative relationship between the growth of debt burden and economic growth in these countries. It is not just Africa that is suffering from the debt crisis. Other developing regions are also having the same negative impacts. Malik et al. (2010) provided the empirical evidence for Pakistan s economy which shows negative and significant relationship of external debt with economic growth. Currently, Pakistan pays around Rs 1,000 billion in debt servicing. Most of the debt is of the nature of deadweight debt. About half of the tax revenue goes to the lenders in paying of interest. 4. Outline of a Financial Architecture Sans Interest 4. Time Value of Money & Islamic Standpoint In investment for trade (which Islam allows), the investment goes through the entire process of a commercial activity that involves risk taking at each stage and any compensation on investment is strictly dependent upon the outcome of the commercial activity. The profit for the businessperson strictly depends upon the actual profit realized after taking market risk including price risk. It does not depend upon time. Time value of money is the basis of interest. Time value of money is the problem for the investor to avoid keeping his/her money idle and to avoid forgoing the use of money that may bring positive value to his/her investment. However, it does not mean that the investor can demand an arbitrary increase (or is given as the case may be) as the cost of using money without taking the market and price risk. 4.2 Equity Over Debt Financing: The Islamic Perspective Increase in financial instruments through issuance in primary market does not add to Gross Fixed Capital Formation unless they are used in a way which increases the productive capacity of the economy. Islamic principles compliment the growth in Gross Fixed Capital Formation or productive capacity of the economy by encouraging entrepreneurship in productive sector. Taking on entrepreneurial risk is at the heart of Islamic economics. This risk can only be eliminated at the cost of compromising the basic distinctions of Islamic economic principles. Effective institutions are required to perform financial intermediation that promote entrepreneurial culture rather than circumvent it. Debt financing is a double-edge sword. Leveraged companies can magnify their returns in booms, but in slumps, they lose the edge and can even go bankrupt and make both their shareholders and creditors suffer. Journal of Islamic Banking and Finance Oct Dec

58 A simplified economic model will highlight the point that equity financing is less risky and better able to give profitable results in boom and in recession. In view of EMH (Efficient Market Hypothesis), profitability would be reflected in market prices. Table 1: Financial Statements of Non-Leverage Company Non-Leverage Company Assets Rs. (in millions) L + O.E Rs. (in millions) F.A 60 Debt 0 C.A 40 Equity 100 Total Assets 100 Total L + O.E 100 Case 1: Economic Boom Income Statement (Non-Leverage Company) Rs in mln Case 2: Economic Recession Income Statement (Non-Leverage Company) Rs in mln Net Sales 100 Net Sales 60 CoGS (70% of sales) 70 CoGS (70% of sales) 42 Gross Profit 30 Gross Profit 18 Operating Expenses 10 Operating Expenses 10 PBIT 20 PBIT 8 Interest Expense (12%) 0 Interest Expense (12%) 0 PBT 20 PBT 8 Tax Expense (20%) 4 Tax Expense (20%) 1.6 Net Income 16 Net Income 6.4 ROE 16% ROE 6.4% A simplified economic model will highlight the point that debt financing can provide better profitability ratios in booms but it is more risky to give profitable results in recession. Table 2: Financial Statements of Leverage Company Leveraged Company Assets Rs. (in millions) L + O.E Rs. (in millions) F.A 60 Debt 60 C.A 40 Equity 40 Total Assets 100 Total L + O.E Journal of Islamic Banking and Finance Oct Dec. 2012

59 Case 1: Economic Boom Income Statement (Leveraged Company) Rs in mln Case 2: Economic Recession Income Statement (Leveraged Company) Rs in mln Net Sales 100 Net Sales 60 CoGS (70% of sales) 70 CoGS (70% of sales) 42 Gross Profit 30 Gross Profit 18 Operating Expenses 10 Operating Expenses 10 PBIT 20 PBIT 8 Interest Expense (12%) 7.2 Interest Expense (12%) 7.2 PBT 12.8 PBT 0.8 Tax Expense (20%) 2.56 Tax Expense (20%) 0.16 Net Income Net Income 0.64 ROE 25.6% ROE 1.6% The model shows that in economic booms, leveraged companies are more profitable than non-leveraged companies, but in recessions, leveraged companies are less profitable and hence riskier than non-leveraged companies. Hence, leveraged companies are depending on the assumption that the economic boom will last indefinitely. Modigliani & Miller (1963) argued that value of a levered firm is greater than the value of an unlevered firm. The difference in value comes from the tax benefit accruing to a levered firm. But, they ignored the bankruptcy costs and the case where even if a company is solvent, the economy may go through a recession. Furthermore, if this tax benefit is provided to an unleveled firm by making dividends to be tax deductible; then, value of a levered firm may cease to have any extra value greater than an unlevered firm. When it comes to the use of debt financing in government operations, Zaman (2001) explained by citing Ricardian Equivalence that borrowing is not a new and different instrument for financing. It is only a method for pushing taxation forward onto later times. It results in not only irresponsible government, but also results in intergenerational injustice. The authors note that banning of interest based debt will encourage responsible government, by not giving them the option of saddling future governments and unborn generations with debt Nominal or Real Interest: Which is Unjust? Some economists argue that Islam has emphasized that in case of transactions involving credit, whether in the case of sale or financial debt, it is highly important that the returned article be absolutely identical to the one borrowed; otherwise there is a danger of interest being involved in the exchange. This principle can be applied Journal of Islamic Banking and Finance Oct Dec

60 to index financial loans in the inflationary or deflationary periods when the value of the amount returned undergoes either depreciation or appreciation compared to what it was when borrowed. In other words, the prohibition of Riba applies to real interest, not nominal interest, as with inflation a ban on the latter may result in negative real interest. This recommendation is a deviation from conventional thought, but following arguments can be raised against it. If this proposal is suggested at macroeconomic level in financial intermediation like in banking, then it is not practicable in the financial system. Indexing loans with inflation will not yield any return for the intermediary (the bank) in two-tier loan based banking (if indexing based on inflation is allowed in both the sourcing of funds i.e. taking deposits and use of funds i.e. lending). Inflation is measured by an index which has an urban bias, period bias and representation bias inherently. If indexation is permitted, we will have to index compensation to other factors of production e.g. wages, rent etc. Plus, inflation is just a measure and there are at least four varieties of inflation measure used by Pakistan Beareau of Statistics (Consumer Price Index, Wholesale Price Index, Sensitive Price Index and Producer Price Index). The results also depend on the statistical methodology. With interest discontinued from the financial system and if all loans are linked with inflation, then more the loans taken, more will be the credit money generation and more will be the rate of inflation. It will give rise to many serious problems: 1) Those who were neither the borrowers nor the lenders will be suffering from inflation. 2) In absence of the opportunity to manoeuvre interest rates for controlling money supply and inflation, the central bank will be incapacitated. Those who were neither the borrowers nor the lenders and are simply earning through wages will demand the same increase in wages. Is this going to be in anyway beneficial for borrowers who will be paying excess over principal (inflation rate) to the lenders and will also have to increase wages? Will they not want to increase the prices and hence inflation will further increase and hence their cost of borrowing too. Who will benefit from all this eventually? The lender! It is like giving him even more power than before and that too after incapacitating the central bank. 3) Cost-push inflation is driven by supply shocks, such as increase in oil prices, decrease in supply and hence increases in prices of electricity, gas etc. Therefore, deterioration in real purchasing power is caused by factors not in the control of the borrower. He cannot be held liable to compensate in a matter in which he was not responsible. The opportunity cost argument in this case, if accepted, will result in distributive injustice to the entrepreneur and if the same argument is taken by every person with investable resources, then, there will be no entrepreneur in the economy. 60 Journal of Islamic Banking and Finance Oct Dec. 2012

61 4.4. Pricing Financial Capital in Islamic Finance Now, we turn to the issue of how to price and compensate capital without using fixed payoffs. First, we mention few proposals by Muslim economists in this regard. In one study, Mirakhor (1996) derived the following formula to calculate the required rate of return for an unlevered firm. ρ = [Y/V](1 d + dq) Where, ρ = Required rate of return Y = Expected value of the firm s accounting earnings in the coming year; V = Present value of the unlevered firm. s = Expected stock financing rate as a fraction of the firm s earnings b = Expected firm s retention rate as a fraction of the firm s earnings d = s + b q = Tobin s q market value of capital divided by its replacement cost In another study, Haque & Mirakhor (1998) proposed a formula to calculate the investment rate of return. They classified government expenditures into i) asset creating and ii) non-asset creating activities. Non-asset creating activities can be financed through tax revenues. But, in asset creating activities, equity modes of financing can be used whereby financing would be generated by way of an instrument. As per their recommendation, this instrument would be priced using the formula: I = w 1 WI + w 2 PPI + w 3 LSI + w 4 ROG Where, WI = World Index LSI = Stock Index, a measure of market performance index based on ROE. PPI = Index representing average returns on commercial papers. ROG = Return on government investments and project. w 1, w 2, w 3 and w 4 are weights assigned to each variable. However, it must be noted that if the resultant rate is stipulated; then, it would be including opportunity cost. Two mutually exclusive equity financed projects cannot arbitrarily set to have same returns on the basis of opportunity cost. In practice, Islamic banks simply use interest based benchmarks like London Interbank Offered Rate (LIBOR), Kuala Lampur Interbank Offered Rate (KLIBOR) etc. The problem is the relevance of these with real economy. A uniform benchmark used for all types of financing transactions for any term whether it is Journal of Islamic Banking and Finance Oct Dec

62 leasing of house, car, consumer appliance, industrial equipment etc or the sale of these assets, is problematic to say the least. If Islamic banks want to pursue debt based financing, then, it makes sense to use the interest based benchmarks. Next, we discuss an alternate benchmark for Islamic finance industry which can be used in equity based financing contracts to rank investment projects. Hanif & Shaikh (2010) conducted equivalence of means test between Nominal GDP and Nominal Interest Rate and confirmed that in 12 out of 14 countries where Islamic finance is prevalent, the means of two variables were equal statistically at 1 percent level of significance. In corporate finance, Nominal GDP growth rate could be used in following valuation models to provide a quantitative mechanism to rank investment alternatives: 1. It will replace risk free rate in Capital Asset Pricing Model (CAPM). 2. Free Cash Flow (FCF) could be calculated using this benchmark rate. 3. It will enable ranking investment projects by Net Present Value (NPV) or Profitability Index (PI) approach. In project valuation, this benchmark rate could be used to find estimated intrinsic value of cash flows. This would be appropriate due to the following: II. I. We are using an enterprise or output related benchmark rather than interest based benchmark. The cash flows will be obtained using equity contractual modes like Mudarabah and Musharakah as underlying contracts. III. In this case, we are doing valuation for the investor and not for the Mudarib. Mudarib or capital deficient partner will not be obliged to provide the returns based on these valuations. But, the investor can use this indicative valuation to rank investment alternatives. Hence, in corporate finance, the instrument will have a different application. It will provide a quantitative mechanism to rank investment alternatives. In actual distribution of income using equity modes of financing, Profit Sharing Ratio (PSR) would be used and agreed upon at time (t) and applied to the actual gross profit earned in time period (t+1). Use of Nominal GDP is appropriate as it accounts for current market prices. We pay Zakat on market prices, we sell goods at market prices, and the actual return in money terms of any transaction in real economy also involves the use of current market prices. Plus, the required rate of return will be accounting for current purchasing power of money by incorporating inflation. In corporate finance, it is not recommendable to use this nominal GDP growth rate as a stipulated return in an underlying loan transaction. The proposal presented here does not provide a benchmark that will become a 'stipulated rate' for all transactions. It will not be an obligatory rate of return to be used in intertemporal 62 Journal of Islamic Banking and Finance Oct Dec. 2012

63 exchange of money capital. It is just a tool to be used by individual parties who want to use the equity based financing contract to assess their positions and payoffs and come up with some initial profit sharing ratio for further bargaining. By using NPV, FCF or CAPM etc or any other models, Nominal GDP growth rate could be used as a discount rate to rank investment projects. For example, if a project ranked 1 is most preferable for investment, so the Rabb-ul-Maal (investor) could prefer to enter into that contract with a slightly lower PSR. A project ranked 10 is least preferable for investment, so the Rabb-ul-Maal (investor) could prefer to enter into that contract only with a slightly higher PSR. Ranking would be facilitated by using Nominal GDP as shadow price of capital in financial valuation models. The two other proposals mentioned at the start of this section can also be used as long as these are not used as stipulated rates in intertemporal exchange of capital in a loan transaction. The merit of these and other proposals will be rested on the criterion that how well they remain close to the actual returns in the particular sectors and overall economy. 5. Concluding Remarks Interest as a system of allocation of resources ensures a fixed return for one and variable and uncertain for another. In contrast, Islam encourages equity financing in which the loss/profit would be shared. This ensures better results from the perspective of redistribution and better co-operative behavior since payoffs for all parties are linked with productive sector of the economy. Consequently, markets will not have to produce speculative surplus output just to service exorbitant amount of debt and that could stabilize business cycles. Islam by prohibiting interest eliminates one important source of distributive injustice (Chapra, 1984). But, it does so in a just manner by allowing all people with capital and labor or one of these to contribute in productive enterprise and earn the rewards out of actual return on productive enterprise. References Africa Action (2008). Campaign to Cancel Africa s Debt, Retrieved from: Ajayi, L. Boboye & Oke, M. Ojo (2012). Effect of External Debt on Economic Growth and Development of Nigeria. International Journal of Business and Social Science, Vol 3 (12), pp Aristotle ( BC). Politics, translated by Benjamin Jowett, with an introduction by Max Lerner, republished in New York: The Modern library. Chapra, M. Umer (1984). The Nature of Riba in Islam. Hamdard Islamicus, Vol 7 (1), pp Chapra, M. Umer (2007). The Case Against Interest: Is It Compelling? Thunderbird International Business Review, Vol 49 (2), pp Clary, J. Betsy (2011). Institutional Usury and the Banks. Review of Social Economy. Vol. LXIX (4), pp Journal of Islamic Banking and Finance Oct Dec

64 Cunningham, Rosemary T. (1993). The Effects of Debt Burden on Economic Growth in Heavily Indebted Developing Nations. Journal of Economic Development. Vol. 18 (1), pp Dempsey, B. (1951). The Usury Element in Inflation. Review of Social Economy, Vol 9 (1), pp Easterly, William (2002). How Did Heavily Indebted Poor Countries Become Heavily Indebted? Reviewing Two Decades of Debt Relief, World Development, Vol 30 (10), pp Hanif, Nadeem & Shaikh, Salman (2010). Central Banking & Monetary Management in Islamic Finance. Journal of Independent Studies and Research, Vol 8 (2). Haque, Nadeem-ul & Mirakhor, Abbas (1998). The Design of Instruments for Government Finance in an Islamic Economy. International Monetary Fund. IMF Working Paper, WP/98/54. Keynes, John M. (1936). Theory of Income, Employment, Interest & Money. New York: Polygraphic Company of America. Keynes, John M. (1932). Economic Future of our Grand Children. Essays in Persuasion New York: Harcourt Brace. Malik, Shahnawaz, Hayat, M. Khizer & Hayat, M. Umer (2010). External Debt and Economic Growth: Empirical Evidence from Pakistan. International Research Journal of Finance and Economics, Issue 44, pp Mirakhor, Abbas (1996). Cost of Capital and Investment in a Non-Interest Economy. Islamic Economic Studies, Vol 4 (1), pp Modigliani, F. & Miller, M. (1963). "Corporate Income Taxes and the Cost of Capital: A Correction". American Economic Review. Vol 53 (3), pp St. Thomas Aquinas, Summa Theologica, trans. Fathers of the English Dominican Province, (London: R. T. Washburne, Ltd., 1918), pp , reprinted in Roy C. Cave & Herbert H. Coulson, A Source Book for Medieval Economic History, (Milwaukee: The Bruce Publishing Co., 1936; reprint ed., New York: Biblo & Tannen, 1965), p. 182 The Council of Islamic Ideology (1980), Report on Elimination of Interest from the Economy, Government of Pakistan. Usmani, Muhammad Taqi (2007). Historic Judgment on Interest. Karachi: Maktaba Ma ariful Quran. Watt, L. S. J. (1945). Usury in Catholic Theology, Oxford: Catholic Social Guild. Zaman, Arshad & Zaman, Asad (2001). Interest and the Modern Economy. Lahore Journal of Economics. Vol 6 (1), pp Journal of Islamic Banking and Finance Oct Dec. 2012

65 THE ANALYSIS OF SHARIAH BANK EFFICIENCY LEVEL IN INDONESIA: A Comparison Between The Intermediary Approach And Production Approach. By 1. Muhamad Nadratuzzaman Hosen 2. Muhammad Dadi Sutisna * Abstract The objective of this study is to measure the efficiency level of Shariah banks and to investigate the determinant factors which influence the level of efficiency. In terms of scope of the research. Shariah banks included in this research are all full-fledged Shariah banks and Shariah windows of conventional banks in Indonesia. The time frame of this research was during the period of , the data used in this research are the data of published annual report of the financial statements (balance sheets and income statements) of Shariah banks in Indonesia. This research applies stochastic frontier approach (SFA) which is well known as parametric approach to measure efficiency using panel data of multiple inputs and outputs. The result of this research is that the efficiency of Shariah banks using the intermediary approach for the period of has decreased each year. While the level of efficiency of Shariah banking using the production approach during the period of fluctuated each year. Keywords: efficiency, SFA, intermediary approach, production approach. 1. Introduction 1.1. Situation Shariah banking system in Indonesia has been developing from time to time since its first establishment. The rapid growth is contributed by some factors, among others are: Indonesia is a country having mostly Muslim population and also there is a better regulatory framework for the Shariah banking businesses. * 1. Muhamad Nadratuzzaman Hosen 2. Muhammad Dadi Sutisna Faculty of Shariah and Law, State Islamic University of Syarif Hidayatullah, Jakarta, Indonesia Journal of Islamic Banking and Finance Oct Dec

66 Although the market shares is very low compared to its conventional counterpart, the Shariah banking market share was 2.14% of the total of our National Banking market share in The need for an inquiry on the efficiency level of Shariah banks arose in view of the above mentioned condition? Is it the lack of profit-sharing financing which could affect the efficiency level of Shariah banking system as a whole? Considering that the efficiency is a measuring tool for the performance parameters, one of the performance measurements in evaluating the entire performance of a company, including banking system Identifications of Problem The Major issues of this research are: 1. How significant are the efficiency level of Shariah banks in Indonesia for the period of using the method of Stochastic Frontier Approach? 2. Which factor has the greater influence on the efficiency level during that period? 1.3 The Objective of the Research: The Objective of this reasearh is to reveal: a. The Level of efficiency of Shariah banks in Indonesia for the period of using the method of Stochastic Frontier Approach. b. Which Factor has the greater influence for the level of efficiency of Shariah bank in Indonesia during that period? 2. References: 2.1 Shariah banks Antonio and Perwataatmadja have given two definitions of shariah bank: a bank that operates as in line with the shariah principles, and a bank in which its system and procedure is directed by the set of orders contained in the holy Qur an and Hadist. 1 As the financial intermediary which facilitates the need of the surplus unit and deficit unit, a bank is related to the macroeconomic condition, therefore the efficiency is happening only if it will affect the entire economic system. Bank Efficiency is not just as an important indicator in the banking system but it is as an important mean to increase the affectivities of monetary regulations. The efficiency of banking system is predicted it will speed up the process of monetary regulatory transmission in which the monetary regulatory will effectively aim its targets. Furthermore, there is an opinion that if the banks do not act optimally and efficiently as a financial intermediary, the expectation from Bank Indonesia as the 1 Perwataamadja, Karnaen., dan Antonio, Muhammad Syafi i., 1992, Apa dan Bagaimana Bank Islam?, Yogyakarta: Dana Bakti wakaf. 66 Journal of Islamic Banking and Finance Oct Dec. 2012

67 Central Bank concerning the relations of Policy Instrument and performance of the economic condition, it will probably not run well, in which it was expected that shariah bank will have more activities in production sectors, or real sectors. 1 As part of the national banking system, although the market share is considered to be relatively low, Shariah banking system has imperative roles in our national economic activities. Therefore the efficiency from Shariah banking will affect our national economic activities; in addition, our Shariah banking system, currently has more activities in production sectors The Efficiency Concept The concept of efficiency pertains to the relationship between output and input; hence efficiency is a ratio between output and input. There are three factors which cause the efficiency: (1). When the input could produce the greater output; (2) The smaller input could produce the same amount of output; (3) The greater input could produce the greatest output. 2 There are two type of efficiency: Cost efficiency and profit efficiency. Berger and Mester (1997) stated that there are three imperative economic efficiencies which divided the Profit efficiency into three classess such as cost efficiency, standard profit efficiency, and alternate profit efficiency. a. Cost Efficiency This concept measures the level of total cost that spent by a bank, compared with the total cost of the best practice bank to produce the same amount of output in the same condition. b. Standard Profit Efficiency This concept uses the profit variable in replacing the cost variable. This concept is to measure how similar is the bank compared to the maximum profit which probably earned in certain level with the input and output pricing. c. Alternative Profit Efficiency This concept is useful when there are some assumptions which are basics of the first two concepts are not optimum. This concept is measuring how similar is a bank to earn a maximum profit with certain level of output, not the pricing of the output. Profit efficiency is more senior compared to Cost Efficiency, with the arguments: a. Profit efficiency - Profit efficiency calculates the inefficiency from both input and output. On the other hand cost efficiency is more toward the input although 1 2 Astiyah, Siti., dan Husman, Jardine A., 2006, Fungsi Intermediasi dalam Efisiensi Perbankan di Indonesia: Derivasi Fungsi Profit, Buletin Ekonomi Moneter dan Perbankan, Vol. 8, No. 4. Ghafur, Muhammad., 2007, Potret Perbankan Syariah di Indonesia Terkini: Kajian Kritis Perkembangan Perbankan Syariah, Yogyakarta: Biruni Press. Journal of Islamic Banking and Finance Oct Dec

68 the inefficiency of the output has a probability of the same or bigger from the input inefficiency. b. In the economic concept, thus the profit efficiency is more acceptable, for example: a bank required additional cost for Rp. a to earn Rp. b (whereas b>a) and the other variables are constants, therefore in economic concept the profit efficiency is more acceptable than cost efficiency. c. Cost efficiency - The foundation of Cost efficiency is based on minimum cost on a level of certain output, although the level of output mentioned is not necessarily on the optimum output level. Based on the opinion of the professionals above mentioned, this research will use a concept of alternative profit efficiency, which is the most suitable concept considering the Indonesian shariah banking market is more toward the imperfectly competitive market, in which one of the characters is that the bank has the power to determine the pricing level and services to obtain certain level of output Efficiency Measurement In evaluating or measuring the efficiency of a bank, there are two approches that are common such as: traditional approach and frontier approach or commonly known as frontier efficiency. Traditional approach is an approach to compare the financial ratio of a bank, while the frontier efficiency is an approach that combines the assets (input-output) in certain standard measurement (frontier). The measurement of the efficiency using the frontier efficiency can be done by two methods: Parametric and non parametric methods. The Parametric methods consist of Stochastic Frontier Approach (SFA), Distribution Free Analysis (DFA) and Thick Frontier Analysis (TFA). From all three, the SFA is most commonly used for the previous researches. In the meantime the Non-Parametric method consists of Data Envelopment Analysis (DEA) and Free Disposal Hull (FDH). As with the SFA, the non-parametric of DEA is the most commonly used in previous researches. This research will use the Parametric SFA which has the excellent result compared to DEA. 3. The Methods of research 3.1 Resources and Data Collecting Techniques This research using secondary data, in the form of Shariah bank financial reports published by Bank Indonesia and literature related to the banking efficiency. The source of data for this research is Bank Indonesia as an authorized institution to publish all banks and Shariah banks financial reports, literature and other documents pertaining to the efficiency. Data gathering technique used in this research is in the form of desk research (by studying the relevant documents) and observation. In desk reasearch technique, the researcher acquired all the data by analysing the financial reports of Shariah banks which was published by Bank Indonesia, by visits or browsing the web site of Bank Indonesia. Other than that, in this technique, data gathering has been done by analysing the other sources of documents such as books, journals, and other research 68 Journal of Islamic Banking and Finance Oct Dec. 2012

69 documents pertaining to the banking efficiency. In observation technique, the researcher had made some visits to banks whose financial report had not yet appeared on the Bank Indonesia s website Population, samples and research samples This research includes all banks that operate based on the shariah principles, that is the full-fledged shariah banks, shariah windows, shariah banks for rural areas, by using the technique of the sampling purposive. The result was that 21 shariah banks qualified to be included for this reasearch, the criterion was their being fullfledged banks and shariah windows which were established before or in 2006 and have produced quarterly financial reports from March 2006 all the way through December Method of Data Analysis In this method, we use the quantitative analysis method that is to process data in the form of input and output taken from the general ledger, income statement, Profit and Loss statement of each bank. In this quantitative analysis, in order to calculate the level of efficiency, the researcher using the method of Stochastic Frontier Approach, the process was using the software FRONTIER v In order to see the factor which has the greater influence on the level of efficiency, the researcher is using the F and t tests whereas the calculation is done by using software SPSS 17, and supported by software ms.excel Stochastic Frontier Approach (SFA) SFA was developed for the first time by Aigner, Lovell and Schmidt. This method is a regression approach which specifically includes error to be distributed normally and the inefficiency component assumption to follow half normal distribution. This methods is Stochastic which mean that it has the capability to capture random shock occurred in a function for an error model from the factor outside the models. The calculation of Profit efficiency using the alternative profit efficiency approach, in the SFA methods has the function of alternative stochastic profit frontier in a log, as follows: ln πn = ƒ (ln wj,n,ln yi,n) + ε n where π n is the total profit of bank n, w j,n is the pricing input of bank n, y i,n is the pricing output i of bank n and ε n the error term which consist of two components: ε n = u n + v n where u n is the controllable factors and v n the uncontrollable factors (random). It is assumed that v normaly distributed, N(0,σ 2 v ) and u is half-normal, distrbuted N(0,σ 2 v ) where u nt = (u n exp (-h(t-t))) 3 and h is the estimated parameterization. In the alternative profit efficiency approach, bank will maximize its profit by determining ouput pricing, p, and the total amount of input, x, to obtain certain Journal of Islamic Banking and Finance Oct Dec

70 output, y, and input pricing, r, which is constant. The function of matching indirect profit is called indirect profit alternative function which is the solution of the optimum issues as follows: (Astiyah dan Husman, 2006) Maxπ = P Q = (p,r)(y,-x) In line with this matter, for example the alternative profit function is as follows: logπ = ƒ (w,y) + log u + log v thus alternative profit efficiency can be represented as follows: ^ ^ π b exp [ f π (w b, y b ) + ln(û πb )] û πb Π ALT EFF b = = = ^ π ^ ^ max exp [ f π (w b, y b ) + ln(û max )] û max as it has been explained before that the calculation of efficiency level is using the software FRONTIER v in which manual calculation is no longer needed Input-output Identification The concepts which are used to define the relations of input and output in the activities of the financial institutions in parametric and non parametric methods are using the production approach, the intermediary approach, and the asset approach). 3 The production approach is to see the fiancial institutions as the producer of deposit account and loans. This approach defined the output as the total amount of those deposits or related transaction. The input is calcualted based on the number of the human resources, the expenditure from the working capital and fixed assets and other matters. Intermediary approach has foreseen the financial institutions as the intermediary for modifying and transferring financial assets from surplus unit to the deficit unit. The input of the institution is in the form of employee s expenditure and working capital and payment of interest of deposits, with the output measurement in the form of loans and financial investments. The asset approach has visualized the prime function of the financial institution as the loans creator, similar to the intermediary approach where the output is defined in the form of assets. In this research the writer is using the production and intermediary approach. In the production approach the total operating income is utilized as the output and the employees expenditure and other expenditure is utilized as the input. In the intermediary approach the fixed assets variable, deposits and employees expenditures are utilized as the input and the financing and other income is utilized as output Regression Model As it has been mentioned above the research is using two kinds of approaches in determining the input and output variables, thus the regression model consist of regression model with intermediary approach and regressiom model with production approach, as follows: a. The Regression Model with Intermediary Approach: 3 Hadad, Muliaman D., dkk., Desember 2003, Analisis Efisiensi industri Perbankan: Penggunaan Metode Nonparametrik Data Envelopment Analysis. 70 Journal of Islamic Banking and Finance Oct Dec. 2012

71 EFF = a + b 1 ln AT + b 2 ln TS + b 3 ln BTK + b 4 ln TPP + b 5 ln PL + ε n Whereas EFF is the shariah banking efficiency, AT is fixed asset, TS is total deposits (DPK), BTK is human resources cost, TPP is the total of receivable and financing, PL is other income. Regeression Model with intermediary approach: EFF = a + b 1 ln TPO + b 2 ln BTK + b 3 ln BNTK + ε n Whereas EFF is the shariah bank efficiency, TPO is the total operations income, BTK is the human resources cost and BNTK is other cost. 4. Analysis and discussion 4.1 The level of shariah banking efficiency analysis with intermediary approach Table 1. The average level of efficiency Shariah banking with Intermediary approach Year 2006 Year 2007 Year 2008 Yearly average Average 95% 84% 81% 87% From the above table we could see that in 2006, the level of efficiency of shariah banking had reached 95% or in other words the in-efficiency of shariah banking in average was around 5%. In year 2007, the level of efficiency of shariah banking had declined by 11.58% from the previous year to 84%. In that year the level of in-efficiency of shariah banking in average was around 16%. In year 2008, just like the previous year, the level of efficiency of shariah banking declined to 81% or in other words the level of in-efficiency was around 19%, or 18.75% more than the previous year. From the above discussion we could see that the level of efficiency of shariah bank has been declining for the period of Or in other words, the intermediary function which should have done well by shariah bank has been falling off every year. Although it is falling off every year, we could see that the efficiency level of shariah banks in yearly average is 87% which is high, we may say that shariah banks could still be relied upon as the intermediary institutions The level of efficiency of shariah bank using production approach Table 2. The average efficiency level of shariah bank using production approach. Year 2006 Year 2007 Year 2008 Yearly average Average 15% 64% 18% 32% Journal of Islamic Banking and Finance Oct Dec

72 In year 2006, the average of effieciency level of shariah bank reached 15%. It is indicated that for the period of 2006, shariah bank had the average of in-efficiency of 85%. In year 2007, the efficiency level of shariah bank had been increasing, 400,67% from previous year, to 64%. Thus, that year the in-efficiency level of shariah bank declined for the average of 36% or to 42,35% from the previous year. Right after the increment of 400,67% in 2007, the level of efficiency of shariah bank is declining once again in 2008, in which that year shariah bank experienced the inefficiency of 82% or has experienced the efficiency of 18%. The differences in using the intermediary approach is that the efficiency level is falling off every year, the level of efficiency using the production approach has a tendency to fluctuate The rank of shariah bank efficiency using the intermediary approach In this section, it can be seen that the highest and the lowest shariah bank efficiency. Table 3. Efficiency level of shariah bank using the intermediary approach. Bank Code Yearly average % 94% 97% 95% 92% 93% 95% 96% 95% 95% 95% 94% 95% 97% 95% 91% 98% 95% 91% 98% 96% 86% 89% 92% 82% 92% 73% 90% 89% 90% 89% 89% 89% 88% 79% 69% 40% 97% 86% 83% 88% 91% 80% 87% 93% 95% 93% 64% 86% 75% 90% 88% 88% 89% 87% 82% 54% 54% 87% 66% 79% 74% 84% 86% 90% 94% 91% 92% 77% 90% 87% 92% 91% 91% 91% 90% 86% 73% 62% 94% 82% 84% 87% 90% Average 95% 84% 81% 87% 72 Journal of Islamic Banking and Finance Oct Dec. 2012

73 4.4. Efficiency Rank using production approach This section will show the highest and lowest level of efficiency of Shariah banks. Table 4.The Level of Efficiency of Shariah banks using the Production approach Bank Code Year 2006 Year 2007 Year 2008 Yearly average % 96% 73% 14% 84% 24% 16% 18% 16% 16% 16% 13% 17% 10% 84% 46% 26% 19% 12% 13% 70% 65% 65% 73% 62% 64% 64% 64% 64% 64% 64% 64% 64% 64% 62% 59% 59% 68% 65% 63% 64% 64% 23% 20% 31% 12% 21% 16% 19% 18% 22% 20% 20% 19% 19% 18% 61% 20% 11% 24% 11% 18% 26% 35% 60% 59% 29% 56% 35% 33% 33% 34% 33% 33% 32% 33% 30% 68% 42% 35% 36% 29% 32% 53% Average 15% 64% 18% 32% Table 5.Summary of efficiency level and Rank of efficiency of Shariah banks for the period of Intermediary approach Production approach Year 2006 Year 2007 Year 2008 Yearly average year 2006 Year 2007 Year 2008 Yearly Average Average 95% 84% 81% 87% 15% 64% 18% 32% The highest Rank of Efficiency (Bank Code) The Lowest Rank of efficiency (Bank Code) 98% (17 and 20) 91% (16 and 19) 97% (17) 40% (16) 95% (4) 54% (15 and 16) 94% (3 and 17) 62% (16) 96% (2) 10% (14) 73% (3) 59% (15 and 16) 61% (15) 11% (17 and 19) 68% (15) 29% (4 and 19) Using Table 3, 4 and 5, it can be seen that the differences of efficiency between intermediary approach and production by year to year among banks. Journal of Islamic Banking and Finance Oct Dec

74 4.5. The Analysis Regression Model using the Intermediary approach a. Classical Test Assumption The results of test show that this model has fulfilled the normal assumption and there is no problem with heterocedasticity, autocorrelation and multicollinearity. b. Variable Test 1) F Test Model ANOVA b Sum of Squares df Mean Square F Sig. 1 Regression a Residual Total a. Predictors: (Constant), ln_pl, ln_at, ln_ts, ln_btk, ln_tpp b. Dependent Variable: eff When df 1 = 5 and df 2 = 174, F-Table is 2,21, where F calculates (= 114,306) > F -table (= 2,21). When Significant 0,000 < 0,05, we could say that the fixed assets variables, total deposits, human resources cost, total receivables and financing, and other income are affected simultaneously to the level of efficiency of the Shariah banks. 2) t test By using two ways test, thus α/2 = 0,05/2 = 0,025, where df = n 2 = 177, t- table is for 1,96. Fixed Assets, with t-calculation (= - 2,632) < t- table (= -1, 96) statistically this variable is significant against the level of efficiency of Shariah banks. Thus the Fixed assets variable is still has a negative influence against the level of efficiency of Shariah banks. Total Deposits, by calculating the t- (= 2,238) > t-table (= 1, 96) statistically this variable is significant against the level of efficiency of Shariah banks. Therefore the total deposits variable is significant against the level of efficiency of Shariah banks. Hence the total deposit has a negative influence against the level of efficiency of Shariah banks. The human resources cost, by calculating the t (= 3,185) > t-table (= 1, 96) statistically this variable is significant against the level of efficiency of Shariah banks. Consequently, the human resources cost variables have a positive influence against the level of efficiency of Shariah banks. The total of receivable and financing, using the t- calculations (= 3,466) > t- table (= 1, 96) statistically is significant against the level of efficiency of Shariah 74 Journal of Islamic Banking and Finance Oct Dec. 2012

75 banks. As a result the total receivable and financing has a positive influence against the level of efficiency of Shariah banks. Other opinions, by using t-calculation (= 2,241) > t-table (= 1, 96) statistically this variable is significant against the level of efficiency of Shariah banks. Thus, the other income variable has a positive influence against the level of efficiency of Shariah banks. 3) Coefficient Determinant test Based on the summary of the table model above, it is shown that the coefficient value and Determinant value is 0,767 or 76, 7 %. It indicates that the level of efficiency of shariah banks for the period of it is clear that the variables of fixed assets, total deposits, human resources cost, total financing and other income for 76,7 %, while the remaining of 23,3 % is elucidated by other factors which are not included in the model. By using the relatively high coefficient determinant, we could say that the regression model has fulfilled the assumption of Goodness of Fit Analysis of the Regression Model Based on the above coefficients Table, thus the form of the regression model is as follows: EFF = - 2,316 0,216 lnat + 0,165 lnts + 0,298 lnbtk + 0,601 lntpp + 0,082 lnpl + ε n Interpretation: a. The constant value of -2,316 has shown that when there is no constant variable, the total deposit, human resources cost, total financing and other income, as a result, the Shariah banks will experience the inefficiency of 231,6 %. b. The Regression coefficient of -0,216 (fixed assets variable) has shown that if the fixed assets increase by 100%, then the Shariah bank will experience the inefficiency of 21, 6 %. c. The Regression Coefficient of 0,165 (Total Deposits variable) has shown that if the total deposit increase by 100 %, then the shariah banks efficiency level will increase by 16,5 %. d. The Regression Coefficient of 0,298 (Human Resources Cost) has shown that if the cost of human resources increase by 100 %, then Shariah bank efficiency level will increase by 29,8 %. e. The Regression Coefficient of 0,601 ( total receivable and financing variables) has shown that if the total of receivable and financing increase by 100%, then the Shariah bank efficiency level will increase by 60,1 %. f. The Regression Coefficient of 0,082 (other income variable) has shown that if other income is shown the increment of 100%, then Shariah bank efficiency level will increase by 8, 2 %. Journal of Islamic Banking and Finance Oct Dec

76 Hence, it is shown that the dominant factors that influence the level of efficiency of Shariah banks using the intermediary approach are the total receivable and financing variables. The summary of regression model analysis using the intermediary approach is as follows: Table 6. Summary of regression model analysis Variables Coefficient Influence (-/+) Influence Value Fixed Assets 0,216 Negative 21,6% Total Deposits 0,165 Positive 16,5% Human Resources Cost 0,298 Positive 29,8% Total Receivable and 0,601 Positive 60,1% Financing Other Income 0,082 Positive 8,2% 4.7. Regression Model Analysis using the Production approach a. Classical Assumption Test The results of the test show that this model has fulfilled the normal assumption and there is no problem with heterocesdaticity, autocorrelation and multicolinearity. b. Variable Test 1) F test ANOVA b Model Sum of Squares df Mean Square F Sig. 1 Regression a Residual Total a. Predictors: (Constant), ln_bntk, ln_btk, ln_tpo When df 1 = 3 and df 2 = 197 and F- table is for 2, 60. Thus the F calculates (= 218,935) > F table (= 2, 60). With significant point of 0,000 < 0,05, it is said that the variables of total operating income, human resources cost and other costs simultaneously affect the level of efficiency of Shariah banks. 2) t- test By using the two ways test, thus α/2 = 0, 05/2 = 0,025, when df = n 2 = 198, t-table is for 1, 96. Operating income, human resource cost and other costs are significant on t-test. 3. Determinant coefficient test It is shown that the value of determinant coefficient is 0,769 or 76, 9%. This means that this level of efficiency of Shariah banks for the period of is supported by the operating income, human resources cost and other cost for 76,9%, 76 Journal of Islamic Banking and Finance Oct Dec. 2012

77 the remaining of 23,1% is supported by other factors which are not included in the model. The higher value of determinant coefficient mentioned above shows that this regression model has fullfilled the assumption of Goodness of Fit Regression Model Analysis Based on the coefficient table mentioned above, the form of regression model is as follows: Interpretations: EFF = - 1, ,641 lntpo - 0,436 lnbtk - 0,369 ln BNTK + ε n 1. The constant value of 1,325 shows that if there is no variable for total operating income, human resources cost and other cost, Shariah banks will experience the inefficiency of 132, 5%. 2. The coefficient regression of 1,641 (total variable) has shown that if the total of operating income increases by 100%, shariah bank efficiency level will increase to 164, 1%. 3. The coefficient regression of -0,436% (human resources cost variable) has show that if the human resources cost variable increased by 100%, thus Shariah banks will experience the inefficiency of 43, 6%. 4. The coefficient regression of -0,369 (other cost variable) has shown that if the other cost increases by 100%, then shariah banks will experience the inefficiency of 36, 9%. Therefore it is shown that the dominant factor that influences the level of efficiency of Shariah banks using the production approach is the total operating income. The table that shows the summary of analysis of regression model using the production approach is as follows: Table 7. Summary of the Regression Model Analysis using production approach Variable coefficient influence (-/+) Influence value Total 1,641 Positive 164,1% Human Resources Cost -0,436 Negative 43,6% Other Cost -0,369 Negative 36,9% When we compare both regression models, it is shown that the production approach is more logical and almost real. It is based on the illogical matters which are included in the regression model using the intermediary approach in which the value of negative coefficient variable of fixed income and the less influenced variable of total deposits against Shariah banks efficiency level using the intermediary approach. The negative value of coefficient of the fixed income variable has shown that the variable has the negative influence against the Shariah bank efficiency level to Journal of Islamic Banking and Finance Oct Dec

78 use the intermediary approach. It has indicated that if this variable increases, then Shariah banks will experience the inefficiency. This is of course not logical, in which the fixed income should have a positive influence of efficiency level on Shariah banks using the intermediary approach. The small influence of total deposits variable againts the level of efficeincy using the intermediary approach is 16,5%, which was unlogical, in which the variable should have the greater influence to the level of efficiency of shariah banks using hte intermediary approach. As we are aware that in doing its function as an intermediary institutions, as the facilitator betwen the surplus spending unit and deficit spending unit, shariah bank depends upon two major components in doing its intemediary function, such as Total Deposits and Total receivable and financing to be distributed to the society. Therefore it is shown that as one of the major components of the intermediary function, the component of total deposits should have a greater influence against the efficiency level of shariah banks by using the intermediary approach. On the other hand, the influence from the total deposits variable has shown that there are some other factors that are happening in shariah banks, whereas not all total deposits are utilized for its major function, but they are utilized for other function such as placement in Shariah banks in the form of SBIS (Syariah money market instruments) with Bank Indonesia and other banks and other shariah money market instruments. 5. CONCLUSSION AND RECOMENDATION 5.1. Conclusion In the yearly average of efficiency level of shariah banks using hte intermediary approach was 87%, whereas the highest average of efficiency level was in 2006, which was 95% and the lowest average of efficiency level was in n 2008, which was 81%. In the meantime, the yearly average of efficiency level of shariah banks using the production approach was 32%, whereas the highest average of efficiency level in 2007 was 64% and the lowest average of efficiency level was in 2008 it was 15%. a. In general, the efficiency level of shariah banks using the intermediary approach for the period of has been decreasing every year. Yet, the level of shariah banks efficiency using the production approach for the period has fluctuated every year. b. Therefore, we could conclude that the increasing number of networking and operational offices of shariah banks during in general is not in line with the efficiency level that they have performed. c. The research hypothesis that said the variables of fixed income, deposits, human resources cost, total receivables and financing, and other income have a simoultaeous influence on the level of efficiency of shariah banks using intermediary approach is acceptable, in which the influence of those variables for the shariah banks efficiency level using the intermedairy approach is 78 Journal of Islamic Banking and Finance Oct Dec. 2012

79 76,7%. So did the research hypothesis which said that the variables of operating income, human resources cost and other cost have simoultaneous influence on the efficiency level of Islamic banks using the production approach is acceptable, in which the influence of those variables using the production approach was 76,9%. d. Based on partial testing ( t-test), it is known that those variables using the intermediary approach in general have influence on the efficiency level of shariah banks, using the intermediary approach, whereas the variables of receivable and financing have the greatest influence which was 60,1%. As with the partial test (t-test) for those variables using the production approach, it is known that those variables have influence on the efficiency level of shariah banks using hte production approach, whereas the total is the greatest influence variable which was 164,1%. e. Based on the comparison of the two types of regeression models, it is the conclusion is that the regression model of production approach is more logical and close to reality Recommendations a. For Central Bank Indonesia, looking at the efficiency level of Shariah banks using the intermediary approach which has been continuously falling off every year and the level of efficiency using the production approach which has fluctuated every year, it is recommended that Central Bank Indonesia as the monetary authority, should take affirmative action which could robust the level of efficiency of Shariah banks every year. b. For all bankers, please notify closely the variable of total receivable and financing and total since both output variable has a positive influence and dominant for the efficiency level of Shariah banks in general. c. For the next researcher, the analysis and result of this research should be in line with the opinion of the researchers, bankers or observers of the banking system, in order to have more comprehensive analysis. Considering that the research objects were not clasified, in which in this research the author is using the Islamic full fledged and shariah windows, the next action for the next researcher is to use the control variable such as the volume of asset. Although, the clasification is not based on type, better yet. All banks are assumed to have the same condition from one to the other. References Astiyah, Siti., dan Husman, Jardine A., 2006, Fungsi Intermediasi dalam Efisiensi Perbankan di Indonesia: Derivasi Fungsi Profit, Buletin Ekonomi Moneter dan Perbankan, Vol. 8, No. 4. Berger, Allen P., Loretta J.Mester (1997), inside the black box: what explain differences in the efficiencies of financial intitutions?, European Journal of operational research, vol 98. Journal of Islamic Banking and Finance Oct Dec

80 Ghafur, Muhammad., 2007, Potret Perbankan Syariah di Indonesia Terkini: Kajian Kritis Perkembangan Perbankan Syariah, Yogyakarta: Biruni Press. Hadad, Muliaman D., dkk., Desember 2003, Analisis Efisiensi industri Perbankan: Penggunaan Metode Nonparametrik Data Envelopment Analysis. Hidayat, Gatot Margali Putro., 2005, Pengukuran Efisiensi Biaya Bank-Bank yang Listing di BEJ dengan Metode Stochastic Cost Frontier, Skripsi, Departemen Manajemen-FEUI. Muhammad.2005, Manajemen Pembiayaan Bank Syariah, Yogyakarta: UPP AMP YKPN Nachrowi, Nachrowi D., dan Usman, Hardius., 2006, Pendekatan Populer dan Praktis EKONOMETRIKA untuk Analisis Ekonomi dan Keuanga, Jakarta: LPFEUI. Perwataamadja, Karnaen., dan Antonio, Muhammad Syafi i., 1992, Apa dan Bagaimana Bank Islam?, Yogyakarta: Dana Bakti wakaf. Santoso, Singgih., 2000, SPSS: Mengolah Data Statistik secara Profesional, Jakarta: PT. Elex media Komputindo. Winarno, Wing Wahyu., 2007, Analisa Ekonometrika dan Statistika dengan Eviews, Yogyakarta: Unit Penerbit dan Percetakan STIM YKPN. 80 Journal of Islamic Banking and Finance Oct Dec. 2012

81 Islamic Financial Products As Alternative To Riba In The Cooperative Sector In Nigeria By Bukhari Sikirullahi * ABSTRACT Economy is an integral part of life without which the latter cannot be meaningful. Islam s relevance to human life manifests in the kind of allowance it accords economy. In the contrast, Islam s kin interest in the elimination of all forms of injustice and cheating among its adherents and among mankind as a whole is justified in its condemnation of riba. The proliferation of Islamic Cooperative Societies in our society is an indication that Muslims are aware of the stand of Islam on riba. However, most of these societies are not familiar with the numerous lawful chances of investment Islam has. This paper, therefore, looks in to some Islamic financial products; their concepts, basis, scopes and relevance to modern day economy with particular reference to Cooperative Society. Keyword: Islamic financial Products, their Concept basis, Scopes and relevance to Modern day Economy with particular reference to Co-operative Society. Introduction: In Nigeria, cooperatives had been in existence even before the country could dream of independence. Its foundation was laid in the early 1930s with the enactment of the Cooperative Society Law in 1935 by the Government of the Colony and Protectorate of Nigeria 1 which was interest-based. Prior to this development, local efforts had been made by indigenous groups to form some organizations particularly among farmers which included among others: The Ibadan Agricultural Society (1904); the Agege Planter Union (1907) and the Egba Farmers Association (1910). 2 Later on, precisely in 1922, the Department of Agriculture under the colonial rule organized these associations under the Department and some incentives were given from the government end among other things. 3 * Author is a Senior Education Officer, with the Kwara State Teaching Sservices commission, Ilorun Nigeria, abuhaneefah1428@yahoo.com Journal of Islamic Banking and Finance Oct Dec

82 At the time of the said enactment there were no cooperatives in Nigeria from which experiences could be drawn. The only close organizations were those of farmers association organized by the Department. After the 1951 regionalization of the country, each of the three regions saw the necessity of drawing up its own cooperative society s law from the original law of 1935 giving birth to the Regional Cooperative Societies Laws which are also interest-oriented. Islam strongly kicks against riba of any form or nature and considers it to be among the greatest sins. The cooperative societies transact majorly on riba and ribabased investment making it difficult for every serious-minded Muslim to better his/her economic status through his/her involvement and participation in these societies. This calls for the Islamization of Cooperative Society so as to get rid of the forbidden practices inherent in the conventional cooperative. Hence, this gives rise to the emergence and proliferation of Islamic Cooperative Societies in the society. It is worthy of note that there are a number of texts from both the Quran and Sunnah preaching, emphasizing and laying the foundation of cooperation and helping one another among Muslims. The stories and the lives of the Prophet (S.A.W) and his companions as well as those of the pious predecessors were full of various indications to the cooperative tendency among the Muslim ummah. This cooperative trend was maintained through ages and times. Hence, the Hajj Tabung of Malaysia which was founded in 1963 as a kind of cooperative movement whose primary aim is to assist members to observe the religious rites of Hajj, and all other Islamic cooperatives anywhere in the globe, have not acted against the wish of their faith. However, it is believed by a cross section of the society that a cooperative can not be run without necessarily charging interest. Their argument is that, a society of this nature requires regular source of fund apart from the members savings for its proper running and administration. Besides, it also needs fund to execute projects such as building its secretariat among others. More so, the charges being levied on these societies by the government and/or other agencies where applicable cannot be afforded should the society do away with interest. Furthermore, there are others who might dogmatically believe in the possibility of running a cooperative without charging interest based on their belief in the relevance of the faith they profess to the society in which they live. Of these are those who could be ranked a bit above others for their awareness about some Islamic financial products even though they can not defend their workability in the modern day economy especially in the cooperative sector. Thus the need to bring the Islamic financial products closer and accessible to people with a view to enabling them find alternative to the prohibited riba from the enormous provisions of Islam. Cooperative Society: An Overview According to the Oxford Advanced Learners Dictionary, Cooperative is defined as a business owned and run be the people involved, with the profit shared by them 4. This definition appears not to be accurate enough because, some of the elements that make up a cooperative are missing in it as we shall later see. The Encyclopedia Americana defines cooperative as a voluntary economic association in which the members share the earned dividends the financial benefits that result 82 Journal of Islamic Banking and Finance Oct Dec. 2012

83 from doing business at cost or without profits. 5 Another definition reads: It is an organization formed by a group of volunteers to serve their own needs. Each member of the group has an equal vote on operative decisions and profits are shared equally between members. 6 A critical thinking on this definition especially, its last clause, reveals its incoherence. This is because economic benefits are distributed proportionally according to each member s level of participation in the cooperative and not on capital invested or equal share. Hence we agree with the Dictionary of Marketing and Advertising which sees it is a voluntary organization set up by producers and/ or consumers to service their own needs by democratic control, distributing profit according to purchases, sales or fixed return on capital. 7 From the above definitions, it can be deduced that a cooperative society is featured or characterized by being a voluntary organization which is economic oriented, whose members have at least one economic interest in common and which is aimed at bettering the lot of its members economically. Besides, it is democratically controlled. Hence any cooperative which is devoid of any of these features is really not a cooperative. Cooperative is as old as human race and it is intrinsic to its organization. That is to say, there is no way a given society of man could survive or live in peace and harmony with one another without owing credit to cooperation. However, cooperative as a movement or organization has its origin traceable to the Agricultural and Industrial Revolution of the 18th and 19th centuries 8 in Europe which gave birth to the formation of some business associations aimed at selling some discounted goods to local workers. 9 Notable among these associations was Fenwick Weavers Society formed in Fenwick 1761 and the attempt made by Robert Owen and his partners in 1810 to introduce better labour standards including discounted retail shops. 10 However, in The Rochdale Friendly Cooperative Society was formed with 60 flannel weavers. This was the earliest attempt at cooperative efforts though it did not record much success owing to the prevailing distress resulting from the revolutions. Eventually, in twenty eight persons who were mostly flannel weavers with some artisans came together in Rochdale to establish the first successful cooperative enterprise. It was named: The Rochadale Society of Equitable Pioneers in Rochdale in England. It had her own store selling food items which members could not otherwise afford 13. The modest society became the springboard for the development of cooperative wholesale movement throughout Europe. 14 Cooperative is a global phenomenon. It is adopted by different people to achieve different but related goals. It can be classified using different criteria. For example, cooperatives can be broadly classified into producer and non-producer cooperatives or classified according to their industrial bases into Agricultural, Industrial, Services, Consumer and Multipurpose cooperatives. However, the orthodox classification which is based on the types and functions of these societies is made thus: 1. Thrift and Credit Societies. 2. Credit and Marketing Societies. 3. Cooperative Group Farming Societies. Journal of Islamic Banking and Finance Oct Dec

84 4. Single Crop Agricultural Cooperatives. 5. Industrial Cooperative. 6. Consumer Cooperative Society 7. Multipurpose Cooperative Society. 15 The Question Of Riba Riba stands to be the most important area of disagreement between Islamic and conventional economics. While the former frowns at it and wages war against it, it receives a warm celebration in the latter. It is an Arabic word which literally means excess, increase, augmentation, expansion or growth 16. An elevated place or hill is called rabwah because of its superiority (or increase) in height in comparison with adjacent places. This increase, originates either in the thing itself or in an exchange or sale of money as the sale of one dirham for two dirham s or commodities as in cases of barter of a measure for more of the same merchandise 17. Since it is not every increase or growth that Islam forbids let us then consider the technical meaning of the term under the Islamic Law. Chapra defines it as the premium that must be paid by the borrower to the lender along with the principal amount as a condition for the loan or for an extension in its maturity 18. As for Al-Qusi, it is a predetermined excess or surplus over and above the loan received by the creditor conditionally in relation to a specified period. 19 A critical look at these two definitions and some other definitions that are in line with them will reveal that they are more or less concentrating on a particular kind of riba. Broadly speaking, riba can be grouped into two viz: riba in loans and riba in sales. Riba in loans, simply put, is a situation where some thing is loaned on the condition of a benefit. This is exactly what the two definitions cited above are describing leaving the other aspect uncovered. On the other hand, riba in sales is further divided to riba-l-fadl which is an exchange of an object for the same kind of an object, with an increase in quantity 20 and riba-n-nasa which is an exchange of an object for the same or for a different object with increase in measurement in return for the deferment of the delivery. 21 Hence, we agree with an Islamic economist, who after having discussed, analyzed and critically examined the existing definitions of riba in various schools of thoughts came up with a simple, concise and all embracing definition which is translated thus: Riba is the excess made in the exchange of some specific items as well as the excess charged on a loan for an extension in its maturity. 22 The term is usually translated to English as either usury or interest. In the conventional sense, interest is allowed since the charge is modest and reasonable while usury is considered as a kind of unjustifiable exploitation. That is, perhaps, the reason why the Oxford Advanced Leaner s Dictionary puts usury as the practice of lending money to people at unfairly high rates of interest. 23 On the other hand, as far as Islam is concerned, whether meager or much nothing should be charged on any loan. A basic principle of business in Islamic Law is that every loan which leads to a benefit is usury. 24 Consequent upon this, riba 84 Journal of Islamic Banking and Finance Oct Dec. 2012

85 and riba-based transactions are no-go area in business no matter the level of attraction and as such engaging in riba under whatever name is prohibited in Islam. Allah, in order to let us realize how grave the crime of riba is declares in the Qur an that He is ready to wage war against the culprits. The prophet is also reported to have warned against riba in harsh and threatening terms. Jabir narrated that the Prophet cursed the one who accepts usury, the one who gives it, the one who records it and the two witnesses to it, saying they are all the same 25. More so, no discrepancy exists among the Muslim scholars in relation to the prohibition of riba, though there are some disagreements among them when it comes to the types of transactions that riba affects. It must be noted that Islam, while standing against riba, stands against injustice. Allah says: و إ ن ت ب ت م ف ل ك م ر ؤ و س أ م و ال ك م لا ت ظ ل م ون و لا ت ظ ل م ون but if you repent, you shall have your capital sums. Deal not unjustly (by asking more than your capital sums) and you shall not be dealt with unjustly (by receiving less than your capital sums). 26 Another basic principle of business in Islamic Law is that benefit goes with damage and revenue follows liability 27. Based on this principle, no creditor should receive any benefit from the credit loaned out unless he is ready to bear part of the loss should the business fail. That is to say that both the gain and loss should be mutually shared. Islamic Financial Products As part of the holistic nature of Islam, it never forbids a thing except for the harm inherent in it whether manifest or hidden. More so, Islam would not have forbidden anything unless there is or it makes alternative(s) for it. Allah says: الر ب ا و ح ر م ال ب ي ع الل ه و أ ح ل Meaning: Allah has permitted trading and forbidden riba. 28 Islam recognizes the fact that man needs livelihood which he may earn through the investment of the little he has. Further still, Islam itself encourages striving for one s need and as such it never forbids investing so long it does not in any form involve interest or other prohibited concept(s). There are quite a number of financial products which Islam has and through which investment could be carried out without interest. The subsequent paragraphs shall examine some of these products namely: Murabahah, Ijarah, Salam and Istisna c. Murābahah (Cost- Plus Sale) The word Murābahah in Islamic Jurisprudential sense means the sale of a commodity for the price for which the seller had bought it in addition to a known or declared profit. 29 In other words, it is a particular kind of sale where the seller Journal of Islamic Banking and Finance Oct Dec

86 expressly mentions the cost of the sold commodity he has incurred, and sells it to another person by adding some profit thereon. 30 Murābahah is supported by the vast majority of scholars among the companions, their successors, and the orthodox schools of law. Nevertheless, the Malikites consider it as being unpreferred. 31 It is the second of the two basic classes of sale the other being Musawwamah (i.e. the normal sale). The latter is differentiated from the former by the disclosure or otherwise of the cost price. A Murabahah transaction is governed by certain basic rules which include: i- The subject of sale must exist at the time of the sale. ii- iii- iv- It should be in the ownership of the seller at the time of the sale. The sale must be constant and absolute. However, the payment could be instant or deferred. The subject matter should be a valuable item. v- It should not be something used for an un-islamic purpose. vi- It must be specifically identified and known to the buyer. vii- The delivery of the sold commodity must be certain. viii- The price must be certain for the sale to be valid. 32 Uses of Murābahah As for the cooperative, Murābahah is a very good instrument of investing capital whose profit s probability is very high. It can be used for financing inventories, equipments, house furniture etc. A cooperative can get these items in wholesale and sell them to the members (and/or to the larger society if necessary) after having added its own profit. The cooperative apart from realizing its own profit from this dealing does its members a double-faced favour. The price at which they buy is likely to be cheaper compared to what obtains in the market. More so, a cooperative member buying through Murābahah sale might not have the cash to buy it outside. Hence, he buys from the cooperative in credit to be paid instalmentally without necessarily being charged anything for the deferment of the payment, beside the added profit. More so, a cooperative society may build or buy a house, cultivate land for Agriculture, or acquire a fixed asset and sell same to the members after having added its own profit to the price at which it buys it. Ijárah (LEASE) Lexically it means rent, lease, tenancy, renting out and leasing 33. But technically, it is the transfer of the usufruct of a particular thing from one person to another for a fixed period of time, in lieu of a fixed amount. The jurists agreed on its permissibility except a very few of them viz: al Hassan al Basri and five others 34. Their argument is that Ijārah is a sale of usufruct, and this is non existent at the time of contract. Hence, it is a sale of non existent and as such it entails gharar. However, Ibn Rushd refuted this argument saying: even though it is non existent at the time of the contract it is deliverable in most cases Journal of Islamic Banking and Finance Oct Dec. 2012

87 Meaning: Some of the evidences in support of Ijārah are: ف ا ن أ ر ض ع ن ل ك م ف ا ت وه ن أ ج ور ه ن Then if they give suck to the children for you, give them their due payment." 36 ق ال ت إ ح د اه م ا ي ا أ ب ت اس ت ا ج ر ه إ ن خ ي ر م ن اس ت ا ج ر ت ال ق و ي الا م ي ن Meaning: The Prophet said: Meaning: And said one of them (the two women): O my father! Hire him! Verily the best of men for you to hire is the strong, the trustworthy. 37 أعطو الا جير أجره قبل ان يجف عرقه 38 Pay the wage of the labourer before his sweat dries up. روى البخاري ان النبي صلى االله عليه وا له وسلم إستا جر رجلا من بنى الديل يقال له: عبد االله أريقط وآان هاديا خريتا أى ماهر. 39 Related Bukhari that the prophet (pbuh) hired a man from the people of ad-dil named Abdullahi al-aryqat who was expert pathfinder. It is an undeniable fact that not everybody could afford to possess all he needs. At the same time, it is not compulsory on those that possess more than their basic needs to release their excess to those in need free of charge. Hence, the rationale behind the permissibility of Ijārah. There are four important elements in Ijārah viz: The lessor, the lessee, offer and acceptance and the wage/usufruct. Ijārah usually takes two forms viz: the one contracted on a period of time such as house or land hiring and the other one contracted on labour such as construction of building, sewing, animal rearing etc. It is different from a sale in the sense that it is within a specified period whereas the contract of sale does not accept timing, rather it is permanent because it denotes the transfer of complete ownership of the sold items 40 although, it can be purchased from the lessee by another lessee provided it is within the validity of contract and with prior permission of the owner. 41 Further still, it must be clearly stated that the wage must not necessarily be in cash. Rather whatever that can be used to purchase in the case of sale can also be used as wage in the case of lease. More specifically, exchange of service or labour in Journal of Islamic Banking and Finance Oct Dec

88 lieu of the wage is allowed. For example, the service rendered by a lessee might be remunerated through another service rendered him by his employer 42. The case of prophet Musa where marriage to his employer s daughter serves as the wage for his eight to ten years service 43 is the basis for the allowance. Some of the rules governing Ijārah include: In lease it is the usufruct and not the ownership that is transferred. 44 The subject of lease should be valuable and specified 45 None of the two parties involved should be under duress 46 The usufruct upon which the contract is made should be known or well spelt. 47 The period of lease must be clearly specified. 48 The usufruct should not be something that is religiously forbidden such as hiring of musicians, female moaners, or assassins, or leasing out apartment for beer parlour, church or a gambling or sooth saying arena. 49 One should not hire a lessee on an act that is compulsory upon himself such as daily prayer. 50 It cannot be terminated without mutual consent of the parties involved except the lessee contravenes any of terms of agreement then the lesser has the right to terminate it. 51 The subject of lease should not be consumable such as money, wheat etc. 52 Uses of Ijārah Islamic economics is distinguished by doing away from lending on the basis of interest. At the same time, it allows the investment and growth of wealth so as to ensure its continuity. Of such ways allowed by Islam to grow wealth is this institution of Ijārah. Cooperatives can use the concept of Ijārah to provide various services based on lease for its members and the larger society. Some of these services are refuse collection/refuse packing, catering/hotel services, rental services, operating transport companies, fast food selling, estate management and care-taking contracts, dry cleaning, consultancies, internet and computer services, establishing and running a hospital, establishing and running a school, coaching classes, driving schools etc 53 The cooperative society could also use the concept for creating job opportunities by acquiring certain working tools and machines which would be leased out to the clients who in turn would pay certain charges as rent while the assets remain the property of the society. On an advanced level, it can go to the extent of providing infrastructures for the populace such as alternative electricity, water or information and communication services on the basis of lease. It can also purchase factory machines, lorries etc. or even establish a factory to be leased out to companies. 88 Journal of Islamic Banking and Finance Oct Dec. 2012

89 Salam (Forward Sale) It is also called salaf. It is known among the people of Hijāz as Salam and Salaf among the people of Iraq. Nevertheless, the latter is wider in scope than the former. This is because the latter is used in Islamic Commercial Jurisprudence in two senses namely: loan and advance payment. 54 Salam is defined as a sale contract in which the payment is advanced and the goods delayed. In other words, it is the sale of a commodity whose payment is made in advance. 55 It must be clarified that Salam is Shari c ah exception to the general rule against sale of what is not in the possession of the seller. 56 The legality of this concept is evidenced in the Qur ān and Sunnah. Allah says: ي ا أ ي ه ا ال ذ ين ا م ن و ا م س م ى ف اآ ت ب و ه ت د اي نت م إ ذ ا أ ج ل إ ل ى ب د ي ن O you believe! When you contract a debt for a fixed period, write it down. 57 It is on record that Abdullah Ibn c Abbās, a companion of the prophet explained that this verse was revealed in relation to a contract in which payment is instant while the delivery is deferred. 58 The prophet said: من سلف فى ثمر فليسلف فى آيل معلوم ووزن معلوم Meaning: Whoever pays money in advance for dates (to be delivered later) should pay it for known specified weight and measure (of the dates). 59 Scholars agree based on the above hadith on the permissibility of contracting Salam on things that can be measured or weighed but differ on other articles of merchandise and animals. The majority of them are of the view that it is also permissible on the articles that have exact descriptions. 60 Some of the conditions to be fulfilled by a Salam contract for its validity are: The price to be paid later and the delivered commodity should be both quantified It is only the goods whose quality and quantity can be exactly specified that can be sold through a Salam contract. The payment should not be delayed otherwise it will tantamount to the sale of debt against a debt which is prohibited. The price should be made in currency. The time of delivery must be fixed. The commodity sold on the basis of Salam, should not, according to the majority of scholars be delivered on spot. 61 Journal of Islamic Banking and Finance Oct Dec

90 Uses of Salam Salam involves the sale of commodity before its maturity. Since people involving in production might at a particular point in time need cash for their personal use and as well as for facilitating the production exercise before its final readiness, instead of going for a loan that will attract interest, it is allowed that they sell their produce/products in advance. In Agriculture circle, a cooperative society can successfully buy in advance, farm produce such as cassava, maize, yam, coca, colanut, or coffee. Products of animal husbandry, poultry or fisheries could also be bought in advance by the society. When these products are eventually delivered they would be sold out and the profit becomes cooperative s. It is worthy of note that Salam is a usually profitable sale in that commodity sold in this manner is usually cheap compared with the one sold with prompt delivery. A cooperative can use this sale to finance the production of goods. The traders in this regard would sell their commodities before hand and collect the cash price which they in turn use to carry out the production of the sold goods and thereafter deliver such to the cooperative. To this end, Salam is beneficial to the two parties involved. The seller receives the price in advance and he is able to use it for the production exercise while the buyer in Salam usually buys at a cheaper rate. ISTIŞNĀ C (Order For Manufacture) Ordinarily, Istişnā c means request for manufacture. While jurisprudentially it is defined by Murshid al-ghayran as a request for production of a particular thing in a particular way. 62 It is a sale transaction where a commodity is transacted before it comes into existence. It is an order to a manufacturer to manufacture a specific commodity for the buyer. The manufacturer uses his own material to manufacture the required goods. 63 Scholars argue that Istişnā c is permissible since it is a combination of two modes of contract that are permissible. It is the combination of Salam which is also a kind of contract on an advance produce and Ijarah which also involves engaging another person in a labour in lieu of a payable wage. 64 The contract for manufacture should contain the following two conditions: The statement of the kind of the manufactured things; its quality, amount and required specifications. The determination of its duration 65 Each of the parties involved in Istişnā c has the right to turn down the contract before its maturity. The manufacturer can also sell the manufactured goods to another buyer provided it has not been presented to the client since the contract made was not on the particular item manufactured. 66 On a final note, it must be noted that the client is not under any obligation to buy the required item after the production if it does not meet his taste or satisfaction Journal of Islamic Banking and Finance Oct Dec. 2012

91 Uses of Istişnā c Istişnā c is another form of transaction where goods are transacted before their existence. Using it as a mode of financing, a cooperative may use it for house or factory financing. A member of the cooperative might request for this kind of service from the society thereby becoming a client. He would request for a house or factory to be erected on a detailed specification. The cooperative serving as the financier provides the service as required and thereafter the payment is made by the client as pre-agreed. This is more done on a contract basis. The cooperative may go to the extent of acting as a contractor dealing with the government, governmental or non governmental agencies etc. It could engage in construction of bridges, roads or drainages as well as building of schools, hospitals, hostels, offices or markets, provision of certain kits containing certain items, installation of office equipment etc. The overall expenses will be calculated by the cooperative and a reasonable profit will be added all to be settled by the client before, during or after the work as mutually agreed upon by the parties involved. However, the cooperative as a contractor can enter into a parallel arrangement with another body or agent on the basis of another Istişnā c or Ijārah to carry out the required job. CONCLUSION So far, the foregoing has briefly taken us through the concept of cooperative covering its meaning, origin and development as well as types. It has also emphasized that Islam accords zero tolerance to riba and as such nothing, whatsoever, should be charged as interest - whether meager or much - on any loan. Moreso, it has been happily established that Islam has tremendous alternative means of growing wealth such as Salam, Ijarah and others. In like manner, it has affirmed the workability of these products within the cooperative sector. It is thus left for the Islamic Cooperative Societies to maximize the benefits and chances proffered by Islamic Economic System. Considering the fact that Islamic Cooperative Society is the only institution that bears the flag of Islamic Finance in most part of the country since the only available Islamic bank Jaiz international is, presently, in not up to four out of the thirty six states of the federation, it becomes essential that the Islamic Financial Products are acquainted with so that Nigerian Muslims who want to better their lots economic wise but are afraid of the spiritual and otherwise evils of interest will have where to resort to based on the premise that if you don t get it all you don t miss it all. This will go a long way in eradicating cheating, unjustified exploitation, economic enslavement, injustice and other social vices that riba stands to promote. However, the challenge that would be faced along the line is the dearth of experts who are balancedly versed in the modern day economics as well as in Islamic Commercial Jurisprudence. This, thus, calls for the training and re-training of personnel by the concerned cooperative union body, the ministry in charge along with the larger society through scholarship award as well as organization and sponsorship of seminars and workshops among others. Journal of Islamic Banking and Finance Oct Dec

92 NOTES AND REFERENCES 1) I.I. Ihimodu, Cooperative Economics, Nigeria, Unilorin Press 1988, p. 50 2) Ibid 3) Ibid 4) A.S. Hornby, Oxford Advanced Learner s Dictionary New York, Oxford Unviersity Press 2001, p ) Scholastic Library Publishing, Encyclopedia Americana USA, Scholastic Library Publishing Inc. 2006, Vol. 7, p ) Geddes and Grosset, A Dictionary of Business Terms Scotland, Geddes and Grosset 2005, p ) J. Farrah, Dictionary of Marketing and Advertising Malaysia, Golden Books Centre 1998, p ) I.I. Ihimodu, p 15. And on cooperatives (19/09/2012) 9) 10) Ibid 11) I. I. Ihimodu, p ) 13) Ibid 14) Scholastic Library Publishing p ) I. I. Ihimodu, p ) M.M al-qusi, p ) Ibid p ) M.U Chapra, Towards a Just Monetary System, United Kingdom, The Islamic Foundation 1985 p 57 19) M.M al-qusi, p ) Ibid p ) K.S. Abu Mālik, Sahihu Fiqh -us- Sunnah Cairo, Al-Tawfikia Bookshop ND Vol. iv, p ) U. A. al-matrak, Ar-Riba wal Mu c āmalāt, Riyadh, Dar al-āsimah 1418 AH 3 rd edition p ) A.S. Hornby, p ) Dar -us- Salam Publication, (tr) Attainment of the Objective in I. H. Al- Asqalāni, bulûghul-marām, Saudi Arabia, Dar-us-Salām Publication (nd). 25) A Ibn Hisam, Kanzu-l- c Ummal fi Sunani-l-Aqwal wa-l-af c al, Madinah, Muassasatu-r-Risalah, ) M.T. Al-Hilali and M.M. Khan, the Noble Qur an in the English Language, Saudi Arabia, Dar-us-salam 1996 Q2:279 27) I.N.As-Sulami, Usulu-l-Fiqh Alladhi la Yasa u-l- Faqiha Jahluh, Riyadh, Kuliyyatush-Shari ah, (ND) p ) M.T. Al-Hilali and M.M. Khan, Q2:276 29) N. Hammād, Mu c jam-ul-muştalahat -il- Iqtişādiyyah fi Lughat -il- Fuqhāh USA IIIT 1981 p ) M. I. A Usmani, Meezanbank s Guide to Islamic Banking, Pakistan, Daru-l- Ishaat, 2002, 1 st ed. p ) W. Az-Zuhayli, Al-Fiqh-ul-Islāmi wa adillatuh, Damascus Dar-ul-Fikr 4 th edition 1997 p ) M. I. A Usmani, pp Journal of Islamic Banking and Finance Oct Dec. 2012

93 33) Research and Studies Centre, The Bilingual Dictionary Arabic English, English Arabic Lebanon, Dar al-kotob Al-Ilmiyyah, 2006, p ) The other five are Abubakr Al-asamm, Ismā c il ibn Ulayah, Al-Qashāni, An- Nahrawāni and Ibn Kysāni. See W. Az-Zuhayli p ) M. A. M. Ibn Rushd, p ) M.T Al-Hilali and M.M khan, Q. 65:6 37) Ibid Q. 28:26 (It continues to the next verse i.e. 27). 38) M.Y. Ibnu Majah, Sunan Ibn Majah, Beirut, Daru-l-Fikr (verified by Muhammad Fuhad) (nd) vol. 2 p ) M.I, Al-Bukhari, Al-Jami us-sahih Al-Mukhtasar, Beirut, Dar Ibn Kathir 3 rd edition, 1987 vol.2 p ) W. Az-Zuhayli, p ) H. A. Abdur-Rahman, Contemporary Jurisprudence Research Journal, Saudi Arabia 1989/ rd edition p ) A. A. M. Ibn Qudāmah, Al-Mughni, Riyadh, Dar Alami-l-Kutub, (special edition verified by Dr. Abdullah At-Turki), 1999, vol 3, 4 th edition p ) Q. 28: ) M.I.A. Usmani, p ) Ibid 46) S. Sabiq, p ) Ibid 48) M. I. A. Usmani, p ) M. A. M. Ibn Rushd, p. 179 and S. Sabiq P ) Ibid 51) M. I. A. Usmani, p ) Ibid p ) S. I. Ganiyu, Cooperative Essentials, Ibadan, Real Success Consult, 2007 pp ) A. Al-Jazīriy, Al-Fiqhu c ala-l- Madhā ib- il- Arba c ah Turkey, Hakĭkat Kitabevi, 1986, Vol. III P ) S. Sābiq, p ) A. Al-Jazīriy, p ) M. T. Al-Hilali and M.M. Khan, Q.2:282 58) I. Ibn Kathir, Vol. I p ) M. M. Khan, (tr) Summarized Sahih Al-Bukhāri Arabic-English in A.A. Az- Zubaydi, Mukhtasar Sahih Al-Bukhari. Saudi Arabia, Dar-us-Salam Pulbications 1994 p ) M. A. M. Ibn Rushd, p ) Ibid pp , M. I. A Usmani, pp and S. Sabiq, p. 121, 62) N. Hammād, p ) M. I. A. Usmani, p ) A. M. Al-Kāsānī, p. 6 65) H. A. Abdur-Rahman, 14 th edition p.52 66) A. M. al-kāsānī, p. 7 and S. M. A. Ad-Darīr, pp ) Ibid (S. M. A. Ad-Darīr pp ) Journal of Islamic Banking and Finance Oct Dec

94 Educational Salam Islamic Financing Mode. Salam is sale of a good/asset at an agreed price to be delivered at a predetermined future date with full advance payment at the spot. This is similar to a conventional forward contract, however, in a Salam sale, the buyer pays the entire amount in full at the time the contract is initiated.in modern Islamic banking Salam contract is generally used for agriculture financing. However it is also used to finance the working capital needs. In Pakistan around 4 percent of overall Islamic banking financing is Salam based. Conditions of Salam: Salam is a unique contract in Islamic finance as it is exception of two general rules i.e. existence of asset and prohibition of forward sale. Due to these general rules, Shariah scholars have defined some conditions that are necessary for the contract to be permissible in terms of Shariah principles. These conditions include 1. The buyer must pay the price in full to the seller at the time of sale. 2. Salam can be affected only in those commodities whose quality and quantity can be specified exactly. 3. Salam cannot be affected on a product of a particular field, farm or factory. 4. The quality of the commodity should be fully specified leaving no ambiguity in order to avoid dispute. 5. The quantity of the commodity must also be agreed upon at the time of contract. 6. The date of delivery must be specified in the contract. 7. Salam cannot be affected for items/goods which must be delivered at spot. 8. Delivery in installments is allowed, if agreed by all parties. Early delivery is allowed if all parties agree and no party is at disadvantage position 9. The contract of Salam, once affected, cannot be cancelled unilaterally. 10. Before delivery of the asset, the risks on the asset lies with the seller and upon delivery, the risks are transferred to the buyer.. Source: State Bank of Pakistan Bulletin Jan-March, Journal of Islamic Banking and Finance Oct Dec. 2012

95 11. Upon delivery of the asset, the buyer is obligated to take possession of the asset if the asset delivered is according to agreed specifications. 12. The buyer can enter into a similar contract with a third party in a parallel Salam. This parallel contract is independent from the first Salam contract. 13. Salam must be concluded with actual physical delivery. Salam Sukuk: Salam is also used as the underlying mode in various Sukuk issuances generally for managing liquidity and for meeting short term liquidity requirements. Like any Salam contract Salam Sukuk also needs to fulfill certain conditions in order for it to be Shariah compliant. These include immediate payment at the time of entering the contract and no ambiguity in the contract in terms of asset quality and quantity, expected delivery date etc. The process of a simple Salam Sukuk structure involves a seller, investors, and an SPV; steps involved in the process are presented in Figure below. 1) The seller creates an SPV and undertakes to deliver the assets to the SPV on the specified future date. 2) The SPV issues Sukuk to investors. 3) Investors pay Sukuk subscription. 4) The SPV passes on Sukuk proceeds to the seller. 5) At the delivery date, the seller delivers the asset to SPV. 6) The SPV sells the asset or appoints the seller as an agent to sell the asset. 7) The SPV pays investors the sale proceeds. Journal of Islamic Banking and Finance Oct Dec

96 The process of a simple Salam Sukuk structure involves a seller, investors, and an SPV; steps involved in the process are presented in Figure below. Limitations of Salam: In modern day banking Salam contract can sometimes be cumbersome for banks as they receive certain commodities from their clients and not money and banks are not conversant with selling these commodities in the market. They cannot sell those commodities before they are actually delivered to them, because it is prohibited in Shariah. However, two solutions to this problem are as follows: 1. After purchasing a commodity the bank may sell it through a parallel contract of Salam for the same date of delivery. OR 2. The bank can obtain a promise to purchase from a third party. This promise should be unilateral from the expected buyer. Being merely a promise, and not the actual sale, their buyers will not have to pay the price in advance. In case of Sukuk, it is pertinent to note that Salam Sukuk cannot be traded in secondary market as it involves debt against advanced payments. Hence this Sukuk is not very popular amongst various Sukuk structures in practice. Another reason for limited availability of Salam Sukuk is due to its uncertainty in providing the assets involved in transactions on time and according to the specification agreed upon in the contract. Sources: 1. Muhammad Taqi Usmani (2000), An Introduction to Islamic Finance, Idaratuk Ma arif Karachi. 2. Sohail Jaffer (2011), Global Growth Opportunities and Challenges in the Sukuk Market, Euromoney books 3. Global Islamic Finance Report 2011, BMB Islamic. 4. The Chancellor Guide to the Legal and Shariah Aspects of Islamic Finance, BMB Islamic (2009). 96 Journal of Islamic Banking and Finance Oct Dec. 2012

97 Introduction Islamic Financing Mode Ijarah An Ijarah is lease of an object involving the transfer of usufruct for a rent consideration. It can either take effect as an operating lease with the asset returning to the lessee at the end of the contract (simple Ijarah) or the more usual lease in financial transactions with the lessor gaining possession of the asset at maturity of contract (Ijarah wa iqtina). Ijarah is widely used by Islamic banks for consumer finance. In Pakistan, Ijarah based financing constitutes more than 10 percent of the overall Islamic banking financing (for details see section on Market Analysis). Model Ijarah Structure: The model Ijarah structure can be explained with the help of an example. The Islamic financial institution (lessor) purchases the asset and then transfers possession to the borrower (lessee). However the bank doesn t sell the asset to the borrower but leases it to the lessee. The lessee pays lease rentals to the lessor during the period of contract. At the end of the tenure, the bank, under a separate agreement, may sell the asset to the customer either by way of gift or a token value (see Figure 1). Due to long term nature of housing finance Ijarah structure is highly suitable as it can be structured as a variable rate financing product. It is worth mentioning that in practice the above mentioned Ijarah structure is also used as a hybrid mode of financing along with other modes such as Istisna, Wakala and Diminishing Musharaka. Basic rules of Ijarah: 1. The subject of lease must have a valuable use. 2. It is necessary for a valid contract of lease that the corpus of the leased property remains in the ownership of the seller, and only its usufruct is transferred to the lessee. Journal of Islamic Banking and Finance Oct Dec

98 3. The rental consideration must be for a fixed value whether payable in a lump sum or installments. 4. The term of Ijarah must be precisely determined. 5. The rent must be specified as a fixed sum for the rental term. However, the rent may escalate or diminish during the rental term so long as the amounts of such escalation and/or decrease are specified and known to both parties. 6. The lessor is responsible for structural maintenance of the assets and the obligations may not be passed to the lessee pursuant to Ijarah. Moreover, if the asset is to be insured, the insurance expense must be borne by the owner /lessor. However, this cost may be factored into the calculation of the lease rental. 7. The lessee cannot use the leased asset for any purpose other than the purpose specified in the lease agreement. If no such purpose is specified in the agreement, the lessee can use it for Shariah permissible purposes. 8. If the lessee defaults in making the lease rental payment, the lessor cannot charge any additional rent. However, the lease agreement contract may require the lessee to make an additional payment towards a charitable cause. 9. If the leased asset has totally lost the function for which it was leased, and no repair is possible, the lease shall terminate on the day in which such loss has been caused. However, if the loss is caused by the misuse or by the negligence of the lessee, he will be liable to compensate the lessor for the depreciated value of the asset as it was immediately before the loss. 10. If the lessee contravenes any term of the agreement, the lessor has a right to terminate the lease contract unilaterally. However, if there is no contravention on the part of the lessee, the lease agreement cannot be terminated without mutual consent. Table 1: Differences between Islamic Ijara and Conventional Lease Islamic Ijara Contract Conventional Lease Contract Payments commence after delivery of asset. Payments commence at the time of funding. Risk of destruction or loss of asset remains Risk of destruction or loss of asset is transferred with lessor, unless caused by negligence or to lessee. misconduct. Major repairs & maintenance are the Repairs & maintenance are passed on to lessee. responsibility of lessor or as agreed between contracting parties. The lessor has a right to terminate the lease contract unilaterally only if the lessee contravenes any term of the agreement. Ijara payments should be stopped if asset is out of order if not due to misuse or negligence of lessee. Late payment penalty should be fixed in the contract in advance that goes to charitable causes. Ijara payments cannot be assigned to third party. Lessor has the unilateral right to cancel the lease contract at his sole discretion Lease payments will not stop if the asset is out of order. Penalty is an interest charge which is earning for conventional lessor. Conventional lease payments can be assigned to thirdparty. 98 Journal of Islamic Banking and Finance Oct Dec. 2012

99 Ijarah Sukuk: Ijarah Sukuk has emerged as one of the most popular Sukuk structures. In particular, sovereign Sukuk are generally based on this structure. This is mainly due to the characteristics of this instrument which is generally simple in nature, provides a secure revenue stream, ownership in the underlying asset and is tradable in secondary market. In Pakistan, more than 75 percent of the Sukuk are based on Ijarah including all sovereign Sukuk (amounting to Rs. 294 billion) issued by government of Pakistan. A typical Ijarah Sukuk structure generally involves three parties; i.e. owner/customer, a special purpose vehicle (SPV) and Sukuk holders. Typically under an Ijarah Sukuk agreement customer enters into an asset sale agreement with another company, typically a SPV for raising finance. SPV raises cash needed to purchase the asset by issuing Sukuk to investors. Thus the SPV acts as an agent for the customer. On behalf of investors, SPV acts as a trustee and leases the same asset to the customer in return of lease payments. The leasing profit is then distributed among the investors and the principal amount is paid at the maturity, when at the end of the Sukuk period, the owner will purchase the asset back from the SPV and this provides SPV with cash to repay Sukuk investors (see Figure 2). Conclusion: Ijarah is widely used by Islamic banks for consumer financing. Moreover for issuance of Sukuk, particularly sovereign Sukuk, Ijarah is considered a preferred mode. However, basic Shariah rules for Ijarah, as mentioned above, must be followed. Sources: 1. Global Islamic Finance Report 2010, BMB Islamic. 2. Global Islamic Finance Report 2011, BMB Islamic. 3. The Chancellor Guide to the Legal and Shariah Aspects of Islamic Finance, BMB Islamic (2009). 4. Strategies for the Development of Islamic Capital Markets: Infrastructures and Legal Aspects of Islamic Asset Securitization, Islamic Financial Services Board (2011). 5. Muhammad Taqi Usmani (2000), An Introduction to Islamic Finance, Idaratuk Ma arif Karachi. 6. M. Kabir Hassan and Mervynn K. Lewis (2007), Handbook of Islamic Banking, Edward Elgar Publishing Limited. Journal of Islamic Banking and Finance Oct Dec