Introduction to Islamic Banking Salman Ahmed Shaikh islamiceconomicsproject@gmail.com www.islamiceconomicsproject.wordpress.com
HISTORY OF ISLAMIC BANKING Islamic banking and the field of Islamic finance has grown appreciably since 1960. In Egypt, first Islamic savings bank was established based on the principle of profit-sharing at Mit Ghamr in 1963. The Islamic financial system in Malaysia was first introduced in 1963. Subsequently, Bank Islam Malaysia Berhad (BIMB) commenced business on July 01, 1983. In 1975, the Islamic Development Bank was established to provide financing to projects in the member countries.
HISTORY OF ISLAMIC BANKING Dubai Islamic Bank was the first modern commercial Islamic bank founded in 1975. Indonesia's first Islamic bank was Bank Muamalat, established in 1991. In Bahrain, first Islamic commercial bank was established in 1978.
OVERVIEW OF ISLAMIC BANKING Islamic Finance is a growing industry which is constantly evolving and has been competitive to reach and sustain its growth momentum amidst even the Great Recession and beyond. Assets of the global Islamic finance industry are estimated to grow to around $1.6 trillion by 2012 (Source: Reuters). Some reports suggest that assets held by Islamic financial institutions may rise five-fold to more than $5 trillion (Source: Moody s Investor Service).
OVERVIEW OF ISLAMIC BANKING According to CIMB Group Holdings, Islamic finance is the fastest-growing segment of the global financial system. Vatican said banks should look at the rules of Islamic finance to restore confidence amongst their clients at a time of global economic crisis. (Source: Osservatore official Vatican newspaper, March 04, 2009). Islamic Finance industry is an emerging and growing industry. Islamic financial industry beyond banking has achieved financial deepening in Asset Management, Investment Banking, Public Finance, Structured Finance and Insurance. On the geographical level too, Islamic banking has grown from Middle East to Europe and now is well positioned in South Asian markets as well.
OVERVIEW OF ISLAMIC BANKING The market value of Islamic banking industry currently stands at $1 trillion. There are quite a few banks in the west who are working extensively in this area to provide an alternative to the clients as the global economy goes through the financial slump. Few banks to mention over here are HSBC, UBS, Credit Suisse, Deutsche Bank, BNP Paribas, Citi bank, Barclays, RBS etc.
ISLAMIC BANKING IN PAKISTAN During the period of Zia ul Haq, extensive reforms were carried out in financial system to make financial institutions comply with Islamic principles in their product offerings. In February of 1980, Council of Islamic Ideology presented a comprehensive report on the elimination of Interest. Operations of specialized financial institutions like National Investment Trust (NIT), Investment Corporation of Pakistan (ICP), and House Building Finance Corporation (HBFC) were transformed to comply with Islamic principles.
ISLAMIC BANKING IN PAKISTAN Banks started offering profit and loss accounts and some Shariah Compliant financing schemes on a limited scale. Federal Shariat Court in 1991 ruled against the compliance of the product offerings of banks with Islamic injunctions. Supreme Court gave a historic verdict on interest on December 23, 1991 declaring all interest based operations to close down.
ISLAMIC BANKING IN PAKISTAN Al-Meezan Investment Bank was established in 1997, which later became Meezan Bank, as the first full fledged Islamic commercial bank established in 2002. SBP Islamic Banking Department was established on 15th September, 2003 with the task of promoting & developing the Shariah Compliant Islamic Banking as a parallel and compatible banking system in the country. Since then, Bank Islami, Dubai Islamic Bank, First Dawood Islamic Bank, Bank Al-Barakah and Emirates Global Islamic Bank have started their operations as full fledged Islamic banks.
ISLAMIC BANKING IN PAKISTAN
ISLAMIC BANKING IN PAKISTAN
ISLAMIC MODES USED IN DEPOSIT PRODUCTS Qard Wadiah Musharakah Mudarabah
QARD Qard means to give anything having value to the other with the condition that same or similar amount of that thing would be paid back on demand or at the settled time. It is that loan which a person gives to another as a help, charity or advance for a certain time. The repayment of loan is obligatory.
DIFFERENCE BETWEEN QARD AND AMANAH The repayment of Qard is obligatory even if the borrowed amount or thing is destroyed by natural calamity. Amanah can not be used by Ameen. Qard can be used for meeting expenses and investment by the borrower.
WADIAH It refers to the deposited property/funds. An Islamic bank acts as the trustee of depositors' funds. It guarantees to return the deposited property on demand. The bank may hibah any part of benefit it received from the deposited property.
MUDARABAH It is a partnership in which there are two partners i.e. Rabb-ul-Maal and Mudarib. Rabb-ul-Maal is the investing party which contributes capital in the partnership. Mudarib is the working party which contributes by rendering services in the partnership.
ROLE OF RABB-UL-MAAL Rabb-ul-Maal is the investing party which contributes capital in the partnership. In case of profit, Rabb-ul-Maal shares in profit based on profit sharing ratio agreed between the Rabb-ul-Maal and the Mudarib. In case of loss, Rabb-ul-Maal bears the complete risk of all financial losses.
ROLE OF MUDARIB Mudarib is the working party which contributes services in the partnership. In case of profit, Mudarib shares in profit based on profit sharing ratio agreed between the Rabb-ul-Maal and the Mudarib. In case of loss, Mudarib loses the remuneration for his services. Mudarib is entitled to receive Ujrat-e-Misl (equivalent wage) if the loss is not caused by his willful neglect.
PROFIT SHARING MECHANISM In Mudarabah, profit sharing ratio has to be agreed at the start of the Mudarabah contract. Profit Sharing ratio does not need to be equal for both parties. Profit sharing ratio in Mudarabah is not the same as loss sharing ratio. Rabb-ul-Maal bears all the financial losses if loss occurs. Neither partner is allowed any fixed profit. Profit sharing ratio is applied to the actual profit earned.
PROFIT SHARING MECHANISM Category Deposit (Rs.) Weightage Weighted Average Profit Rate Savings 3,000 0.1 300 57 1.89% 1 Month 1,000 0.3 300 57 5.66% 3 Months 3,000 0.5 1,500 283 9.43% 6 Months 6,000 0.6 3,600 679 11.32% 1 year 7,000 0.7 4,900 924 13.21% Total 20,000 10,600 2,000
MUDARABAH IN LIABILITY PRODUCTS Mudarabah is widely used in Islamic Finance in liability products. Islamic banks use Mudarabah contract while offering remunerative deposit products. Mudarabah is used in offering both checking and non checking remunerative deposits by Islamic banks. The accountholders (depositors) are Rabb-ul-Maal and Bank acts as Mudarib.
MUDARABAH IN LIABILITY PRODUCTS: CONTINUED Since the depositors are large and vary with respect to amount of investment and tenure of their investment, weightage mechanism is used besides profit sharing ratio. Weightage mechanism is used to allow more profit distribution to depositors who have kept funds for a longer tenure. This is strictly dependent upon occurrence of profit which is not guaranteed. Horizontal distribution between depositors is done based on weightage mechanism after vertical distribution between Mudarib and Rabb-ul-Maal (as a category) has taken place.
MUDARABAH IN ASSET PRODUCTS Mudarabah in Asset side products i.e. in providing finance is rarely used by Islamic banks. On a limited scale, Islamic banks use Mudarabah in treasury placements. The reason for the rare use of Mudarabah in providing finance is lack of documentation, lack of trust and the fact that risk of all financial loss has to be borne by Rabb-ul-Maal alone.
MUSHARAKAH It is a partnership in which partners invest as well as perform services for the firm. In Musharakah, there is no limitation on partners as to who can work and who can invest. Each partner can invest as well as work for the firm. It can be formed between two or more persons.
PROFIT SHARING MECHANISM In Musharakah, profit sharing ratio has to be agreed at the start of the Musharakah contract. Profit Sharing ratio does not need to be equal for all parties. Profit sharing ratio in Musharakah does not need to be equal to capital contribution ratio. It is possible that a partner with lower capital ratio is assigned a greater profit sharing ratio if it is mutually agreed.
PROFIT SHARING MECHANISM No partner is allowed any fixed profit. Profit sharing ratio is applied to the actual profit earned. Incase of loss, loss is shared between partners based on limited liability principle. All partners bear losses only to the extent of their investment.
MUSHARAKAH IN LIABILITY PRODUCTS Musharakah is used in Islamic Finance in liability products. Islamic banks use Musharakah contract while offering remunerative deposit products. Musharakah can be used in offering both checking and non checking remunerative deposits by Islamic banks. If bank as Mudarib also wants to invest in the investment pool, then, a hybrid of Mudarabah and Musharakah is used.
MUSHARAKAH IN ASSET PRODUCTS Musharakah in Asset side products i.e. in providing finance is rarely used by Islamic banks. On a limited scale, Islamic banks use Musharakah in treasury placements and while offering financing to blue chip companies. As compared with Mudarabah, bank has lesser risk in Musharakah as in case of loss, it is shared between the partners. Moreover, the loss is borne by bank and the client to the extent of capital invested. Finally, the investment is also shared while in Mudarabah, the whole investment is provided by Rabb-ul-Maal.
MUSHARAKAH IN ASSET PRODUCTS The reason for the rare use of Musharakah in providing finance is: Lack of documentation, Lack of trust and The fact that Bank provides bulk of the capital and is liable to incur loss to the extent of capital provided by it, which is usually higher than client s capital contribution.
MURABAHA Murabaha is a sale transaction. Technically, Murabaha Muajjal it is a deferred payment sale. Murabaha is the most widely used alternative for short term trade financing involving sale of an asset. Murabaha is used in working capital financing, SME financing and trade financing. The customer is asked to buy the asset acting as an agent to the bank because he has more knowledge about the product and better relationships with the supplier to obtain the goods at a competitive price and in a timely and appropriate manner.
PROCESS FLOW OF A MURABAHA TRANSACTION The process flow is as follows: 1. Islamic bank and the client sign a Master Murabaha Finance Agreement and an agency agreement. 2. According to the agency agreement, the customer purchases goods from the supplier on bank s behalf. 3. The customer submits order form which the bank signs after scrutiny and thereby give the client (its agent) the permission to buy the asset from the supplier by submitting this signed order form to the supplier.
PROCESS FLOW OF A MURABAHA TRANSACTION 4. The customer undertakes to purchase the asset from the bank. It is a one-sided promise and undertaking. 5. The bank pays the supplier preferably directly and obtains title and physical/constructive possession of the asset. 6. The customer in most cases obtains constructive possession for bank on bank s behalf at its premises. 7. Authorized person of the bank authenticates delivery at client s warehouse and ensure that bank s asset remains distinct and does not mix up with other similar asset of the client.
PROCESS FLOW OF A MURABAHA TRANSACTION 8. The customer signs a declaration that he has purchased the goods on bank s behalf and now he is willing to purchase the asset. 9. Bank accepts the offer and the sale is executed. 10. Now, the customer is able to use or sale the asset as he becomes the owner of the asset irrespective of the fact that he has fully paid the bank or will do so by deferred payment. 11. The customer pays the agreed price to the bank either in installments or in lump sum now or in future.
ISSUES IN MURABAHA It is necessary that the client does not consume the asset before the signing of declaration. It is necessary that subject matter of sale must be Halal. It is necessary that the client does not sale the subject matter of sale prior to signing declaration. Signing Order form must always precede Declaration. Date on order form must be earlier than date on declaration form when they are signed.
APPLICATION OF IJARAH IN ISLAMIC FINANCE Consumer Financing Using Reverse Murabaha as an alternative to Credit Cards Corporate Financing Industrial Raw Material Local and Imported Industrial Machinery Local and Imported Plant & Equipment Local and Imported Agricultural Output Local and Imported Industrial Output Local and Imported
IJARAH Ijarah means to sell usufruct of an asset on rent. The term is also used in hiring someone to do a job or service. In Ijarah, right of use of a property is transferred to another person for a consideration. It is an Islamic alternative for leasing a tangible asset.
IJARAH IN ISLAMIC FINANCE The lease period starts when the asset has been delivered by the lessor in a usable condition. The bank (Lessor) bears the ownership related costs and the customer (Lessee) bears the usage related cost. Insurance, installation, import duty, delivery charges are paid by the bank and are added in its cost and are taken into account when quoting rentals to the customer at the time of entering into the Ijarah agreement.
IJARAH IN ISLAMIC FINANCE If the asset is destroyed or becomes unusable, the bank stops taking rent and does not charge rent for that period. Penalty for late payment is charged for maintaining financial discipline and is paid to charity. The asset/property remains in the ownership of the bank until the bank sells the asset to the customer in a separate agreement. The client is not obliged to buy the asset at the end of the lease period. However, in some countries, banks now take an undertaking from the client to purchase the asset from the bank when the lease period expires.
PROCESS FLOW OF AN IJARAH TRANSACTION The process flow is as follows: 1. The customer approaches the bank for obtaining an asset on lease. 2. The customer undertakes to make periodic lease payments for the lease period. 3. Lease agreement and agency agreement is signed. 4. The customer as an agent to the bank buys the asset. Bank receives the title of the asset and pays the vendor.
PROCESS FLOW OF AN IJARAH TRANSACTION 5. The bank leases the asset and the customer starts using the asset and pays rent for each period. 6. In the end, the customer can purchase the asset from the bank by way of a separate purchase agreement.
APPLICATION OF IJARAH IN ISLAMIC FINANCE Consumer Financing Vehicle Financing Car, Motorcycle, Rickshaw, Truck etc. Consumer Appliance Financing Fridge, Refrigerator, Microwave, UPS etc. Corporate Financing Industrial Machinery Local and Imported Plant & Equipment Local and Imported
SALAM Salam is a sale transaction. It is regarded as an exceptional sale as it does not follow all the basic rules of Sale from Islamic point of view. In a Salam transaction, delivery of the subject matter is deferred. While payment in a Salam transaction for the subject matter is immediate.
SALAM It is used in financing goods and services that are not ready for spot sale and will have to be delivered later. In Salam, payment is spot, but the delivery is deferred. It is used in special cases to facilitate transactions. In Islamic Finance practice, it is used in currency trade as an alternative for bill of exchange discounting and in agriculture financing.
PROCESS FLOW OF A SALAM TRANSACTION The process flow is as follows: 1. Islamic bank and the client sign a Salam Agreement whereby the Islamic bank purchases certain goods from the client by paying in full at spot. 2. Client gets the payment for the sale of subject matter which does not exist now and will be delivered later at a specified date. 3. Islamic bank sign a parallel Salam contract with another client and whereby the Islamic bank sells the same goods to the client.
PROCESS FLOW OF A SALAM TRANSACTION 4. The client who purchases goods in parallel Salam contract purchases the goods from the Islamic bank by paying in full at spot. 5. Period in Salam contract with client where Islamic bank is the buyer is longer than the contract period of parallel Salam where Islamic bank is the seller. 6. Islamic bank gets delivery from the client of the first Salam contract as a buyer and delivers the goods to the client of the parallel Salam contract. 7. Different in price in both Salam contract is the profit for the bank.
ISSUES IN SALAM TRANSACTION Salam contract can only be done of commodities whose characteristics can be specified. It is necessary that the Salam contract does not involve partial payment. Full immediate payment is necessary for the validity of the Salam contract. Goods which are traded using Salam contract must be specified and quantified in a manner that no ambiguity or uncertainty is left.
ISSUES IN SALAM TRANSACTION It is necessary that goods sold in the Salam contract exist and are available in the market from the date of Salam contract to the date of delivery. In a parallel Salam contract, it is necessary that the client in the parallel Salam contract must not be the same client or his associates as in the first Salam contract.
APPLICATION OF SALAM IN ISLAMIC FINANCE Corporate Financing Industrial Raw Material Agricultural Crop Financing Alternate for Bill Discounting in Trade Finance
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