The activity of Islamic banking system

History of introduction of a modern banking system to the Muslim countries, features of their development and functioning in today's market economy. Perspectives of future development of Islamic banking in the world and in the Republic of Kazakhstan.

Рубрика Банковское, биржевое дело и страхование
Вид курсовая работа
Язык английский
Дата добавления 19.04.2012
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Table of content


Chapter I. Historical development of Islamic banks

Chapter II. The financial analysis of Islamic bank's activity

Chapter III. Perspectives of future development of Islamic banking in the world and in the Republic of Kazakhstan. The Islamic Development Bank




Modern banking system was introduced into the Muslim countries at a time when they were politically and economically at low ebb, in the late 19th century. The main banks in the home countries of the imperial powers established local branches in the capitals of the subject countries and they catered mainly to the import export requirements of the foreign businesses. The banks were generally confined to the capital cities and the local population remained largely untouched by the banking system. The local trading community avoided the “foreign” banks both for nationalistic as well as religious reasons. However, as time went on it became difficult to engage in trade and other activities without making use of commercial banks. Even then many confined their involvement to transaction activities such as current accounts and money transfers. Borrowing from the banks and depositing their savings with the bank were strictly avoided in order to keep away from dealing in interest which is prohibited by religion.

Today Islamic banks are developing very rapidly, thus many bankers and entrepreneurs of the entire world are considered with this phenomenon. However, majority of the western entrepreneurs with difficulty understands the specific character of Islamic business, which complicates their relations with the Islamic business partners. Until now, Islamic financial institutions remain “thing in itself” they despite the fact that they are possessed by significant potential by the acknowledgement of many specialists.

The system of Islamic banks is characterized by large specific character, and themselves they in essence come out as the self-contained unit, since entire structure is in the state of evolution, but the search for forms and methods of its activity, optimization of the bases of interaction with the external world is not yet completed.

An increase in the Islamic banks against the background of the crisis, which enveloped practically entire world, looks contrastingly. In light of the search for investment resources, the Islamic banking occur interest for non-Muslim countries, since in the recent decades as a result of the inflow of petrodollars this region became one of the most important suppliers of capital for the world markets.

The study of Islamic banking is necessary for understanding of the essence of the activity of banking system in the Islamic countries and possible methods of collaboration with Islamic capital.

In connection with this purpose of this course work is to analyse the activity of Islamic banking system.

Of for achievement stated goal the following tasks were formulated:

1. To examine the history of the formation of Islamic banks;

2. To examine the mechanisms of the functioning of banks;

3. To investigate the development of Islamic banking system in the world;

4. To study the classification of Islamic banks at present, the structure of interest-free banks, Islamic Development Bank and their role in the world economy;

5. To note the prospects for the development of Islamic banks in the world, the particularly in the Republic of Kazakhstan

The objectives of the course work is to give an overview of the nature and characteristics of Islamic banking as a concept and how it is implemented by the new generation of institutions called Islamic banks.

The review of basic points of the Islamic banking system and economy and the essential foundations of Islamic banking and its financial analysis will be introduced in the course paper. Furthermore the effect of Islamic banking on economy and economic life, future challenges for Islamic banking and finance in the last chapter of course work will be underlined.

The informational and methodological base for the study were the laws and legal documents regulating the activities of Islamic banks, financial and credit institutions of the world, the various statistical sources, data from the National Bank, Ministry of Finance, publications and monographs of foreign journalists, scientists of economy and finance on topics under study, information from the Internet.

Chapter I. Historical development of Islamic banks

It seems that the history of interest-free banking could be divided into two parts. First, when it still remained an idea; second, when it became a reality - by private initiative in some countries and by law in others. We will discuss the two periods separately. The last decade has seen a marked decline in the establishment of new Islamic banks and the established banks seem to have failed to live up to the expectations. The literature of the period begins with evaluations and ends with attempts at finding ways and means of correcting and overcoming the problems encountered by the existing banks.

Interest-free banking seems to be of very recent origin. The earliest references to the reorganization of banking on the basis of profit sharing rather than interest are found in Anwar Qureshi (1946), Naiem Siddiqi (1948) and Mahmud Ahmad (1952) in the late 1940-es, followed by a more elaborate exposition by Mawdudi in 1950. Muhammad Hamidullah's 1944, 1955, 1957 and 1962 writings too should be included in this category. They have all recognized the need for commercial banks and the evil of interest in that enterprise, and have proposed a banking system based on the concept of Mudarabha - profit and loss sharing. [1]

The first modern experiment with Islamic banking was undertaken in Egypt under cover, without projecting an Islamic image, for fear of being seen as a manifestation of Islamic fundamentalism which was anathema to the political regime. The pioneering effort, led by Ahmad El Najjar, took the form of a savings bank based on profit-sharing in the Egyptian town of Mit Ghamr in 1963. This experiment lasted until 1967 (Ready 198l), by which time there were nine such banks in the country. These banks, which neither charged nor paid interest, invested mostly by engaging in trade and industry, directly or in partnership with others, and shared the profits with their depositors (Siddiqi 1988). Thus, they functioned essentially as saving investment institutions rather than as commercial banks. The Nasir Social Bank, established in Egypt in 197l, was declared an interest-free commercial bank, although its charter made no reference to Islam or Shariah (Islamic law).

In the next two decades interest-free banking attracted more attention, partly because of the political interest it created in Pakistan and partly because of the emergence of young Muslim economists. Works specifically devoted to this subject began to appear in this period. The first such work is that of Muhammad Uzair (1955). Another set of works emerged in the late sixties and early seventies. Abdullah al-Araby (1967), Nejatullah Siddiqi (1961, 1969), al-Najjar (1971) and Baqir al-Sadr (1961, 1974) were the main contributors.

Early 70-es saw the institutional involvement. Conference of the Finance Ministers of the Islamic Countries held in Karachi in 1970, the Egyptian study in 1972, First International Conference on Islamic Economics in Mecca in 1976, International Economic Conference in London in 1977 were the result of such involvement. The involvement of institutions and governments led to the application of theory to practice and resulted in the establishment of the first interest-free banks. The Islamic Development Bank, an inter-governmental bank established in 1975, was born of this process.

The first private interest-free bank, the Dubai Islamic Bank, was also set up in 1975 by a group of Muslim businessmen from several countries. Two more private banks were founded in 1977 under the name of Faisal Islamic Bank in Egypt and the Sudan. In the same year the Kuwaiti government set up the Kuwait Finance House. However, small scale limited scope interest-free banks have been tried before. One in Malaysia in the middle of 1940-es and another in Pakistan in the late 50-es. Neither survived. In 1962 the Malaysian government set up the “Pilgrim's Management Fund” to help prospective pilgrims to save and profit. The savings bank established in 1963 at Mit-Ghamr in Egypt was very popular and prospered initially and then closed down for various reasons. However this experiment led to the creation of the Nasser Social Bank in 1972. Though the bank is still active, its objectives are more social than commercial. [2]

In the ten years since the establishment of the first private commercial bank in Dubai, more than 50 interest-free banks have come into being. Though nearly all of them are in Muslim countries, there are some in Western Europe as well: in Denmark, Luxembourg, Switzerland and the UK. Many banks were established in 1983 (11) and 1984 (13). The numbers have declined considerably in the following years.

In most countries the establishment of interest-free banking had been by private initiative and were confined to that bank. In Iran and Pakistan, however, it was by government initiative and covered all banks in the country. The governments in both these countries took steps in 1981 to introduce interest-free banking. In Pakistan, effective 1 January 1981 all domestic commercial banks were permitted to accept deposits on the basis of profit-and-loss sharing (PLS). New steps were introduced on 1 January 1985 to formally transform the banking system over the next six months to one based on no interest. From 1 July 1985 no banks could accept any interest bearing deposits, and all existing deposits became subject to PLS rules. Yet some operations were still allowed to continue on the old basis. In Iran, certain administrative steps were taken in February 1981 to eliminate interest from banking operations. Interest on all assets was replaced by a 4 percent maximum service charge and by a 4 to 8 percent `profit' rate depending on the type of economic activity. Interest on deposits was also converted into a `guaranteed minimum profit.' In August 1983 the Usury-free Banking Law was introduced and a fourteen-month change over period began in January 1984. The whole system was converted to an interest-free one in March 1985.

The subject matter of writings and conferences in the eighties have changed from the concepts and possibilities of interest-free banking to the evaluation of their performance and their impact on the rest of the economy and the world. Their very titles bear testimony to this and the places indicate the world-wide interest in the subject. Conference on Islamic Banking: Its impact on world financial and commercial practices held in London in September 1984, Workshop on Industrial Financing Activities of Islamic Banks held in Vienna in June 1986, International Conference on Islamic Banking held in Tehran in June 1986, International Conference on Islamic Banking and Finance: Current issues and future prospects held in Washington, D.C. in September 1986, Islamic Banking Conference held in Geneva in October 1986, and Conference `Into the 1990's with Islamic Banking' held in London in 1988 belong to this category. The most recent one is the Workshop on the Elimination of Riba from the Economy held in Islamabad in April 1992. [3] Reference should also be made to some Islamic financial institutions established in countries where Muslims are a minority. There was a proliferation of interest-free savings and loan societies in India during the seventies. The Islamic Banking System (now called Islamic Finance House), established in Luxembourg in 1978, represents the first attempt at Islamic banking in the Western world. There is also an Islamic Bank International of Denmark, in Copenhagen, and the Islamic Investment Company has been set up in Melbourne, Australia.

Currently the world market for Islamic financial services has been growing considerably. The development of Islamic finance in the world and their stability during the global financial crisis, growing demand for Islamic financial products among population, and increasing need for the investments to real sector created favorable conditions for the industry development in Kazakhstan. Now Kazakhstan takes the leading role among the CIS countries and Central Asian region in the development of Islamic finance. One of the necessary conditions for a nation's effective economic development is a vigorous investment policy that pursues development of industries, support of social welfare systems, introduction of new technologies, and promotion of competitiveness. In this regard, one of the priority directions of the Kazakhstan government's economic policy is strong support for investment activities and creation of a favorable investment climate in the country.

The recent global financial crisis has revealed an acute problem of insufficient liquidity that has impacted the development of investment processes across the world. The inflow of foreign direct investment to Kazakhstan decreased by 20% in 2009. In this connection, Kazakhstan welcomed Islamic financing as an additional source of funding that proved its sustainability during the crisis.

Chapter II. Financial analysis of Islamic bank's activity

Islamic banking has the same purpose as conventional banking except that it operates in accordance with the rules of Shari'ah. The basic principle of Islamic banking is the sharing of profit and loss and the prohibition of Riba. The main implication of the Shariah rules is that Islamic banking is restricted to Islamically acceptable deals, which exclude those involving alcohol, pork, gambling, etc. Thus, ethical investing is the only acceptable form of investment. In addition, financial transactions are structured to reallocate risk-sharing and profits by using the concepts such as Murabaha (cost plus), Musharakah (joint venture), Mudarabah (profit sharing), Wadiah (safekeeping), and Ijarah (leasing).

Therefore, in an Islamic loan transaction, instead of loaning the buyer money to purchase the item, an Islamic bank might buy the item itself from the seller, and re-sell it to the buyer at a profit, while allowing the buyer to pay the bank in installments. However, the fact that this profit cannot be made explicit and therefore there are no additional penalties for late payment, Islamic banks use the concept of Murabaha to protect itself against default, by asking for strict collateral. The goods or land is registered to the name of the buyer from the start of the transaction. Another approach applied by Islamic banks is Musharaka where they lend their money to companies by issuing loans in a way that the bank's profit on the loan is equal to a certain percentage of the company's profits. Once the principal amount of the loan is completely repaid, the profit sharing arrangement is concluded. Further, Mudarabah is venture capital funding of an entrepreneur who provides labor while financing is provided by the bank so that both profit and risk are shared. In this transaction, an owner entrusts funds to a trustee, who returns the principal and a share of profits after using the funds for a specified purpose. Such participatory transactions between capital and labor reflect the Islamic view that the borrower must not bear all the risk/cost of a failure, resulting in a balanced distribution of income. In the case of Musharakah, the joint venture which allows partners to share losses based on the proportion of their capital contributions; And in Ijarah, the transaction allows a bank to purchase equipment or machinery and lease it to clients who may ultimately take absolute ownership. [4]

Furthermore, exchange transactions can be for immediate or deferred exchange. Yet, it is recommended that future contracts be evidenced in writing. Spot transactions need not be evidenced in writing but witnesses are recommended. And the item for sale should be under ownership of the seller and in his physical or constructive possession at the time of contracting the sale. However, Islamic banks may agree to sell defined goods to the customers which they have not yet purchased provided that it does not involve Gharar. Therefore, in Salam and Istisna'a transactions, where a price is paid at the time the contract is formulated, but delivery takes place at a future date, goods must be defined, quantified and available in the market at the agreed time of delivery.

Generally speaking, all interest-free banks agree on the basic principles. However, individual banks differ in their application. These differences are due to several reasons including the laws of the country, objectives of the different banks, individual bank's circumstances and experiences, the need to interact with other interest-based banks, etc. In the following paragraphs, we will describe the salient features common to all banks.

Deposits from savers are an important source of financial strength for the Islamic banks. They use it to increase their capacity for financing operations and thereby increase profit for the shareholders. Islamic Banks raise funds generally based on Amanah or Wadiah arrangements, on Mudarabah and on Wakalah for Fund Management. There are two main bases of mobilization of deposits by Islamic banks that are Current account deposits and Savings deposits. Banks may also get permanent or redeemable equity capital through investment deposits that practically take the form of a running partnership between the depositors. Depositors in Islamic finance can be compared with investors/shareholders in companies, who earn dividends when the investment makes a profit or lose part of their capital if the investment posts a loss. The contractual agreement between depositors and Islamic banks does not pre-determine any rates of return, it only sets the ratio according to which profits and losses are distributed between the parties to the deposit contract. In Islamic banks, Current Account deposits are based on the principle of Amanah / Wadiah or that of Qard. In the first type, interest-free deposits are held by the banks either in trust (Amanah), or in safe-keeping (Wadiah). Under Amanah arrangement, the Islamic bank treats the funds as a trust and cannot use these funds for its operations; it does not guarantee the refund of the deposit in case of any damage or loss to the Amanah resulting from circumstances beyond its control. In Wadiah, the bank is deemed as a keeper and trustee of funds and has the depositors' permission to use the funds for its operations in a Shari?ah compliant manner. Deposits under Wadiah take the form of loans from depositors to Islamic banks and the bank guarantees refund of the entire amount of the deposit. While these deposits can be withdrawn at any time, the depositors have no right to any return/profit on such deposits. However, depositors, at the bank's discretion, may be rewarded with a Hibah provided such gifts do not become a custom or a permanent practice. In the second type, the client gives the bank authority to use current accounts funds to invest in its operations, in that case, the deposit amount is considered as a non-interest loan by the depositor to the bank. The bank has the obligation of to return the credit balance upon demand clients who have no right to receive any profit on their balances. The liability to return a Qard deposit is not affected by the bank's solvency or otherwise. [5]

Savings deposit accounts operate in a different way. The depositors allow the banks to use their money invested in profitable business ventures which are legal and Shari?ah compliant. Generally, deposits in savings accounts are accepted by Islamic banks on the basis of Mudarabah where the depositor is rabb-ul-mal (investor) and the bank is the Mudarib (fund manager). The profit will be shared as per a pre-determined ratio upon, while loss will be borne by the rabb-ul-mal. Profit distribution amongst the depositors and the shareholders will be made according to the weightage assigned usually at the beginning of each month to their investments. Savings deposits are generally paced in a joint investment pool with other deposits mobilised by the Islamic banks.

Investment deposits are accepted for a fixed period of time or term and are governed by the Mudarabah contract with the bank. When deposits are for an agreed fixed term no withdrawal is normally allowed until the end of the deposit term. However, some banks are allowing early withdrawals in an agreed notice period. Term deposits are arrangement where depositors seek some return on their investments; they are taken on a Mudarabah basis. These deposits are allocated to a number of investment pools and the Islamic banks invest the pooled amount in Shari?ah-compliant businesses. All direct expenses are charged to the respective pools; the net proceeds are distributed between the bank and the pools and then among the depositors represented by the pool. The profits from the assets are shared between the depositors and the bank according to a pre-determined ratio agreed upon at the outset. The profit sharing weight ages are assigned based on the various tenures and the amount invested under the arrangement. And as required under Mudarabah, depositors have to be informed in advance of the formula used for sharing the net earnings of the investment pool with the bank. In case of the unlikely event of loss, the depositors have to bear the loss on a pro-rata basis while bank goes un-rewarded for all its efforts. If a bank contributes its equity capital in a pool at the time of setting up an investment pool, the relationship will be a combination of Musharakah and Mudarabah, and the bank would be entitled to a proportionate profit on its own investment in relation to the total Mudarabah investment pool. Islamic banks can also open may announce Murabaha and leasing funds in which the risk-averse investors may purchase units and be treated as rabb-ul-mal and get the quasi fixed-return from profits or rentals earned by the respective funds from the trading and leasing activities.[6]

Statistical data of development of Islamic Bank's activity
The growth of the Islamic banking and financial sector coincided with the surplus of revenue of Islamic oil-exporting countries. More recently, the globalization of the economy, the liberalization of capital flow, and privatization have paved the way for the expansion of the Islamic financial sector. [7]
The majority of recent studies of Islamic finance have commented on the spectacular growth of Islamic assets. While the volume of Islamic financial assets at the turn of the millennium was estimated to be in excess of 150 billion dollars (Niquet, 2008), it is currently deemed to be in excess of 700 billion dollars, including nearly 300 billion dollars of assets and over 400 billion dollars of financial investments managed by Islamic banks. The growth rate of assets owned by Islamic banks, which increased from 15% in 2000 to 23% in 2008, is significantly higher than the growth rate of assets owned by conventional banks. Another remarkable and exceptional fact is that in countries such as the United Kingdom, Islamic assets have continued to grow in spite of the severity of the subprime crisis and the subsequent credit crunch (Jouini & Pastre, 2008). Islamic banking remains highly concentrated geographically, since nearly two-thirds of Islamic financial assets are located in the Gulf, while almost 20% are located in South-East Asia (Hassoune & Satel, 2008). The available studies and statistics indicate that the growth rate of Islamic assets is approximately 39% in the GCC zone as opposed to just 15-20% in the rest of the world (MIFC 2009). Another remarkable fact is apparent from the wide range of publications in the field, i.e. the good financial health of Islamic financial institutions. To cite just two examples, the average return on equity (ROE) of the “Kuwait Financial House” and the “Al Rajhi Bank” over the course of the last ten years is approximately 30%. There are two reasons which account for this high level of financial performance. In terms of resources, Islamic banks have access to a vast amount of relatively cheap deposits (the current total amount of available savings in the Gulf and south-east Asia is estimated at around 5000 billion dollars). In the realm of employment, the price of Islamic products remains relatively high. The level of risk on the main market of Islamic banks - the retail market - is relatively low. [7]
bank muslim islamic economy
Table 1 provides an overview of the descriptive statistics for the values of variables used in the assessment of efficiency scores of Islamic banks. The statistics indicate that the sample is homogeneous, since the coefficient of variation remains stable over time. The coefficient of variation, represented by the у µ / , is included in a narrow interval: [1.25; 2.24] over the studied period. The interval is [1.28; 2.15] for 2005, [1.30; 2.15] for 2006, [1.19; 1.96] for 2007 and [1.01; 2.25] for 2008. Note that over the four studied years, the level of dispersion is significantly low for staff costs and operating costs (excluding staff costs). The highest level of dispersion was for the fixed assets. The other variables are characterized by an average level of dispersion. A two-stage approach was used to achieve the two objectives outlined above, i.e. the evaluation of the performance of Islamic banks operating in the GCC region and the identification of the explanatory factors of efficiency. The first stage involved elaborating a non-parametric frontier using the DEA method for the assessment of the various components of productive efficiency. The second stage involved explaining the differences in performance.
Table 2. Benchmark Performance Measures of Islamic Banks vis-a-vis Conventional Banks
According to the information given on the table 2 Average of Commercial Banks with similar asset size in the countries where Islamic Banks are present. Commercial banks are selected in a way they are similar to Islamic Banks in size, measured in total assets. All commercial banks are selected the third quartile by size in each country in 2001. The value of each ratio represents the average in the period 1994-2001. [8]
Figure 1. Share of Islamic Banks in Total Banking System in Selected Countries, 2006 (Percent)
Because the number of banks alone does not give a full picture of how important Islamic banks are, we compare the number of Islamic banks with the total number of banks across countries (Figure 1). Even in countries with only a few Islamic institutions, such as Brunei, Islamic banks have a strong presence. What we see is that in the Gulf region in general and in some African countries with sizeable Muslim population, the number of Islamic banks is relatively large. In other regions, the share of Islamic banks is in the single digits, indicating less importance. [8]
Deposit accounts

All the Islamic banks have three kinds of deposit accounts: current, savings and investment.

Current accounts. Current or demand deposit accounts are virtually the same as in all conventional banks. Deposit is guaranteed.
Savings accounts. Savings deposit accounts operate in different ways. In some banks, the depositors allow the banks to use their money but they obtain a guarantee of getting the full amount back from the bank. Banks adopt several methods of inducing their clients to deposit with them, but no profit is promised. In others, savings accounts are treated as investment accounts but with less stringent conditions as to withdrawals and minimum balance. Capital is not guaranteed but the banks take care to invest money from such accounts in relatively risk-free short-term projects. As such lower profit rates are expected and that too only on a portion of the average minimum balance on the ground that a high level of reserves needs to be kept at all times to meet withdrawal demands.
Investment account. Investment deposits are accepted for a fixed or unlimited period of time and the investors agree in advance to share the profit (or loss) in a given proportion with the bank. Capital is not guaranteed. [8]

Loans and Debts

There are different ways through which funds could be raised to meet individuals and organizations needs and funding requirements. Raising loans is one of the various ways these requirements can be fulfilled. In the terminology of Islamic framework, Qard and Dayn relate to the giving or taking of loans. However, the word Dayn has a broader connotation then the word Qard. Dayn incurs in any way which leaves a debt as a liability to another party to be paid later without any profit over the principal amounts. Whereas, Qard could be defined as an interest-free loan for needy borrowers extended on a goodwill basis; in particular Qard al Hasan provides funds for humanitarian and welfare purposes without any profit accruing to the lender. In fact, Qard consists on giving ownership of anything having value for the benefit of another by way of virtue. The ownership of the loaned objects is transferred to the borrower who can use, buy, sell, or donate them as the borrower wishes. Qard is only applied when one gets obliged to return the equivalent of the thing taken and repayment is for the same amount as the amount lent. Goods of the same kind will be paid back on demand or at the settled time. Qard should not bring any return or addition to the lender because that would be equivalent to taking Riba. However, a borrower can pay more than the amount borrowed, but it must not be stipulated in the contract. Further, the date of payment of the loan may or may not be included in the Qard contract as the lender can demand repayment at any time. And the loan should not be conditional upon any other contract, such as Bai? and vice-versa.

Ariyya is another structure of borrowing goods in a virtuous act. However, in the case of Ariyya, the exact borrowed commodity has to be returned to its owner, not any replacement. While in Qard, the same kind of the loaned commodity with essentially the same nature or character could be paid back.

On the other hand, a Dayn is the result of any contract or credit transaction. The created debts ought to be returned without any profit over their principal amounts. Salaf is a form of Dayn that is similar to Salam. It is used for a loan of fixed tenure and in that sense it is closer to Dayn; Salaf includes loans for short, intermediate and long term loans and the price of the commodity is paid in advance, while it is delivered at a future date. The amount given as Salaf cannot be called back before its due date. Therefore, this creates a liability for the seller to supply the commodity in the future.

In addition, in all credit transactions, Islam recommends witnesses and documentation. This provides safeguards against disputes and allows credit transactions for a fixed or known time period. And since Islamic banks can neither pay interest nor charge any return on loans, they have the right to ask for collateral to ensure recovery of the loan amount. In fact, the client cannot refuse to repay the loan or debt in case he has incurred loss in the business conducted with the bank's loan. Also, The Shari?ah puts a great deal of emphasis on repayment of loans/debts and the borrower also has a moral obligation to repay a loan. For that reason, banks can include, with mutual consent of the clients, a penalty clause in the credit contract to mitigate the risk of default, but the penalty charged on any default has to go to charity. With regard to a possible rebate that could be given to the debtor for repaying the loan earlier than the due date, the Shari?ah considers that as a reduction of interest in the financing costs arising from prepayment of the amount that would be stipulated in a contract. And, there is unanimity about the illegality of remitting a part of the debt payable by anyone and getting the remaining part. However, Muslim jurists have differentiated between loans or debts that have become due or can be called back at any time (Duyoon Haalah), and loans where time of payment settled between the creditor and the debtor and the debt is not yet due (Duyun Mu'ajjalah). Duyoon Haalah are allowed by almost all Muslim jurists on the rationale that in such loans, delay is not the right of the debtor. In fact, rebate should neither be provided in the agreement nor be made a condition in the loan contract. In opposition, remission of a part of a debt not yet due involves Riba. [8]

Modes of financing
In recent times, Islamic financing services have increased phenomenally around the world. Islamic banks offer now, to their clients, different modes to investment their money and finance their projects. These modes include solutions for short, medium, and long-term project-financing and investments.
Profit-and-loss-sharing is the most common mode proposed by Islamic banks for import financing, pre-shipment export financing, working capital financing and financing of all single transactions. This mode could also be used in the case of socio-economic projects such as infrastructure projects. PLS instruments include Mudaraba, an equity participation contract under which one of the parties participates with capital and the other with know-how. If the project ends in profit they share the profit in a pre-arranged proportion and if it results in loss the entire loss is borne by the financier, and the entrepreneur gains no benefit out of his effort, which was his part of the investment. PLS instruments also include Musharaka, an equity participation contract under which a bank and its client contribute jointly to finance a project. Ownership is distributed according to each party's share in the financing. Besides, Islamic banks propose non-PLS modes of investment that include Shari'ah acceptable forms of trade and leasing. Murabaha, salam and Istinasa are the most known Trade-based techniques. Murabaha is a purchase and resale contract in which an asset is purchased by the bank for its customer, with the resale price determined based on cost plus profit mark-up. As opposite to Murabaha, Salam is a purchase contract with deferred delivery of goods. While, Istisna is a medium-term contract, whereby the manufacturer, or the seller, agrees to provide the buyer with described goods after they have been manufactured within a certain time and for an agreed price.
Under, leasing-related financing, Islamic banks agree to purchase and maintain the assets and afterwards dispose of them according to Shari'ah rules. Ijara, for example, is a leasing contract whereby a party leases an asset for a specified rent and term. The bank bears all risks associated with ownership.
Finally, Islamic banks could use other schemes of financing such as the investment deposit scheme that provides investors with an Islamic alternative to making short-term investments by participating in the financing activities of the Bank. Under this scheme, the Bank accepts deposits from both individual and institutional investors for use in its Import Trade Financing Operations.

Banks adopt several modes of acquiring assets or financing projects. But they can be broadly categorized into three areas: investment, trade and lending. [9]

Investment financing
In the modern economic system, Islamic banks are mostly using the debt-creating modes of trade and leasing for their financing activities, while the main basis for mobilizing deposits from the public are the partnership modes of Musharakah and Mudarabah. Both modes belong to profit-and-loss sharing or the risk-sharing techniques involved in partnerships. If the financier wants to finance the whole project, the form of Mudarabah can come into operation. If investment comes from both sides, the form of Musharakah can be adopted.
An Islamic bank arranges Musharakah on the basis of a written agreement with the client for a specific transaction or project for a fixed period of time that can be renewed. It could be used to finance industry, trade, real estate, contracting and almost all legal enterprises through partnership. A Musharakah business or its assets can also be securitised by selling Musharakah Certificates in the market. The Musharakah Certificate represents the ownership of the holder in a proportion of the assets of the project. It could be sold in the marker only if it represents non-liquid assets. If the certificate only represents a proportion of liquid assets of the project; it could not be sold in the market except, as it could be assimilated to a trade of money and thus would be similar to Riba.
In addition, the returns of the Islamic bank in Musharakah have been tied up with the actual profits accrued through the enterprise. Thus the client is required to provide the bank periodically with the results of operations of the business. The bank should also share the losses of the business. And if the enterprise earns enormous profits, all of it cannot be secured by the industrialist exclusively, but they will be shared by the common people as depositors in the bank. And since financial institutions do not normally want to remain partner of a specific project for good, they can sell their share to other partners of the project as aforesaid.
Mudarabah is another agreement between the Islamic bank and an entrepreneur, whereby the entrepreneur can mobilize the funds of the bank for its business activity. It is considered as the basis of Islamic banking in the sense that funds are mobilized by banking and non-banking financial institutions mainly under this kind of partnership. The bank acts as a mudarib for the savers and investors and as financier for the entrepreneurs. If the bank employs the client's deposits without committing any of its own, it acts as mudarib for the client until the conclusion of the business transaction for which the funds were invested; whereas the entrepreneur provides his expertise, labor and management of the project. Profits made are shared between the bank and the entrepreneur according to predetermined ratio. In case of loss, the bank loses the capital, while the entrepreneur loses his provision of labor. It is this financial risk, according to the Shari'ah, that justifies the bank's claim to part of the profit. The profit-sharing continues until the loan is repaid. The bank is compensated for the time value of its money in the form of a floating rate that is pegged to the debtor's profits. Its liability mudarabah is limited to the amount of capital provided and the creditors of a mudarabah have no recourse to other assets of the Islamic bank. Financial institutions can also mobilize funds for investment by issuing negotiable investment instruments called Mudarabah Certificates; they represent ownership in the funds collected. It would distribute a percentage of the profit earned from the investment of those funds on Mudarabah principles. Mudarabah Certificates are registered in the name of their owners in proportion to the each one's share therein. A Mudarabah Sukuk can also be issued on the Mudarabah principle.
In addition, Islamic banks can use Mudarabah to finance import trade on a single transaction or a consignment basis where the whole investment has to be made by the bank. Mudarabah can also be used for the purpose of securitization. Similarly, Mudarabah can be for the whole business of a company or for any specific project whose expenses and revenues can be set aside from the main business.
And in order to insure a mutual trust in this relationship, the accounts of Mudarabah projects are periodically audited in order to determine the distributable profit, after taking into account all expenses. Furthermore, in cross-border financings, exchange and political risks have to be taken into consideration before contracting any transaction of Mudarabah. The bank may also closely monitor the performance of the mudarib during implementation of the project in order to ensure that the project or the business is managed in accordance with custom and the original agreement. The bank may even appoint its representative to the boards of the financed institution. [10]

Scope of Musharakah and Mudarabah certificates

Musharakah is a mode of financing which can be securitized easily, especially, in the case of large projects that requires huge amounts which a limited number of individuals cannot afford to collect. A Musharakah certificate represents the proportionate ownership of the client in the assets of the Musharakah project. If all the assets of the joint project are in liquid form, the certificate will represent a certain proportion of money owned by the project.

Trading in Musharakah certificates is not allowed when all the assets are still in liquid form, as an increase would fall under the prohibition of riba. Therefore, after the project is started by acquiring substantial non-liquid assets representing tangible assets, Musharakah certificates can be treated as negotiable instruments and can be bought and sold in the secondary market. In fact, the subject matter of the sale, under the Shari'ah, is a share in the tangible assets and not in money alone; therefore the certificate may be taken as any other commodity which can be sold at a profit or at a loss.

And when the money subscribed in Musharakah is employed in purchasing non-liquid assets like land, building, machinery, raw material etc. the Musharakah certificates will represent the holders' proportionate ownership in these assets. However, in most cases, the assets of the project are a mixture of liquid and non-liquid assets. In such cases, most of Muslim jurists find it acceptable to trade in Musharakah Certificates, when the Musharakah portfolio comprises more than 50% in the form of non liquid assets.

Similarly, Mudarabah Certificates are investment instruments, which mobilize the Mudarabah capital by floating certificates, registered in the name of their owners; they represent shares of equal value. Joint owners of shares in the venture capital or whatever shapes it may take, in proportion to the each one's share therein. Mudarabah is considered as the basis of Islamic banking in the sense that funds are mobilised by financial institutions mainly under this arrangement by issuing negotiable Mudarabah certificates, representing ownership in the funds collected and providing for the profit earned from the investment of those funds to be distributed on Mudarabah principles. And as it is the case in Musharakah certificates; Mudarabah certificates will not be negotiable in the eye of Shari'ah, if all the assets are in nature of liquid. In addition, Islamic banks could act as a mudarib for the savers and investors and as financier for the entrepreneurs. If the bank employs the client's deposits without committing any of its own, it acts as mudarib for the client until the conclusion of the business transaction for which the funds were invested. Finally, the liability of the Islamic bank under Mudarabah is limited to the amount of capital provided by the bank and the creditors of a Mudarabah have no recourse to other assets of the bank. [11]

Trade financing

Trade financing is also done in several ways. The main ones are: a) Mark-up where the bank buys an item for a client and the client agrees to repay the bank the price and an agreed profit later on. b) Leasing where the bank buys an item for a client and leases it to him for an agreed period and at the end of that period the lessee pays the balance on the price agreed at the beginning an becomes the owner of the item. c) Hire-purchase where the bank buys an item for the client and hires it to him for an agreed rent and period, and at the end of that period the client automatically becomes the owner of the item. d) Sell-and-buy-back where a client sells one of his properties to the bank for an agreed price payable now on condition that he will buy the property back after certain time for an agreed price. e) Letters of credit where the bank guarantees the import of an item using its own funds for a client, on the basis of sharing the profit from the sale of this item or on a mark-up basis.


Main forms of Lending are: a) Loans with a service charge where the bank lends money without interest but they cover their expenses by levying a service charge. This charge may be subject to a maximum set by the authorities. b) No-cost loans where each bank is expected to set aside a part of their funds to grant no-cost loans to needy persons such as small farmers, entrepreneurs, producers, etc. and to needy consumers. c) Overdrafts also are to be provided, subject to a certain maximum, free of charge. [12]

Chapter III. Perspectives and future development of Islamic banking in the world

Islamic banks, while functioning within the framework of Shariah, can perform a crucial task of resource mobilization, their efficient allocation on the basis of both PLS (Musharaka and Mudaraba) and non-PLS (trading & leasing) based categories of modes and strengthening the payments systems to contribute significantly to economic growth and development. Sharing modes can be used for short, medium and long-term project financing, import financing, pre-shipment export financing, working capital financing and financing of all single transactions. In order to ensure maximum role of Islamic finance in development of the economy it would be necessary to create an environment that could induce financiers to earmark more funds for Musharakah/Mudarabah based financing of productive units, particularly of small enterprises.

The non-PLS techniques, as acceptable in the Islamic Shariah, not only complement the PLS modes, but also provide flexibility of choice to meet the needs of different sectors and economic agents in the society.

Trade-based techniques like Murabaha with lesser risk and better liquidity options have several advantages vis-a-vis other techniques but may not be as fruitful in reducing income inequalities and generation of capital goods as participatory techniques. Ijarah related financing that would require Islamic banks to purchase and maintain the assets and afterwards dispose of them according to Shariah rules, require the banks to engage in activities beyond financial intermediation and can be very much conducive to the formation of fixed assets and medium and long-term investments.

On the basis of the above it can be said that supply and demand of capital would continue in an interest free scenario with additional benefit of greater supply of risk-based capital along with more efficient allocation of resources and active role of banks and financial institutions as required in asset based Islamic theory of finance. Islamic banks can not only survive without interest but also could be helpful in achieving the objective of development with distributive justice by increasing the supply of risk capital in the economy, facilitating capital formation, and growth of fixed assets and real sector business activities. [13]

Salam has a vast potential in financing the productive activities in crucial sectors, particularly agriculture, agro-based industries and the rural economy as a whole. It also provides incentive to enhance production as the seller would spare no effort in producing, at least the quantity needed for settlement of the loan taken by him as advance price of the goods. Salam can also lead to creating a stable commodities market especially the seasonal commodities and therefore to stability of their prices. It would enable savers to direct their savings to investment outlets without waiting, for instance, until the harvesting time of agricultural products or the time when they actually need industrial goods and without being forced to spend their savings on consumption.

Banks might engage in fund and portfolio management through a number of asset management and leasing & trading companies. Such companies/entities can exist in the economy on their own or can be an integral part of some big companies or subsidiaries, as in the case of Universal Banking in Europe. They would manage Investors Schemes to mobilize resources on Mudarabah basis and to some extent on agency basis, and use the funds so collected on Murabaha, leasing or equity participation basis. Subsidiaries can be created for specific sectors/operations, which would enter into genuine trade and leasing transactions. Lowrisk Funds based on short-term Murabaha and leasing operations of the banks in both local as well as foreign currencies would be best suited for risk-averse savers who cannot afford possible losses, in PLS based investments. Under equity based Funds, banks can offer a type of equity exposure through specified investment accounts where they may identify possible investment opportunities from existing or new business clients and invite account-holder to subscribe. Instead of sharing in the bank's profit, the investors would share the profits of the enterprise in which funds are placed with the bank taking a management fee for its work. Banks can also offer open-ended Multiple Equity Funds to be invested in stocks.

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