THE PERFORMANCE OF MALAYSIAN ISLAMIC BANK

DURING 1984-1997: AN EXPLORATORY STUDY

Abdus Samad & M. Kabir Hassan

The study evaluates intertemporal and interbank performance of Islamic bank (Bank Islam Malaysia Berhad (BIMB) in

profitability, liquidity, risk and solvency; and community involvement for the period 1984-1997. Financial ratios are

applied in measuring these performances. T-test and F-test are used in determining their significance. The study found that

BIMB is relatively more liquid and less risky compared to a group of 8 conventional banks. Our analysis of the primary data

identified reasons why the supply of loans under profit sharing and joint venture profit sharing is not popular in Malaysia.

40% to 70% bankers surveyed indicated that lack of knowledgeable bankers in selecting, evaluating and managing

profitable project is a significant cause.

I. Introduction

Evaluation of bank performance is important for all parties: depositors, bank managers and regulators. In a competitive

financial market bank performance provides signal to depositor-investors whether to invest or withdraw

funds from the bank. Similarly, it flashes direction to bank managers whether to improve its deposit service or loan

service or both to improve its finance. Regulator is also interested to know for its regulation purposes.

Bank Islam Malaysia Bhd (BIMB) is a single full-fledged Islamic bank in Malaysia. The important underlying force

that led to the establishment of this Islamic bank in Malaysia was the elimination of riba that is used for interest.

Tabung Haji took the initiative to do business without using interest considered as being predetermined rate of

return to a deposit. Tabung Haji is an organization for the Muslim for taking care of pilgrims to Mecca. It is

basically act as a privately to facilitate the Muslims to perform their Hajj with the feeling of minimum financial

burden. Its objective is to implement Muslim code of life (shariah) in Hajj and all business transactions. All transactions

in the conventional banks are based on interest or "riba" which is prohibited by Islam. Tabung Hajj wanted

to get rid of "riba" (interest). Islamic bank is sought as a solution to it. With the increase in Muslim populations and

awareness of Islamic values, there was a greater demand for Islamic bank and interest-free finance by Muslim

consumers, traders, investors, and businessmen.

Bank Islam Malaysia was established in July 1983 to meet these demands and challenges. Since then BIMB

introduced and marketed various interest free products such as Wadiah ad Dhamana account, Mudarabah,

Musharakah and others. Bank's business has expanded over the years. Its assets and deposits have increased

from RM 325 mil to RM 4,440 mil in 1997. The financing of loans and services increased to RM 991 mil in 1997.

The number of branches increased to 75 in 1998.

However, 15 years have passed since BIMB was established. There has been no study as to how the bank

performed in liquidity, profitability, risk and solvency, as well as its commitment to economy and Muslim community

during 1984-1997. The previous studies on profitability and other measures, Samad (1998), Ariff (1989), Dirrar

(1996), Mohiuddin (1991) Sum (1995) and Hassan (1999) are far from satisfactory. These studies used neither

statistical technique nor made inter-temporal and inter-bank comparisons with three sets of conventional banks.

However, such issues of profitability, liquidity, risk and solvency; and community involvement of the bank during

1984-1997 are very important to depositors and investors. So, the present study intends to evaluate the performance

of Islamic banks using the above mentioned criteria. This study is different from the earlier studies with

respect to contents, coverage of years and methodology. In evaluating BIMB's performances, this study also

wants to test two hypotheses. The first hypothesis states that the liquidity ratios of Islamic banks are expected to

be higher in earlier years of operation than later years due to a learning curve. The second hypothesis states that as

International Journal of Islamic Financial Services Vol. 1 No.3

Islamic banking makes its inroad in the society, the volume of two truly islamic financial modes of lending

(Mudharabah and Musharakah) are expected to grow larger in later years of its operation.

Hassan (1999) examines the Islamic banking principles in theory and its application with a case study of Bangladesh.

The abundance of short-term funds compared to long-term funds available for lending is a rational response on

behalf of banks to solve informational asymmetries prevalent in credit market. In traditional finance literature, it is

shown that debt contract (murabaha) is superior to equity contract. However, equity contract can be superior to

debt contract in an economy where informational asymmetries resulting from adverse selection and moral hazard

are smaller. In Islam, business is an Ibadah (worship) and is recommended whereas riba (interest) is prohibited.

From business point of view Islamic bank is not only a firm but also a moral trustee of the depositors where deposits

are trust given to banking firm. It is naturally expected that as a custodian of trust for the depositors' deposits,

Islamic bank is likely to be more liquid and become more solvent compared to its counterpart conventional banks.

Islamic bank management, according to Islamic ethics, is accountable to the depositors in this world and the world

hereafter for their failure to keep the trust entrusted upon them. It is, therefore, expected that the liquidity and

solvency ratio of the Islamic bank will be higher than conventional banks.

However, it is also expected that the liquidity ratio of the Islamic bank may decline during the later periods compared

to its early eras. As the bank grows, it acquires more skill and the art of banking business, it will keep less

liquidity and thus the liquidity ratio may decline. This paper wants to test the hypothesis that the liquidity ratio and

solvency for Islamic banks in the early periods are higher than those of later periods are.

Instead of interest based contract, Islamic bank is founded on different philosophy; and it delivers a set of distinguished

products in the financial market. Unlike conventional banks where interest is an integral part of bank

business, Islamic bank was established to avoid interest in all bank transactions. It does not deal with interest.

Interest is avoided because "riba" is prohibited in Islam. As a business firm BIMB delivers special financial products

that are different from the conventional banks. It delivers interest-free products. For example, trust profit

sharing (called Mudarabah) and joint venture profit sharing (called Musharakah) are two distinguished and unique

products of an Islamic bank. The important feature of this loan (Mudarabah and Musharakh) is that they are

interest-free. There are no elements of interest involved in this transaction. For the Muslims there is a great

demand for them. BIMB was established to meet these demands. With the increase in Muslim population, business

firms and entrepreneurs in Malaysia, the supply of Mudarabah and Musharakah loan was a long waited product. In

these transaction Muslims can serve religious obligation and at the same time can earn profits. With the economic

development of Malaysia and the increase in Muslim population, Islamic values, Muslim business and firms, it is

expected that demand for these products (Mudarabah and Musharakah) are likely to increase gradually over the

years. It is also expected that the information gap between bank and the bank borrowers to be minimum because

both party jointly working to maximize profit and minimize losses. Projects undertaken under the Mudarabah and

Musharaka are constantly supervised and monitored by the Islamic bank. So the chances of failures are minimized.

Based on the expectation of minimum failure it is expected that the supply of these loans will increase over the

years. This paper will test the hypothesis that the supply for this loan (Mudarabah and Musherakah) of the Islamic

bank increases over years.

The paper is organized as follows. Following introduction and rational of this study in section I, Section II describes

methodology, data and the tools for measuring bank performance. Section III provides empirical evidence and

analysis. Summary and Conclusion are provided in Section IV.

II. Methodology and data:

Financial management theories provide various indexes for measuring a bank's performance. One of them is

accounting ratios. The uses of the financial ratios are quite common in the literature. Bank regulators, for example,

use financial ratios to help evaluate a bank's performance. Booker (1983Z), Korobow (1983), Patnam (1983), Sabi

(1996), Samad (1999), Akkas (1994), Meister and Elyasiani (1988) and Spindler (1991) gave employed financial

ratios for evaluating a bank's performance. In order to see how Islamic Bank (BIMB) performed over 14 years,

this study approaches an analysis of inter-temporal performance of Islamic bank. In other words, the paper makes

International Journal of Islamic Financial Services Vol. 1 No.3

comparison of performance of BIMB between two periods 1984-1989 and 1990-1997. Year by year comparison of

performance and explanation is difficult specially for a study of extended years. Secondly, it is easy to see and

explain the differences between two periods. In the context of present study, bank performance of the yearly

periods 1984-1989 is compared to that of later period 1990-1997. This is not a new method (Elyasiani, 1994). In

addition to inter temporal comparison, the study makes comparison of Islamic bank (BIMB) and conventional

banks performances. First, BIMB is compared with a conventional bank (Bank Pertanian) which is a smaller (in

terms of asset) bank than BIMB. Second comparison is made with another conventional bank (Perwira Affin)

which is larger than BIMB. Third, comparison of BIMB and the 8 conventional bank is made here. This type of

inter-bank analysis is common in bank performance study (Sabi (1996). In the competitive financial market, performance

of a bank can be better understood by an analysis of inter-bank comparison. The study uses fourteen

financial ratios for bank's performance. These ratios are grouped under four broad categories. The analysis of

bank performance concentrates on the following on four financial ratios: a. profitability; b. liquidity; c. risk and

solvency; d. commitment to domestic and Muslim community.

1. Profitability Ratios:

The profitability can be judged by the following criteria.

1 Return on asset (ROA) = Profit after tax/ total asset

2 Return of equity (ROE) = Profit after tax/ equity capital

3 Profit expense ratio (PER) = profit/total expense. A high PER indicates that a bank is cost efficient and

makes higher profit with a given expense.

ROA and ROE are the indicators of measuring managerial efficiency [Ross (1994), Sabi (1996), Hassan (1999)

and Samad (1998)]. ROA is net earning per unit of a given asset. It shows how a bank can convert its asset into net

earnings. The higher ratio indicates higher ability and therefore is an indicator of better performance. Similarly,

ROE is net earnings per dollar equity capital. The higher ratio is an indicator of higher managerial performance.

However, profitability is only part of bank performance story.

2. Liquidity Ratios

Bank and other depository institutions share liquidity risk because transaction deposits and saving accounts can be

withdrawn at any time. Thus when withdrawal exceeds new deposit significantly over a short period, banks get into

liquidity trouble. There are several measures for liquidity.

1 Cash deposit ratio (CDR) = cash/deposit. Cash in a bank vault is the most liquid asset of a bank. Therefore,

a higher CDR indicates that a bank is relatively more liquid than a bank which has lower CDR. Depositors'

trust to bank is enhanced when a bank maintains a higher cash deposit ratio.

2 Loan deposit ratio (LDR) = Loan/deposit. A higher loan deposit ratio indicates that a bank takes more

financial stress by making excessive loan. Therefore, lower loan deposit ratio is always favorable to higher loan

deposit ratio.

3 Current ratio = Current asset (CA) / current liability (CL) (1) It indicates how the bank management has

been able to meet current liability i.e. demand deposit with the current asset. A high ratio is an index that shows

bank has more liquid asset to pay back the trust (deposit) of the depositors. When withdrawals significantly exceed

the new deposits banks usually recourse to replace this shortage of funds by selling securities. Government securities

are easily sold and are considered liquid. As such the current ratio as measured above is expected to be more

preferable to lower current ratio.

4 Current asset ratio (CAR) = current asset/total asset. A high CAR indicates that a bank has more liquid

asset. A lower ratio is a sign for illiquidity as more of the assets are long term in nature.

International Journal of Islamic Financial Services Vol. 1 No.3

b. Risk and Solvency Ratios

A bank is solvent when the total value of its asset is greater than its liability. A bank becomes risky if it is insolvent.

The following are the commonly used measures for a risk and insolvency.

1 Debt equity ratio(2) (DER) = Debt/equity capital. Bank capital can absorb financial shock. In case asset

values decrease or loans are not repaid bank capital provides protection against those loan losses. A lower DER

ratio is a good sign for a bank.

2 Debt to total asset ratio(3) (DTAR) = Debt/total asset indicates the financial strength of a bank to pay its

debtor. A high DTAR indicates that a bank involves in more risky business.

3 Equity multiplier (4) (EM) = total assets/share capital. It is the amount of assets per dollar of equity capital.

A higher EM indicates that the bank has borrowed more funds to convert into asset with the share capital. The

higher value of EM indicates greater risk for a bank.

4 Loan to deposit ratio (LDR) = loans/deposit measures liquidity as well as credit risk for a bank. A high

value indicates a potential source of illiquidity and insolvency.

b. Commitment to Economy and Muslim Community

1 Long term loan ratio (LTA) = long term loan/total loans. A high LTA indicates a bank commitment for

supporting long term development project.

2 Government Bond Investment (GBD)=Deposit invested in government bond/Total Deposit. A higher GBD

indicates high liquidity and less risk.

3 Mudaraba-Musharaka Ratio (MM/L)=Mudaraba-Musharaka/Total Loans. A higher percentage of MM/

L indicates a greater commitment to community developments.

The performance of Islamic bank BIMB is measured in three stages. First, the performance of initial 5 years is

compared with the performance of the subsequent 6 years by using the performance measures as delineated

above. Second, Islamic bank is compared with two selected banks. Of the two banks, one (Bank Pertanian) is a

smaller and the other (Perwira Affin) is larger than BIMB. Third, BIMB is compared with banking industry

represented by a group of 8 banks.(5)

In all three stages of comparison, ANOVA is used to test the null hypothesis of the equality of means in order for

our comparison more reliable and meaningful. Since MSB/MSW is the estimated F-value, so if the estimated Fvalue

is higher than the critical value, there is sufficient evidence to reject Ho that the means of performance of the

two banks are equal. In other words, ANOVA supports the conclusion that the population means of the variable for

the two banks are not identical. On the other hand, if the F-statistics is less than its critical, ANOVA supports that

the performances are not statistically different from each other.

III. Analysis of Empirical Results

Table 1 shows means and standard deviation of various performance measures of the Islamic bank (BIMB)

between 1984-1989 and 1990-1997. All profitability measures PER, ROA and ROE (6) in Table 1 indicate that

BIMB makes significant progress in profitability during 1984-1997. This improved performance is statistically

significant as the means of ROA and ROE ratios are different between the two periods. The higher returns might

have been due to higher risky investments by the bank. This is supported by the increased debt equity and equity

multiplier ratio. These two measures of risk and insolvency, that is DER and EM are statistically significant at 5%

level.

International Journal of Islamic Financial Services Vol. 1 No.3

This improved profitability (PER) performance when compared with a conventional bank/banks show that (Table

2, Table 3, and Table 4) BIMB is lagging behind the conventional bank. An average profit of BIMB is 21%

whereas the average profit of the conventional bank for the same periods was 36%. This difference in profitability

performance is statistically significant at 5% level. These results are consistent with those of Samad (1999) and

Hassan (1999). There are various reasons for lower profitability performance of BIMB. First, BIMB does not

have wide scope for investment in any stock or security because of religious constraints. It can only invest in

Shariah approved projects. It can not invest beyond the Shariah Board approved investments even if it can earn

higher rate of returns. Shariah Board supervises bank investment. Secondly, investment in government bond is a

major source of earnings. The rate of return of government bond is lower than other types investments. (7) Thirdly,

in order to provide the guarantee of depositors' deposits and trust (amanah), BIMB maintains more liquidity than

the conventional banks. This is evident from inter-bank comparison of liquidity ratio. Inter-bank comparison in

Table 1 shows that liquidity position of BIMB has not changed over 13 years. All four measures of liquidity do not

show statistically any significant difference. The means of the two periods for CDR, LDR, CR are not statistically

different. This indicates that bank's maintenance of liquidity position remains unchanged between 1984-1989 and

1990-1997. This unchanged liquidity position rejects our hypothesis that BIMB will hold less liquidity in the subsequent

years of operation when bank becomes matured. However, inter-bank comparison of liquidity measures of

performance among the group of eight bank and two individual banks provides no evidence in either way. In terms

of most liquid asset i.e. cash, cash-deposit ratio, BIMB shows better performance than Perwira Affin and it is

significant at 5% level. Despite better performance, BIMB is behind the group of eight banks.

Bank performance of risk and solvency between 1984-1989 and 1990-1997 (Table 1) reveals that BIMB's involvement

in risky business measured in DER, DTAR, EM increased over years. The means of debt-equity ratio (DER)

and equity multiplier (EM) increased from 9.14 to 19.59 and from 10.38 to 19.49 respectively, and are statistically

significant at 0.5% level. Other measures, like DTAR and LDR show deterioration of risk but are not statistically

significant. However, when BIMB is compared with conventional banks in table 2, table 3 and table 4 it is found

that BIMB is relatively less risky and more solvent than two other individual conventional banks (Pertanian and

Perwira Affin) and the group of eight banks. The average debt-equity and the equity multiplier for Islamic bank are

14.78 and 14.95 as compared to 43.33 and 47.34 for the Partanian Bank and 41.78 and 43.60 for the Perwira Affin

bank respectively. The difference in means in DER and EM for two individual banks (Pertanian and Perwira

Affin) versus BIMB is statistically significant. The comparison of means for risk measure in DTAR for BIMB and

the group of eight conventional banks in Table 4 indicates that the average debt-asset ratio for Islamic bank is 0.80

as compared to 0.92 of the conventional banks and this difference in means is statistically different. ANOVA

suggests that the null hypothesis (Ho) of the equality of two means for BIMB and the group of eight banks be

rejected at 1% level of significance. This implies that these two performance measures are not equal.

First, the reason for low risk of the Islamic bank (BIMB) is that its investments in government securities are much

larger than the conventional banks. This difference in investments is statistically significant. Secondly, it has more

equity capital compared to assets shown by its equity multiplier (EM). Larger equity capital indicates a higher

shock absorbing capacity for the Islamic bank. It can withstand more assets or loan losses compared to bank

(banks) which has (have) less capital. . However, lack of data on loan losses and non-performing loans in Islamic

and conventional banks prevents us from making a conclusive judgment.

Banks' involvement in delivering special products (Mudarabah and Musharakah) shows that between 1984-1989

and 1990-1997, the average supply of loans under this category has increased from .0002 to .002 and the difference

in means of the two periods is not statistically significant. Therefore, we cannot conclude decisively that the

supply of Mudarabah and Musharakah loans has increased over this time period (Table 1).

Our primary data provides several reasons why Mudarabah and Musharakah are not popular in Malaysia. The

analysis of the primary data in Table 5a indicates that 40% of the respondents consider that (B)(8) as a major

cause. 32% of the respondents support that (A) is a cause, i.e. Mudarabah and Musharakah are not popular

because the alternative modes of financing are more profitable and less risky than Mudharabah and Musharakah.

20% of the respondents indicates that they do not feel comfortable with the idea of sharing joint management (C).

Only 8% support that hypothesis that the monitoring cost of the Mudaraba and Musharaka is very high for the

bank.

International Journal of Islamic Financial Services Vol. 1 No.3

The distribution of responses is based on raking made in the alternative answer. Table 5b shows that only 70%

respondents put "B" in the first rank, 62.5% people have ranked "A" in the first rank, 18.7% people rank it 2nd and

3rd. "D" has been ranked 2nd and 3rd by 50% of the respondents.

It appears from the replies of the respondents that the problem of moral hazard and adverse selection still exists in

Islamic banking system. The Islamic bank cannot altogether eliminate the problem of asymmetric information and

that is why the supply of loan under this category has not increased, contrary to our expectation.

With regard to BIMB's community commitment measured by the investment in government securities and loans as

a percentage of total assets, LTA, it is found that there has been no difference in performance over the two

periods. The low t-ratio for the period suggests that the means for the two measures are not statically significant

(Table 1)

Interestingly, the Malaysian experience in Islamic Banking is very similar to those found in Bangladesh. The data

on Islamic Bank Bangladesh Limited (IBBL) shows that majority of financing operation is in short-term trade

financing and long-term financing is rarely given to entrepreneurs. Musharaka financing has hovered around in the

vicinity of 2% during the bank's 16 years existence. Financing to the agriculture has been minimal. (Hassan, 1999)

IV. Summary and Conclusion

The examination of various performance measure and the inter-temporal comparison of BIMB's performance

reveal that Islamic bank made (statistically) significant progress on return on assets (ROA) and return on equity

(ROE) during 1984-1997. The average ROA, PER and ROE during this period were 0.43, 21.5 and 8.07 respectively.

The comparison of BIMB with a group of conventional bank on ROA and ROE does not show (statistically)

any difference in performance. The liquidity performance between 1984-89 and 1990-97 in various measures such,

as cash-deposit ratio (DER), loan-deposit ratio (LDR), and current ratio (CR) show neither deterioration nor

improvement. However, inter bank comparison of liquidity performance suggests that Islamic bank appears to be

statistically more liquid compared to a group of 8 conventional banks at least in cash-deposit measure. The average

cash-deposit ratio of BIMB is 0.021 compared to 0.012 of the conventional bank.

Risk and insolvency measures between 1984-89 and 1990-97 found that BIMB risk increased and it is statistically

significant in debt-equity (DER) and equity multiplier (EM). DER and EM increased from 9.16 to 19.59 and 10.38

to 19.49 respectively. However, the comparison of Islamic bank and a group of conventional bank indicate that

Islamic bank is still less risky and more solvent measured in DER, DTAR, EM and LDR. The difference in risk

measured in debt-equity is statistically significant. Although the means of other measures such as DTAR, EM and

LDR of the Islamic Bank are lower compared to a group of conventional banks, they are not statistically significant.

Islamic bank's performance in community financing and participating in government project measured in GBD,

LTA and MM/L does not show any statically difference between 1984-1989 and 1990-1997. The comparison of

Islamic bank and the group of eight conventional banks reveal that there is no difference in economic participation

(measured by LTA) between them. ANOVA also supports this finding, as the F-value is statistically insignificant.

Send instant messages to your online friends http://uk.messenger.yahoo.com

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New Postal Codes to be Launched Today in BVI

The new postal code system is expected to be implemented today in the British Virgin Islands, during the ceremony which will begin at 4.45 pm.

Benefits of new postal code system including more efficient mail service were already discussed in September when BVI Government has announced on the adoption of the postal code system in the BVI. The three main benefits of implementing postal codes were also stressed during a press briefing at the chief minister's office by Postmaster General Kevin Smith. These are commercial recognition for online shopping, more efficient way of sorting and processing local mail and international recognition.

The local postal service worked along with the United States postal service to change the way mail has traditionally been transported to the BVI. Smith stated that in the past a dispatch would take from 15 to 45 days depending on the season or the route, while now the dispatches are coming to the BVI from the two transit points in New York and Miami within 3 or 4 business days.

Smith has pointed at the main difference between the old and newly implemented postal systems: traditionally every branch and sub-post office in the BVI was responsible for sorting its own mail, but now, with the introduction of the new code, there will be a hub where all mail will be processed, and the branches will focus on retail services.

The postal code structure is based on the fact that the codes which are to be revealed today will be physically linked to a post office or one's postal address. Also, by words of Smith, each island including Anegada, Virgin Gorda and Jost Van Dyke will have different code, and the major island Tortola will have three zones – East, Central and West – each having different postal code. There is also enough place allowed within the numerical system of the code for expanding with the growth of the postal infrastructure and network.

Thorough public education campaign has been planned in an effort to get the public to utilize the codes as quickly as possible. It is, however, anticipated that only 10% of the population would start using the codes in the first year and a half.

Smith also informed the publics about his intention to bring the best service in the region, and in that connection to open an Express Mail service in 2007. For this, the BVI post office is working with a US based private company to develop a data base that would feature to some degree GPS mapping and provide house delivery service.

Brian Obvi,
Offshore Analyst

Article any source

Too many errors in CAP payments

In its annual report on the EU's farm accounts in 2005, the Court of Auditors 'found that CAP expenditure [€48.466 billion last year] was still affected by a material level of error which is not detected or prevented bt the supervisory and control systems.' It noted 'weak internal controls for the majority of EU expenditure, both within member states, and at the Commission, and a high incidence of errors in the underlying transactions.'

Greece was singled out as the worst offender. The Court declared that the quality of inspections in Greece was low and that the reporting of results was unreliable. Farmers' unions are responsible in Greece for inputting all data into the computer system, and can make changes whenever they want - without the changes being recorded. Not surprisingly, instances of farmers exaggerating the size of their land are not uncommon.

All of the olive oil subsidies examined in southern countries were found to contain either an overpayment and/or one of more formal errors. This led the Court to ask whether the Geographical Information System, the system of aerial photographs used to verify the existence of olive tree parcels was doing its job.

The Commission got quite humpy about the Court's findings complaining about its 'focus on finding individual errors in small smaples of transactions.' The Commission noted with apparent pride that it had clawed back €2.17 billion in ineligible payments in 2005. So that's all right then.Any source

Gloomy prognosis on Doha Round

Recent conventional wisdom has been that the Doha Round talks will get under way once the US elections are out of the way with a window of opportunity between then and the spring. After then it would be too late to get an agreement through Congress using trade promotion authority (once known as fast track) although a few months' extension might be possible.

However, the chair of the agriculture negotiations, Crawford Falconer, has now said that he thinks the Doha Round will fail. He still thinks that both the US and the EU have room within their negotiating mandates to improve their offers on reducing farm support, but he suggested that the political will was missing on both sides. There was still the possibility of finding 'an outcome that would work and one that would make a difference', but time was running out.

Falconer's intervention could be a ploy to encourage a focus on the issues and to offset overly optimistic pronouncements by politicians. Nevertheless, it is easy to fall into the comforting belief that, as happened in the Uruguay Round, it will be 'all right on the night'. This time it may not be and the consequences for agricultural trade and further policy reform would be serious.Any source

THE PROPHET AND THE PROFITS
Islamic finance

Islamic banking and financial institutions grew along with political Islam: it declined, they did not. In fact, Islamic finance is now a confident part of the new global world of venture capital, ethical investment and profit-and-loss sharing.

By Ibrahim Warde

The assets of Islamic financial institutions now top the $230bn mark. That is more than a 40-fold increase since 1982 (1). Most of the large Western financial institutions, following the example of Citibank, have their own Islamic subsidiaries or, at the very least, Islamic "windows" or products aimed at their Islamic clientele. As proof of how many companies are compatible with Islamic law - and not just from within the Muslim world - there is now even a Dow Jones Islamic market index.

This may seem strange. We often hear it said that Islam is incompatible with the new world order that emerged with the end of the cold war (2). How can practices rooted in the Middle Ages thrive in the age of technology-driven global finance? Or institutions that are suspicious of interest operate within a global, interest-based financial system? And how can Islamic finance, often considered a facet of political Islam, experience its most rapid growth just as that same political Islam is on the wane (3) ?

Modern Islamic finance began in the early 1970s at the intersection of two important developments in the Muslim world: the rise of pan-Islamism and the oil boom. The 1967 Six Day war marked the end of the secular pan-Arab Nasserite movement and the start of the regional dominance of Saudi Arabia under a pan-Islamic banner (4). With the start of the Organisation of the Islamic Countries movement (OIC) in 1970, the idea of updating traditional Islamic banking soon became part of the agenda. It was something that had preoccupied Islamic scholars, particularly in Pakistan, for a number of years.

Research institutes focusing on Islamic economics and finance began to spread throughout the Muslim world. In 1974 the OIC summit in Lahore voted, after oil prices quadrupled, to create the inter-governmental Islamic Development Bank (IDB). Based in Jedda, this became the cornerstone of a new banking system inspired by religious principles. In 1975 the Dubai Islamic Bank - the first modern, non-governmental Islamic bank - was opened. In 1979 Pakistan became the first country to embark on a full Islamisation of its banking sector; and Sudan and Iran followed suit in 1983.

The first paradigm of modern Islamic banking was established in those years. Islamic jurisprudents reinterpreted a rich legal but pre-capitalist tradition to suit the requirements of the modern era. There was a central problem: although commerce had always been central to the Islamic tradition (the Prophet Mohammad was himself a merchant), profits from pure finance were viewed with suspicion. The Koran says, for example, that despite their superficial resemblance, profits from commerce are fundamentally different from those generated by money-lending (sura 2, verse 275). More specifically, Islam prohibits riba. Though the term literally means "increase", it has been variously interpreted: sometimes as usury (or excessive interest), more often as any kind of interest. The majority of Islamic scholars still equate riba with interest, even though major scholars - including the current head of Egypt’s Al-Azhar, one of Islam’s oldest and most prestigious centres of learning - have condoned the use of certain forms of interest.

Pricing time

Islamic scholars accepted that time must be priced, but objected to the fixed, pre-determined aspects of interest-based lending with its inherent risk of lender exploiting borrower (5). In the early days of Islam, the dominant form of finance consisted in a partnership between lender and borrower, based on the fair sharing of both profits and losses - a logic similar to today’s venture capital where financiers link their fate to the firms in which they invest. For instance, in medieval Arabia, wealthy merchants financing the caravan trade would share in the profits of a successful operation, but could also lose all or part of their investment if the merchandise was stolen, lost or sold for less than its cost.

A distinctive feature of Islamic banking was to be its focus on developmental and social goals. Profit-and-loss-sharing (PLS), or partnership finance, with its focus on cash-poor but promising entrepreneurs, held more economic potential than conventional, collateral-based lending, which favours established businesses. Islamic finance also promised to benefit local communities and draw into the banking system people who had shunned riba-based finance. In addition, banks were to contribute to, as well as manage, zakat funds (6) earmarked for a variety of charitable and social purposes.

The first Islamic banks were committed to partnership finance - mudaraba(commenda partnership) and musharaka (joint venture) - though most of their operations consisted of cost-plus operations such as murabaha, where the bank would purchase the goods needed by the borrower, then resell them to the borrower at a profit. Remuneration of deposits (current, saving or investment accounts) was based on a profit-and-loss sharing logic: investment accounts were remunerated based on the performance of specific investments by the bank; and holders of savings accounts shared in the bank’s overall profits.

After a few years Islamic finance began to look like no more than an exercise in semantics: Islamic banks were really no different from conventional banks, except in the euphemisms they used to disguise interest. Forays into profit-and-loss sharing were disappointing, and often abandoned. The image of Islamic banks was also tainted by the failure of Islamic Money Management Companies (IMMCs) in Egypt in 1988 and by scandals such as the BCCI (Bank of Credit and Commerce International) collapse in 1991. People dismissed Islamic finance as a passing fad associated with the oil boom.

In reality, it was on the cusp of a major boom. Deregulation and technological change had produced a major readjustment in international finance. And the Islamic world had been transformed by new political, economic and demographic circumstances (the impact of the Iranian revolution, the Gulf war, the collapse of the Soviet Union, the emergence of new Islamic states, a changing oil market, the rise of Asian tigers, a growing Islamic presence in the West, the emergence of new Islamic middle classes).

The traditional world of finance, dominated by commercial, interest-based banking, could raise potentially troublesome theological issues. But Islamic finance thrived in the new world, with its downgrading of interest income, financial innovation and blurring of distinctions between commercial banking and other areas of finance. The downgrading of interest (and the concomitant rise of fees as a major source of revenue for financial institutions) allowed Islamic bankers to sidestep the controversial riba issue. Deregulation fostered the creation of tailor-made Islamic products. Until the 1970s financial institutions could sell only a narrow range of financial products. With the lifting of constraints on products that could be devised to suit every need, religious or not, Islamic products could be created. For example, the process of slicing and splicing makes it possible to split the interest and principal components of a bond, and sell them separately.

Moralising finance

At the ideological level, the Islamist critique of statism converged with the emerging "Washington consensus". The Islamic commitment to private property, free enterprise and the sanctity of contracts meshed with the emphasis on privatisation, deregulation and the rule of law. The reliance on zakat and other religiously-based redistribution schemes matched increased preference, since the Thatcher-Reagan years, for the downsizing of the welfare state. In many countries, Islam became a tool for entrepreneurs seeking to get around restrictive regulation, and the best excuse to disengage the state from the economy. Malaysia and Bahrain used Islam as a tool of financial modernisation - essentially as a way of countering the rentier inclinations of the private sector and the anti-competitive leanings of entrenched elites who benefited from the status quo. The Financial Times noted that Islamic institutions are now often at the forefront of innovation and dynamism.

Perhaps the main impetus behind the current boom in Islamic finance lies in the excesses of global finance (7). Just as current business excesses have spawned a preoccupation with ethics, the amorality of contemporary finance has generated an interest in "moralising" finance. And whereas Western or Judeo-Christian finance has become thoroughly secularised (the religious origin of many financial institutions has long receded from people’s minds), the idea of Islamic finance was bound, at a time of rising pietism (8), to strike a chord. Islam has a positive view of economic activities, while providing for a strict ethical framework; and Islamic finance offers a fruitful compromise between finance and ethics.

This explains the current tendency to focus on the spirit, or "moral economy", of Islam. In contrast to the 1970s, when literal, legalistic and scholastic interpretations dominated, the ijtihad (interpretation) now underway focuses on making modern financial instruments compatible with Islamic principles. The modernist slant disavows the view that whatever did not exist in the early days of Islam is necessarily un-Islamic. Challenging common perceptions that Islam is rigid and fossilised, it emphasises those adaptive mechanisms - such as departures from tradition for reasons of local custom (’urf), public interest (maslaha) or necessity (darura) - that have allowed the religion to thrive on every continent for 14 centuries.

Whereas the early years of Islamic finance were dominated by oil-producing Arab states (primarily Saudi Arabia ), and to a lesser extent Egypt and Pakistan, the new paradigm reflects the diversity of the Islamic world. A wide range of Islamic products is now available in at least 75 countries. Even countries that have Islamised their entire financial systems have done so under different circumstances and in vastly different ways. In addition, much innovation and scholarship now originates within Muslim minorities outside the Islamic world.

Today the fastest growing segments of the industry are outside traditional banking products and in areas of finance that were either initially dismissed as unacceptable to Islam (such as insurance or takaful) or that barely existed in the 1970s (such as micro-lending and Islamic mutual funds). Funds invested in stocks acceptable to Islam (shunning unethical or highly-indebted firms, or engaged in gambling, alcohol sales and other prohibited activities) are increasingly popular, just like their "socially-responsible" secular counterparts. Islamic finance still faces a host of challenges (strategic, economic, regulatory, political, religious), but the current boom does not seem likely to abate.

Any source

Islamic Financial System

Introduction

Islamic finance is an old concept but a very young discipline in the academic sense. It lacks the required extent and level of theories and models needed for expansion and implementation of the framework provided by Islam. In these circumstances, unawareness and confusion exist as to the form of the Islamic financial system and instruments.

The main difference between the present economic system and the Islamic economic system is that the later is based on keeping in view certain social objectives for the benefit of human beings and society. Islam, through its various principles, guides human life and ensures free enterprise and trade. That is the reason why the conventional banker does not have to be concerned with the moral implications of the business venture for which money is lent.

Socio-economic justice is central to the Islamic way of life. Every religion has the same basic aim. In an Islamic environment, an individual not only lives for himself, but his scope of activities and responsibilities extend beyond himself to the welfare and interests of society at large. The Qur'an is very precise and clear on this issue. There are basically three components of an Islamic economic paradigm:

1. That as viceregent, man should seek the bouties of the land that God has bestowed on humanity. From the wealth thus obtained, he should enjoy his own share.
2. That he should be magnanimous to others and use a part of the wealth so obtained also for the benefit of his fellow-beings.
3. That his actions should not be wilfully damaging to his fellow-beings.

Human society in Islam is based upon the validity of law, of life and the validity of mankind. All these are natural corollaries of the faith. Islamic laws promote the welfare of people by safeguarding their faith, life, intellect, property and their posterity. God nurtures, nourishes, sustains, develops and leads humanity towards perfection. Even though an individual may be making a living because of his efforts, he is not the only one contributing towards that living. There are a number of divine inputs into this effort and therefore, the results of such an effort obviously cannot be construed as entirely proprietary.

Whereas the Islamic banker has a much greater responsibility. This leads us to a very fundamental concept of the Islamic financial system i.e. the relation of investors to the institution is that of partners whereas that of conventional banking is that of creditor-investor.

The Islamic financial system is based on equity whereas the conventional banking system is loan based. Islam is not against the earning of money. In fact, Islam prohibits earning of money through unfair trading practices and other activities that are socially harmful in one way or another.

Those who swallow down usury cannot arise except as one whom Shaitan has prostrated by (his) touch does rise. That is because they say, trading is only like usury; and Allah has allowed trading and forbidden usury. To whomsoever then the admonition has come from his Lord, then he desists, he shall have what has already passed, and his affair is in the hands of Allah; and whoever returns (to it) - these are the inmates of the fire; they shall abide in it [Sura 2:275].

Not that there was any ambiguity in the Command of Allah. Far be it from Him to give any order to His Servants, which they can not comprehend. The fact is that those who had surplus money and wanted to earn profit did so either by lending it through riba (usury) or by investing it in trade and hypocrites were not prepared to forgo the first option. Hence, they argued that since both were means of earning profit, they were alike and the prohibition of riba did not stand to reason.

The practice of riba i.e. usury was so deep-rooted in society and continuance of the practice was so undesirable, that Allah warned the believers that if they did not desist, they should be prepared for a war against Allah and His Apostle. This warning was heeded by the Muslim Ummah and for more than a thousand years the economies of Muslim states were free from riba. With the ascendancy of Western influence and its suzerainty over Muslim states, the position changed and an interest-based economy became acceptable. Efforts in Muslim countries to revert to an interest-free economy were hampered by many obstacles.

The Role of Money

The traditional definition of the time value of money leads one to assume that profit maximisation is the objective of investors irrespective of whether or not the earning of profit has made someone else worse off. Some economists have termed the maximisation of profit as the sole objective of corporations. This view cannot be supported or defended since the profit maximisation process may lead to perverse outcomes. When financial operations are removed of moralistic tone, competitive markets fail to achieve the efficient allocation of a country's resources.

In Islam money in itself is not considered, as actual capital only exists when money, along with other resources, is sunk into productive activities. Linking the use of money to productive purposes invariably brings into action the factor of labour, a process from which benefits pass on to society.

Types of Islamic Financial Instruments

Demand for monetary instruments is influenced by the variation and level in the market rate what is meant as the market rate of return. The demand for household monetary instruments is mainly for the purpose of circulation of income. Banks need these instruments for:

1. transaction purposes;
2. precautionary purposes, in that some unexpected payments have to be made while some expected inflows may not be forthcoming on their due date, and;
3. not only to avoid loss but also to obtain gains in the capital value of financial assets under the expectation that the market rate of return may move in a certain direction.

What differentiates a traditional financial market from others markets is that no tangible good or service is exchanged for any monetary consideration; only a "financial claim" changes hands in the form of a promissory note or a title to any future flow of income adjusted for any capital appreciation. Not all Islamic instruments are purely financial claims. Some of the instruments also represent ownership of the underlying assets together with a claim to underlying cash flows. Basically there are the following four types of Islamic financial instruments:

1. Type "A" is a financial claim of monetary value with recourse to underlying durable assets and related cash flows. This type has a predictable future income stream, is marketable and can be discounted since with the changing of hands, the instrument passes title to the goods and not to the debt. It is basically lease-based.
2. This instrument is partly backed by durable assets and its income is not predictable, but evaluated through an asset valuation process at the end of an agreed and declared duration. The underlying transactions can be a mix of ijara, modaraba, musharaka etc., contracts. This Type may be traded in the secondary market at its fair market price acceptable to the parties involved but not discounted.
3. Type "C" is purely a monetary claim to an expected income stream forthcoming from underlying commercial transactions. Income is evaluated through an asset-valuation process at the end of an agreed and declared period. A transaction of this type may comprise morabaha, istasna etc., contracts which are debt claims against third parties in respect to actual commercial transactions. The Type may be traded at its face value declared at the end of each accounting period but cannot be discounted.
4. The Type "D" is purely a financial claim of monetary value but with recourse to certain precious metals such as gold, silver, platinum, etc., or commodities quoted on exchanges. The instrument entitles the holder to take delivery of the underlying asset but does not carry any attached revenue stream except that its price is pegged to the price of the underlying precious metal or commodity quoted at recognized international exchange rates. It can be traded but not discounted.

Risk Mitigating Features

The phenomenon of risk plays a pervasive role in economic life. Without it, financial and capital markets would consist of the exchange of a single instrument each period, the communications industry would cease to exist in so far as this market is concerned and the profession of investment banking would be reduced to that of accounting. Risk is further segregated from uncertainty. A situation is said to involve risk if the randomness facing an economic agent can be expressed in terms of specific numerical probabilities (these probabilities may either be objectively specified, as with lottery tickets or else reflect the individual's own subjective beliefs). Situations where the agent cannot (or does not) assign actual probabilities to alternative possible occurrences are said to involve uncertainty.

While it is not always true that a riskier asset will pay a higher average rate of return, it is usually return. Risk is an opportunity in financial markets and also a problem. Risk-averse investors require additional return to be at additional risk and, in effect, in a competitive market higher return is accompanied by higher risk. An investor evaluates an asset in terms of its marginal contribution to his/her portfolio.

The fundamental principal of valuation is that the value of any financial asset is the present value of the cash expected. The process requires two steps:

1. estimating the cash flow, and;
   
2. determining the appropriate interest rate that should be used to calculate the present value.
   
   

The following are the Shari'ah compliant risk mitigating features:

1. By prior arrangements in the instrument, the investing company, through its banker, would have a priori right in profit sharing up to an agreed upon ratio.
2. The profit will be paid on account on a monthly basis to the investing company as provided in the projected accounts.
3. The final accounting and settlement is accomplished at the end of the term of the instrument when the profit and loss accounts are finalised.
4. In order to mitigate the risk and as per the terms of the instrument, a Takaful fund is established for the term of the instrument.
5. In this Takaful fund where the investee company earmarks a part of their reserves for the Takaful fund.
6. The investing company will contribute 1% of the invested amount.
7. This 1% contribution is made through an advance by the investee company on account of future profits.
8. In case of any loss during the tenancy of the instrument, it will be adjusted against the Takaful fund.
9. The balance will be distributed between investor and the at the end of the term of instrument.
10. Through a valuation, value of the investment would be established for the purpose of exercising the put option.
11. The investing company shall have the option to exercise its put option at the value price and the company shall buy this instrument.

Islamic Leasing

But before describing leasing, as aforesaid, let me very briefly touch upon two of the basic or fundamental principles of Islamic finance in order to develop a premise for meaningful discussions on leasing.

1. It has to be asset-based financing:
   
   The first fundamental principle of Shari'ah is that as opposed to conventional monetary dealing, profit is generated when something having intrinsic utility is sold or offered for use. Money has no intrinsic value. As such dealing in money (same currency) cannot generate profit but a Riba unless converted into real assets to deal with.
2. There has to be an element of risk:
   
   The second basic element of Shari'ah is that one cannot claim a profit or fee for a property/transaction, the risk of which was never borne by him.

Based on the above fundamental principles, the most ideal mode or instrument of financing in Shari'ah are Musharaka and Modarabah followed by Salam and Istinsa.

Morabaha and leasing are not originally modes of finance. However, to meet certain specific needs where ideal modes like Musharaka or Mudaraba are not workable for whatever reasons, they have been reshaped and allowed in Shari'ah subject to certain conditions.

1. Leasing described For leasing, IJARAH is an Arabic term with origins in Islamic Fiqah, meaning to give something to rent. There are two types of Ijarah. One relates to employing or hiring the services of a person for wages whereas the second type relates to the hiring of any asset or property in order to reap its benefits without the transfer of ownership, or what is called in English "Usufrukt". The price or consideration of this is the rent.
   It is the second type of Ijarah which is the subject matter of the discussion here because it is generally used as a form of investment and also as a means of finance.
   As described earlier, in the light of the two basic cornerstones of Shari'ah, leasing is a contract whereby usufruct rights to an asset are transferred by the owner, known as the lessor, to another person, known as the lessee, at an agreed-upon price called the rent, and for an agreed-upon period of time called the term of lease.
2. Lease as a mode of financing Strictly speaking leasing is not a means of finance as originally envisaged. It is simply a transaction much as a sale/purchase. As described above, the leasing transaction simply denotes the transfer of the usufruct of a property from one person to another for an agreed-upon price called rent without transferring the corpus i.e. ownership of that asset. Accordingly, the rules of "leasing" closely resemble the rules governing "sale" because in both cases something is transferred to second person for valuable consideration.
   Leasing differs from sale only in-so-much-as not transferring the corpus or ownership of the property which remains with the transferor. As such in Shari'ah, a lease transaction is governed by a separate set of rules, which we shall outline in the following paragraphs.
   Although leasing, as originally conceived, is not a means of finance, the financial institutions and the corporate world have adopted it as such. Due to several factors (including tax concessions, etc.), instead of providing an interest-bearing loan, certain financial institutions in the West started to provide requisite equipment to their customers. To arrive at the rent, the total cost of the asset is calculated plus interest or mark-up to be recovered during the period of lease on a monthly or quarterly basis. This type of lease in the West is known as a finance lease, to be distinguished from an operating lease, wherein various basic features of the leasing transaction are ignored which is tantamount to Riba.
   Knowing that leasing is lawfully allowed under Sharia'h, since it meets one of the basic criteria of asset-based finance, a number of Islamic financial institutions have adopted leasing on this model as carried out by conventional financial institutions without making the necessary modifications that really conform to the rules under Sharia'h, particularly in regards to assuming the risk of ownership in the leased asset. Great care needs to be exercised to ensure various Sharia'h requirements, as rendered below, based on the basic two principles of:
   1. Asset based finance, and;
      
   2. Assuming a risk element connected to the ownership of the asset.
      
      
3. Basic Rules of Leasing
   The description or definition given above, under part A, contains the following essential ingredients for outlining the basic rules under Shari'ah:
   1. That it is a contractual obligation.
   2. That there has to be a valuable use of the asset and transferability of that usufruct.
   3. That the ownership of the asset is retained by the transferor or lessor throughout the lease period. Consumable articles cannot be leased.
   4. That the risk and liabilities of ownership lie with the lessor. The leased asset shall remain the risk of the lessor throughout the lease period. Any loss or harm caused by factors beyond the control of the lessee shall be borne by the lessor. However, the lessee is liable to compensate the lessor for any harm to the leased asset caused by any misuse or negligence on the part of the lessee.
   5. That the risk and liabilities associated with the use of the asset shall be borne by the lessee. For instance, taxes and other government levies, utilities, etc. However, the contract must specify these items for clarity's sake.
   6. That the term of the lease, period of the lease, its renewal or early termination must be stipulated.
   7. Purpose of use. The lessee cannot use the leased assets other than for the purpose specified in the contract or agreed to by the lessor expressly.
   8. Commencement of lease. The lease commences from the date of delivery of the asset to the lessee and not from the day of payment or lease agreement, with reference to the commencement of rentals.
   9. Determination of rental. The rent for the entire period of the lease must be determined at the time of the contract. Different rates of rent for different phases during the lease period are permissible. This point will be elaborated in the following discussion of the issues.

Issues

While operating a leasing business, a number of practical issues have cropped up which warrant discussion and interpretation under Sharia'h. An exhaustive and conclusive list of such issues is impossible to make. However, certain important and salient issues need to be taken up in these discussions as follows:

1. Joint ownership (Lessors)/Joint Lessees - (permissible)
2. Insurance - Islamic Takaful - (by the owner)
3. Renewal of or variation in the lease period - (permissible if mutually agreed-upon)
4. Future date. Agreement to commence lease on some future date is allowed. However, the rent has to commence from the date of delivery. If the lessee has paid the price and delivery of the asset is delayed by the supplier, then no rent is liable to be paid for the period of delay. It must be noted that future or forward sale in sale/purchase transaction is not permissible in Sharia'h. This is another major point after ownership transfer which differentiates leasing from a sale/purchase transaction under Sharia'h.
5. Acquisition of an asset by the lessee. For various reasons, the asset subject to lease may be acquired by the lessee and payment may be dibursed? through him by the lessor. This is permissible under Sharia'h on the principles of agent and principal. Here there are two relationships separate from and independent of one and other. The first relationship is that before becoming a lessee, an individual acts as an agent for and behalf of the lessor to acquire the asset. This is an independent arrangement. Once the asset has been acquired with all the risk and reward of ownership to the lessor, then a second relationship is created i.e. the lessor and the lessee under the lease agreement. That cost of acquisition shall be borne by the lessor being owner and not by the lessee.
6. Rentals.
   1. Advance rentals are admissible subject to the condition of adjustment against the actual rental when due upon commencement of the lease as discussed before.
   2. Unilateral increase by the lessor is not permissible even if stipulated in the contract.
   3. Bench marks. The fixing of any bench mark for determining the amount of rent, as with an inflation index etc., is permissible provided that the lease agreement clearly stipulates the same e.g. if the inflation rate as declared by an authoritative body like the State Bank etc. is said to be 10% per annum, then the rent can be increased every year by that percentage.
7. Penalty for late payment of rentals. Penalty or compensation for late payment is not permissible. Rentals once due become a debt obligation or monetary asset which cannot generate profit under Sharia'h. This situation has been exploited by unscrupulous lessees. In such circumstances, contemporary scholars have provided a solution whereby a penalty can be charged to the lessee for delayed payment though the amount recovered is only to be used for charitable purposes by the lessor. In other words, the late payment charges cannot be taken as income by the lessor. A suitable clause, therefore, is to be incorporated into the lease agreement to avoid any misunderstanding in this regard.
8. Premature termination of lease. Premature termination of lease is allowed provided that the lessee has violated or contravened the terms of the lease or it is by mutual consent of the lessee and the lessor. Any unilateral or unconditional termination of the lease either by the lessor or the lessee without prior notification is contrary to the principles of justice and equity, hence not allowed under Sharia'h.
9. Repossession of an asset. In the event of early termination, or upon maturity of the term of lease, assets have to return to the lessor unless he voluntarily relinquishes his rights or makes a gift of the leased assets to the lessee. However, rent would be payable only upto the date of termination and not beyond. Entitlement or the right of the lessor to claim rent from any period after termination, even if expressly stipulated in the contract, is not valid under Sharia'h.
10. Residual value. It is accepted under Sharia'h that ownership of the asset belongs to the lessor and, therefore, assets should revert back to him upon expiry of the lease. Any stipulation to the contrary in the contract that the lessor can sell or transfer the asset to the lessee upon the expiry of the term of the lease at a pre-determined price called residual value is not considered valid from the point of view of Sharia'h. However, this point is currently a subject matter of debate among contemporary scholars. They are of the view that if a lessor unilaterally undertakes or promises to transfer the ownership to the lessee as a gift or at a token price separate from the lease agreement, then this can be considered validly binding on the lessor at the option of the lessee.
11. What is imortant is that under Shari'ah the leasing and sale/purchase transactions are two separate things and should not be mixed up in one contract, as both are independent and governed by separate rules. Nothing, however, in Sharia'h stops the lessor from giving away the ownership of his assets at his own discretion or good will toward the lessee at any mutually agreed-upon price or as a gift upon the expiry of the leasing contract.
12. Sale and lease back. This is allowed, but only as two separate transactions. That in the first place there is a sale of assets to be purchased by the lessor. This is governed by Sharia'h rules of sale/purchase at a fair market value. Once the ownership title is validly passed on to the lessee, a lease transaction can then be executed separately through a lease agreement.
13. Sub-lease. Sub-lease by the lessee is permissible under Shari'ah subject to the consent of the lessor and can be expressly outlined in the lease agreement. In Sharia'h, however, there are divergent views if the rent arising from the sub-lease is higher than the rent payable on the original lease. Some scholars allow the differential to be retained by the lessee while others feel that the surplus received from the sub-lease should be passed on to the owner i.e. main lessor.
14. Assigning of the lease. Also permissible under Shari'ah, the lessor can sell the leased assets to a third party along with his rights and obligations. The relationship between lessor and lessee in this case will be determined between the new owner and the lessee. However, the lessor cannot assign the lease without transferring the ownership for monetary consideration. Here the basic Sharia'h cornerstone of asset-back transaction is not there. Rent receivable are debt obligation which cannot therefore be transacted for a monetary price. Assignment of lease rentals without monetary consideration is, however, not prohibited in Shari'ah.
15. Securing of the lease. Leased assets can be secured along the same principles governing the assignment i.e. ownership of assets along with the rent. Rent alone without ownership of the assets cannot be secured for the reason of being a debt obligation as discussed before. Securing a lease can be made wholly or partly to one party or to a number of persons. Documentation has to be carefully prepared to ensure the securing instrument represents assets and not the debt or monetary obligation alone.

Some Difficulties (Pakistan)

Major hurdles faced by Islamic finance houses are the absence of a necessary legal framework and the lack of adequate infrastructure in the banking and investment fields.

The modern banking system is based on the concept that money should be treated like any other factor of production and must earn some return over a period of time. It is argued that the establishment of large-scale enterprises, and hence material progress, is not possible unless there is an agency that can mobilise financial resources from the public by paying them some interest, while lending these resources to entrepreneurs. By charging these entrepreneurs a higher interest, these agancies were able to utilise the difference (called a spread) to meet their expenses and to make some profit for the owners of the agency (i.e. share-holders). Banks were established to fulfil this need and from the beginning were only authorised to perform this function. They were legally prohibited from entering into trade or industry. When the Government of Pakistan decided to introduce an interest-free banking system, this prohibition was removed. After a lot of in-house the banks were told in June 1984 that they were allowed to deal in only 1 to 12 means of financing (only two were classified as "Financing by Lending").

These two permitted lending without interest by charging the actual expense incurred by the banks to meet their cost of operation and Qarde Hasana. All the rest were either trade-related or investment-type models. These included the purchase of goods by banks and their sale to clients at an appropriate mark-up price on a deferred payment basis, in case of default there being no further mark-up. This sale of goods on mark-up is known as Murabiha. Other types of financing were hire-purchase, leasing, Musharika or profit- and-loss-sharing, equity participation and purchase of shares, etc.

Since Murabiha was the type nearest to lending and since it did not requre any expertise in buying and selling commodities, bankers limited most of their financing to this type. In order to eliminate the risk of prospective buyers refusing to accept goods purchased by the banks by reason of not being strictly in accordance with the specifications, banks were allowed to appoint the prospective buyer as their agent for the purchase of the goods and later for the sale of the goods to the buyer's firm. Furthermore, to give as much leeway to the banks, as safeguards of public money, as possible, the Ulama did not fixe a waiting period between the two stages of buying and selling.

The banks did not assume the role of trader and Morabiha degenerated into lending on mark-up. The banks rarely hired persons who knew even the basics of trading, nor did they train their existing staff to learn the art. They did not even bother to find out whether their agents had actually purchased the goods or not. The inability, or reluctance of banks and financial institutions to change over their operations from lending to trading has been a serious impediment to the Islamisation of the economy.

The blame does not entirely fall on the bankers. Depositors have become so accustomed to their money remaining safe and yet earning profit that if a bank had really ventured to trade and incurred a slight loss, then the depositors would have immediately demanded their money back causing the bank to go bankrupt. In the existing state of morality this was more likely to happen. It actually did happen to a few investment companies that had started with good intention, but could not go on giving away handsome profits to their depositors.

A lack of seriousness and dedication in those responsible for the implementation was also another great impediment to the achievement the goal of an interest-free economy. Many of these individuals thought that in the present world, there was no alternative to interest, yet something had to be done because of demands from the government. Some, who were more influenced by Western education and culture, thought that interest banking was not prohibited by Islam. Yet others thought that the efforts being made were only superficial and in reality the new system was no different from the existing system.

One weakness in the implementation of the proposals to eliminate interest from the system was that people were not sufficiently motivated to sacrifice a part of their financial interests for the sake of carrying out the commands of Allah (SWT), and The Prophet (SAW). Anyone attempting to change a well-established practice must be prepared to make some sacrifice for this, as arguably no noble cause has been achieved without any sacrifice. The prevailing level of public morality within the existing legal and taxation system of the state made it an up-hill struggle to rid the banking system of interest. And it remains so. Beyond this, there are many avenues of making profit that would have to be forgone and many types of modern banking services which which also could not be provided by a bank working strictly on Islamic principles. For example, they could not keep their surplus cash in fixed or saving deposits. In spite of these difficulties, those who were engaged in the task of Islamisation took it upon themselves to portray as successful the reforms, while those who pointed out the difficulties were labelled as either a cynic or an opponent of the new system. Anyone who uttered a word of caution was regarded as someone who did not want the experiment of Islamisation to succeed. As a matter of fact, reward in the Hereafter (aakhirat) should have been the main purpose of Islamisation. It might not have attracted many people, but the foundation would have been firm.

One great obstacle in the realisation of the goal of an interest-free economy has been absence of a proper environment. Unfortunately nothing has been done to produce an ideal or a near ideal Islamic environment by government or public leaders. The most important pre-requisite for the enforcement of Sharia'h is a'dl [translation!!!!!!]. Establishment of the rule of law and ensuring justice to aggrieved persons should be the first task of an Islamic state, yet nothing has been done to achieve this end.

One very important requirement of an ideal evironment is an inflation-free economy. Inflation erodes the real value of money, meaning that when a person gives a sum of money on loan and receives the same amount back after one year, he has made a net loss. A major source of inflation is deficit financing. The printing of notes to meet budgetary deficit is in fact an injustice to the public, since the real value of their money is consequently eroded. In this respect too, the government's performance is very discouraging. Government borrowings at high interest rates and the quantum of the government's domestic and foregn debts has reached a level which cannot be sustained. There has also been no effort to change the taxation structure so as to bring it to conform with Shari'ah.

Musharika

Musharika represents the most desirable form of Islamic financing arrangements. Yet, in terms of its ability to be an effective and efficient instrument for replacing interest-based transactions, it poses formidable problems.

The salient features of the Musharika agreement, as practised by the commercial banks, were as follows:

1. It was a short-term financing arrangement specific only to the parties to the contract.
2. Investment by the banks was made in the form of the sanctioning of a funding limit to the client and the degree of employment of funds was determined on the basis of daily product of outstanding balances due to the bank.
3. All participative funds, including equity, reserves and other non-debt capital was included in the definition of capital qualifying for profits.
4. Profit sharing ratio was determined through negotiations within the boundaries specified by the SBP.
5. Profits for the purpose of sharing were to be determined after apportioning a share of net-income as a management fee to the firm.
6. Provisional profits, based on projected profits, were to be paid to the bank on quarterly basis, subject to a final adjustment on the basis of actual profits or losses.
7. Shortfalls or excess profits were to be settled through the creation of a [participation] reserve fund, which would attempt to smooth out the payments to the bank.
8. Losses, if any, were to be shared in strict proportion to the bank's investment in the total capital of the firm.
9. Against the apportioned loss of the bank, ordinary shares were to be issued, which qalified for reconversion in Musharika investment under the original terms of the agreement in case profits accrued in future.
10. Standard securities in the form of pledging and hypothecation stocks or the mortgaging of properties were required against Musharika financing.

Some of these features of the instrument attracted criticism. For example, the profit sharing arrangement did not strictly conform to the requirements of Sharia'h particularly in the treatment of losses and the payment of provisional profits or their adjustment through the participation reserve. Secondly, despite being a sharing arrangement, the actual agreement was cast within the framework of a creditor-debtor relationship, and was also protected as such in law. Three, Musharika also demanded securities which were akin to the relationship between a creditor and debtor. Finally, in the absence of a legal framework regulating the operation of Musharika, there was no standardisation of the agreement, and the terms and conditions of various agreements varied considerably.

Modaraba

Modaraba represents another of the more desirable forms of Islamic financing arrangements.

The salient features of Modaraba companies and their operations are as follows:

1. Only registered companies or those established under specific laws are eligible to register as Modaraba companies.
2. Modaraba can either be specific purpose or multi-purpose and can either be for a fixed term or in perpetuity.
3. On fulfilment of certain conditions, and with the prior approval of the Registrar, Modaraba companies may float Modarabas on the stock exchange, and their certificates of issue will be tradable securities.
4. Each Modaraba will be a separate business and its operations must conform to those approved under the injunctions of Sharia'h.
5. A Religious Board, to be periodically constituted under the ordinance, will be empowered to declare whether the operations of Modaraba were in conformity with the provisions of Sharia'h or not.
6. Many disclosure requirements, similar to those applicable to listed companies, are applicable to Modarabas, including statutory audit, annual meetings and investments and loans to and from the directors of the Modaraba company.

Evidently, the entire scheme was an elegant formulation of the simple relationship required under a modaraba contract between labour (darib) and capital (rabbul ma'l). The management company was to be renumerated through a fixed management fee paid out of the net income of the modaraba and the remainder was to go to modaraba certificate holders, with adequate provisions for retained earnings to ensure future growth.

CONCLUSIONS

To outline the broad features of a strategy which holds the promise of successfully implementing an Islamic system of finance are as follows:

1. The process has to be guided by basic legislative efforts covering all the essential elements of the proposed programme.
2. The legislation would define Riba and prohibit transactions connected with Riba.
3. The application of the law would be unqualified and without exception, thus the entire financial sector, covering banking government finance and foreign transactions would be covered in its ambit.
4. Given the unqualified and non-exceptional nature of the proposed law, even existing relations will have to be converted into permissible forms, for which a suitable time frame, within a phasing-in period, will be allowed.
5. The law should also provide for the Constitution of a Sharia'h Board which would assist the SBP to formulate permissible means of financing. Such means, specified with the prior approval of the Board, will only be illustrative and no restrictions will be placed on banks and financial institutions to design means of financing which are free of Riba.
6. A major portion of the law will have to be devoted to a plan of restructuring the fiscal policy which comprises a scheme for the privatisation of public sector assets and the use of its proceeds for the settlement of the outstanding stock of public debt.

The proposed strategy is based on the clear recognition of the scope implied by the prohibition of Riba. This is critical, for otherwise the solution will continue to elude us.

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