Islamic Banking

INTRODUCTION TO ISLAMIC BANKING 

BANKING AND ITS IMPORTANCE  

Banking is a very important sector of the modern day economy. 

• Provides an investment opportunity to the household with surplus capital in terms of returns and tenors & security. 
• Provides an opportunity to Small and Large businesses & Governments to finance their projects/activities through obtaining surplus funds. 

ISSUES IN BANKING

• Lending money and getting it back with compounding interest is the fundamental function of the conventional banks 
• Functions and operating modes of conventional banking are based on fully man made principles 
• The investor is assured of a predetermined rate of interest
• It aims only at maximizing profits without any halal/haram restriction 

IMPORTANCE OF PURIFYING THE SOURCE ON INCOME IN ISLAM  

• The body which is nourished by non-pure sources is bound to hellfire. 
• On the day of Judgment, a person will not be moved from the place where he stands until he is asked about the sources of his income, and the ways he spent it. 
• Purifying the source of ones’ nourishment is one of the important reasons for the acceptance of supplications by Allah. 
• Concept of Taharat/Nijasat & Hillat/ Hurmat. 

WHAT IS SHARI’A? 

General Meaning: 

Shari’a is synonym to Islam, which is the entire body of teachings revealed to the Prophet (SAW) in the form of the Holy Quran and the Sunnah or derived from them by the Shari’a scholars; and it contains: 

• Aqayed, 
• Ibadat, Mu’amalat, 
• Mu’ashart, Akhlaqiat 

Specific Meaning: 

As a term recently has been used to denote that body of knowledge which discusses rules governing practical affairs of day-to -day life.

‘A perfect combination is required by Islam’ 

UNANIMOUS SOURCES OF SHARI’A 

1-Primary Sources:

1. Qur’an 
2. Sunnah 

2-Secondary Sources: 

1. Ijma’a 
2. Qiyas 

RULES GOVERNING IBADAT AND MUAMLAT 

• According to the rules of Shari’a all methods of Ibaadat are forbidden except those that are described by Allah and His Prophet.
• However, all Muamalat are allowed except those made Haram/forbidden by Allah and His Prophet.
• This means that if Haram elements of any financial transaction are removed it becomes permissible and Shariah compliant. 

Some Misconceptions 

• Importance of Wahi (Revelation) 
• are based on their process flows not on their end results. Sharia rulings are based on Illat (Effective Reasons) not only on Hikmat (Wisdoms/benefits). 
• Meanings of Shariah Compliant/Jaiz/Islamic. 

 RIBA – INTEREST  

• The Holy Qur’an did not give any definition of Riba for a very simple reason. (e.g Adultery) 
• The word Riba in Qur’an refers to practices* known as Riba not only to Arabs but to all the previous societies as well. 

*Advancing a term-loan with an increase over and above the principal amount. 

*Periodic payment of increase, principal payment at maturity or rescheduling with new increase. *Allowing additional time against additional amount in deferred payment sale. 

Types of RIBA – INTEREST  

• Riba an Nasi’ah: Stipulated increase on the loan amount given for a specified period OR increase charged in a deferred payment sale directly linked with time. 
• Riba al Fadl: This applies to barter (exchanging one commodity/currency for another), where commodities of the same type are exchanged in unequal amounts or one consideration is deferred.
• The Prophet sallaAllahu 'alayhi wa sellem said, "Gold for gold, and silver for silver, and wheat for wheat, and barley for barley, and dates for dates, and salt for salt, like for like, equal for equal, from hand to hand (the transaction must be completed before the two sides leave each other). But if the types are different then sell as you wish, as long as it is hand to hand." (Muslim) 

RIBA – INTEREST  

• If currencies are exchanged homogenously, quantity from both sides should be the same and no deferment is allowed. 
• If currencies are exchanged heterogeneously, the delivery must be immediate. However, the quantities from both sides may differ.
• If one currency is delivered at spot and other is deferred there are two views: 

             1-The transaction is invalid (they apply the same rule of gold and silver) 

             2-It is allowed provided that the price is that of spot sale 

PROHIBITION OF RIBA IN ISLAM 

Riba or Interest / Usury has been forbidden in Quran at following different occasions: 

• Al Baqara 
• Aal Imran 
• Al Nisa 
• Al Roum

“Those who devour Riba shall rise up before Allah like men whom Shaitan has demented by his touch; for they claim that trading is like usury. But Allah has permitted trading and forbidden usury. He that receives an admonition from his Rabb and mends his ways may keep what he has already earned; his faith is in the hand of Allah. But he that pays no heed shall be among the people of fire and shall remain in it forever.”

“O you who believe, Fear Allah and give up what remains of your demand for Interest, if you are indeed a believer. If you do not, then you are warned of the declaration of war from Allah and His Messenger; But if you turn back you shall have your principal: Deal not unjustly and you shall not be dealt with unjustly.” 

PROHBITION OF RIBA – IN SUNNAH 

It is narrated from Jabir (RA), who said: the Messenger of Allah (SAWS) cursed the one who charges riba, he who gives it, the one who records it, and the two witnesses, saying that “they are all equal” 

The Messenger of Allah (SAWS) said: “every loan that entails benefit is Riba”. 

WHY RIBA IS HARAM? 

An Example: 

 "All that we had borrowed up to 1985 or 1986 was around $5 billion and we have paid about $16 billion yet. We are still being told that we owe about $28 billion. That $28 billion came about because of the injustice in the foreign creditors' interest rates.

 If you ask me what is the worst thing in the world, I will say it is compound interest.“ 

President of Nigeria, G8 summit, Okinawa, 2000 

FAQs ABOUT RIBA 

1-What is interest? Is there any difference between interest and Riba? 
2-Is interest/riba related only to personal loans or does it apply to commercial loans also? 
3-Does the prohibition of Riba apply equally to the loans obtained from or extended to Muslims as well as non-Muslims? 
4-If Islamic banks do not invest in interest based activities then how do they generate profit to pay to their customers? 
5-Islamic banks use interest base system (KIBOR) as a Bench Mark while determining       profit; how Islamic banking can be said to be Islamic? 
6-Fixed rate of return is not permitted under Shariah? 

GHARAR 

• Lexically it means delusion, risk or uncertainty. 
• Ambiguous situation which has chance of non agreement or dispute upon disclosure of details. 

Qimar (Gambling):

• Gambling has been strictly prohibited due to the inherent element of uncertainty and chance. 
• Lotteries are modern day examples that fall under the category of Qimar. e.g. betting in cricket matches, paid mobile sms schemes etc. 
• Conventional Insurance. 

PROHBITED SALES

• Incompetency of the parties involved 
• Sale of something non-existing or weak existence 
• Sale of something which is not deliverable easily 
• Sale of debt to someone other than the debtor 
• Sale with Jahalah (subject matter or price or time is unknown) 
• Contingent & future sale 
• Sale before taking possession 
• Bai Ina’h 
• Sale of Haram or Najaiz subject matter 
• Sale of grapes to the producer of wine 
• Sale with wrong condition 
• Combining sale with loan 

KINDS OF FINANCIAL CONTRACTS 

Commutative (Uqood Muawadha) Contracts that include exchange of counter values by both the transacting parties, such as a contract of sale/purchase, Ijara, etc. 

Non-Commutative (Uqood Tabarru’) These are non compensatory contracts where the donor, donates his property without consideration e.g. Qard-e-Hasan, Aariya, Hiba, sadaqah, Wasiyyah, Waqf, etc. 

DEFINITIONS OF SALE CONTRACT (Aqd ul Bai) 

Exchange of a thing of value with another thing of value, with mutual consent. 
OR 
It is the sale of a commodity in exchange for cash. 

TYPES OF SALE (Aqd ul Bai) 

• Valid Sale (Bai’ Sahih) 
• Void Sale (Bai’ Batil) 
• Executed but void due to defect (Bai’ Fasid) 
• Valid but disliked sale (Bai’ Makrooh) 

1- VALID SALE (BAI SAHIH-بيع صحيح ): 

• A sale is valid if all its essential elements and conditions are fulfilled. 
• Essential elements of a valid sale are: 

a )   Contract                          (Aqd عقد - ) 
b )   Subject matter               (Mabee’e مبيع - ) 
c  )   Price                                (Thaman ثمن - ) 
d )   Possession                      (Qabdh قبض - ) 

CONTRACT  (AQD): 

It is a combination of offer and acceptance in a manner that results in the desired consequence (transfer of ownership) in the subject matter. 

Features: 

Offer and Acceptance (Ijab-wa-Qabool) can be: 

• Explicit (Oral or Written) 
• Implied (Hukmi) 

Buyer and Seller (Muta’aqedain) must be: 

• Sane 
• Mature 

Sale Contract must be: 

• Non-contingent 
• Immediate (Exceptions) 

SUBJECT MATTER (MUBEE’E): 

The thing that is being sold and purchased by the parties is called “Subject Matter” 

The subject matter must be: 

1. Existing (Exception of Salam & Istisna’a) 
2. Seller must have title/ownership and possession 
3. Valuable (in the view of Shariah) 
4. Usable 
5. Specified and Quantified 
6. Delivery must be certain and non-contingent 

PRICE (THAMAN): Should be 

•  Specified 
• Quantified 
• Valuable in view of Shariah 
• Certain 

DELIVERY OR POSSESSION (QABDH): 

The forms of taking delivery or possession of items differ according to their nature and market practices. Taking possession can be: 

• Actual/ Physical 
• Constructive. 

VOID SALE (BAI’ BATIL بيع باطل - ): 

The sale becomes void if certain essential elements of a contract are not found, such as: 

• Conditions for buyer and seller 
• Sane and Mature 

Conditions for sold Goods where goods should be: 

• Existing 
• Valuable 
• Usable 

This means the sale cannot be executed under any circumstances and shall not make any effect. 

SALE EXECUTED BUT VOID DUE TO DEFECT (FASID فاسد - ): 

Sale executed initially but void because certain conditions of the contract are not fulfilled and ownership doesn’t transfer such as: 

• Subject matter has not been identified or specified clearly 
• Price is uncertain at the time of sale contract. 

 This sale must be corrected or canceled. It doesn’t transfer ownership to the buyer until he possesses the subject matter with the permission of the seller. Sale will be concluded on the market value or just cost. Profit if any should be given in charity. 

VALID BUT DISLIKED SALE (BAI MAKROOH بيع مكروه - ): 

Sale is valid but not liked due to certain external issues: 

• Sale after Jum’a ‘Azan 
• Sale by contriving with a third party to pose as a potential buyer and attract the real buyer to purchase the asset, or to raise the price. 

OTHER KIND OF SALE CONTRACTS: 

Sale of the corpus: when the actual subject matter is sold in its entirety. The title and ownership is transferred to the buyer. 
Sale of the usufruct: when the benefit or utility of a nonperishable item is rented out or leased for a defined period of time. The title and ownership is not transferred to the buyer.

Bai’ Sarf: This refers to the sale of gold, silver and currency. 

WHAT DISTINGUISHES ISLAMIC BANKING FROM CONVENTIONAL BANKING

ISLAMIC BANKING IN PRACTICE 

LIABILITY SIDE OF AN ISLAMIC BANK 

• Current Accounts and associated DONTs 
• Mudaraba (Savings A/c, Term Deposits etc.) 
• Profit Distribution & Weightages 
• Common Mudaraba Pool Working 
• Liability Side FAQs 

CURRENT ACCOUNTS

• The basis of deposit mobilization into current account is ‘Qard’. 
• There is no distribution or sharing of profit or loss in this kind of accounts. 
• Any profit or loss sustained shall solely be the bank’s. 
• As per Shari’a principles the current accountholders should not be promised any special benefits and services linked with their balances, except those benefits and services provided to other accountholders, because as per hadith every loan that entails benefit is Riba.

MUDARABA OVERVIEW مضاربة - :

• It is an investment contract in which one party (Rab ul-Mal رب المال -) contributes capital while the other party (Mudarib مضارب - ) makes efforts for generation of profit. 
• In Islamic banks, it is a contract in which the capital is provided by the depositor/fund provider and the bank acts as Mudarib. 
• The profit is shared in pre-agreed ratio and loss (if any) unless caused by negligence or violation of terms of the contract by the Mudarib, is borne by the depositor/investors. 
• Is it allowed for Mudarib to invest his/its own funds in Mudaraba pool? 

PROFIT DISTRIBUTION 

• The bank calculates the profit of the deposit pool every month 
• In reality the bank does not distribute net profit it distributes gross profit. 
• This means that the Mudarib does not deduct overheads such as salaries, rent, utility bills etc. from the Mudaraba’s pool profit. 
• All such expenses are borne by the Mudarib from its share of Mudaraba pool. 
• Therefore, even though as per the Mudaraba contract the Rab ul Maal bears all the loss, this does not mean that the Mudarib does not bear any loss. 
• Incase there is no profit in a certain month that would mean that all the expense done by the bank shall be from its own funds and without any return. 

INTER DEPOSITOR RELATIONSHIP 

• The relationship between depositors is based on Musharaka (Shirkat-ul-Aqd). 
• The profit is distributed among the customers on the basis of predetermined weightages, announced at the beginning of the month, based on their respective category/tiers. 

Loss Sharing: 

• In case of any loss, it will be shared by the members of Investment Pool in ratio of their investment. 

WEIGHTAGES 

1-Weightage is the value of depositor’s money in the eye of Bank for the purpose of Profit Distribution only. 

2-Weightages are assigned based on: 

• Investment tenure 
• Profit payment option 
• Amount tiers 
• Product Features 
• Market Conditions 

3-Weightages are used for distributing profits among different types of depositors having different maturities and values. These weightages are available on the website and notice boards of the bank. 

4-Is it possible to have a tier of any remunerative account with ZERO weightage?

LIABILITY SIDE FAQs

• Can a bank offer free of cost services to Current account holders on maintaining a certain amount of balance? 
• If No, then How can Priority Banking be Sharia Compliant? 
• What is Hiba? Are there any options available for a bank to facilitate its depositors with higher return without giving any Hiba?. 
• How is it possible for a bank to distribute profit to its depositors at competitive rate despite of having overall Net Loss in its Profit & Loss Account of Financial Statements. 
• If a profit bearing account of Islamic Banks is based on PLS, why there is no loss at all?

ASSET SIDE PRODUCTS OF AN ISLAMIC BANK 

• Murabaha 
• Istisna 
• Salam 
• Ijarah 
• Shirkat-ul-milk cum Ijarah 

COMMON TYPES OF SALE 

• Bai Murabaha: It is a sale contract in which a seller sells his goods/asset at cost plus an agreed profit i.e. the cost and profit margin are both disclosed. The sale price can be paid on spot or deferred to be paid in lump sum or in installments. 
• Bai Tawliya: In this sale contract the seller discloses his cost and sells the goods at the cost price i.e. without any profit. 
• Bai Wadi’a: In this sale contract the seller sells his goods at less than the cost price i.e. incurring a loss on the sale. 
• Bai Musawama: is a general and regular kind of sale in which price of the commodity to be traded is bargained between seller and the buyer without any reference to the price paid or cost incurred by the former 
• Ijara: this the sale of the usufruct. It is similar to an operating lease where an assets is given on rent by the owner. 
• Istisna: is a sale contract in which the buyer purchases from the manufacturer fully described assets/goods which the manufacturer undertakes to produce and deliver from raw material of his own. The payment can be made through any mutually agreed terms. 
• Salam: this is when full spot payment is made by the buyer for the delivery of fully specified goods in the future. It is most commonly used in agriculture finance. 

MURABAHA مرابحة - : 

• It is a sale contract in which a seller sells his goods/asset at cost plus an agreed profit. 
• The sale price could be paid on spot or deferred to be paid in lump sum or in installments. 
• In Islamic banking, normally the goods/asset is purchased after a customer requests the bank to purchase the goods/asset in order to sell the same to the customer on Murabaha (cost plus profit) basis on deferred payment. This type of transaction is called Murabaha to the Purchase Orderer 

MURABAHA مرابحة - : 

Basic rules for Murabaha financing: 

• Asset to be sold must exist. 
• Sale price should be determined. 
• Sale must be unconditional. 
• The seller should be genuinely a third party. 

Assets to be sold: 

Should not be used for un-Islamic purpose. 

Should be in ownership and possession of the seller at the time of sale; physical or constructive. 

ISTISNA’ استصناع - : 

1-Istisna’ is a sale contract in which the buyer purchases from the manufacturer/the would-be seller fully described assets/goods which the manufacturer undertakes to produce and deliver from raw material of his own. 

• The subject matter of an Istisna' contract is always something which requires manufacturing; 
• Price may be paid under any agreed schedule; 
• Contract may be cancelled unilaterally before the manufacturer starts work; 
• May change with the consent of the contractors; 

2-Price in Istisna' should be preferably fixed but it may be tied up with the time of delivery; For example the buyer may fix 'X' price for delivery in 10 days and 'Y' price (reduced price) if the manufacturer delays delivery from the agreed time schedule; The reason for this flexibility is resemblance of Istisna' with Ijara. 

3-Istisna’ cum Wakala: Under this product, the customer manufactures fully described goods for the Bank. After delivery of the goods to the bank, the Bank appoints the customer its Agent to sell the goods in the market against at least the following Sale Price: 

4-Sale Price = Cost Price + Desired Profit (Calculated on the basis of the desired profit rate and the transaction tenure) + Any other costs incurred by the Bank (if any) 

5-If the Customer is able to sell the goods at a price higher than the agreed Sale Price, the Bank may, at its own discretion, the additional amount as Incentive for good performance.

SALAM : 

1-Salam is a type of Sale in which the seller undertakes to supply some specific goods to the buyer at a future date, against an agreed fully paid advance price with deferred delivery of the sold commodity. 

2-Salam sale is an exception to the general rules of sale because it is allowed before existence of goods, so the element of Gharar is obvious here; To minimize the element of Gharar certain conditions have been laid down by Shari'ah which makes element of Gharar for this special type of sale in control (Gharar-e-Yaseer): 

• Salam can be effected only in those commodities that can be exactly specified in quantity and quality; ‘Dhawatul-Amthal’ (ذوات ﺍﻷﻣﺜﺎﻝ); The term ‘Dhawatul-Amthal’ refers to such commodities, the units of which are homogeneous in characteristics; 
• Subject matter of Salam should be of common nature; therefore Salam cannot be effected on a particular commodity of a particular field or farm. 
• Both the quality and quantity of the goods should be very clearly agreed upon. 
• The exact date and place of delivery must be specified in the contract. 
• The commodity which is the subject of Salam contract is normally available in the markets at the time of delivery. 

IJARAاجارة - 

1-Ijara is leasing of a property under which a specified permissible benefit, in the form of a usufruct, is obtained for a specified period in return for a rental payment. 

2-Ijara Muntahiya Bit Tamleek اجارة منتهية بالتمليك – 

• Ijara MBT is a lease that includes a promise from the lessor to transfer the asset to the lessee. 
• This can be done at the end of the lease term or by stages during the term of the contract.
• The transfer can be done through gift or sale for an agreed price. 

BASIC RULES OF IJARA 

• Transferring of usufruct not ownership (To another person for an agreed price, at an agreed consideration) 
• Subject of lease (Valuable, Identified and Quantified) 
• Consumable things cannot be leased out (Anything which cannot be used without consuming cannot be leased out; e.g., money, wheat etc.) 
• Period of lease (Must be determined in clear terms at the time of contract) 
• Lessee as Ameen (The lessee is liable to compensate the lessor for every harm to the leased asset caused by any misuse or negligence.) 
• The leased asset shall remain in the risk of the lessor throughout the lease period. (All Liabilities of ownership are borne by lessor) 

BASIC RULES OF IJARA 

• The lessor cannot increase the rent unilaterally, and any agreement to this effect is void. 
• The rent or any part thereof may be payable in advance before the delivery of the asset to the lessee, but the amount so collected by the lessor shall remain with him as 'on account' payment and shall be adjusted towards the rent after its being due. 

SHARIKAT UL MILK CUM IJARA (HOME FINANCE & AUTOS) 

• It is a combination of two contracts namely Musharaka and Ijara. 
• As per this product, the Bank and the Customer form a Musharaka to purchase an Asset (Home/Auto) 
• After this the Bank leases its share to the Customer for a pre-specified term through an Ijara Agreement. 
• Once the lease agreement is signed between the partners, the Musharaka becomes non-operative and the relationship between the two partners, in principle, changes to a lessor and lessee with all its implications and consequences.  

SHARIKAT UL MILK CUM IJARA (HOME FINANCE & AUTOS) 

1-The rental payments are calculated keeping in mind the following: 

• Fixed Rent: This is the portion of rent that is taken against the principle amount. 
• Variable Rent: This is the portion of rent that represents the bank’s profit.
• Advance/Supplementary Rent: This is a portion of rent that is charged to recover any additional expense incurred by the bank such as takaful etc. 

2-Premature Termination: Incase a customer wants to completely settle the Sharikat ul Milk cum Ijara financing facility he must purchase the bank’s share in the asset. From a Shari’a point of view the bank can quote any price for its share in the asset. However, as per our practice we ask the customer to pay the outstanding principle plus a certain percentage of profit. Please note that the additional amount is profit and not a penalty. 

3-Difference b/w this product and Diminishing Musharaka 

SHARIKAT UL MILK CUM IJARA (C&IB) 

• This product is also used in the corporate sector to finance machinery and plants. 
• It has also been applied to import machinery like turbines and generators. 
• It is important to note that the lease payments cannot begin without the machine/asset becoming usable. 

INVESTMENT CONTRACTS 

1. Mudaraba (Skill Financing) 

2. Musharaka (Partnership based financing) 

3. Wakala (Agency) 

MUDARABA CONTRACT مضاربة - : 

• It is an investment contract in which one party (Rab ul-Mal رب المال -) contributes capital while the other party (Mudarib مضارب - ) makes efforts for generation of profit. 
• In Islamic banks, it is a contract in which the capital is provided by the depositor/fund provider and the bank acts as Mudarib. 
• The profit is shared in pre-agreed ratio and the loss (if any), unless caused by negligence or violation of terms of the contract by the Mudarib, is borne by the depositor. 

TYPES OF MUDARABA:

• A Mudaraba contract is either an unrestricted or a restricted Mudaraba. 
• An unrestricted Mudaraba is a contract in which the capital provider permits the Mudarib to invest Mudaraba fund without any restriction. 
• A restricted Mudaraba is a contract whereby the capital provider restricts the Mudarib’s actions to a particular location or specific type of investment. 
• However, as per Mudaraba principles the restriction should not be in a manner that would unduly constrain the Mudarib in his operations. 

MUSHARAKA مشاركة - : 

• Musharaka means commingling by two or more persons either their money or work to earn a profit or appreciation in value and to share the profit and loss. 
• In case of a loss it shall only be shared according to the partners proportionate share in the Musharaka. 
• The profit can be shared in any ratio if the partners are active/working partners. 
• However, a sleeping partner cannot have a profit sharing ration higher than his proportionate share of investment. 
• Diminishing Musharaka: it is a form of partnership in which one of the partners promises to buy the equity share of the other partner gradually until the title to the equity is completely transferred to him. 

WAKALA: 

Wakalah is a contract whereby the principal, appoints the agent, to substitute him or perform on behalf of the principal. The principal is called “Aseel/Muwakkil” and the agent is called “Wakeel”. 

The profit/loss earned/sustained is solely of the principal and the agent may take a fixed remuneration against its services.

 THANK YOU