"Islamic banks operate in the Middle East, Europe, Asia and Africa. At the threshold of the 21st century, Islamic banks had about US $700 billion in funds under their management"
A few decades ago, modern banking and financial institutions that encompass Islamic values within their principles and practices seemed to be merely a remote dream. Today, however, Islamic banking has become a viable financial approach that attracts an increasing amount of capital investment.
As a concept Islamic Banking was developed as a result of the religious prohibition of the payment or receipt of interest.
The fundamental principles of Islamic Banking go back over one thousand four hundred years. They are set out in Shari'a law and are enshrined in the Qur'an, the Hadith and the Sunna. Today, these principles form the basis of the contemporary Islamic Banking range of Islamic financial products & services.
There is no standard way of grouping Islamic Financial Institutions, but in terms of services rendered, today
Islamic Financial Institutions can be divided into the following broad categories:
1- Islamic Banks.
2- Islamic Windows.
3- Islamic finance/Investment Banks.
4- Islamic Mortgage companies.
5- Takaful Companies. 6- Mudarabah Companies.
7- Islamic investment funds
Although it draws inspiration from practices and values that go back centuries to the dawn of Islam as inclined above, Modern Islamic banking started in the early 1960s concurrently in Egypt and Malaysia. In 1962, the Pilgrimage Fund, TABUNG HAJI, was established in Malaysia to accept saving deposits form persons who intend to make the pilgrimage to Makkah and invest the proceeds in accordance with the Islamic law. The Fund grew to provide full scale banking services and to become one of the largest banks in Malaysia.
Around the same time and completely independently a series of small saving/investment banks were established in Egypt's countryside, beginning in 1963 in the village of Mit Ghamr. These small banks also practiced the same principle of interest-free banking.
The Idea continued to develop theoretically until 1974, when the first Islamic commercial Islamic bank was established in Dubai, the United Arab Emirates. The same year also witnessed signing the agreement to establish the Islamic Development Bank IDB as an inter-governmental pan-Islamic bank.
The IDB main objective is to finance development projects in the Muslim countries in accordance with the rules and ethics of Islamic finance, followed a short time later by Faisal Islamic Bank in Egypt and Sudan (1977), Bahrain Islamic Bank, and Jordan Islamic Bank (1978).
By the mid 1980s, this new species of ethical banks, based on Islamic principles became an established part of mainstream banking in the Middle East and South Asia.
They continued to sprout across South and East Asia in addition to Turkey and the Arab countries. Subsequently, ethical banks and financial institutions, based on
Islamic principles, spread in countries where Muslims are minorities, such as UK, Luxemburg, Denmark, Australia,India and the United States. Many Muslims flocked to these new banking institutions, not only for ethical and religious reasons, but also because they provided professional and friendly services to their customers.
What is an Islamic Bank
There is no standard way of defining what is an Islamic bank is, but broadly speaking an "Islamic bank is an institution that mobilize financial resources and invest that money in an attempt to achieve pre-determined islamically - acceptable social and financial objectives. Both mobilization and investment of money should be conducted in accordance with the principles of Islamic Shari'a".
Principles of Islamic Banking
1- Prohibition of Interest or Usury
The principles of Islamic finance are established in the Qur'an, which Muslims believe are the exact Words of God as revealed to the Prophet Mohammed. These Islamic principles of finance can be narrowed down to four individual concepts.
The first and most important concept is that both the charging and the receiving of interest is strictly forbidden.
This is commonly known as Riba1 or Usury. Money, on its own, may not generate profits. When Riba infects an entire economy, it jeopardises the well-being of everyone living in that society. When investors are more concerned with rates of interest and guaranteed returns than they are with the uses to which money is put, the results can only be negative.
Adherents of Islam believe that the Qur'an is the final book of God's word following both the Torah and the Bible.
As a result, there are a number of similarities between the Islamic, Christian and Jewish faiths.
Quoting Shaikh Saleh Abdullah Kamel, Chairman and Founder of Albaraka Banking Group; Usury is forbidden in all the
three religions, Judaism, Christianity and Islam, but it is the people who forget the rules of Allah.
All societies, nowadays - Muslims, Christians and Jews - deal with Usury.
2- Ethical Standards
The second guiding principle concerns the ethical standards. When Muslims invest their money in something, it is their religious duty to ensure that what they invest in is good and wholesome.
It is for this reason that Islamic investing includes serious consideration of the business to be invested in, its policies, the products it produces, the services it provides, and the impact that these have on society and the environment.
In other words, Muslims must take a close look at the business they are about to become involved in.
In all facets of the financial system, Islam has certain rules, certain regulations as to how Muslims should go about participating in these activities. For example, in share trading or the securities market, Islam looks at the activities of the companies, to establish whether or not the companies are involved in activities which are in line with Sharia'a.
3- Moral and Social Values
The third guiding principle concerns moral and social values. The Qur'an calls on all its adherents to care for and support the poor and destitute. Islamic financial institutions are expected to provide special services to those in need.
This is not confined to mere charitable donations but has also been institutionalised in the industry in the form of profit-free loans or Al Quard Al Hasan.
An Islamic bank's business includes certain social projects, as well as charitable donations.
Islamic banks provide profit-free loans. For example, if an individual needs to go to hospital or wants to go to university, we give what is called Quard Al Hasan. This Quard Hasan is normally given for a short period of one year and the Islamic bank
does not charge anything for that.
4- Liability and Business Risk
The final principle concerns the overarching concept of fairness, the idea that all parties concerned should both share in the risk and profit of any endeavor.To be entitled to a return, a provider of finance must either accept business risk or provide some service such as supplying an asset, otherwise the financier is, from a Sharia'a point of view, not only an economic parasite but also a sinner.
This principle is derived from a saying of the Prophet Mohammed (May Peace be upon Him) "Profit comes with liability".
What this means is that one becomes entitled to profit only when one bears the liability, or risk of loss. By linking profit with the possibility of loss, Islamic law distinguishes lawful profit from all other forms of gain.
In order to insure that these principles are followed, each Islamic institution must establish and provide itself with an advisory council known as a Sharia'a Board. The members of Sharia'a Boards can include bankers, lawyers or religious scholars as long as they are trained in the Islamic law, or Sharia'a.
In 2001, the Industry witnessed a remarkable development in this regard by the initiative of the Accounting and Auditing Organization for the Islamic Financial Institutions or AAOIFI.
At that time, AAOIFI's standards were enhanced to include elements that aim at broadening the role of the external auditor. Now according to these new developments the external auditor is also required to look for compliance with Sharia'a rules as defined by the Sharia'a supervisory board of each bank and in accordance with the Sharia'a standards AAOIFI has begun to issue.
Differences from conventional banks
Murabaha is a financing arrangement whereby the bank agrees to purchase an asset at the request of the customer.
The bank takes legal possession of the asset that is then sold to the customer at an agreed sale price consisting of the amount of financing plus the profit margin. It is a cost plus transaction.
RESPONSIBILITY OF THE PARTIES
the bank buys the asset from the supplier for P
the customer then buys the asset from the bank at a marked up price (P+X), which is payable on a deferred payment basis
the period covering the deferred payment is effectively the period of financing
The title to the assets is transferred to the customer at the time of purchase but usually the bank requires its customers to pay an amount as an initial advance in order to secure the sale of the Murabaha asset to the customer (Hamish gedyyah).
Hamish gedyyah (security from customer) is presented as an obligation by the
customer in the financial statements.
Murabaha Sale is divided into two types:
Ordinary Murabaha Sale
There are two parties to it, the seller and the buyer. The seller is an ordinary trader who buys a commodity without depending on a prior promise of purchase, then he displays it for Murabaha sale for a price and a profit to be agreed upon.
Murabaha Sale connected with a promise
There are three parties to it. The seller, the buyer and the bank as an intermediary trader between the buyer and the seller.
The bank here does not purchase unless the buyer specifies its desire and a prior outstanding promise to purchase.
The mode of Murabaha sale connected to a promise is used by the Islamic banks which undertake the purchase of commodities according to the specifications requested by the customer and then resell them on Murabaha to the one who promised to buy for its cost price plus a margin of profit agreed upon previously by the two parties.
Mudarabah is an Islamic mode of financing between the bank, providing a specified amount of capital, and the Mudarib, providing management for carrying out the venture, trade or service with a view to earning profit.
It is aspecial kind of partnership where one partner gives money to another for investing it in a commercial enterprise.
The former is called Rabb - ul - mal and the latter is called Mudharib.
Thus, Mudaraba is a contract between those who have capital and those who have expertise, where the first party provides capital and the other party provides the expertise with the purpose of earning Halal (lawful) profit which will be shared in a mutually agreed upon proportion.
This type of business venture serves the interest of the capital owner and the Mudarib (agent).
The capital owner may not have the ability or the experience to run a profitable business. On the other hand, the agent (the Mudarib) may not have adequate capital to invest in a business or project.
Therefore, by entering into a contract of Mudarabah each party complements one another, allowing a business venture to be financed.
The bank provides to the customer (Mudarib) all the capital to fund a specified enterprise.
The customer does not contribute capital but contributes management expertise (or entrepreneurship).
The customer is responsible for the day to day management of the enterprise and is entitled to deduct its management fee (Mudarib fee) from the enterprise's profits.
The Mudarib fee could be a fixed fee (to cover management expenses) and a percentage of the profits or a combination of the two.
Classical Mudarib fee is based on percentage of the profits only.
The balance of the profit of the enterprise is payable to the bank. If the enterprise makes a loss, the bank (as the fund provider or rab al maal) has to bear all the losses unless the loss has resulted from negligence on the part of the Mudarib. The Mudarib, in turn, will lose his efforts.
Musharaka is an Islamic mode of financing in the form of a partnership between the bank and its client whereby each party contributes to the capital of the partnership in equal or varying degrees either to establish a new project or share in an existing project.
The accruing profit is divided between the partners pre-agreed formula, while losses are shared on pro rata basis.
The word Musharakah is derived from the Arabic word Sharikah meaning partnership.
Islamic jurists point out that the legality and permissibility of Musharakah is based on the injunctions of the Qur'an, Sunnah, and Ijma (consensus) of the scholars. It may be noted that Shirkah in the Islamic Fiqh is divided into two kinds:
Shirkat Milk, defined as joint ownership of this or more person in a property.
Shirkat ul Aqd, defined as partnership effected by a mutual contract. Shirkat Aqd is also divided into three kinds:
Shirkat Amwal, Shirkat Amal and Shirtal Wujoot.
Constant and Diminishing Musharakah:
Musharakah agreement may be entered into for a short-term or long-term period. The capital contributed by the bank
in a Musharaka may remain constant throughout the contracted period.
This is referred to as constant Musharakah. Otherwise the bank gradually transfers its share in the Musharaka to the Musharik so as to decrease its share in order to transfer the ownership of the venture to the other party. This is a diminishing Musharakah.
Profits are shared in accordance with the Musharakah agreement. Losses are normally shared in proportion to the capital contributed by each Musharik.
Ijarah and Ijarah Muntahia Bittamleek.
Ijarah is an operating lease whereby the bank will buy and lease out equipment required by the customer for an agreed rental fee.
The agreement does not include a promise that the leased asset at the end of the lease term will be transferred to the lessee.
Ijarah is defined in Fiqh as a possession of a usufruct or benefits for consideration in the Islamic Fiqh. This term is used to denote two things:
To employ the services of a person on wages given to him as consideration for hhis hired services.
It relates to the usufruct of assets and properties. Here it means To transfer the usufruct of a particular property to another person and exchange for a rent claim from him.
Ijarah is divided into two kinds:
According to this mode, the Islamic bank maintains a number of various assets to respond to the needs of different customers.
These assets usually have a high degree of marketability. The bank lets these assets to any party so desirous to utilize for a term to be agreed upon. After the termination of the lease period the assets return to the bank, on its part the bank looks for a new lessee.
The distinguishing feature of this mode is that the assets remain the property of the Islamic bank to put them up for rent every time the Lease period terminates so as not to remain unutilized for long periods of time.
Under this mode the bank bears the risk of recession or diminishing demand for these assets.
The operation lease divides into:
Specific or determined lease: It is the lease of real property or other assets that one can point to.
Lease described on liability: It is the Lease of benefit determined by specifications agreed upon to be on liability such as a car or a ship, not particular but precisely described to forbid dispute.
Ijarah Muntohia Bitamleek
It is a lease whereby the bank will buy and lease out equipment required by the customer for an agreed rental fee.
However, it differs from Ijarah in that such an arrangement provides an option for the customer to acquire the ownership at the end of a specified period.
The bank may also enter into a sale and leaseback agreement with the customer whereby the bank will purchase the asset from the customer and leaseback under Ijarah or Ijarah Muntohia Bittamleek arrangement.The accounting implications for the bank will remain the same as for Ijarah / Ijarah Muntohia Bittamleek transactions.
The option for the lessee to acquire the leased asset may be exercised during the tenor of the total lease period or at the end of the lease term as stipulated in the lease agreement.The purchase option is obligatory for the customer (lessee).
Ijarah Muntohia Bittamleek concludes with the legal title in the leased asset being passed to the lessee.
This includes the following types:
gift (transfer of legal title for no consideration)
transfer of legal title (sale) at the end of a lease for a token consideration or other amount as specified in the lease contract.
transfer of legal title (sale) prior to the end of the lease term for a price that is
equivalent to the remaining Ijarah instalments applicable under gradual transfer of legal title (sale) of the leased asset.
Ijarah and Ijarah Muntohia Bittamleek contracts have three major elements:
offer and acceptance
two parties: the bank as lessor (the owner of the leased asset) and the client as lessee (the party who reaps the services of the leased asset)
the object of the Ijarah contract, which includes the rental amount and the service (transferred to the lessee).