TOPIC 7 & 8

ISLAMIC
BANKING AND
FINANCE
Part 2
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• Islamic banking or Islamic finance (Arabic:
‫ ) مصـرـفية إـسالمـية‬or sharia-compliant finance is
banking or financing activity that complies with
sharia (Islamic law) and its practical application
through the development of Islamic economics.
• Some of the modes of Islamic banking/finance
include Mudarabah (profit-sharing and loss-
bearing), Wadiah (safekeeping), Musharaka
(joint venture), Murabahah (cost-plus), and Ijara
(leasing).

• The Qur'an prohibits riba, which literally means "increase". Technically riba is the increase when liquid
or fungible assets (cash, debt, grains, etc.) are exchanged other than at par value. The most prevalent
example in today's economy is lending money at interest, for example an exchange of $100 cash now
for $110 payable in a year's time, an increase of $10. (Some Muslims dispute whether there is a
consensus that interest is equivalent to riba).
• Investment in businesses that provide goods or services considered contrary to Islamic principles (e.g.
pork or alcohol) is also haraam ("restricted, or excluded").

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• The industry has been lauded for returning to the
path of "divine guidance" in rejecting the "political
and economic dominance" of the West, and noted
as the "most visible mark" of Islamic revivalism, its
most enthusiastic advocates promise "no inflation,
no unemployment, no exploitation and no poverty"
once it is fully implemented.
• However, it has also been criticized for failing to
develop profit and loss sharing or more ethical
modes of investment promised by early promoters,
and instead selling banking products that "comply
with the formal requirements of Islamic law", but
use "ruses and subterfuges to conceal interest",
and entail "higher costs, bigger risks“ than
conventional (ribawi) banks.
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PRINCIPLES

To be consistent with the principles of Islamic law (Shariah) -- or at least an orthodox interpretation of the law—and
guided by Islamic economics, the contemporary movement of Islamic banking and finance prohibits a variety of activities,
some not illegal in secular states:

• Paying or charging interest. "All forms of interest are riba and hence prohibited". Islamic rules on transactions (known
as Fiqh al-Muamalat) have been created to prevent use of interest.
• Investing in businesses involved in activities that are forbidden (haraam). These include things such as selling alcohol or
pork, or producing media such as gossip columns or pornography.
• Charging extra for late payment. This applies to murâbaḥah or other fixed payment financing transactions, although
some authors believe late fees may be charged if they are donated to charity, or if the buyer has "deliberately refused"
to make a payment.
• Maisir. This is usually translated as "gambling" but used to mean "speculation" in Islamic finance. Involvement in
contracts where the ownership of a good depends on the occurrence of a predetermined, uncertain event in the future
is maisir and forbidden in Islamic finance.
• Gharar. Gharar is usually translated as "uncertainty" or "ambiguity". Bans on both maisir and gharar tend to rule out
derivatives, options and futures. Islamic finance supporters (such as Mervyn K. Lewis and Latifa M. Algaoud) believe
these involve excessive risk and may foster uncertainty and fraudulent behaviour such as are found in derivative
instruments used by conventional banking.
• Engaging in transactions lacking "`material finality`. All transactions must be "directly linked to a real underlying
economic transaction", which excludes "options and most other derivatives".
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Money on the most common type of Islamic financing — debt-based contracts — "must be made from a
tangible asset that one owns and thus has the right to sell — and in financial transactions it demands that
risk be shared." Money cannot be made from money. Another statement of the Islamic banking theory of
finance is: "Money has no intrinsic utility; it is only a medium of exchange.

Other restrictions include:

• Islamic banks are to collect zakat (obligatory religious alms giving) from customers' accounts — at least
according to some sources.
• A board of Shariah experts is to supervise and advise each Islamic bank on the propriety of transactions
to "ensure that all activities are in line with Islamic principles". Interpretations of Shariah may vary by
country. According to Humayon Dar, interpretation of the Shariah is more strict in Turkey or Arab
countries than in Malaysia, whose interpretation is in turn more strict than the Islamic Republic of Iran.
• Mohammed Ariff also found less exacting Shariah compliance in Iran where the Islamic government had
decreed "that government borrowing on the basis of a fixed rate of return from the nationalized banking
system would not amount to interest" and consequently would be permissible." Mahmud el-Gamal found
interpretations most strict in Sudan and least in Malaysia.)[99]
• Risk sharing. symmetrical risk and return on distribution to participants so that no one benefits
disproportionately from the transaction.
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• In general, Islamic banking and finance has been described as having the "same purpose" as conventional
banking but operating in accordance with the rules of shariah law (Institute of Islamic Banking and
Insurance), or having the same "basic objective" as other private entities, i.e. "maximization of
shareholder wealth" (Mohamed Warsame).
• In a similar vein, Mahmoud El-Gamal states that Islamic finance "is not constructively built from classical
jurisprudence". It follows conventional banking and deviates from it "only insofar as some conventional
practices are deemed forbidden under Sharia."

• A broader description of its principles is given by the The "guiding principles" for Islamic finance
Islamic Research and Training Institute of the Islamic include: "fairness, justice, equality,
Development bank, transparency, and the pursuit of social
harmony"
• "The most important feature of Islamic banking is that it
promotes risk sharing between the provider of funds
(investor) on the one hand and both the financial
intermediary (the bank) and the user of funds (the
entrepreneur) on the other hand ... In conventional
banking, all this risk is borne in principle by the
entrepreneur."
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As noted above, the primary focus of Islamic banking is on financing without interest to avoid riba, while trade
is not an issue (per the Quranic statement that "God has permitted trade and forbidden riba [usury]". However
trade transactions that involve gambling (maisir), or excessive risk (bayu al-gharar) are not permitted. Among
the financial instruments and activities common in conventional finance that are considered forbidden (or at
least Islamically problematic) by many Islamic scholars and Muslims are:
• Margin trading: This uses borrowed money to buy shares of stock or other financial
instruments. It both involves forbidden interest on the borrowed money, and much
greater risk than non-margin investing because losses can be greater than the
amount borrowed;
• Short selling: borrowing/renting shares of stock or some other instruments and
selling it, sometimes without possessing it, on the hope that it can be later
repurchased at a lower price for a profit. It is traditionally thought to violate the
hadith stating "Do not sell which you do not possess," and has been declared
impermissible by numerous sources (Raj Bhala, IslamQA, Taqi Usmani, and
Humayon Dar.
• Day trading: very short term buying and selling of financial instruments) has been
called unIslamic because the short period of "ownership" means day traders do not
truly own what they trade, and furthermore pay interest. Among the sources calling
it unIslamic include Yusuf Talal DeLorenzo, and Focus Business Services of the UAE.
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• Derivatives: contracts that derive their value from the performance of an
underlying asset; (The "notional value" of the world's over-the-counter
derivatives at the end of 2007 was $596 trillion and the gross market value of
all outstanding derivatives was $14.5 trillion.) Options, futures and "other
derivatives" are "generally" not used in Islamic finance "because of the
prohibition against maisir“. Sources stating that most derivative or some kinds
of derivative are banned by Islamic scholars include Juan Sole and Andreas
Jobst, P.S.Mills and J.R.Presley, and Taqi Usmani. The most commonly used
derivative are:

 Forwards: customized contracts to buy or sell an asset at a specified price on a

future date. unlike futures contracts forward contracts are not traded on any
exchanges;
 Futures: a legal agreement to buy or sell a particular commodity or financial
instrument at a predetermined price at a specified time in the future;
 Options: contracts offering the buyer the right, but not the obligation, to buy
(call) or sell (put) a security or other financial asset at an agreed-upon price (the
strike price) during a certain period of time or on a specific date (exercise date);
 Swaps: contracts through which two parties exchange financial instruments to
transfer risk.
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JUSTIFICATION FOR ISLAMIC BANKING
It has been praised — or at least described positively — for

• Turning a "theory" into a trillion dollar "reality", asserted Islam into international financial markets (according to Taqi
Usmani);
• Enriched the Islamic legal system by providing it with real world business questions to find shariah-compliant solutions
for (Usmani);
• Creating an "ethical, sustainable, environmentally- and socially-responsible" system (according to Abayomi A. Alawode);
• Drawing conventional banks into the industry in search of Muslim customers (Munawar Iqbal and Philip Molyneux);
• Drawing new customers and money into banking, rather than taking existing customers and their money away from
conventional banking, (Laurent Gheeraert).
• Creating a less risky form of finance (according to Zeti Akhtar Aziz and others):
 By forbidding speculation, so that, for example, the excesses that led to the global financial crisis of 2007–2008 are
avoided (according to Ibrahim Warde);
 By use of two kinds of accounts:
"current accounts" — where funds earn no return and (in theory) are held, not invested by the bank, so not subject to risk;
and mudarabah accounts — where the depositors share in any losses with the bank, so diminishing the bank's risk.

While the industry has problems and challenges, these can be explained by
• Its relative youth and low position on the "learning curve" that will solved these difficulties over time;
• By non-Islamic influences which can only be eliminated when the industry operates in a truly Islamic society and
environment.[196]
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FINANCIAL ACCOUNTING STANDARDS

• The Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI), has been
publishing standards and norms for Islamic financial institutions since 1993.
• By 2010, it had issued "25 accounting standards, seven auditing standards, six governance standards,
41 shari'ah standards and two codes of ethics."
• By 2017 it had issued 94 standards in the "areas of Shari’ah, accounting, auditing, ethics and
governance".)
• Although it is an independent body, its "pronouncements on the acceptability or otherwise of
contractual structures in relation to Islamic financial instruments are to be viewed in the same vein as
regulatory edicts."
• Its standards are mandatory for Islamic financial institutions in Bahrain, Sudan, Jordan and Saudi
Arabia, and recommended for other Muslim countries and Islamic financial institutions.
• Established in Algiers in 1990, its original name was Financial Accounting Organization for Islamic
Banks and Financial Institutions. It later moved its headquarters to Bahrain.

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• The International Islamic Financial Market — a standardization body of the Islamic
Financial Services Board for Islamic capital market products and operations — was
founded in November 2001 through the cooperation of the governments and central
banks of Brunei, Indonesia and Sudan.
• Its secretariat is located in Manama Bahrain. It is not a regulatory body and its
recommendations are "not implemented by most Islamic banks".
• The controlling body (Islamic Financial Services Board) is different from the other
Islamic Financial standards organ, the AAOIFI,

 The AAOIFI sets best practices for handling the financial reporting requirements of
Islamic financial institutions, IFSB standards are mainly concerned with the
identification, management, and disclosure of risk related to Islamic financial
products.

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PRODUCTS, SERVICES AND
CONTRACTS
• PROFIT AND LOSS SHARING
• ASSET BACKED FINANCING
• CHARITABLE LENDING
• CONTRACT OF SAFETY, SECURITY AND SERVICE

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• While the original Islamic banking
proponents hoped profit-loss sharing (PLS) PROFIT AND LOSS
would be the primary mode of finance
replacing interest-based loans,[151] long-
SHARING
term financing with profit-and-loss-sharing
mechanisms is "far riskier and costlier" than MUDARABAH
the long term or medium-term lending of
the conventional banks — according to
MUSHARAKAH (Joint
critics such as economist Tarik M. Yousef— Venture)
and has "declined to almost negligible
proportions“. DIMINISHING
• Loans are permitted in Islam if the interest
that is paid is linked to the profit or loss MUSHARAKA
obtained by the investment. The concept of
profit acts as a symbol in Islam as equal
sharing of profits, losses, and risks.
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Mudarabah
• A mudarabah or mudharabah contract is a profit sharing partnership in a
commercial enterprise. One partner, rabb-ul-mal, is a silent or sleeping
partner who provides money. The other partner, mudarib, provides
expertise and management.[262] The arrangement is similar to venture
capital in conventional finance, in which a venture capitalist finances an
entrepreneur, who provides management and labor.

• Profits are shared between the parties according to a pre-agreed ratio,

usually either 50%–50%, or 60% for the mudarib and 40% for rabb-ul-mal.
If there is a loss, the rabb-ul-mal loses the invested capital, and the
mudarib loses the invested time and effort. The sharing of risk reflects the
view of Islamic banking proponents that under Islam, the user of capital
— labor and management — should not bear all the risk of failure.
Sharing of risk, according to proponents, results in a balanced distribution
of income, and prevents financiers from dominating the economy.

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Musharakah (joint venture)
• Like mudaraba, musharakah is also a profit and loss
sharing partnership, but one where investment
comes from all the partners, all partners are given the
option of participating in the management of the
business, and all partners share in losses according to
the ratio (pro rata) of their investment.

• Musharakah may be "permanent" or "diminishing". It

is often used in investment projects, letters of credit,
and the purchase or real estate or property. Use of
musharaka is not great. In Malaysia, for example, the
share of musharaka (or at least permanent
musharaka) financing declined from 1.4 percent in
2000 to 0.2 per cent in 2006.

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Diminishing Musharaka
• Musharaka al-Mutanaqisa, (literally "diminishing partnership"), is a popular
type of financing for major purchases such as housing. In it, the bank and
purchaser (customer) have joint ownership of a purchased asset with the
customer also leasing the asset.[270] As the customer gradually paying off
the cost the bank's equity share diminishes from all but the customer
percentage of downpayment to nothing.
• If the customer defaults and the asset is sold, the bank and the customer
split the proceeds according to each party's current equity.

• It would assist at this point to highlight how Musharaka al-Mutanaqisa is

different than conventional banking mortgages, so that the salient
difference, both in terms of law and practice is understood. To assist in this
understanding, let's first see how regular mortgages work in USA:

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• Once a buyer wishes to purchase a home, she approaches the lender and requests a loan. The lender in
turn, if buyer qualifies, will lend money to buy the house, and the bank will usually set a fixed
percentage of interest to be paid to the lender.
• Each payment to lender will then include a return of the portion of principal and the interest accrued
on the remaining balance for that period. Over time, the entire principal is paid back to the lender,
together with all the interest that is due.
• In terms of the ownership of the house, the buyer/borrower/debtor will have legal title to the house
during the term of repayment and thereafter too. In the county title records office, the borrower will
have a title deed showing the buyer as the title holder, and not the bank. Any diminishing value of the
house is the risk of the borrower and not the bank.
• On the other hand, any appreciation is also of the borrower and the bank cannot ask for more principal
due to the appreciation. Hence, the bank and the borrower know at the outset the exact obligations to
each other.
• The bank, in an effort to secure its loan, will place a lien (a charge) on the property, so that if the
borrower does not repay the loan, the bank gets the right to foreclose on the borrower's right to hold
title and have the title be transferred to the bank (or the house be auctioned and the proceeds
received by bank). In USA, most states have a judicial foreclosure process where the bank asks the
Court to sell the property to recover the balance of its loan and accrued interest, plus any other costs
of the suit.

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Asset-backed or debt-type
instruments (also called contracts
ASSET BACKED
of exchange) are sales contracts FINANCING
that allow for the transfer of one
commodity for another commodity, Murabaha
the transfer of a commodity for
Musawamah
money, or the transfer of money for
money. Salam
They include Murabaha, Istisna’a
Musawamah, Salam, Istisna’a, and Ijarah
Tawarruq.[273]
Tawarruq
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Murâbaḥah

• Murabahah (or murabaha) is an Islamic contract for a sale where the buyer and
seller agree on the markup (profit) or "cost-plus" price for the item(s) being sold.
• In Islamic banking it has become a term for both a marked-up price and deferred
payment — a way of financing a good (home, car, business supplies, etc.)
whereby the bank buys the good and resells it to the customer at higher price
(informing the customer of the price increase), and offering to take payment in
installments or in a lump sum.

• Murabahah has also come to be the most common type of Islamic finance.
• One estimate is that 80% of Islamic lending is by Murabahah.
• This is despite the fact that (according to Uthmani) Islamic finance Shari‘ah
supervisory boards "are unanimous" in agreement that Murabahah loans "are
not ideal modes of financing", and should be used only "when more preferable
means of finance — "musharakah, mudarabah, salam or istisna‘ — are not
workable for some reasons".

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• Murabahah differs from conventional finance (such as mortgages
for homes or hire purchase for furniture or appliances), in that the
fixed return with which the bank is compensated is called "profit"
and not interest, and that the financier may not keep for itself any
penalties for late payment.

• Economists have questioned whether Murabahah is actually

distinct from debt- and interest-based finance.
• The fact that there is a principal and a payment plan means that
there is an implied interest rate, based on conventional banking
interest rates such as LIBOR.
• Others complain that in practice most "murabaḥah" transactions
do not involve actual buying or selling of goods or commodities,
but are merely cash-flows between banks, brokers and borrowers.
• In contrast to LIBOR, Islamic banks lend money based on their own
reference rate known as the Islamic Interbank Benchmark Rate
which “uses expected profits from short-term money and a
forecasted return on the assets of the bank receiving funds.”

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Bai' muajjal
• In Islamic jurisprudence (fiqh), Bai-muajjal, also called bai'-bithaman ajil, or BBA,
is a credit sale or deferred payment sale, i.e. the sale of goods on a deferred
payment basis. In Islamic finance, the bai' muajjal product also involves the price
markup of a murabahah contract, and a murabahah product involves a bai-muajjal
deferred payment.
• Thus the terms and are often used interchangeably, (according to Hans Visser), or
"in practice ... used together" (according to Faleel Jamaldeen).

• However, according to another (Bangladeshi) source, Bai' muajjal differs from

Murabahah in that the client, not the bank, is in possession of and bear the risk
for the goods being purchased before completion of payment.
• And according to a Malaysian source, the main difference between BBA (short for
bai'-bithaman ajil) and murabaha — at least as practiced in Malaysia — is that
murabaha is used for medium and short term financing and BBA for longer term.

 Bia'muajjal as a finance product was introduced in 1983 by Bank Islam Malaysia

Berhad.

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Bai' al 'inah (sale and buy-back agreement)
• Bai' al inah (literally, "double sale"[289] or "a loan in
the form of a sale"),is a financing arrangement where
the financier/bank buys some asset from the customer
on spot basis, with the financier's payment
constituting the "loan".
• The asset is then sold back to the customer who pays
in installments over time, essentially "repaying the
loan".
• Since loaning of cash for profit is forbidden in Islamic
Finance, some scholars do not believe Bai' al 'inah is
permissible in Islam.
• According to the Institute of Islamic Banking and
Insurance, it "serves as a ruse for lending on interest",
but Bai' al inah is practiced in Malaysia and similar
jurisdictions.
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Musawamah
• A Musawamah (literally "bargaining")
contract is used if the exact cost of
the item(s) sold to the bank/financier
either cannot be or is not
ascertained.
• Musawamah differs from Murabahah
in that the "seller is not under the
obligation to reveal his cost or
purchase price".
• Musawamah is the "most common"
type of "trading negotiation" seen in
Islamic commerce.
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Istisna and Bai Salam
• Istisna (also Bia Istisna or Bai' Al-Istisna) and Bia Salam (also Bai us
salam or just salam) are "forward contracts"— customized
contracts where immediate payment is made for goods in the
future — goods not yet manufactured, built, or harvested.
• Istisna contracts (literally, a request to manufacture something) are
limited by Islamic fiqh to use for manufacturing, processing, or
construction,while salam "can be effected on anything"— except
gold, silver, or currencies based on these metals.
• On the other hand, a salam contract cannot be cancelled
unilaterally, the full price must be paid in advance, and the time of
delivery must be specified— restrictions that do not apply to
istisna.

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• In a istisna contract, the financer/bank can makes payments in stages, to
finance raw materials (in the case of manufacturing), or construction
materials (in the case of the construction project). When the
product/structure is finished and sold, the bank can be repaid.
• Bia salam and istisna contracts should be as detailed as possible to avoid
uncertainty.
• Salam contracts predate istisna and were designed to fulfill the needs of
small farmers and traders.
• Salam is a preferred financing structure and carries higher order of
Shariah compliance than contracts such as Murahabah or Musawamah.

Examples of use of istisna in the Islamic finance world include use by the
Kuwait Finance House and the Barzan gas project in Qatar. Examples of
banks using Salam are ADCB Islamic Banking and Dubai Islamic Bank.

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Ijarah
• Ijarah, (literally "to give something on rent") is a leasing or renting
contract.
• In traditional Islamic jurisprudence (fiqh), it means a contract for the
hiring of persons, services, or the "usufruct" of a property, generally for
a fixed period and price.

• In Islamic finance, al Ijarah usually refers to a leasing contract that also

includes a sales contract. Property such as plant, office automation, or
motor vehicle, is leased to a client for stream of rental and purchase
payments, so that the end of the leasing period coincides with
completion of purchase payments and transfer of ownership to the
lessee, and otherwise follows Islamic regulations.
• There are several types of ijarah in Islamic finance ("operating ijarah" or
ijarah tashgheeliah, are leases without sales and finance):
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Ijarah thumma al bai' and Ijarah wa-iqtina
• Ijarah thumma al bai` (hire purchase) and Ijarah wa-iqtina
("lease and ownership") involve the leasing/renting/hiring of
a good, paid in installments and ending with its purchase (or
option to purchase) by/for the customer.
• Both involve two contracts — a lease and a transfer of
ownership of the asset or the property — that should be
recorded in separate documents.

• The two modes differ in that in Ijarah wa-iqtina (or ijara

muntahia bittamleek) sale/ownership transfer is "an option
given to the lessee" and cannot be a precondition.
• In ijara thumma bai’ sale is part of the contract.

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ijara mawsoofa bi al dhimma
• In a "forward ijarah" or ijara mawsoofa bi al dhimma Islamic
contract, the service or benefit being leased is defined, rather
than the particular unit providing that service/benefit.
• In contemporary Islamic finance, it is used to finance
construction (of a home, office, factory, etc.) combined with a
Istisna contract.
• The party begins leasing the asset after "taking delivery" of it.

Ijarah challenges
• Among the complaints made against ijara are that in practice
some rules protecting the customer are overlooked.
• That its rules provide weaker legal standing and consumer
protection and less flexibility than conventional mortgage loan
or car finance, as well as higher costs.

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Tawarruq
• A Tawarruq (literally "turns into silver", or "monetization") contract/product where the
client/customer can raise cash to be repaid later by buying and selling some readily saleable
asset.
• An example of this would be a customer wishing to borrow $1000 in cash having their bank buy
$1,100 worth of a commodity such as iron from a supplier, buying the iron from the bank on
credit with 12 months to pay the $1100 back, immediately selling the metal back to the bank for
$1000 cash to be paid on the spot. The bank resells the iron to the supplier. (This would be the
equivalent of borrowing $1000 for a year at an interest rate of 11 per cent.)

• Like Bai' al inah mentioned above, the greater complexity of this transaction means more fees and
higher costs than a conventional bank loan, but (in theory) compliance with shariah law because
of the tangible assets that underlie the transactions .
• However, critics complain that "billions of dollars" of putative commodity-based tawarruq
transactions have evaded the required commodity trades; and Islamic scholars both
contemporary and classical have forbidden the practice.
• Nonetheless, as of 2012 Islamic banks using Tawarruq include the United Arab Bank, QNB Al
Islamic, Standard Chartered of United Arab Emirates, and Bank Muamalat Malaysia.

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CHARITABLE LENDING
Qardh-ul Hasan
• Taqi Usmani insists that "role of loans" (as opposed to investment or finance) in a truly Islamic society is
"very limited", and that Shariah law permits loans not as an ordinary occurrence, "but only in cases of dire
need".
• A shariah-compliant loan is known as Qardh-ul Hasan, (also Qard Hasan, literally: "benevolent loan" or
"beneficence loan"). It is often described as an interest-free loan extended to needy people.
• Such loans are often made by social service agencies, or by a firm as a benefit to its employees, rather than
by Islamic banks. They are analogous to the microcredit of conventional finance, when it does not provide
for an interest.

Quoting prophet Muhammad (pbuh) some sources insist that lenders may not gain "any advantage or benefits"
from the loan, let alone interest.

However, some Islamic banks offer products called qardh-ul hasan which charge lenders a management fee,
and others have savings account products called qardh-ul hasan, (the "loan" being a deposit to a bank account)
where the debtor (the bank) may pay an extra amount beyond the principal amount of the loan (known as a
hibah, literally gift) if the extra is not an obligation of the account/loan agreement.

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TO BE CONTINUED
IN PART 3 ………

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