1. WHAT IS Islamic BANKING?
Concept, Instruments Issues, Theory and Practice
AUSAF AHMAD
Azerbaijan State Economics University
Baku
April 7-11, 2008

2. In the name of Allah, the most Beneficent, the Most Merciful.

3. This presentation includes:
What is Islamic banking?
Basic function: Financial Intermediation
An Introduction to Islamic financing techniques.
Practices of Islamic Banking and Finance
Observations on some common misconceptions.

4. Clarification on Nomenclature
Islamic Banking is known by several names:
Interest free banking (Iran)
PLS Banking (Pakistan)
Islamic Banking (Gulf)
Special Finance Houses (Turkey)
All expressions are used interchangeably.
Is it a contradiction in terms?

5. Clarification on Nomenclature contd.
Some people prefer Islamic Finance House instead of Islamic bank. (Beit ul tamweel)
It is argued that banking is purely Western Phenomenon
Islamic banking and Islamic finance are also used interchangeably.

6. Common interface between Islamic and contemporary banks
Same purpose: Financial intermediation
Same Objective: Profit
Successful Operation of Islamic banks has shown that financial intermediation is possible even without interest.

7. FINANCIAL INTERMEDIATION
Goods
Real Flow
SURPLUS
HOUSEHOLDS
DEFICIT
HOUSEHOLDS
[Firms}
FINANCIAL INTERMEDIATION
Financial Flow
FINANCIAL INTERMEDIARIES
Financial Flow

8. FINANCIAL MARKET THE FIRM INDIVIDUALS FINANCIAL INTERMEDIARIES
Indirect financing
Indirect financing

9. DIRECT FINANCING Financial Flow Households Businesses
Flow of Real goods

10. Financial Institutions
Indirect Financing
Return on Investment
Return on Investment
Business
Households
Financial Institutions
Financial Resources
Financial Resources
Goods
goods
Goods

11. STRUCTURE OF FINANCIAL MARKETS
Supervisory Bodies
Indirect Finance
Direct Finance
Bonds
Equities
Depository
Institutions
Contractual
Savings
Institutions
Investment
Intermediaries
Secondary
Markets
Commercial
Banks
Insurance
Companies
Mutual
Funds
Primary
Markets
Saving & Loan
Associations
Pension
Funds
Finance
Companies
Investment
Banks
Dealers and
Brokers
Stock
Exchanges
Over-the-Counter
Exchange
Cooperatives

12. Islamic Banks and Other businesses
ALL BUSINESSES
Financial Institutions
All Banks
Islami
Banks

13. Theoretical considerations

14. Social and Moral Norms Should not indulge in Riba
Should not involve Gharar
Should not indulge in fraudulent behavior
Should not coerce
Should assure fairness to all parties.
No financing of socially undesirable goods such as alcohol, drugs, pornography.
Should not resort to morally reprehensible practices such as cheating, bribing, fraudulent practices.

15. The Views on Bank Interest
No distinction is made between usury and interest.
No distinction is made between consumption loans and productive loans.
No distinction between constant and variable interest rates.
No distinction is made between individual and institutional rate of interest.

16. AVOIDANCE OF GHARAR Definition of Gharar Uncertainty / Ambiguity
Ambiguity of Quantity [Gharar fil Miqdar]
Ambiguity of Attributes [Gharar fis sifah] such as
Ambiguity in time or place of delivery
Ambiguity in price etc.

17. DEBT FINANCE Vs. Islamic FINANCE
Islamic finance, in comparison, to debt finance is:
More just [Treats creditor and borrowers equally]
More equitable [ Interest rate is exploitative ]
More efficient [ allocates resources on the basis of profitability ]
More growth oriented. [ Increases productive Capacity of the society ]

18. Practices of Islamic banking

19. PRESENT SCENE Islamic Banks in the Government Sector
Pakistan, Sudan, Iran
Islamic Banks in the Mixed Sector
- Malaysia
Islamic Banks in the Private Sector
Gulf
Non Banking Financial Institutions
Al Ameen [ Bangalore, India]
Islamic Financing by standard Commercial Banks in the Domestic Sector
Saudi British, NCB, Saudi American, Misr Bank
Islamic financing by Commercial banks in the foreign sector.
Islamic Banks established by multinational Banks
Citibank, HSBC Amanah Bank,

20. TYPES OF ISLAMIC BANKS
Predominantly social banks such as Nasser Social Bank
Predominantly international development banks such as Islamic Development Bank
Predominantly financial investment bank such as Kuwait Finance House
Completely government owned banks such as Nasser Social Bank
Banks owned by several Islamic governments such as Islamic Development Bank
Multipurpose non government banks such as Dubai Islamic Bank[1]
[1] Al Hawary, Ma Ma’na Bunk Islami ( Arabic) Cairo: International Association of Islamic Banks, 1982 p. 49

21. Other Classifications
Islamic Banks in the Government Sector
Pakistan, Sudan, Iran
Islamic Banks in the Mixed Sector
Malaysia
Islamic Banks in the Private Sector
Gulf
Non Banking Financial Institutions
Islamic Financing by standard Commercial Banks

22. Elementary Observations
EMERGENCE O F ISLAMIC BANKS
WHAT IS AN ISLAMIC BANK?
THE DIFFERENCE BETWEEN AN ISLAMIC BANK AND AN ISLAMIC FINANCIAL INSTITUTION.
EVOLUTION OF ISLAMIC BANKING.
PRESENT SCENE.

23. A TYPICAL BALANCE SHEET
Uses of Funds
Murabaha
Musharakah
Mudarabah
Ijarah
Qard Hasan
Sources of Funds
Current Account
Saving Accounts
Investment Acc
Special Invest. Acc

24. Business Practices : Sources of Funds
Current Accounts
Saving Accounts
Saving a/c without authorization
Saving a/c with authorization to invest
Investment Accounts
General Investment accounts
Limited Period Investment accounts
Specified Investment accounts

25. Current Deposits [sources of funds]
Very Similar to standard commercial banks
No return paid back to depositors
Checking facilities
Are Current deposits a loan to the bank from depositors ?
Are Current deposits a trust by depositors to banks ?
Use of Current deposits by the banks on their own risk.

26. Saving Deposits [Sources of Funds]
Saving deposits without authorization to invest
Saving deposits with authorization to invest
Return to depositors who provide authorization to invest.
Saving deposits as a part of trust accounts.
Saving deposit as Notice account

27. Investment Deposits [Sources of Funds]
Islamic Banking counterpart of Fixed Deposits.
Withdrawal allowed only in special cases
Investment deposits as Mudarabah Accounts.
Depositor: Rabbal Mal; Bank: Aamil
Share profit on agreed basis, bear full loss.
Investment pool
Distribution of profits on pro rata basis.

28. Special Investment Deposits [Sources of Funds]
Concept of Wakalah
The bank acts as a wakeel. Implement\s the instruction of the Mawakkil.
Special purpose investment, Specify, purpose, sector, industry, or even project.
The bank gets a fee for the services rendered.
Full profit or loss goes to the depositor. The bank will share in loss only in case of proven neglect.

29. USES OF FUNDS MUDARABAH MUSHARAKAH MURABAHAH IJARAH (Leasing)
IJARAH WA IQTINA (Lease Purchase)
MUSHARAKAH MUTANAQISAH
LOAN ON SERVICE CHARGE
INTEREST FREE LOANS.

30. TYPES OF CONTRCTS

31. TYPES OF CONTRCTS
Contracts of Sale / Lease are Muawadat. Gharar is not allowed in such contracts.
Mudarabah and Musharakah are contracts of Partnerships. Some amount of gharar may be tolerated in such contracts.
Sadaqat and Hadaya are Tabarruat. No objection to Gharar in these type of contracts.

32. Financing Techniques
These techniques were devised in the classical period for the commodity trade
Their application to financial sector is an innovation of the modern era.
The application of these techniques requires new documentation which was not required in the early period.

33. MURABAHAH [USES OF FUNDS] - I
The word MURABAHA is derived from the word Ribh, meaning profit in Arabic.
Sale with a profit.
Cost-plus financing.
Examples of Murabahah.
Two contracts: A contact of intent to conduct a Murabaha Sale and another contact to buy the good ordered in previous contract.
Promise is not a legal binding. It introduces an element of risk in the transaction.
The element of risk justifies the profit in Murabaha sale : Fiqhi principle : Al Kharaj bi Daman.

34. MURABAHAH [USES OF FUNDS] - II
Applications of Muraqbaha:
In domestic trade
In foreign trade
In financing consumer durables
In financing real estaes
ABUSES OF MURABAHA
MURABAH AND BAY EINA.

35. MURABAHAH [USES OF FUNDS] - II
Applications of Muraqbaha:
In domestic trade
In foreign trade
In financing consumer durables
In financing real estaes
ABUSES OF MURABAHA
MURABAH AND BAY EINA.

36. MUSHARAKAH [USES OF FUNDS]
Musharakah is from the word Sharikah.
More than one partners: Partnership in capital proportion and project supervision.
A partner may waive his right of supervision or delegate it to another partner.
Arrangements: Sharing of Profit and loss in accordance with capital proportion agreed proportion.
Variant: Share of profit in agreed proportion, share of loss in capital proportion.
Applications of Musharakah:
i. in Import trade
Ii. In Agriculture

37. MUDARABAH [USES OF FUNDS]
Mudarabah existing from pre-Islamic times.
Permitted on the Cannon of Necessicity.
Profit and loss sharing is a wrong translation.
Arrangement: Profit is shared on an agreed basis, loss is borne by the Rabbal Mal.
Bank: Rabbal Mal, Entrepreneur : Aamil
Double tier Mudarabah.
Requirements for a successful Mudarabah

38. Other Financing Techniques
Loans on Service Charge
Qard Hasan [interest free loans]
Service Charge is to be equal to actual administrative expenditure
Qard Hasan is limited to social purposes only.

39. IJARAH [USES OF FUNDS]
Ijarah is emerging as a popular technique of financing amongst the Islamic banks
Elements of a lease contact: Lessor, Lessee, instrument and period of lease,
The asset remains in the ownership of the lessor. Maintenance is the responsibility of the owner.
Ijarah muntahi bit tamlik

40. Other Financing Techniques
Diminishing Musharakah
Loan of Service Charges. Only administrative expenses can be charged.
Interest free loans are provided as a social service

41. A TYPICAL BALANCE SHEET
Uses of Funds
Murabaha
Musharakah
Mudarabah
Ijarah
Qard Hasan
Sources of Funds
Current Account
Saving Accounts
Investment Acc
Special Invest. Acc

42. These are all empirical issues !
MAIN QUESTIONS
How Islamic Banks use these techniques?
What is the incidence of their use?
Are some techniques more amenable to certain sectors?
Which techniques are easier to use?
Which techniques have lesser documentation requirements?
These are all empirical issues !

43. Salient features of the Survey
Results based on a Sample survey
Period: April –October 1985
IV and V Meetings of the Directors of Islamic Banks
30 Banks approached, 8 Banks responded
55 questions asked.
Information to be supplemented by other sources.

44. Responding Islamic Banks
Jordan Islamic Bank (1979)
Faisal Islamic Bank, Egypt (1977)
Islamic Bank for Western Sudan (1981)
Tadamon Islamic Bank, Sudan (1981)
Qatar Islamic Bank (1983)
Islamic Bank International Denmark (1983)
Islamic Bank, Bangladesh (1983)
Sudanese Islamic Bank, Sudan (1983)

45. Financial Operations of Islamic Banks [Financing Techniques]
Mudarabah
Musharakah
Bay al ajal
Murabaha
Ijarah
Lease purchase financing
Qard Hasan

46. FINANCING TECHNIQUES [CONTD. ]
These techniques were devised in the classical period for the commodity trade
Their application to financial sector is an innovation of the modern era.
The application of these techniques requires new documentation which was not required in the early period.

47. Relative Significance of Islamic Financing Techniques
Dominance of Murabaha in 1984
Jordan Islamic Bank 72%
Bangladesh Islamic Bank 65%
Sudanese Islamic Bank 53%
Tadamon Islamic Bank 61%
Qatar Islamic Bank 97%
Significance of Musharakah
Hybrid Techniques

48. Financing By Modes for 10 Islamic Banks 1994-96
Weighted Average
Simple Average
Modes
65.66
70.19
Murabaha
9.83
6.49
Musharakah
8.17
7.29
Mudarabah
3.73
4.84
Ijarah
12.61
11.2
Other

49. Mode wise Finance of Islamic Bank, Bangladesh
1996
1995
Mode
50.28
53.54
Murabah
18.34
17.28
Deffered sale
16.66
14.57
Hire purchase
7.22
7.18
Purchase and Negotiation
3.18
3.87
Musharaka
4.32
3.56
Qard Hasan

50. Sector Wise Distribution of Finance 1984
Trade
Real estate
SSI
Mfg.
Agriculture
Name
Of the Bank
32.79
25.67
1.00
39.79
0.53
Jordan
Islamic Bank
90.34
9.35 -
Qatar Islamic Bank
73.01
26.10
0.83
Islamic
Bank
Bangladesh

51. Sectoral Financing by Nine Islamic Banks, 1994-96
Weighted Average
Simple average
Sector
34.1
42.4
Trade
2.7
2.4
Agriculture
9.2
11.0
Industry
19.7
11.2
Services
14.8
12.9
Real Estate
19.4
19.1
Other

52. Relative Significance of Islamic Financing Techniques
Dominance of Murabaha in 1984
Jordan Islamic Bank 72%
Bangladesh Islamic Bank 65%
Sudanese Islamic Bank 53%
Tadamon Islamic Bank 61%
Qatar Islamic Bank 97%
Significance of Musharakah
Hybrid Techniques

53. Financing By Modes for 10 Islamic Banks 1994-96
Weighted Average
Simple Average
Modes
65.66
70.19
Murabaha
9.83
6.49
Musharakah
8.17
7.29
Mudarabah
3.73
4.84
Ijarah
12.61
11.2
Other

54. Mode wise Finance of Islamic Bank, Bangladesh
1996
1995
Mode
50.28
53.54
Murabah
18.34
17.28
Deffered sale
16.66
14.57
Hire purchase
7.22
7.18
Purchase and Negotiation
3.18
3.87
Musharaka
4.32
3.56
Qard Hasan

55. Sector Wise Distribution of Finance 1984
Trade
Real estate
SSI
Mfg.
Agriculture
Name
Of the Bank
32.79
25.67
1.00
39.79
0.53
Jordan
Islamic Bank
90.34
9.35 -
Qatar Islamic Bank
73.01
26.10
0.83
Islamic
Bank
Bangladesh

56. Sectoral Financing by Nine Islamic Banks, 1994-96
Weighted Average
Simple average
Sector
34.1
42.4
Trade
2.7
2.4
Agriculture
9.2
11.0
Industry
19.7
11.2
Services
14.8
12.9
Real Estate
19.4
19.1
Other

57. TERM STRUCTURE OF FINANCE
Term structure means temporal distribution of finance
Significance of term structure
Heavy dominance of short term finance
Reasons for this dominance: asymmetry between term structure of deposits and term structure of finance.

58. Latest Trends in Islamic Financial Markets
Derivatives and secondary market
Evolution of Financial Instruments and Financial Papers
Securitization
Musharakah bonds
Ijarah bonds

59. SOME MISCONCEPTIONS ISLAMIC BANKING IS RELIGION BASED.
ISLAMIC BANKING IS FOR A SPECIFIC COMMUNITY
ISLAMIC BANKING REPLACES INTEREST RATE WITH PROFIT AND THAT IS ALL.