ISLAMIC BANKING

14th Jan 2009
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Although the concept of financial arrangement based on interest is prevalent since time immemorial, Islamic Banking is relatively a pristine area in the field finance in India. This is a two part article. Today I will be discussing basic principles and instruments involved in Sharia Banking. Next week I will talk about its prospects in India. Financial arrangements constitute an integral part of the process of economic development. A financial system consisting of financial institutions, instruments and markets provides an effective payment and credit supply network and thereby assists in channeling of funds from savers to the investors in the economy.

Islamic economics is based on ‘socio economic justice’ as the primary objective. It is based on the belief that human beings are a creation of that one & the only god and all resources at their disposal are held by them in trust for the god to be used in a just manner for wellbeing of all. Islam provides guidelines to regulate the economy and seeks to curb the unbridled race for material pursuit. Concern for equity and justice, halal and haram and a sense of responsibility towards the weaker sections of society and the need to share the economic resources with them, are some of the principles which guide and control the economic activity in Islam.


Fundamentals of Islamic Banking

All interest-free banks agree on the same basic principles. However, individual banks differ in their application. These differences can be because of several reasons including the laws of the country, objectives of the different banks, individual banks circumstances and experiences, the need to interact with other interest-based banks, etc

.

The basic principle of Islamic banking is -

• Sharing of profit and loss and

• Prohibition of riba(usury)

• Prohibits any dealing in pork, pornography, and anything else which the Sharia deems haram.

• Gharar, which is uncertainty about the terms of contract or the subject matter, e.g. prohibits selling something which one does not own



Deposit accounts

All the Islamic banks have three kinds of deposit accounts: current, savings and investment.


Current accounts

Current or demand deposit accounts are virtually the same as in all conventional banks. Deposit is guaranteed.


Savings accounts

Savings deposit accounts operate in different ways. In some banks, the depositors allow the banks to use their money but they obtain a guarantee of getting the full amount back from the bank. Banks adopt several methods of inducing their clients to deposit with them, but no profit is promised. In others, savings accounts are treated as investment accounts but with less stringent conditions as to withdrawals and minimum balance. Capital is not guaranteed but the banks take care to invest money from such accounts in relatively risk-free short-term projects. As such lower profit rates are expected and that too only on a portion of the average minimum balance on the ground that a high level of reserves needs to be kept at all times to meet withdrawal demands.


Investment account

Investment deposits are accepted for a fixed or unlimited period of time and the investors agree in advance to share the profit (or loss) in a given proportion with the bank. Capital is not guaranteed.


INSTRUMENTS INVOLVED

Sale and Buy Back Agreement (Bai' al-Inah)

• The financier sells an asset to the customer on a deferred-payment basis, and then the asset is immediately repurchased by the financier for cash at a discount.

• The buying back agreement allows the bank to assume ownership over the asset in order to protect against default without explicitly charging interest in the event of late payments or insolvency.


Deferred Payment Sale( Bai' Bithaman Ajil)

• Sale of goods on a deferred payment basis at a price, which includes a profit margin agreed to by both parties.

• This is similar to Murabahah, except that the debtor makes only a single installment on the maturity date of the loan.

• By the application of a discount rate, an Islamic bank can collect the market rate of interest.


Credit Sale( Bai muajjal)

• This is like a credit sale.

• It is a contract in which the bank earns a profit margin on the purchase price and allows the buyer to pay the price of the commodity at a future date in a lump sum or in installments.

• It has to expressly mention cost of the commodity and the margin of profit is mutually agreed.


Profit Sharing (Mudaraba)

• An arrangement between the bank, and an entrepreneur, whereby the entrepreneur can mobilize the funds of the former for its business activity.

• The entrepreneur provides expertise, labor and management.

• Profits made are shared between the bank and the entrepreneur according to predetermined ratio.

• In case of loss, the bank loses the capital, while the entrepreneur loses his provision of labor.

• It is this financial risk that justifies the bank's claim to part of the profit.

• The profit-sharing continues until the loan is repaid.

• The bank is compensated for the time value of its money in the form of a floating rate that is pegged to the debtor's profits.


Cost Plus (Murabaha)

• Sale of goods at a price, which includes a profit margin agreed to by both parties.

• The purchase and selling price, other costs, and the profit margin must be clearly stated at the time of the sale agreement.

• The bank is compensated for the time value of its money in the form of the profit margin.

• This is a fixed-income loan for the purchase of a real asset (such as real estate or a vehicle), with a fixed rate of profit determined by the profit margin.


Musawama

• 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.

• Thus, it is different from Murabaha in respect of pricing formula.

• Both the parties negotiate on the price.

• All other conditions relevant to Murabaha are valid for Musawamah as well.


Bai salam

• A contract in which advance payment is made for goods to be delivered later on.

• The seller undertakes to supply some specific goods to the buyer at a future date in exchange of an advance price fully paid at the time of contract.

• It is necessary that the quality of the commodity intended to be purchased is fully specified leaving no ambiguity leading to dispute.

• The objects of this sale are goods and cannot be gold, silver, or currencies. Barring this,

• Bai Salam covers almost everything that is capable of being definitely described as to quantity, quality, and workmanship.


Gift (Hibah)

• This is a token given voluntarily by a creditor to a debtor in return for a loan.

• This usually arises in practice when Islamic banks involuntarily pay their customers interest on savings account balances.


Istisnaa

• Under Istisna’a a party (bank) undertakes to produce a specific thing that is possible to be made according to agreed specifications at a determined price and fixed date of delivery

• As banks do not normally carry out manufacturing, a parallel contract for manufacture is instituted

• The bank charges the buyer the price it pays to the manufacturer plus a reasonable profit (monetary installment) and takes the risk of manufacture of the asset


Tawarruq

• Tawarruq is the mode adopted by banks to lend cash

• The customer buys a commodity from the bank under Murabaha which is then sold to a third person on cash at a price less than the purchase price.

• The customer hence obtains cash without taking an interest-based loan

• If the customer resells that commodity to the bank, it is called Al-'inah


Ijarah

• The bank buys and leases out the asset for a rental fee, which includes the capital cost of the equipment plus a profit margin.

• The ownership of the equipment remains with the lessor bank and in case of a finance lease, is transferred on pre-determined terms.

• Available under both operating lease and finance lease (Ijara-wa-iktana)

• Widely used in house and aircraft financing


Joint Venture(Musharakah)

• A relationship between two parties or more, of whom contribute capital to a business, and divide the net profit and loss pro rata.

• This is often used in investment projects, letters of credit, and the purchase or real estate or property.

• In the case of real estate or property, the bank assesses an imputed rent and will share it as agreed in advance.

• The profit is distributed among the partners in pre-agreed ratios, while the loss is borne by each partner strictly in proportion to respective capital contributions.


Good Loan( Qard Hassan)

• This is a loan extended on a goodwill basis

• The debtor is only required to repay the amount borrowed.

• However, the debtor may, at his or her discretion, pay an extra amount beyond the principal amount of the loan (without promising it) as a token of appreciation to the creditor.

• In the case that the debtor does not pay an extra amount to the creditor, this transaction is a true interest-free loan.


Islamic Bonds (Sukuk)

• An Islamic equivalent of bond.

• However, fixed-income, interest-bearing bonds are not permissible in Islam.

• Hence, Sukuk are securities that comply with the Islamic law and its investment principles, which prohibit the charging or paying of interest.

• Financial assets that comply with the Islamic law can be classified in accordance with their tradability and non-tradability in the secondary markets.


Islamic Insurance (Takaful)

• Takaful is insurance based on mutual co-operation, responsibility, protection and assistance between groups of participants

• It is akin to a cooperative insurance wherein members contribute a specific sum of money to a common pool

• Every policyholder pays his subscription to help those that need assistance

• Losses are divided and liabilities spread according to the community pooling system


Safekeeping (Wadiah)

• A bank is deemed as a keeper and trustee of funds.

• A person deposits funds in the bank and the bank guarantees refund of the entire amount of the deposit, or any part of the outstanding amount, when the depositor demands it.

• The depositor, at the bank's discretion, may be rewarded with a hibah (gift) as a form of appreciation for the use of funds by the bank.

• In this case, the bank compensates depositors for the time-value of their money (i.e. pays interest) but refers to it as a gift because it does not officially guarantee payment of the gift.


Agency (Wakalah)

• This occurs when a person appoints a representative to undertake transactions on his/her behalf, similar to a power of attorney.

As already mentioned I will discuss the Sharia Banking in India next week.

To be continued…

Syed Burhanur Rahman, Attorney,New Delhi

Syed Burhanur Rahman is an alumnus of St. Stephen's College and Campus Law Center,Delhi University.A Quiz aficionado,he has featured in premier T.V Quiz shows including Mastermind India(BBC),University Challenge Quiz(BBC) and Nat Geo Genius(National Geographic Channel).An Attorney working with INDUS G & D Law(Delhi),his practice areas include Corporate Law,IPR and Taxation Law

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