Islamic banking is growing and is here to stay

Research Report on Islamic Banking – Part 4 – Glossary, Appendix and References

by Mohamed Ariff, University of Malaya, taken from Asian-Pacific Economic Literature, Vol. 2, No. 2 (September 1988), pp. 46-62

Glossary

al-wadiah = safe keeping

bai’muajjal = deferred-payment sale

bai’salam = pre-paid purchase

baitul mal = treasury

fiqh = jurisprudence

Hadith = Prophet’s commentary on Qur’an

hajj = pilgrimage

halal = lawful

haram = unlawful

ijara = leasing

iman = faith

mithl = like

mudaraba = profit-sharing

mudarib = entrepreneur-borrower

muqarada = mudaraba

murabaha = cost-plus or mark-up

musharaka = equity participation

qard hasan = benevolent loan (interest free)

qirad = mudaraba

rabbul-mal = owner of capital

riba = interest

Shariah = Islamic law

shirka = musharaka

Appendix

Islamic Financial Institutions (outside Pakistan and Iran)
Australia Islamic Investment Company, Melbourne.

Bahamas Dar al Mal al Islami, Nassau Islamic Investment Company Ltd, Nassau, Masraf Faisal Islamic Bank & Trust, Bahamas Ltd.

Bahrain Albaraka Islamic Investment Bank, Manama, Bahrain Islamic Bank, Manama, Bahrain Islamic Investment Company, Manama, Islamic Investment Company of the Gulf, Masraf Faisal al Islami, Bahrain.

Bangladesh Islamic Bank of Bangladesh Ltd, Dhaka.

Denmark Islamic Bank International of Denmark, Copenhagen.

Egypt Albaraka Nile Valley Company, Cairo, Arab Investment Bank (Islamic Banking Operations), Cairo., Bank Misr (Islamic Branches), Cairo, Faisal Islamic Bank of Egypt, Cairo, General Investment Company, Cairo, Islamic International Bank for Investment and Development, Cairo, Islamic Investment and Development Company, Cairo, Nasir Social Bank, Cairo.

Guinea Islamic Investment Company of Guinea, Conakry, Masraf Faisal al Islami of Guinea, Conakry.

India Baitun Nasr Urban Cooperative Society, Bombay.

Jordan Islamic Investment House Company Ltd Amman, Jordan Finance House, Amman, Jordan Islamic Bank for Finance and Investment, Amman.

Kibris (Turkish Cyprus) Faisal Islamic Bank of Kibris, Lefkosa.

Kuwait Al Tukhaim International Exchange Company, Safat., Kuwait Finance House, Safat.

Liberia African Arabian Islamic Bank, Monrovia.

Liechtenstein Arinco Arab Investment Company, Vaduz, Islamic Banking System Finance S.A. Vaduz.

Luxembourg Islamic Finance House Universal Holding S.A.

Malaysia Bank Islam Malaysia Berhad, Kuala Lumpur, Pilgrims Management and Fund Board, Kuala Lumpur.

Mauritania Albaraka Islamic Bank, Mauritania.

Niger Faisal Islamic Bank of Niger, Niamy.

Philippines Philippine Amanah Bank, Zamboanga.

Qatar Islamic Exchange and Investment Company, Doha, Qatar Islamic Bank.

Saudi Arabia Albaraka Investment and Development Company, Jeddah, Islamic Development Bank, Jeddah.

Senegal Faisal Islamic Bank of Senegal, Dakar, Islamic Investment Company of Senegal, Dakar.

South Africa JAAME Ltd, Durban.

Sudan Bank al Baraka al Sudani, Khartoum, Faisal Islamic Bank of Sudan, Khartoum, Islamic Bank of Western Sudan, Khartoum, Islamic Cooperative Development Bank, Khartoum, Islamic Investment Company of Sudan, Khartoum, Sudan Islamic Bank, Khartoum, Tadamun Islamic Bank, Khartoum, Jersey The Islamic Investment Company, St Helier, Masraf Faisal al Islami, St Helier.

Switzerland Dar al Mal al Islami, Geneva., Islamic Investment Company Ltd, Geneva, Shariah Investment Services, PIG, Geneva.

Thailand Arabian Thai Investment Company Ltd, Bangkok.

Tunisia Bank al Tamwil al Saudi al Tunisi.

Turkey Albaraka Turkish Finance House, Istanbul, Faisal Finance Institution, Istanbul.

U.A.E. Dubai Islamic Bank, Dubai, Islamic Investment Company Ltd, Sharjah.

U.K. Albaraka International Ltd, London, Albaraka Investment Co. Ltd, London, Al Rajhi Company for Islamic Investment Ltd, London, Islamic Finance House Public Ltd Co., London.

The list includes Islamic banks as well as Islamic investment companies but it does not include Islamic insurance or takaful companies.

Source: Siddiqi (l988)

References

Abdallah, A., 1987. ‘Islamic banking’, Journal of Islamic Banking and Finance, January-March, 4(1): 31-56.

Abdeen, A.M. and Shook, D.N., 1984. The Saudi Financial System, J. Wiley and Sons, Chichester.

Abdel-Magib, M.F., 1981. ‘Theory of Islamic banks: accounting implications’, International Journal of Accounting, Fall: 78-102.

Aftab, M., 1986. ‘Pakistan moves to Islamic banking’, The Banker, June: 57-60.

Ahmad, Sheikh Mahmud, l952. Economics of Islam, Lahore.

____, n.d. ‘Interest and Unemployment’, Islamic Studies, Islamabad, VIII (l): 9-46.

Al-Arabi, Mohammad Abdullah, l966. ‘Contemporary banking transactions and Islam’s views thereon’, Islamic Review, London, May l966: l0-l6.

Al-Jarhi, Ma’bid Ali, l983. ‘A monetary and financial tructure for an interest- free economy, institutions, mechanism and policy’, in Ziauddin, Ahmad et al. (eds.), Money and Banking in Islam, International Centre for Research in Islamic Economics, Jeddah, and Institute of Policy Studies, Islamabad.

Ali, M. (ed.) l982. Islamic Banks and Strategies of Economic Cooperation, New Century Publishers, London.

____ (ed.) 1984. Papers on Islamic Banking, New Century Publishers, London.

Ariff, M. l982. ‘Monetary policy in an interest-free Islamic economy – nature and scope’ in M. Ariff, (ed.), Monetary and Fiscal Economics of Islam, International Centre for Research in Islamic Economics, Jeddah.

____ 1988. Islamic Banking in South-east Asia, Institute of Southeast Asian Studies, Singapore.

Bruce, N.C., 1986. ‘Islamic banking moves east’, Euromoney, July: 142-5.

Chapra, M. Umer, l982. ‘Money and banking in an Islamic economy’ in M Ariff (ed.), above.

____ l985. Toward a Just Monetary System, The Islamic Foundation, Leicester.

Choudhury, Masul Alam, l986. Contributions to Islamic Economic Theory: A Study in Social Economics, St Martin Press, New York.

Council of Islamic Ideology (CII), Pakistan, l983. ‘Elimination of interest from the economy’, in Ziauddin, Ahmed et al. (eds.).

El-Asker, A.A.F., 1987. The Islamic Business Enterprise, Croom Helm, London.

El-Din, A.K., 1986. ‘Ten years of Islamic banking’, Journal of Islamic Banking and Finance, July-September, 3(3):49-66.

Halim, Abdul, l986. ‘Sources and uses of funds: a study of Bank Islam Malaysia Berhad,’ paper presented to the Seminar on Developing a System of Islamic Financial Instruments, organized by the Ministry of Finance Malaysia and the Islamic Development Bank, Kuala Lumpur.

Hjarpe, Jan, l986. ‘Mudaraba banking and taka-ful insurance: the question of “Islamic Banks”, their significance and possible impact’, in Jan Selmer, and Loong Hoe Tan, Economic Relations between Scandinavia and ASEAN: Issues on Trade, Investment, Technology Transfer and Business Culture, University of Stockholm and Institute of South-east Asian Studies, Singapore.

Homoud, S.H., 1985. Islamic Banking, Arabian Information, London. Huq, Azizul, l986. ‘Utilization of financial investments: a case study of Bangladesh’, paper submitted to the Seminar on Developing a System of Islamic Financial Instruments, organized by the Ministry of Finance Malaysia and the Islamic Development Bank, Kuala Lumpur.

Iqbal, Zubair and Mirakhor, Abbas, l987. Islamic Banking, International Monetary Fund Occasional Paper 49, Washington D.C.

Irshad, S.A., l964. Interest-Free Banking, Orient Press of Pakistan, Karachi.

Kahf, Monzer, l982a. ‘Saving and investment functions in a two-sector Islamic economy’, in M. Ariff (ed.) , above.

____ l982b. ‘Fiscal and monetary policies in an Islamic economy’, in M. Ariff (ed.),above.

Karsten, I., 1982. ‘Islam and financial intermediation’, IMF Staff Papers, March, 29(1):108-42.

Khan, Abdul Jabbar, l986. ‘Non-interest banking in Pakistan: a case study’, paper presented to the Seminar on Developing a System of Islamic Financial Instruments, organized by the Ministry of Finance Malaysia and the Islamic Development Bank, Kuala Lumpur.

Khan, M. Fahim, l983. ‘Islamic banking as practised now in the world’ in Ziauddin, Ahmad et al. (eds.).

Khan, M. S.,1986.’Islamic interest-free banking’, I M F Staff Papers, March, 33(1):1-27.

____, 1987 ‘Principles of monetary policy in an Islamic framework’, paper presented to the International Institute of Islamic Economics, Islamabad, Pakistan, July.

A logo of Bank Islam Malaysia is seen at the bank`s headquarters in Kuala Lumpur

Research Report on Islamic Banking – Part 3

by Mohamed Ariff, University of Malaya, taken from Asian-Pacific Economic Literature, Vol. 2, No. 2 (September 1988), pp. 46-62

Literature: Practice

Recent years have brought an increasing flow of empirical studies of Islamic banking. The earliest systematic empirical work was undertaken by Khan (1983). His observations covered Islamic banks operating in Sudan, United Arab Emirates, Kuwait, Bahrain, Jordan, and Egypt. Khan’s study showed that these banks had little difficulty in devising practices in conformity with Shariah. He identified two types of investment accounts: one where the depositor authorized the banks to invest the money in any project and the other where the depositor had a say in the choice of project to be financed. On the asset side, the banks under investigation had been resorting to mudaraba, musharaka and murabaha modes. Khan’s study reported profit rates ranging from 9 to 20 per cent which were competitive with conventional banks in the corresponding areas. The rates of return to depositors varied between 8 and l5 per cent, which were quite comparable with the rates of return offered by conventional banks.

Khan’s study revealed that Islamic banks had a preference for trade finance and real estate investments. The study also revealed a strong preference for quick returns, which is understandable in view of the fact that these newly established institutions were anxious to report positive results even in the early years of operation. Nienhaus (1988) suggests that the relative profitability of Islamic banks, especially in the Middle East in recent years, was to a large extent due to the property (real estate) boom. He has cited cases of heavy losses which came with the crash of the property sector.

The IMF study referred to earlier by Iqbal and Mirakhor (l987) also contains extremely interesting empirical observations, although these are confined to the experience of Iran and Pakistan, both of which have attempted to islamize the entire banking system on a comprehensive basis. Iran switched to Islamic banking in August l983 with a three-year transition period. The Iranian system allows banks to accept current and savings deposits without having to pay any return, but it permits the banks to offer incentives such as variable prizes or bonuses in cash or kind on these deposits. Term deposits (both short-term and long-term) earn a rate of return based on the bank’s profits and on the deposit maturity. No empirical evidence is as yet available on the interesting question as to whether interest or a profit-share provides the more effective incentive to depositors for the mobilization of private saving. Where Islamic and conventional banks exist side by side, central bank control of bank interest rates is liable to be circumvented by shifts of funds to the Islamic banks.

Iqbal and Mirakhor have noted that the conversion to Islamic modes has been much slower on the asset than on the deposit side. It appears that the Islamic banking system in Iran was able to use less than half of its resources for credit to the private sector, mostly in the form of short-term facilities, i.e., commercial and trade transactions. The slower pace of conversion on the asset side was attributed by the authors to the inadequate supply of personnel trained in long-term financing. The authors, however, found no evidence to show that the effectiveness of monetary policy in Iran, broadly speaking, was altered by the conversion.

The Pakistani experience differs from the Iranian one in that Pakistan had opted for a gradual islamization process which began in l979. In the first phase, which ended on l January l985, domestic banks operated both interest- free and interest-based ‘windows’. In the second phase of the transformation process, the banking system was geared to operate all transactions on the basis of no interest, the only exceptions being foreign currency deposits, foreign loans and government debts. The Pakistani model took care to ensure that the new modes of financing did not upset the basic functioning and structure of the banking system. This and the gradual pace of transition, according to the authors, made it easier for the Pakistani banks to adapt to the new system. The rate of return on profit-and-loss sharing (PLS) deposits appears not only to have been in general higher than the interest rate before islamization but also to have varied between banks, the differential indicating the degree of competition in the banking industry. The authors noted that the PLS system and the new modes of financing had accorded considerable flexibility to banks and their clients. Once again the study concluded that the effectiveness of monetary policy in Pakistan was not impaired by the changeover.

The IMF study, however, expressed considerable uneasiness about the concentration of bank assets on short-term trade credits rather than on long-term financing. This the authors found undesirable, not only because it is inconsistent with the intentions of the new system, but also because the heavy concentration on a few assets might increase risks and destabilize the asset portfolios. The study also drew attention to the difficulty experienced in both Iran and Pakistan in financing budget deficits under a non-interest system and underscored the urgent need to devise suitable interest-free instruments. Iran has, however, decreed that government borrowing on the basis of a fixed rate of return from the nationalized banking system would not amount to interest and would hence be permissible. The official rationalization is that, since all banks are nationalized, interest rates and payments among banks will cancel out in the consolidated accounts. (This, of course, abstracts from the banks’ business with non-bank customers.)

There are also some small case studies of Islamic banks operating in Bangladesh (Huq l986), Egypt (Mohammad l986), Malaysia (Halim l988b), Pakistan (Khan l986), and Sudan (Salama l988b). These studies reveal interesting similarities and differences. The current accounts in all cases are operated on the principles of al-wadiah. Savings deposits, too, are accepted on the basis of al-wadiah, but ‘gifts’ to depositors are given entirely at the discretion of the Islamic banks on the minimum balance, so that the depositors also share in profits. Investment deposits are invariably based on the mudaraba principle, but there are considerable variations. Thus, for example, the Islamic Bank of Bangladesh has been offering PLS Deposit Accounts, PLS Special Notice Deposit Accounts, and PLS Term Deposit Accounts, while Bank Islam Malaysia has been operating two kinds of investment deposits, one for the general public and the other for institutional clients.

The studies also show that the profit-sharing ratios and the modes of payment vary from place to place and from time to time. Thus, for example, profits are provisionally declared on a monthly basis in Malaysia, on a quarterly basis in Egypt, on a half-yearly basis in Bangladesh and Pakistan, and on an annual basis in Sudan.

A striking common feature of all these banks is that even their investment deposits are mostly short-term, reflecting the depositors’ preference for assets in as liquid a form as possible. Even in Malaysia, where investment deposits have accounted for a much larger proportion of the total, the bulk of them were made for a period of less than two years. By contrast, in Sudan most of the deposits have consisted of current and savings deposits, apparently because of the ceiling imposed by the Sudanese monetary authorities on investment deposits which in turn was influenced by limited investment opportunities in the domestic economy. There are also interesting variations in the pattern of resource utilization by the Islamic banks. For example, musharaka has been far more important than murabaha as an investment mode in Sudan, while the reverse has been the case in Malaysia. On the average, however, murabaha, bai’muajjal and ijara, rather than musharaka represent the most commonly used modes of financing. The case studies also show that the structure of the clientele has been skewed in favor of the more affluent segment of society, no doubt because the banks are located mainly in metropolitan centres with small branch networks.

The two main problems identified by the case studies are the absence of suitable non-interest-based financial instruments for money and capital market transactions and the high rate of borrower delinquency. The former problem has been partially redressed by Islamic banks resorting to mutual inter-bank arrangements and central bank cooperation, as mentioned earlier. The Bank Islam Malaysia, for instance, has been placing its excess liquidity with the central bank which usually exercises its discretionary powers to give some returns. The delinquency problem appears to be real and serious. Murabaha payments have often been held up because late payments cannot be penalized, in contrast to the interest system in which delayed payments would automatically mean increased interest payments. To overcome this problem, the Pakistani banks have resorted to what is called ‘mark-down’ which is the opposite of ‘mark-up’ (i.e., the profit margin in the cost-plus approach of murabaha transactions). ‘Mark-down’ amounts to giving rebates as an incentive for early payments. But the legitimacy of this ‘mark-down’ practice is questionable on Shariah grounds, since it is time- based and therefore smacks of interest.

Finally, in the most recent contribution to the growing Islamic banking literature, Nien-haus (l988) concludes that Islamic banking is viable at the microeconomic level but dismisses the proponents’ ideological claims for superiority of Islamic banking as ‘unfounded’. Nienhaus points out that there are some failure stories. Examples cited include the Kuwait Finance House which had its fingers burned by investing heavily in the Kuwaiti real estate and construction sector in l984, and the Islamic Bank International of Denmark which suffered heavy losses in l985 and l986 to the tune of more than 30 per cent of its paid-up capital. But then, as Nienhaus himself has noted, the quoted troubles of individual banks had specific causes and it would be inappropriate to draw general conclusions from particular cases. Nienhaus notes that the high growth rates of the initial years have been falling off, but he rejects the thesis that the Islamic banks have reached their ‘limits of growth’ after filling a market gap. The falling growth rates might well be due to the bigger base values, and the growth performance of Islamic banks has been relatively better in most cases than that of conventional banks in recent years.

According to Nienhaus, the market shares of many Islamic banks have increased over time, notwithstanding the deceleration in the growth of deposits. The only exception was the Faisal Islamic Bank of Sudan (FIBS) whose market share had shrunk from l5 per cent in l982 to 7 per cent in l986, but Nien-haus claims that the market shares lost by FIBS were won not by conventional banks but by newer Islamic banks in Sudan. Short-term trade financing has clearly been dominant in most Islamic banks regardless of size. This is contrary to the expectation that the Islamic banks would be active mainly in the field of corporate financing on a participation basis. Nien-haus attributes this not only to insufficient supply by the banks but also to weak demand by entrepreneurs who may prefer fixed interest cost to sharing their profits with the banks.

Conclusion

The preceding discussion makes it clear that Islamic banking is not a negligible or merely temporary phenomenon. Islamic banks are here to stay and there are signs that they will continue to grow and expand. Even if one does not subscribe to the Islamic injunction against the institution of interest, one may find in Islamic banking some innovative ideas which could add more variety to the existing financial network.

One of the main selling points of Islamic banking, at least in theory, is that, unlike conventional banking, it is concerned about the viability of the project and the profitability of the operation but not the size of the collateral. Good projects which might be turned down by conventional banks for lack of collateral would be financed by Islamic banks on a profit-sharing basis. It is especially in this sense that Islamic banks can play a catalytic role in stimulating economic development. In many developing countries, of course, development banks are supposed to perform this function. Islamic banks are expected to be more enterprising than their conventional counterparts. In practice, however, Islamic banks have been concentrating on short-term trade finance which is the least risky.

Part of the explanation is that long-term financing requires expertise which is not always available. Another reason is that there are no back-up institutional structures such as secondary capital markets for Islamic financial instruments. It is possible also that the tendency to concentrate on short-term financing reflects the early years of operation: it is easier to administer, less risky, and the returns are quicker. The banks may learn to pay more attention to equity financing as they grow older.

It is sometimes suggested that Islamic banks are rather complacent. They tend to behave as though they had a captive market in the Muslim masses who will come to them on religious grounds. This complacency seems more pronounced in countries with only one Islamic bank. Many Muslims find it more convenient to deal with conventional banks and have no qualms about shifting their deposits between Islamic banks and conventional ones depending on which bank offers a better return. This might suggest a case for more Islamic banks in those countries as it would force the banks to be more innovative and competitive. Another solution would be to allow the conventional banks to undertake equity financing and/or to operate Islamic ‘counters’ or ‘windows’, subject to strict compliance with the Shariah rules. It is perhaps not too wild a proposition to suggest that there is a need for specialized Islamic financial institutions such as mudaraba banks, murabaha banks and musharaka banks which would compete with one another to provide the best possible services.

"Banking Without Interest" by Muhammad Siddiqi

Research Report on Islamic Banking – Part 2

by Mohamed Ariff, University of Malaya, taken from Asian-Pacific Economic Literature, Vol. 2, No. 2 (September 1988), pp. 46-62

Anatomy

As mentioned earlier, Islam does not deny that capital, as a factor of production, deserves to be rewarded. Islam allows the owners of capital a share in a surplus which is uncertain. To put it differently, investors in the Islamic order have no right to demand a fixed rate of return. No one is entitled to any addition to the principal sum if he does not share in the risks involved. The owner of capital (rabbul-mal) may ‘invest’ by allowing an entrepreneur with ideas and expertise to use the capital for productive purposes and he may share the profits, if any, with the entrepreneur- borrower (mudarib); losses, if any, however, will be borne wholly by the rabbul-mal. This mode of financing, termed mudaraba in the Islamic literature, was in practice even in the pre-Qur’anic days and, according to jurists, it was approved by the Prophet.

Another legitimate mode of financing recognized in Islam is one based on equity participation (musharaka) in which the partners use their capital jointly to generate a surplus. Profits or losses will be shared between the partners according to some agreed formula depending on the equity ratio.

Mudaraba and musharaka constitute, at least in principle if not in practice, the twin pillars of Islamic banking. The musharaka principle is invoked in the equity structure of Islamic banks and is similar to the modern concepts of partnership and joint stock ownership. In so far as the depositors are concerned, an Islamic bank acts as a mudarib which manages the funds of the depositors to generate profits subject to the rules of mudaraba as outlined above. The bank may in turn use the depositors’ funds on a mudaraba basis in addition to other lawful modes of financing. In other words, the bank operates a two-tier mudaraba system in which it acts both as the mudarib on the saving side of the equation and as the rabbul-mal on the investment portfolio side. The bank may also enter into musharaka contracts with the users of the funds, sharing profits and losses, as mentioned above. At the deposit end of the scale, Islamic banks normally operate three broad categories of account, mainly current, savings, and investment accounts. The current account, as in the case of conventional banks, gives no return to the depositors. It is essentially a safe-keeping (al-wadiah) arrangement between the depositors and the bank, which allows the depositors to withdraw their money at any time and permits the bank to use the depositors’ money. As in the case of conventional banks, cheque books are issued to the current account deposit holders and the Islamic banks provide the broad range of payment facilities – clearing mechanisms, bank drafts, bills of exchange, travellers cheques, etc. (but not yet, it seems, credit cards or bank cards). More often than not, no service charges are made by the banks in this regard.

The savings account is also operated on an al-wadiah basis, but the bank may at its absolute discretion pay the depositors a positive return periodically, depending on its own profitability. Such payment is considered lawful in Islam since it is not a condition for lending by the depositors to the bank, nor is it pre-determined. The savings account holders are issued with savings books and are allowed to withdraw their money as and when they please. The investment account is based on the mudaraba principle, and the deposits are term deposits which cannot be withdrawn before maturity. The profit- sharing ratio varies from bank to bank and from time to time depending on supply and demand conditions.4 In theory, the rate of return could be positive or negative, but in practice the returns have always been positive and quite comparable to rates conventional banks offer on their term deposits.5

At the investment portfolio end of the scale, Islamic banks employ a variety of instruments. The mudaraba and musharaka modes, referred to earlier, are supposedly the main conduits for the outflow of funds from the banks. In practice, however, Islamic banks have shown a strong preference for other modes which are less risky. The most commonly used mode of financing seems to be the ‘mark-up’ device which is termed murabaha. In a murabaha transaction, the bank finances the purchase of a good or asset by buying it on behalf of its client and adding a mark-up before re-selling it to the client on a ‘cost-plus’ basis. It may appear at first glance that the mark-up is just another term for interest as charged by conventional banks, interest thus being admitted through the back door. What makes the murabaha transaction Islamically legitimate is that the bank first acquires the asset and in the process it assumes certain risks between purchase and resale. The bank takes responsibility for the good before it is safely delivered to the client. The services rendered by the Islamic bank are therefore regarded as quite different from those of a conventional bank which simply lends money to the client to buy the good.

Islamic banks have also been resorting to purchase and resale of properties on a deferred payment basis, which is termed bai’ muajjal. It is considered lawful in fiqh (jurisprudence) to charge a higher price for a good if payments are to be made at a later date. According to fiqh, this does not amount to charging interest, since it is not a lending transaction but a trading one.

Leasing or ijara is also frequently practised by Islamic banks. Under this mode, the banks would buy the equipment or machinery and lease it out to their clients who may opt to buy the items eventually, in which case the monthly payments will consist of two components, i.e., rental for the use of the equipment and instalment towards the purchase price.

Reference must also be made to pre-paid purchase of goods, which is termed bai’salam, as a means used by Islamic banks to finance production. Here the price is paid at the time of the contract but the delivery would take place at a future date. This mode enables an entrepreneur to sell his output to the bank at a price determined in advance. Islamic banks, in keeping with modern times, have extended this facility to manufactures as well.

It is clear from the above sketch that Islamic banking goes beyond the pure financing activities of conventional banks. Islamic banks engage in equity financing and trade financing. By its very nature, Islamic banking is a risky business compared with conventional banking, for risk-sharing forms the very basis of all Islamic financial transactions. To minimize risks, however, Islamic banks have taken pains to distribute the eggs over many baskets and have established reserve funds out of past profits which they can fall back on in the event of any major loss.

Literature: Theory

It is not possible to cover in this survey all the publications which have appeared on Islamic banking. There are numerous publications in Arabic and Urdu which have made significant contributions to the theoretical discussion. A brief description of these in English can be found in the Appendix to Siddiqi’s book on Banking without Interest (Siddiqi l983a). The early contributions on the subject of Islamic banking were somewhat casual in the sense that only passing references were made to it in the discussion of wider issues relating to the Islamic economic system as a whole. In other words, the early writers had been simply thinking aloud rather than presenting well-thought-out ideas. Thus, for example, the book by Qureshi on Islam and the Theory of Interest (Qureshi l946) looked upon banking as a social service that should be sponsored by the government like public health and education. Qureshi took this point of view since the bank could neither pay any interest to account holders nor charge any interest on loans advanced. Qureshi also spoke of partnerships between banks and businessmen as a possible alternative, sharing losses if any. No mention was made of profit-sharing.

Ahmad, in Chapter VII of his book Economics of Islam (Ahmad l952), envisaged the establishment of Islamic banks on the basis of a joint stock company with limited liability. In his scheme, in addition to current accounts, on which no dividend or interest should be paid, there was an account in which people could deposit their capital on the basis of partnership, with shareholders receiving higher dividends than the account holders from the profits made. Like Qureshi, above, Ahmad also spoke of possible partnership arrangements with the businessmen who seek capital from the banks. However, the partnership principle was left undefined, nor was it clear who would bear the loss if any. It was suggested that banks should cash bills of trade without charging interest, using the current account funds.

The principle of mudaraba based on Shariah was invoked systematically by Uzair (l955). His principal contribution lay in suggesting mudaraba as the main premise for ‘interestless banking’. However, his argument that the bank should not make any capital investment with its own deposits rendered his analysis somewhat impractical.

Al-Arabi (l966) envisaged a banking system with mudaraba as the main pivot. He was actually advancing the idea of a two-tier mudaraba which would enable the bank to mobilize savings on a mudaraba basis, allocating the funds so mobilized also on a mudaraba basis. In other words the bank would act as a mudarib in so far as the depositors were concerned, while the ‘borrowers’ would act as mudaribs in so far as the bank was concerned. In his scheme, the bank could advance not only the capital procured through deposits but also the capital of its own shareholders. It is also of interest to note that his position with regard to the distribution of profits and the responsibility for losses was strictly in accordance with the Shariah.6 Irshad (l964) also spoke of mudaraba as the basis of Islamic banking, but his concept of mudaraba was quite different from the traditional one in that he thought of capital and labour (including entrepreneurship) as having equal shares in output, thus sharing the losses and profits equally. This actually means that the owner of capital and the entrepreneur have a fifty-fifty share in the profit or loss as the case may be, which runs counter to the Shariah position. Irshad envisaged two kinds of deposit accounts. The first sounded like current deposits in the sense that it would be payable on demand, but the money kept in this deposit would be used for social welfare projects, as the depositors would get zero return. The second one amounted to term deposits which would entitle the depositors to a share in the profits at the end of the year proportionately to the size and duration of the deposits. He recommended the setting up of a Reserve Fund which would absorb all losses so that no depositor would have to bear any loss. According to Irshad, all losses would be either recovered from the Reserve Fund or borne by the shareholders of the bank.

A pioneering attempt at providing a fairly detailed outline of Islamic banking was made in Urdu by Siddiqi in l968. (The English version was not published until l983.) His Islamic banking model was based on mudaraba and shirka (partnership or musharaka as it is now usually called). His model was essentially one based on a two-tier mudaraba financier-entrepreneur relationship, but he took pains to describe the mechanics of such transactions in considerable detail with numerous hypothetical and arithmetic examples. He classified the operations of an Islamic bank into three categories: services based on fees, commissions or other fixed charges; financing on the basis of mudaraba and partnership; and services provided free of charge. His thesis was that such interest-free banks could be a viable alternative to interest-based conventional banks.

The issue of loans for consumption clearly presents a problem, as there is no profit to be shared. Siddiqi addressed this problem, but he managed only to scratch the surface. While recognizing the need for such interest-free loans (qard hasan), especially for meeting basic needs, he seemed to think it was the duty of the community and the State (through its baitul mal or treasury) to cater to those needs; the Islamic bank’s primary objective, like that of any other business unit, is to earn profit. He therefore tended to downplay the role of Islamic banks in providing consumption loans, but he suggested limited overdraft facilities without interest. He even considered a portion of the fund being set aside for consumption loans, repayment being guaranteed by the State. He also suggested that consumers buying durables on credit would issue ‘certificates of sale’ which could be encashed by the seller at the bank for a fee. It was then the seller not the buyer who would be liable as far as the bank was concerned. However, the principles of murabaha and bai’ muajjal were not invoked.

Strangely, Siddiqi favoured keeping the number of shareholders to the minimum, without advancing any strong reasons. This is contrary to the general consensus which now seems to have emerged with reference to Islamic banks operating on a joint stock company basis, a consensus which incidentally is also in line with the Islamic value attached to a broad equity base as against heavy concentration of equity and wealth. Ironically, Siddiqi thought that interest-free banking could operate successfully ‘only in a country where interest is legally prohibited and any transaction based upon interest is declared a punishable offense’ (l983b:l3). He also thought it important to have Islamic laws enforced before interest-free banking could operate well. This view has not gained acceptance, as demonstrated by the many Islamic banks which operate profitably in ‘hostile’ environments, as noted earlier.

Chapra’s model of Islamic banking (Chapra l982), like Siddiqi’s, was based on the mudaraba principle. His main concern, however, centered on the role of artificial purchasing power through credit creation. He even suggested that ’seigniorage’ resulting from it should be transferred to the public exchequer, for the sake of equity and justice. Al-Jarhi (l983) went so far as to favor the imposition of a l00 per cent reserve requirement on commercial banks. Chapra was also much concerned about the concentration of economic power private banks might enjoy in a system based on equity financing. He therefore preferred medium-sized banks which are neither so large as to wield excessive power nor so small as to be uneconomical. Chapra’s scheme also contained proposals for loss-compensating reserves and loss-absorbing insurance facilities. He also spoke of non-bank financial institutions, which specialize in bringing financiers and entrepreneurs together and act as investment trusts.

Mohsin (l982) has presented a detailed and elaborate framework of Islamic banking in a modern setting. His model incorporates the characteristics of commercial, merchant, and development banks, blending them in novel fashion. It adds various non-banking services such as trust business, factoring, real estate, and consultancy, as though interest-free banks could not survive by banking business alone. Many of the activities listed certainly go beyond the realm of commercial banking and are of so sophisticated and specialized a nature that they may be thought irrelevant to most Muslim countries at their present stage of development. Mohsin’s model clearly was designed to fit into a capitalist environment; indeed he explicitly stated that riba-free banks could coexist with interest-based banks. The point that there is more to Islamic banking than mere abolition of interest was driven home strongly by Chapra (l985). He envisaged Islamic banks whose nature, outlook and operations could be distinctly different from those of conventional banks. Besides the outlawing of riba, he considered it essential that Islamic banks should, since they handle public funds, serve the public interest rather than individual or group interests. In other words, they should play a social-welfare-oriented rather than a profit-maximizing role. He conceived of Islamic banks as a cross-breed of commercial and merchant banks, investment trusts and investment-management institutions that would offer a wide spectrum of services to their customers. Unlike conventional banks which depend heavily on the ‘crutches of collateral and of non-participation in risk’ (p. l55), Islamic banks would have to rely heavily on project evaluation, especially for equity-oriented financing. Thanks to the profit-and-loss sharing nature of the operations, bank-customer relations would be much closer and more cordial than is possible under conventional banking. Finally, the problems of liquidity shortage or surplus would have to be handled differently in Islamic banking, since the ban on interest rules out resort to the money market and the central bank. Chapra suggested alternatives such as reciprocal accommodation among banks without interest payments and creation of a common fund at the central bank into which surpluses would flow and from which shortages could be met without any interest charges.

The literature also discusses the question of central banking in an Islamic framework. The general opinion seems to be that the basic functions of a modern central bank are relevant also for an Islamic monetary system, although the mechanisms may have to be different. Thus, for example, the bank rate instrument cannot be used as it entails interest. Uzair (l982) has suggested adjustments in profit-sharing ratios as a substitute for bank rate manipulations by the central bank. Thus, credit can be tightened by reducing the share accruing to the businessmen and eased by increasing it. Siddiqi (l982) has suggested that variations in the so-called ‘refinance ratio’ (which refers to the central bank refinancing of a part of the interest-free loans provided by the commercial banks) would influence the quantum of short-term credit extended. Siddiqi has also proposed a prescribed ‘lending ratio’ (i.e., the proportion of demand deposits that commercial banks are obliged to lend out as interest-free loans) that can be adjusted by the central bank according to changing circumstances. In this context, reference may also be made to a proposal by Uzair (l982) that the central bank should acquire an equity stake in commercial banking by holding, say, 25 per cent of the capital stock of the commercial banks. The rationale behind this proposal was that it would give the central bank access to a permanent source of income so that it could effectively act as lender of last resort. The discussion of central banking in an Islamic context is somewhat scanty, presumably because Islamic central banking is viewed as too far-fetched an idea, except in Iran and Pakistan.

It emerges from all this that Islamic banking has three distinguishing features: (a) it is interest-free, (b) it is multi-purpose and not purely commercial, and (c) it is strongly equity-oriented. The literature contains hardly any serious criticism of the interest-free character of the operation, since this is taken for granted, although concerns have been expressed about the lack of adequate interest-free instruments. There is a near-consensus that Islamic banks can function well without interest. A recent International Monetary Fund study by Iqbal and Mirakhor (l987) has found Islamic banking to be a viable proposition that can result in efficient resource allocation. The study suggests that banks in an Islamic system face fewer solvency and liquidity risks than their conventional counterparts. The multi-purpose and extra-commercial nature of the Islamic banking operation does not seem to pose intractable problems. The abolition of interest makes it imperative for Islamic banks to look for other instruments, which renders operations outside the periphery of commercial banking unavoidable. Such operations may yield economies of scope. But it is undeniable that the multipurpose character of Islamic banking poses serious practical problems, especially in relation to the skills needed to handle such diverse and complex transactions (Iqbal and Mirakhor l987).

The stress on equity-oriented transactions in Islamic banking, especially the mudaraba mode, has been criticized. It has been argued that the replacement of pre-determined interest by uncertain profits is not enough to render a transaction Islamic, since profit can be just as exploitative as interest is, if it is ‘excessive’ (Naqvi l98l). Naqvi has also pointed out that there is nothing sacrosanct about the institution of mudaraba in Islam. Naqvi maintains that mudaraba is not based on the Qur’an or the Hadith but was a custom of the pre-Islamic Arabs. Historically, mudaraba, he contends, enabled the aged, women, and children with capital to engage in trade through merchants for a share in the profit, all losses being borne by the owners of capital, and therefore it cannot claim any sanctity. The fact remains that the Prophet raised no objection to mudaraba, so that it was at least not considered un-Islamic.

The distribution of profit in mudaraba transactions presents practical difficulties, especially where there are multiple providers of capital, but these difficulties are not regarded as insurmountable. The Report of Pakistan’s Council of Islamic Ideology (CII l983) has suggested that the respective capital contributions of parties can be converted to a common denominator by multiplying the amounts provided with the number of days during which each component, such as the firm’s own equity capital, its current cash surplus and suppliers’ credit was actually deployed in the business, i.e., on a daily product basis. As for deposits, profits (net of administrative expenses, taxes, and appropriation for reserves) would be divided between the shareholders of the bank and the holders of deposits, again on a daily product basis.

Islamic Development Bank in Jeddah, Saudi Arabia

Research Report on Islamic Banking – Part 1

by Mohamed Ariff, University of Malaya, taken from Asian-Pacific Economic Literature, Vol. 2, No. 2 (September 1988), pp. 46-62

Islamic banking is a new phenomenon that has taken many observers by surprise. The whole banking system has been islamized in both Iran and Pakistan. In addition, there are some thirty Islamic banks in operation in other parts of the globe, including the Jeddah-based Islamic Development Bank (IDB) but excluding numerous non-bank Islamic financial institutions (see Appendix). What is more, the speed with which Islamic banks have sprung up and the rate at which they have progressed make it worth-while to study them systematically. An attempt is made in this paper (a) to survey the growing literature on Islamic banking, in particular (b) to trace the growth and development of Islamic banking, and (c) to highlight its salient characteristics.

Evolution

The first modern experiment with Islamic banking was undertaken in Egypt under cover, without projecting an Islamic image, for fear of being seen as a manifestation of Islamic fundamentalism which was anathema to the political regime. The pioneering effort, led by Ahmad El Najjar, took the form of a savings bank based on profit-sharing in the Egyptian town of Mit Ghamr in l963. This experiment lasted until l967 (Ready l98l), by which time there were nine such banks in the country. These banks, which neither charged nor paid interest, invested mostly by engaging in trade and industry, directly or in partnership with others, and shared the profits with their depositors (Siddiqi l988). Thus, they functioned essentially as saving- investment institutions rather than as commercial banks. The Nasir Social Bank, established in Egypt in l97l, was declared an interest-free commercial bank, although its charter made no reference to Islam or Shariah (Islamic law).

The IDB was established in l974 by the Organization of Islamic Countries (OIC), but it was primarily an inter-governmental bank aimed at providing funds for development projects in member countries. The IDB provides fee- based financial services and profit-sharing financial assistance to member countries. The IDB operations are free of interest and are explicitly based on Shariah Principles.

In the seventies, changes took place in the political climate of many Muslim countries so that there was no longer any strong need to establish Islamic financial institutions under cover. A number of Islamic banks, both in letter and spirit, came into existence in the Middle East, e.g., the Dubai Islamic Bank (l975), the Faisal Islamic Bank of Sudan (l977), the Faisal Islamic Bank of Egypt (l977), and the Bahrain Islamic Bank (l979), to mention a few.

The Asia-Pacific region was not oblivious to the winds of change. The Philippine Amanah Bank (PAB) was established in l973 by Presidential Decree as a specialized banking institution without reference to its Islamic character in the bank’s charter. The establishment of the PAB was a response by the Philippines Government to the Muslim rebellion in the south, designed to serve the special banking needs of the Muslim community. However, the primary task of the PAB was to assist rehabilitation and reconstruction in Mindanao, Sulu and Palawan in the south (Mastura l988). The PAB has eight branches located in the major cities of the southern Muslim provinces, including one in Makati (Metro Manila), in addition to the head office located at Zamboanga City in Mindanao. The PAB, however, is not strictly an Islamic bank, since interest-based operations continue to coexist with the Islamic modes of financing. It is indeed fascinating to observe that the PAB operates two ‘windows’ for deposit transactions, i.e., conventional and Islamic. Nevertheless, efforts are underway to convert the PAB into a full-fledged Islamic bank (Mastura l988).

Islamic banking made its debut in Malaysia in l983, but not without antecedents. The first Islamic financial institution in Malaysia was the Muslim Pilgrims Savings Corporation set up in l963 to help people save for performing hajj (pilgrimage to Mecca and Medina). In l969, this body evolved into the Pilgrims Management and Fund Board or the Tabung Haji as it is now popularly known. The Tabung Haji has been acting as a finance company that invests the savings of would-be pilgrims in accordance with Shariah, but its role is rather limited, as it is a non-bank financial institution. The success of the Tabung Haji, however, provided the main impetus for establishing Bank Islam Malaysia Berhad (BIMB) which represents a full- fledged Islamic commercial bank in Malaysia. The Tabung Haji also contributed l2.5 per cent of BIMB’s initial capital of M$80 million. BIMB has a complement of fourteen branches in several parts of the country. Plans are afoot to open six new branches a year so that by l990 the branch network of BIMB will total thirty-three (Man l988).

Reference should also be made to some Islamic financial institutions established in countries where Muslims are a minority. There was a proliferation of interest-free savings and loan societies in India during the seventies (Siddiqi l988). The Islamic Banking System (now called Islamic Finance House), established in Luxembourg in l978, represents the first attempt at Islamic banking in the Western world. There is also an Islamic Bank International of Denmark, in Copenhagen, and the Islamic Investment Company has been set up in Melbourne, Australia.

Rationale

The essential feature of Islamic banking is that it is interest-free. Although it is often claimed that there is more to Islamic banking, such as contributions towards a more equitable distribution of income and wealth, and increased equity participation in the economy (Chapra l982), it nevertheless derives its specific rationale from the fact that there is no place for the institution of interest in the Islamic order.

Islam prohibits Muslims from taking or giving interest (riba) regardless of the purpose for which such loans are made and regardless of the rates at which interest is charged. To be sure, there have been attempts to distinguish between usury and interest and between loans for consumption and for production. It has also been argued that riba refers to usury practiced by petty money-lenders and not to interest charged by modern banks and that no riba is involved when interest is imposed on productive loans, but these arguments have not won acceptance. Apart from a few dissenting opinions, he general consensus among Muslim scholars clearly is that there is no difference between riba and interest. In what follows, these two terms are used interchangeably.

The prohibition of riba is mentioned in four different revelations in the Qur’an.1 The first revelation emphasizes that interest deprives wealth of God’s blessings. The second revelation condemns it, placing interest in juxtaposition with wrongful appropriation of property belonging to others. The third revelation enjoins Muslims to stay clear of interest for the sake of their own welfare. The fourth revelation establishes a clear distinction between interest and trade, urging Muslims to take only the principal sum and to forgo even this sum if the borrower is unable to repay. It is further declared in the Qur’an that those who disregard the prohibition of interest are at war with God and His Prophet. The prohibition of interest is also cited in no uncertain terms in the Hadith (sayings of the Prophet). The Prophet condemned not only those who take interest but also those who give interest and those who record or witness the transaction, saying that they are all alike in guilt.2

It may be mentioned in passing that similar prohibitions are to be found in the pre-Qur’anic scriptures, although the ‘People of the Book’, as the Qur’an refers to them, had chosen to rationalize them. It is amazing that Islam has successfully warded off various subsequent rationalization attempts aimed at legitimizing the institution of interest.

Some scholars have put forward economic reasons to explain why interest is banned in Islam. It has been argued, for instance, that interest, being a pre-determined cost of production, tends to prevent full employment (Khan l968; Ahmad n.d.; Mannan l970). In the same vein, it has been contended that international monetary crises are largely due to the institution of interest (Khan, n.d), and that trade cycles are in no small measure attributable to the phenomenon of interest (Ahmad l952; Su’ud n.d.). None of these studies, however, has really succeeded in establishing a causal link between interest, on the one hand, and employment and trade cycles, on the other. Others, anxious to vindicate the Islamic position on interest, have argued that interest is not very effective as a monetary policy instrument even in capitalist economies and have questioned the efficacy of the rate of interest as a determinant of saving and investment (Ariff l982). A common thread running through all these discussions is the exploitative character of the institution of interest, although some have pointed out that profit (which is lawful in Islam) can also be exploitative. One response to this is that one must distinguish between profit and profiteering, and Islam has prohibited the latter as well.

Some writings have alluded to the ‘unearned income’ aspect of interest payments as a possible explanation for the Islamic doctrine. The objection that rent on property is considered halal (lawful) is then answered by rejecting the analogy between rent on property and interest on loans, since the benefit to the tenant is certain, while the productivity of the borrowed capital is uncertain. Besides, property rented out is subject to physical wear and tear, while money lent out is not. The question of erosion in the value of money and hence the need for indexation is an interesting one. But the Islamic jurists have ruled out compensation for erosion in the value of money, or, according to Hadith, a fungible good must be returned by its like (mithl): ‘gold for gold, silver for silver, wheat for wheat, barley for barley, dates for dates, salt for salt, like for like, equal for equal, and hand to hand …’.3

The bottom line is that Muslims need no ‘proofs’ before they reject the institution of interest: no human explanation for a divine injunction is necessary for them to accept a dictum, as they recognize the limits to human reasoning. No human mind can fathom a divine order; therefore it is a matter of faith (iman).

The Islamic ban on interest does not mean that capital is costless in an Islamic system. Islam recognizes capital as a factor of production but it does not allow the factor to make a prior or pre-determined claim on the productive surplus in the form of interest. This obviously poses the question as to what will then replace the interest rate mechanism in an Islamic framework. There have been suggestions that profit-sharing can be a viable alternative (Kahf l982a and l982b). In Islam, the owner of capital can legitimately share the profits made by the entrepreneur. What makes profit- sharing permissible in Islam, while interest is not, is that in the case of the former it is only the profit-sharing ratio, not the rate of return itself that is predetermined.

It has been argued that profit-sharing can help allocate resources efficiently, as the profit-sharing ratio can be influenced by market forces so that capital will flow into those sectors which offer the highest profit- sharing ratio to the investor, other things being equal. One dissenting view is that the substitution of profit-sharing for interest as a resource allocating mechanism is crude and imperfect and that the institution of interest should therefore be retained as a necessary evil (Naqvi l982). However, mainstream Islamic thinking on this subject clearly points to the need to replace interest with something else, although there is no clear consensus on what form the alternative to the interest rate mechanism should take. The issue is not resolved and the search for an alternative continues, but it has not detracted from efforts to experiment with Islamic banking without interest.

1. Research Report on Islamic Banking, Part 1
2. Research Report on Islamic Banking, Part 2
3. Research Report on Islamic Banking, Part 3
4. Research Report on Islamic Banking, Part 4 – Glossary, Appendix and References

Muslim scholars say the Qur’an prohibits collecting interest on loans. But many banks, both global and local, have found clever ways to meet religious strictures. It’s a system that may be hypocritical, but also profitable.

The coverage can be a little bit breathless: “La finance Islamique en plein boom,” Le Figaro reported in September. Yes, Islamic banking, structured along the lines that religion decrees, is in full boom. But is it really banking? And is it really kosher?

Islam prohibits the payment of interest on loans, so observant Muslims require specialized alternative arrangements from their banks. Many of the largest global financial companies, including Deutsche Bank and JPMorgan Chase, have established thriving subsidiaries that strive to meet these requirements. As a result, optimists speculate that the common pursuit of lucre—divinely sanctioned, filthy, or otherwise—will bring bickering civilizations together. They may be right.

The Islamic aversion to interest collection comes from the Qur’an. Not that the term “interest” is ever used: the Arabic injunction forbids something called riba. The Qur’an offers no exact definition of what riba meant in seventh-century Arabia, the time and place of the Prophet Mohammed—let alone what the term should mean today. In particular, the passages are ambiguous on the question of whether riba refers to all kinds of interest collection, or only usurious interest—that is, lending practices that are, according to some ill-defined standard, unfair and exploitative. What is clear in the divine financial critique is that, whatever riba may be, Jews are doing it. At one point God warns that they will face a “painful day of doom” if they keep it up.

This ambiguity was a practical problem for the early Muslim jurists, who formalized religious rules in a code called sharia. They were divided on the subject, but as time went on, the weight of consensus came to rest on the side of prohibiting all interest collection.

The financial instruments that 20th-century Islamic theorists championed were updated versions of medieval commercial instruments, still known in the Islamic financial sector by their Arabic names: in addition to bonds, known as sukuk, there are profit-and-loss sharing instruments known as musharaka or mudaraba, Islamic leases known as ijara, and a commercial trade instrument called murabaha, the flexibility of which has made it extremely popular among Islamic financial firms.

Banking, as an institution, evolved at the same time as the unprecedented economic growth in Europe over the past 500 years. That growth was made possible in part by the codification, in the 12th century, of a distinction between usury and interest in the Christian tradition.

The Islamic world witnessed the development of corporate contract law and the European banking system from afar. A mixture of traditional arrangements and, later, imported Western practices prevailed in Muslim countries. But it wasn’t until the 1960s that anyone tried to combine the two, governing a modern bank according to Islamic law.

Islamic financial institutions, the argument went, would boost the economic development of Muslim societies. The fraternal style of Islamic banking—with its emphasis on equity financing rather than lending—would enhance social responsibility. In practice, however, Islamic finance has had to bend to the same pressures as any other kind of finance. Social, religiously oriented investment in the development of the Islamic world is something people are more interested in publicly championing than personally doing. Khalid Ikram, who represented the World Bank in Egypt, says of Islamic banking, “it hasn’t had a lot to do with development.”

Pinning down the growth of Islamic banking is a challenge. Whether a banking system truly counts as halal—that is, compliant with the laws of sharia, or, in another religious context, kosher—is a religious question, hard for accountants to answer. Take Iran: should the country’s whole banking system, which is nominally Islamic, be counted as part of the sector even though many experts raise questions about its legitimacy?

The numbers I found were anecdotal. Rodney Wilson, professor of economics at Durham University in Britain and editor of the essay collection The Politics of Islamic Finance, estimates total assets within halal banking systems at just under $500 billion. That’s roughly the size of Wells Fargo Bank, America’s fourth-largest. Hussein A. Hassan of Deutsche Bank predicts that Islamic finance will be the world’s fastest-growing banking sector for years, based on what he calls a modest estimate of 20 percent annual increases in deposits.

So it’s big business, getting bigger, and those who hesitate to enter it now risk suffering an expertise deficit later. The number of professionals trained to structure sharia-compliant products, and of religious scholars qualified to certify them, is small enough to be already causing problems. Governments are getting in the game, too: Japan is planning to become the first non-Muslim country to issue sharia-compliant bonds; the UK, Gordon Brown announced last summer, is revising its laws to make London the “gateway” for Islamic finance in Europe; and Malaysia has proposed substantial tax incentives in its 2007 budget for its Islamic financial sector.

Deutsche Bank, Chase, and HSBC, the giant London-based financial institution with an extensive presence in Asia, have all entered the sector within the last ten years. Their moves coincide with rising oil prices, echoing a phenomenon three decades ago. When the 1970s oil boom gave Muslims and their governments wealth that seemed barely countable, Islamic financial institutions bloomed: the Islamic Development Bank (1975), the Kuwait Finance house (1977), the Faisal Islamic Bank of Egypt (1977), the Jordan Islamic Bank (1978), and others. In 1979, Bank Misr, a conventional financial house in Egypt, became the first mainstream bank to build a halal subsidiary, which in the late 1990s began to attract more capital than its chief domestic competitor, the Faisal Islamic Bank.

Oil prices and religious fervor are both on the rise again. This time, Western financial firms have noticed that you don’t have to be Islamic to bank in accordance with sharia. All you need is a board of religious scholars to approve your operation. Muslim is as Muslim does.

The Islamic world witnessed the development of corporate contract law and the European banking system from afar.

Hussein Hassan of Deutsche Bank is an example of the sort of expert required. He structures specialized Islamic bonds, or sukuk. For a bond to qualify as sharia-compliant, there must be an underlying asset backing it. One cannot simply issue bonds to raise money, the way it’s been done elsewhere for centuries, in return for a promise of a fixed rate of return. To be Islamic in nature, the securities that look like bonds must represent fractions of an equity asset, rather than fractions of a loan.

According to sharia scholars signing off on the prospectuses, the practices of the multinationals are fully Islamic. That is good news for corporations that want to raise money from Muslims, and for the observant clients themselves. But the potential clientele is by no means captive. As Hassan put it to me, “money always looks for the best deal.” if Islamic finance couldn’t provide results close to those of secular institutions, it wouldn’t exist.

Khalid Ikram, who headed the World Bank’s operations in Egypt in the late 1990s, looked into the performance of Faisal Islamic Bank of Egypt (FIBE) back during the early boom days. It turned out that, despite the bank’s citing “religious fervor” to him as the reason for its growth, Coptic Christians made up about 10 percent of the bank’s clients, just as they do of the country’s population. When returns dropped, so did investment and market share. Egyptians with foreign capital generally preferred to keep their cash overseas, even though the returns there were less than the roughly 20 percent returns FIBE was promising on current accounts. The greater security of foreign deposits made up for their lower rate of return. The rational profit motive never lost its place as the key factor in investor behavior.

Timur Kuran, professor of economics and law at the University of Southern California and author of Islam and Mammon: The Economic Predicaments of Islamism, points out that investing in sharia-compliant fashion doesn’t just buy you decent returns—it can also buy political legitimacy. “Islamic finance didn’t come into its own until the 1970s. Why during the oil boom? Huge amount of assets, petrodollars, were accumulating in the sheikdoms and with the Saudis. These regimes were considered quite illegitimate, and there were a lot of opposition movements, so they wanted to legitimize their regimes and invest the money at the same time…. They could claim that they were promoting Islam and avoiding interest.”

Since the inception of Islamic economics as a distinct discipline in the 20th century, it has always been held up as a champion of ethical development. Islamist writers such as Sayyid Qutb and Sayyid Abul-A’la Maududi envisioned Islamic finance as the economic arm of a new, sharia-guided political order. Free of the scourge of interest, the instrument by which fat-cat colonial and imperial capitalists make money from money, Islamic financial institutions would effectively become private equity or venture capital firms, providing sorely needed investment and support for the region’s economy. By investing in Islamic finance, you weren’t just being pious—you were aiding development and helping the poor as well.

But the post-capitalist utopia that reliance on these instruments was meant to inaugurate was dead on arrival. Those involved in the first wave of Islamic banks realized that equity financing does not make for a stable banking sector, and, after a series of shocks and bad investments, they became very conservative. It was a race to the loopholes—a search for means of sharia compliance less risky than straight-out equity investing.

The chief loophole was murabaha. Let’s say that you, a small businessman, wish to go into business selling cars. A conventional bank would examine your credit history and, if all was acceptable, grant you a cash loan. You would incur an obligation to return the funds on a specific maturity date, paying interest each month along the way. When you signed the note and made the promise, you would use the proceeds to buy the cars—and meet your other expenses—yourself. But in a murabaha transaction, instead of just cutting you the check, the bank itself would buy the cars. You promise to buy them from the bank at a higher price on a future date—like a futures contract in the commodities market. The markup is justified by the fact that, for a period, the bank owns the property, thus assuming liability. At no point in the transaction is money treated as a commodity, as it is in a normal loan.

But here’s the catch: most Muslim scholars agree that there is no minimum time interval for the bank to own the property before selling it to you at the markup. According to Timur Kuran, the typical interval is “under a millisecond.” The bank transfers ownership of the asset to its client right away. The client still pays a fixed markup at a later date, a payment that is usually secured by some sort of collateral or by other forms of contractual coercion. Thus, in practice, murabaha is a normal loan.

Since murabaha must be asset-based, however, it can’t help a small businessman who needs a working-capital loan, for example, to provide cash on hand to meet payroll or other expenses. To get such capital from an Islamic financial institution, an entrepreneur would have to sell the bank an equity interest in his business. This is far riskier for the bank and thus much harder to obtain.

The experts tell me that every Islamic bank has at least three-quarters of its investments structured as murabaha. Even the inaptly named Islamic Development Bank was, as of the mid-1980s, doing four-fifths of its business through murabaha, and only 1 percent through equity transactions.

What the “Islamic” label might mean is left to the beholder. The sharia scholars make it their business to pronounce only upon the letter of the law. Like legal practitioners everywhere, they focus on the technicalities. The spirit, being intangible, tends not to cloud their rulings. The leading critics of this inconsistency are political Islamists themselves. Majed Jarrar, a personable young man who studies electrical engineering, wears a long beard, and is keen to discuss his faith, recently opened an account with FIBE here in Cairo, only to let it sit empty. He’s been investigating whether “it’s actually Islamic or not,” and he doesn’t like what he’s finding.

When I asked him about the sort of innovation that, for example, Hussein Hassan at Deutsche Bank is involved in, Majed scoffed. Recalling a similar campaign by a Gulf-based Islamic financial house (“creative Islamic Solutions” was the slogan), Majed argued that sharia law is less about innovation than it is about a return to the ways of seventh-century Arabia.

Despite the zeal of purists like Jarrar, an entire banking sector without debt would be far too unstable. Such a system has never had to exist—medieval Islam had extensive regulations governing trade relations and individual contract law, but there was no banking, so there were no banking rules.

While no one I interviewed argued that sharia-compliant financing directly retards economic and social development, there was agreement that it does much less than the original rhetoric claimed. Not only are working-capital loans, critical to many small businesses, rare, but also sharia-compliant transactions tend to be short-term.

Still, there’s something reassuring about the way that the rational profit motive trumps strict ideology. The willingness to put profit first is, it turns out, the real shared value that links Islamic and Western civilizations.

Aaron MacLean lives in Cairo. From 2003 to 2006 he was a Marshall Scholar at Oxford University, where he researched medieval Arabic thought.

The UK’s first Islamic Child Trust Fund(CTF) has been launched.

There are now a range of products – including current accounts, mortgages and even personal loans – which comply with Sharia Islamic law.

BBC News examines Islamic finance and how it works.

What is Sharia law?

Under Sharia Islamic law, making money from money, such as charging interest, is usury and therefore not permitted.

Wealth should be generated only through legitimate trade and investment in assets.

But investment in companies involved with alcohol, gambling, tobacco and pornography is strictly off limits.

How does Islamic finance work?

The overarching principle of Islamic finance is that all forms of interest are forbidden.

The Islamic financial model works on the basis of risk sharing.

The customer and the bank share the risk of any investment on agreed terms, and divide any profits between them.

The main categories within Islamic finance are: Ijara, Ijara-wa-iqtina, Mudaraba, Murabaha and Musharaka.

Ijara is a leasing agreement whereby the bank buys an item for a customer and then leases it back over a specific period.

Ijara-wa-Iqtina is a similar arrangement, except that the customer is able to buy the item at the end of the contract.

Mudaraba offers specialist investment by a financial expert in which the bank and the customer shares any profits.

Customers risks losing their money if the investment is unsuccessful, although the bank will not charge a handling fee unless it turns a profit.

Murabaha is a form of credit which enables customers to make a purchase without having to take out an interest bearing loan. The bank buys an item and then sells it on to the customer on a deferred basis.

Musharaka is a investment partnership in which profit sharing terms are agreed in advance, and losses are pegged to the amount invested.

What types of Islamic financial products are currently available?

Nearly all the traditional retail banking services expected from established High Street banks are available in a Sharia compliant format.

The Islamic Bank of Britain offers a Sharia compliant current account, mortgage and even personal loan.

HSBC offers a Islamic current account and mortgage.

A handful of other banks – including some of the biggest international names and the Middle East’s biggest traditional banks – also offer financial products in the UK tailored for Muslims.

And from 1 September, Children’s Mutual is to offer a Sharia compliant Child Trust Fund.

How strong is the demand for Islamic finance?

Banks are hoping to attract business from Britain’s two million Muslims, many of whom do not use established banking services because they are in conflict with Sharia.

Children’s Mutual is targeting the parents of 120,000 Muslim babies with it’s Sharia compliant Child Trust Fund.

In a survey last year, Datamonitor said that demand for sharia-compliant mortgages was strong, and could yield up to £4.5bn in advances by 2006.

Conventional insurance involves the elements of uncertainity (Al-gharar) in the contract of insurance, gambling (Al-maisir) as the consequences of the presence of uncertainty and interest (Al-riba) in the investment activities of the conventional insurance companies which contravene the rules of Shariah. Takaful is an alternative form of cover which a Muslim can avail himself against the risk of loss due to misfortunes.

The insurance providers in year 2001 and beyond should find Takaful sector an exciting sector of insurance to be in. This presentation focuses on growth potential that exists in Takaful with great many opportunities for innovative development of unique products, techniques and systems needed to fill gaps in insurance penetration in many of the markets around the globe. This paper presents an insight into the size of the current takaful industry worldwide and sketches the signs of change that may lead to realization of the potential that exists in this sector.

Overview of takaful

The takaful brand of insurance is a classic example of consumer-driven response to their needs. For generations, Muslims around the world have grown with a mind set that insurance (especially life insurance) is taboo because it contravenes some of the Islamic tenets. Life insurance as sold in conventional way was declared unacceptable in 1903 by some prominent Islamic scholars in the Arab countries. The search was on for an acceptable alternative ever since, and not until the 1970′s the debate took sufficient momentum to reach a consensus. In 1985, the Grand Counsel of Islamic scholars in Makkah, Saudi Arabia, Majma al-Fiqh, approved takaful system as the alternative form of insurance written in compliance with Islamic Sharia. It is outside the scope of this presentation to explain how the takaful system works except to say that it is a concept of protection for the good of society, a concept that was never an issue in Islam in the first place. The Grand Counsel approved this system as a system of co-operation and mutual help but the exact method and operation was left to Islamic scholars and insurance practitioners to resolve, develop and implement.

Takaful industry is still not past its formative years and there are many areas unresolved, especially in life insurance. The key areas to resolve are the global standardization of takaful terminology, the development of an acceptable form of life insurance (family takaful) especially for countries in the Arab regions and a common consensus for a system to determine profits (or surplus) distributable to participants and shareholders.

The very first Takaful company was established in 1979 – the Islamic Insurance Company of Sudan. Today there are some 28 registered Takaful companies worldwide writing takaful directly and 10 more as Islamic windows or marketing agencies placing insurance risk with conventional and takaful companies. In fact the number of takaful companies is higher as all insurance companies in Sudan are deemed to operate in accordance with Islamic Sharia principles. In addition, new takaful companies have been established recently in Sri Lanka and Tunisia. At least four more Takaful companies are under formation in the Middle East (viz. Kuwait, UAE and Egypt). Several other Takaful companies are being contemplated in various countries such as Pakistan, Australia and Lebanon. It is also understood that interest is shown in Takaful in South Africa, Nigeria, and some of the former states of the Soviet Union.

Takaful industry in the Middle East is under-developed compared to other markets such as Malaysia. The more successful companies in the Middle East have grown at 10% p.a. whereas in Malaysia the rate of growth has been 60% p.a.

A broad estimate of the total Takaful industry in 2000 is approximately US$550m for both life and non-life business, of which around $193m pertains to Asia Pacific. Malaysia is one of the largest markets outside the Arab region for Takaful, writing 72% of the non-Arab takaful business. A geographical spread of takaful business is as follows.

Table 1: Geographical spread of Takaful business – 2000

The growth in Takaful business in Malaysia has been impressive. Starting from a low base in 1994, the annualized average growth used to be in the order of 92% in Family Takaful and 34% in General. Since 1998, the growth rate has slowed down to around 30% in Family Takaful and 17% in General. In Family Takaful the products sold were individual and group term and savings products, mortgage policies and pension plans. In General takaful all classes of business were sold.

Exchange rate RM2.43 to $ (1997 prices)

Table 2: Growth of Takaful in Malaysia

Takaful in Arab Countries

To illustrate the penetration of takaful in the private sector, the following table provides a picture of business written by companies in the Arab countries excluding NCCI in Saudi Arabia. This company’s business is mainly generated from government sources and its exclusion from the figures provide a better measure of how takaful companies are doing in the market place where they compete with conventional insurance companies.

Takaful figures estimated, Market figures from Sigma SwissRe & Arig

* Takaful share for Saudi Arabia increases from 8% to 36% if NCCI’s premium is included above.

Table 3: Takaful business in the Arab Region – 1999
Takaful business has generally grown at a higher rate than the total insurance business in each of these countries. Growth rates reflect the increasing market share of Takaful business over the same period, 1995 to 1999 for these countries:

Reinsurance or RetakafulReinsurance of takaful business on Islamic principles has been an area of much debate. Reinsurance on Islamic principles is known as retakaful. The problem has been one of lack of retakaful companies in the market. This has left the takaful companies with a dilemma of having to reinsure on conventional basis, contrary to the customer’s preference of seeking cover on Islamic principles. The Sharia scholars have allowed dispensation to takaful operators to reinsure on conventional basis so long as there was no retakaful alternative available. Takaful companies therefore actively promote co-insurance. A number of large conventional reinsurance companies from Muslim countries take on retrocession. Still there is a lack of capacity within the Takaful industry worldwide. A certain proportion of risk is placed with international reinsurance companies that operate on conventional basis. The retrocession from Takaful companies ranges from some 10% in the Far East where Takaful companies have relatively smaller commercial risks (so far), to the Middle East where up to 80% of risk is reinsured on conventional basis.

Market characteristicsThe market characteristics of the Arab region are quite different from other regions. The main differences are in terms of the attitude to risk and lack of insurance awareness. The level of awareness is very low about financial protection amongst individuals. This is not the case for Malaysia, Indonesia and Brunei, certainly not to the same extent. This is illustrated by comparing insurance density and penetration of conventional insurance and Takaful aggregated.

The average ratio of capital to premiums for many Arab insurers is around 1 whereas the ratio should be in the region of 2.5 times.

The Middle East and indeed many of the Muslim countries are a mixture of some rich and some poorer economies. Insurance density and penetration in some of these countries show the low expenditure in life insurance in Saudi Arabia of $1 per head and UAE of $68. In comparison, the world average life premium per capita was $235, the UK $2,503, USA $1,447 and Switzerland $2,914 (highest). The GDP in many of these countries is high, such as Kuwait, Saudi Arabia and UAE, and yet insurance penetration is not commensurate with the high GDP. This reflects the indifferent attitude to risk in these countries.

The insurance penetration in the UK was 13.35% (life 10.30%), USA 8.55% (life 4.23%), and South Africa 16.54% (life 13.92%) the highest. Insurance penetration for the Middle East is very low at 1.6%.

Traditionally the reasons for low penetration for insurance in the Middle East, particularly in life insurance, used to be:

• lower disposable incomes, except for the Arabian Gulf countries.
• greater reliance on social welfare provisions
• extended family system
• attitude to personal risk

Nevertheless many of the classic parameters of old are changing, such as the extended family system. The pace of change has increased manifold due to urbanisation and industrialisation and the recent phenomenon of liberalisation and globalisation. Moreover, populations of many developing Muslim countries are skewed towards younger age groups, which has put greater pressure on limited resources and employment.

The economic factors have kept insurance low in many of these countries. People may be aware of insurance needs but cannot afford to buy the required protection. The minority, who can afford, are either not convinced or are not interested. Poor marketing has been one of the contributory factors

Company ProfilesThe status and type of activities carried out by takaful companies worldwide, is mainly based on data collected directly from the companies through a questionnaire sent to some 30 companies. All except Takaful USA are continuing to transact business. The position about Takaful USA is not clear as of March 2001.

The more successful Takaful companies in the Arab region managed a dividend of up to 8%. Nevertheless, they can do much better if the critical mass of business is built up. Lack of capacity to write different classes of business, low retention, limited product range and lack of good service have been the impediments of the past and these parameters are fast changing for the better, especially in Jordan, Bahrain and Qatar. New Takaful companies in Kuwait and the UAE are expected to add to this improving scenario for Takaful industry.

Signs of Change: Tracing For Takaful PotentialThe world population in 1999 is estimated to be around 6 billion as per the Global Population Project based in the United States. The data on Muslim population is not readily available. It was estimated by using information contained in a publication entitled Islamic Beliefs and Teachings from India. Accordingly there may be around 1.5 billion Muslims making up for 25% of the total world population in 1999. As we look around throughout the Muslim world it is quite evident that people have not taken to life insurance in the same way as in most other countries.

The growth of insurance in Muslim countries was examined by looking at the past trends and taking a conservative view on future growth. This provided a consistent pattern of slower growth in mature markets and higher growth in many of the developing countries. Most of the Muslim countries have potential to at least double their insurance volumes.

One of the main reasons for low penetration of insurance in these countries is the under-development of life insurance. As stated earlier, decades of misunderstandings created a mind-set amongst Muslims that did not help to develop life insurance to any great extent. And yet life insurance is so essential in providing the vital protection to the family. The insurance industry globally was US$ 2.3 trillion in 1999 (up by 7.3% on 1998), with life insurance 61% of total. The size of the Middle East insurance market was US$ 7.9 billion or 2.4% of world premium, and life insurance 31% of the market. Iran experienced strong growth at 25.2% for 1999, compared to average for the region of 5.2%. Life insurance in the region increased by around 3% in 1999 compared to 12.5% in Iran and 5.3% in Kuwait.

The takaful industry holds the key to unlocking this potential where life insurance can actually be provided through “family takaful” naturally acceptable to the masses. The demand for Islamic products is evident from the success of Islamic finance and banking that has now firmly established itself with a total of more than $7 billion of capital, $4.1 trillion of assets and more than $120 billion of deposits.

The potential takaful volumes were estimated by taking into account the growth inertia that can be achieved through the introduction of family takaful and the following factors:

A greater awareness of Takaful system is achieved

• More Takaful companies are set up and run professionally
• More global coverage is secured through international companies’ network and the use of modern IT technology
• Sale through banks
• Companies are well capitalized and demonstrate secure haven for the funds
• Retakaful capacity with triple A rating is available

Other factors were also taken into account such as literacy levels in each country and the take up rates for takaful products as opposed to conventional products.

Twenty-seven countries were selected where most of the demographic and insurance statistics was available. It was estimated that the global takaful premium could be in the region of US$7.4 billion in 15 years’ time, growing at nearly 20% per annum. This is not an unachievable task when we have Malaysian takaful business growing at 60% pa and the Middle East at 10%. With concerted effort on part of the Takaful operators worldwide, a growth of 20% pa should be very much possible.

ConclusionInsurance, especially life insurance is an essential part of the social protection needed for any society. It has its rightful place in Islam but years of misunderstanding and misconception have created mental blocks against insurance in the Muslim culture. I believe Takaful or Co-operative Insurance is the right way forward towards the breakdown and removal of such mental blocks. This type of insurance has great deal to offer in Muslim countries where the spread of insurance per person and per cent of GDP can increase manifold if the system of takaful is projected correctly and understood properly. It can genuinely enlarge the insurance market in areas where traditional insurance has not been able to grow, as it should have done. This is true of personal lines, especially of life insurance or family takaful.

In order to create the essential trust and confidence, which is needed to remove the mental blocks just mentioned, the efforts to develop and manage takaful business must be genuine. Investors, entrepreneurs and insurers have good opportunity to take up the challenge of developing insurance business on Islamic principles. After all Takaful is intrinsically in accordance with the indigenous consumer needs.

Reprinted from the website of the IIBI

“The Prophet (s.a.w.) told a Bedouin who left his camel untied to the will of Allah: Tie your camel first, then put your trust in Allah”

(Narrated by at-Tirmizi and Ibn Majah)

Nowadays, insurance is seen as a means of action undertaken to reduce the risk of loss due to misfortunes. An alternative form of cover a Muslim can avail himself against the consequences of catastrophe and disaster is by participating in Takaful schemes. It is a scheme based on solidarity, shared responsibility and brotherhood among members. Participants of this scheme all agree to mutually help each other by contributing financially on the basis of tabarru’ (donation).

Insurance as a concept does not contradict the practices and requirements of Syari’ah. In essence, insurance is synonymous to a system of mutual help. It is the pooling of resources to help the needy, a scheme which is similar to the principles of compensation and shared responsibility among the community, as practised between the Muhajirin of Mecca and the Ansar of Medina following the hijra of the Prophet over 1400 years ago. However, Muslim Jurists are of the opinion that the operation of the conventional insurance, in its presence form, does not conform to the rules and requirements of Syari’ah as it embodies the following three elements:

(i) Gharar

The unknown or uncertain factors in operation of a contract in life insurance contracts.

(ii) Maisir

Gambling arises as the consequence of the presence of Gharar, particularly in the case of life insurance.

(iii) Riba

Interest and other related practices that do not conform to the Syari’ah in the investment activities.

Birth of Takaful in Malaysia

The foundation for the development of Takaful or Islamic insurance was set by the wish of Muslim to realign more to Islamic practices in the economic activities coupled with the strong support from the Government for Islamic financial services. In the same manner as conventional banking requires the services of insurance, Islamic banking also needs the services of insurance. It is befitting that the insurance services for Islamic banking must be based on a system acceptable to Islam. A special body, “Task Force on the Study of Establishing Islamic Insurance Company in Malaysia”, was formed in 1982 to study the possibility of establishing Islamic insurance to complement the services of Islamic banking.

Following the recommendation of the task force, the Malaysian Parliament enacted the Takaful Act in 1984. In November 1984, the first Takaful operator, Syarikat Takaful Malaysia Sdn Bhd (STMB), was incorporated with a paid-up capital of USD2.6 million. Bank Islam Malaysia Berhad held the majority stake in STMB while the other shareholders Islamic Religious Councils and Baitulmals of certain states in Malaysia. The paid-up capital of STMB was increased to USD14.5 million via bonus and rights issue, followed by public floatation of its shares on the main board of the Kuala Lumpur Stock Exchange in July 1996. In 1994, MNI Takaful Sdn Berhad (which changed its name to Takaful Nasional Sdn Berhad on 19 November 1998) was established, a subsidiary of a conventional insurer licensed in the country. To support the re-takaful needs of Takaful operators in the region, a full-fledged re-takaful company, ASEAN Retakaful International (L) Ltd (ARIL) was incorporated in Malaysia’s offshore financial centre in Labuan in May 1997. Currently, shareholders of ARIL are Takaful operators in Malaysia, Brunei and Singapore.

Takaful Concept

In Malaysia, the provision of insurance cover as a form of business in conformity with Syari’ah is based on the following Islamic principles:

(i) Al-Takaful

The pact among a group of people called participants, reciprocally guaranteeing each other against loss or damage that may befall any one of them.

(ii) Al-Mudharabah

The commercial profit sharing contract between the provider(s) of funds (participants) for a business venture and the entrepreneur who actually conducts the business.

(iii) Tabarru’

The agreement by a participant to relinquish as tabarru’ (donation), a certain proportion of the Takaful contribution that he agrees or undertakes to pay, thus, enabling him to fulfil his obligation of mutual help and joint guarantee should any of his fellow participants suffer a defined loss.

Thus, the operation of Takaful may be envisaged as a profit sharing business venture between Takaful operator and the individual members of a group of participants who wish to reciprocally guarantee each other against certain loss or damage endured by any one of them. The operation of Takaful is confined within the Tijari (commercial) sector or popularly known as the private sector. The traditional aspects of the commercial activity of Takaful must be subject to Islamic contractual laws to ensure its compliance with Syari’ah. Within this fundamental framework contract of tijari, Takaful is therefore based on the Islamic principle of Al-Mudharabah.

The tabarru’ concept is incorporated in Takaful contract to eliminate the uncertainty element. A participant shall agree to relinquish as tabarru‘, certain proportion of his Takaful contributions that he agrees or undertakes to pay. Consequently, enables him to fulfil his obligation of mutual help and joint guarantee should any of his fellow participants suffer a defined loss. The sharing of profit or surplus that may emerge from the operations of takaful, is made only after the obligation of the assisting the fellow participants is fulfilled. It is imperative for a Takaful operator to maintain adequate assets of the defined funds under its care whilst simultaneously striving prudently to ensure the funds are sufficiently protected against undue over-exposure.

Reprinted from Bank Negara Malaysia

Wadiah Yad Dhamanah (savings with guarantee)

Refers to goods or deposits, which have been deposited with another person, who is not the owner, for safekeeping. As wadiah is a trust, the depository becomes the guarantor and, therefore guarantees repayment of the whole amount of the deposits, or any part thereof, outstanding in the account of depositors, when demanded. The depositors are not entitled to any share of the profits but the depository may provide returns to the depositors as a token of appreciation.

Mudharabah (profit-sharing)

Refers to an agreement made between a capital provider and another party who acts as the entrepreneur. This arrangement will enable the entrepreneur to carry out business projects and profits are distributed based on a pre-agreed profit sharing ratio. In the case of losses, the losses are borne by the provider of the funds.

Musyarakah (joint venture)

Refers to a partnership or joint venture for a specific business, whereby the distribution of profits will be apportioned according to an agreed ratio. In the event of losses, both parties will share the losses on the basis of their equity participation.

Murabahah (cost plus)

Refers to the sale of goods at a price, which includes a profit margin as agreed to by both parties. Such sales contract is valid on the condition that the price, other costs and the profit margin of the seller are stated at the time of the agreement of sale.

Bai’ Bithaman Ajil (deferred payment sale)

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

Bai’ al-Dayn (debt trading)

Refers to the buying and selling in the secondary markets of debt certificates, securities, trade documents and papers which are Shariah compliance. Only documents evidencing real debts arising from bona fide merchant transactions can be traded.

Bai’ al-Inah (sell and buy back)

It refers to a contract which involves sell and buy back transactions of an asset by a seller to the customer. The seller will sell the asset on cash basis but the customer will buy back the asset on deferred payment at a price higher than the cash price.

Ijarah Thumma al-Bai’ (leasing and subsequently purchase)

Refers to an Ijarah (leasing/renting) contract to be followed by Bai’ (purchase) contract. Under the first contract, the hirer leases the goods from the owner at an agreed rental over a specified period. Upon expiry of the leasing period, the hirer enters into a second contract to purchase the goods from the owner at an agreed price.

Ijarah (leasing)

Refers to an arrangement under which the lessor leases equipment, building or other facilities to a client at an agreed rental fees or charges, as agreed by both parties.

Qard (interest-free loan)

A loan extended on a goodwill basis and the borrower is only required to repay the principal amount borrowed. However, he may pay an extra amount at his absolute discretion, as a token of appreciation.

Bai’ Salam (future delivery)

Refers to an agreement whereby payment is made in advance for delivery of specified goods in the future.

Bai’ Istijrar (supply contract)

Refers to an agreement between the client and the supplier, whereby the supplier agrees to supply a particular product on an on going basis, for example monthly, at an agreed price and on the basis of an agreed mode of payment.

Kafalah (guarantee)

Refers to a contract of guarantee by the contracting party or any third party to guarantee the performance of the contract terms by contracting parties.

Rahnu (collateralised borrowing)

Refers to an arrangement whereby a valuable asset is placed as collateral for debt or right of claim. The collateral may be disposed in the event of default.

Wakalah (nominating another person to act)

Refers to a situation, where a person nominates another person to act on his behalf.

Hiwalah (remittance)

Refers to a transfer of funds/debt from the depositor’s/debtor’s account to the receiver’s/ creditor’s account whereby a commission may be charged for such service.

Sarf (foreign exchange)

Refers to the buying and selling of foreign currencies.

Ujr (fee)

Refers to commissions or fees charged for services.

Hibah (gift)

Refers to gifts award voluntarily in return for any transactions given or provided.

Reprinted from Bank Negara Malaysia

I think the first person who introduced the idea of credit cards to me was Wilma Flintstone of the kids’ cartoon The Flintstones.

She and her friend Betty Rubble would occasionally, holding small semi-rectangular cards, announce in unison “Charge!”, then set off for the shopping mall to what I assume was the chagrin of their husbands Fred and Barney.

“Charge!” meant “let’s shop till we drop” and for many, it still does.

But credit cards and the debt people incur using them is not about child’s play or children’s cartoons.

According to Ameridebt, a non-profit credit counseling organization with offices in Maryland, New York and Florida, national consumer debt in the United States has reached an all-time high of over one trillion dollars. Credit card debt accounts for approximately 400 billion dollars of that figure.

Credit cards are one example of Riba or interest.

What is Riba

The Arabic word Riba refers to an amount that is charged on the principal used.
Riba is made up of three elements. The first is excess or surplus over and above the capital of the loan. The second is the determination of this excess rate in relation to time. The third is that a transaction is conditional on the payment of a predetermined surplus.

These three elements jointly make up Riba and any deal or bargain or credit transaction in money or in kind which has these elements is considered a transaction of Riba.

Some examples of items that people usually buy on interest are houses and cars. Since these are very expensive, instead of waiting, many decide to realize their dream of having their own home or the newest car on the market before they have the funds to afford them. They can buy the house by taking out a loan. But the catch is the longer they take to repay, the more interest is added. This makes the house very, very expensive in the long run. The Quran and Ahadith are very clear about interest.

Credit cards

Credit cards are the major pillar of consumerism. They are the prime example of something which encourages you to spend even if you don’t have the money. In a nutshell, credit cards are good for the banks and bad for you. They also involve Riba.

By using credit cards to buy, you end up paying far more than the original price of an item because of impatience and inappropriate planning. Every year hundreds and thousands of people are declared unworthy of credit.

Some cite convenience as the reason in buying using these cards as opposed to dragging cash for purchases.

But this is a weak excuse to use this piece of plastic. Someone who has a personal financial plan in place already knows approximately how much they will need for groceries, for example. In this case, they can take an adequate amount of cash instead of the card.

As well, the added bonus of doing this is that you can stick to buying what you really planned to instead of wasting your time and money on useless items. This is actually a great way to control your money and spending habits.

More on credit card debt

A study by the Consumer Federation of America released in mid-December 1997 noted that credit card debt increased that year at more than double the inflation rate, that this debt imposed serious financial burdens on tens of millions of households, and that a major reason for the debt rise was aggressive marketing and credit extension by issuers.

In the same press release, it encouraged Christmas shoppers to “consider spending only what they can afford to pay off in a month or two. Better yet, they should make purchases by cash, check or debit card”

“If looks too good to be true it is,” one expression notes. This does apply in the case of credit. Buying something when you don’t have the funds for it is a huge mistake. In some cases, it may not be drastic. But getting involved in smaller cases creates the habit of spending what you don’t have which can lead to financial ruin in the future.

Credit debt is like slavery

An African-American brother once threw away his cards calling it a liberation from financial slavery.

Debt from credit is really slavery. You can never free yourself since the interest just keeps growing as time passes. It’s sad but true. Whether you are a student who has taken out loans to further your education or a businessman or woman trying to start up a new venture, that loan which you may fully attempt to repay in the future may never be completely cleared because the longer you wait the higher the interest.

Do you really need a credit card?

Twenty-nine percent of all American adults do not own a credit card.

One pioneer of the Muslim community in Chicago who is an engineer now in his sixties has raised three children in America. He does not own a credit card and he never has one. He never felt that it was necessary.

Sometimes, we feel that we just have to have something. Advertisements encouraging the “buy now pay later” culture make you think less prudently for a moment when you are making a purchase decision.

Use debit cards instead of credit cards

One argument in favor or using credit cards is that it’s just safer for when you are buying bigger items like a car or furniture. This is true. But there is an alternative to the credit card: the debit card.

These are issued in relation to how much money you actually have in your bank account. In a debit card, money goes out of your account as soon as you use it or within a day or two of the transaction in which the card was used. This way, then, you don’t pay more than the actual price of the product.

There are four keys to avoiding credit and getting caught in the web of Riba through credit cards specifically: sincerity, commitment, planning and follow through.

Sincerity

Given the fact that you cannot completely escape interest and credit even in Muslim countries, some may think it is just better to go with the flow and use it anyway, despite it being Haram.

But we have to try as best as possible to avoid it and the venues really are there if we look for them and we have the sincerity to pursue them. One brother I know, a born Muslim who was “born again” into Islam, sold off all of his property and then went through a very, very difficult financial period, after losing his job. Alhamdolillah, today he is in a better financial position, but the point is, he was sure and committed that he was going to turn his life around and he did. But that came only after a sincere commitment to Allah.

Similarly, if we really are serious, and pray to Allah to help us avoid the Riba trap for His sake, He will open a way out for us. Don’t forget where there is a will, Allah can create a way.

Commitment

Like with the above mentioned brother, there has to be a real commitment to change following the realization that things are not as they should be.

This commitment can be exercised dramatically or gradually, but it has to be exercised to have any impact on the way you deal with credit. Maybe you can start by canceling a credit card you rarely use. Or you can pay off one on which you don’t owe very much and have it canceled. Just take one step, and Insha Allah, it’ll have a domino effect.

Planning

While small steps may get the ball rolling, it is really a reasonable and well thought out plan that can help you avoid credit. That means sitting down and working out a financial plan to start paying back debts. It also means planning before you go shopping or to spend money on a weekly basis at least.

If you have a list, for instance, you can stick to what you have to get, and then apportion the right amount of money for this. This way you don’t have to whip out a credit card. You can pay by cash or if you decide to use a debit card, you know you have to limit yourself to the funds already in your account.

Follow through

If necessary, reward yourself in the beginning of implementing your plan to give you the additional push or get a family member or friend to help you and encourage you to eventually completely stop buying on credit and relying on credit cards for purchases.

Credit cards, even when being used carefully are better avoided. There are clear alternatives, like the debit card for avoiding this possible trap for Riba. Let’s make the commitment to stop the habit of charging and be more realistic in our financial dealings.