Demystifying

Islamic Banking

An introduction to
Islamic Banking
 Dedication

 This presentation is dedicated to the

affected civilians during the uneven war
imposed on Palestine by Israel.
 Fundamental Questions
• Why do we need a different type of
banks, while we already have an efficient
banking system around us?
• How Islamic banks are different from
conventional banks?
• How the major products of Islamic
Banks are designed?
Geographical Distribution of Islamic banks
 An Estimate of the industry size
 Currently, there are estimated to be over
265 Islamic banks with a market
capitalization in excess of US$ 13 billion.
 Total assets are estimated at over US$ 262.
 Deposits in Islamic banks are estimated to
be over US$ 202 billion worldwide.
 The average annual growth rate of the
Islamic banking industry ranged between
10-20% over the past decade.
 International Dedicated Orgs
 Accounting and Auditing Organization for
Islamic Financial Institutions (Bahrain).
 Islamic Financial Services Board (Malaysia).
 International Islamic Rating Agency
(Bahrain).
 Liquidity Management Centre (Bahrain).
 International Islamic Financial Market
(Malaysia).
 Conventional Banking
• It has very rich history of more than a
thousand years across the world.
• Facilitates financial intermediation with
a view to ensuring efficiency.
• The business of a bank is lending and
borrowing. Accepts loans from
depositors in return for interest. Extends
loans to finance-seekers in return for
interest.
Benefits of Islamic Banking
 Completeness of financial market
 New products in the market will complement existing
conventional products enhancing customer choice.
 Competitiveness of financial market
 New products will strengthen competition in the
financial market enhancing consumer surplus.
 Catering for Muslim investors’ tastes
 New products promise to conform to religious norms
ensuring Muslim investors’ purity in financial life.
 What are the basic objections?
• Islam prohibits interest, in every form.
Prohibition came both in the Quran and
the Hadith.
• Islam does not allow investments in
projects which are not legitimate
themselves in the eye of Islam.
• While efficiency is important, the need
for equity has also been emphasized.
 What to do then?
 There is nothing wrong in the business of
banking. A modern society can not do
without it.
 All we have to do is to change the
business as to make it acceptable in
Islamic framework.
 Islam not only stresses on acceptability of
what we do (The Ends), it also emphasizes
on how we do ( The Means) certain things.
 How to change it?
 First, we simply remove those aspects of
banking that contradict Islamic standards.
 But, we can keep those elements of
banking that don't violate Islamic norms.
 While making these changes, we refer to a
set of Islamic norms, collectively known as
Shariah, which is based on the Quran and
The Sunnah (the Prophet’s tradition).
 The Major Objection: The Riba
 Riba, the Arabic equivalent of interest, is
the amount of money (or anything else)
that the borrower is obligated to pay to
lender in excess to the principle amount.
 Conventional banks pay interest on
deposits and receive interest on loans.
 This is the prime reason why conventional
banks do not conform to the norms of
Shariah.
 Prohibition of Riba
 People who indulge in riba shall be raised like those
who have been driven to madness by the touch of
Devil. That is because they say that a riba-based
transaction is like trading, while God has permitted
trade and prohibited riba (al-Baqarah 2:275) .

 O believers! Fear God and give up outstanding riba if

you are true believers. Watch out! If you do not obey
this commandment, then God declares war against
you from Himself and from His Prophet. . But, if you
give up your outstanding riba, then you can claim
your principals. (al-Baqarah 2:278-279) .
 What is Riba or interest?
 Before moving to an easier definition of
riba, for a definition of interest we can
refer to the work of J M Keynes:

 Interest in economics denotes the price paid

on money in exchange for the use of a sum
of money, the premium, obtained on current
cash over deferred cash. (Keynes, 1937)
A comprehensive Definition of Riba
 The International Institute of Islamic
Economics (IIIE), defines interest in ‘the
Blueprint of Islamic Financial System’ in
1999 as follows:
 ‘Riba is a discrepancy, which results
from the contractual obligation of a
party in the context of a direct
exchange of money between two
parties.’
 Interest Vs. Rent, Profit and Fees

 Not every known income is interest.

 Rent is a known payment to use a leased item.
 Fees are a known payment to buy services.
 Interest is a known payment to use money.
 Profit is the difference between revenue and
costs. It is, however, not known in advance. It is
therefore not fixed, but variable.
 Interest forms part of production costs. Profits
are the difference between revenues and costs.
So “Loan” can’t be a business tool!
 Islam does not allow anyone to give and
take anything extra on a loan.
 But, today banks make money from the
loan business.
 Depositors receive interest on their loan to
banks. Banks receive interest on their
loans to Entrepreneurs (Finance-seekers).
 Islamic banks cant make use of such loans.
Where to strike, then?
 Basic Business Contracts Available
 Partnership
 Mudharaba (Profit-Sharing agreement)
 Musharaka (Profit and Loss Sharing
agreement)
 Trade / Sale
 Murabaha ( Cost-plus Sale)
 Bai Muajjal (Cost-plus sale with deferred
payment)
 Leasing
 Ijara (Operating lease)
 Initial or Classical Model
 Two-Tier Mudharaba or Partnership
 On the Liability side, banks (i.e. shareholders)
form a partnership with depositors to invest
funds. They agree on the profit sharing ratio.
 On the Asset side, banks form partnership
with entrepreneurs or finance-seekers. They
agree on a profit sharing ratio as well.
 The difference between two ratios contributes
towards bank profits after deducting costs.
 Deposit Products

1. Current Account

 It is organized as wadiah or safe-keeping. The

deposits are held in trust and utilized by the
bank at its own risk.
 There is no big difference here between
conventional and Islamic banks, as normally no
interest is paid on such account.
 2. Savings Account

 This account is based on Mudharaba principle.

 Depositors are owners of funds and the bank is
owner of labor.
 Profits are shared by both parties as per pre-
agreed ratio fixed through negotiation.
 If loss occurs, it is borne by depositor only as
owners of fund. The bank loses its effort.
 3. Investment Account

 Core deposits of an Islamic bank. Based on the

concept of Mudharaba. Islamic counterpart of the
conventional fixed deposit products.

1. General Investment Deposits: Open to any

project as selected by the bank.

2. Special Investment Deposit: Tied to any specific

project agreed upon by both parties.
 Financing Products (Variable Income)

(Trustee Partnership ( .1Mudharaba

 The bank provides capital finance for a specific
venture indicated by the customer.
 The bank is the owner of the capital and the customer-
entrepreneur provides labor.
 Profit is shared according to a pre-agreed ratio.
 Losses, if any, are entirely absorbed by the bank.
 2. Joint Venture (Musharaka)

 Both the bank and its customer-client contribute to

entrepreneurship and capital.
 The customer and the bank agree to combine financial
resources to undertake any type of business venture, and
agree to manage it together.
 Profits are shared between the bank and the customer in
the pre-agreed ratio. Losses are shared in proportion to
their respective capital share.
 2A. Declining Musharaka: An Innovation

 A declining Musharaka is a recent phenomenon.

 In it, the bank's share in the equity is diminished each
year through partial return of capital.
 The bank receives periodic profits based on its reduced
equity share that remains invested during the period.
 The share of the client in the capital increases over time,
resulting in complete ownership of the venture.
 Areas of Application
 Mudharaba is useful for financing projects, such
as, real estate, construction of buildings,
corporate plants etc.
 Musharaka is suitable for financing any kind of
business venture, where the bank is willing to
act as partner.
 Diminishing Musharaka is used primarily in the
area of housing finance.
 Financing Products (Predictable Income)

 Early models of Islamic banks are based on a

two-tier Mudharaba or partnership structure.
 Subsequent models of Islamic banks use an
expanded framework of debt-based
mechanisms, e.g. , Murabaha, Bai Muajjal and
Ijara, where income can be predicted.
 3. Deferred Payment (Bai Muajjal) or Cost-Plus
Sale (Murabaha)

 Bai Muajjal is a sale where payment of price is

deferred to a future date. Often it includes
features of a Murabaha, which implies a sale on a
cost-plus basis.

 As a financing product, Bai Muajjal and Murabaha

is a very popular, and perhaps the most popular
Islamic financing product. Bai Muajjal is a
Shariah approved mechanism. So is Murabaha.
 A Simple model of Murabaha

• Client identifies supplier of the commodity that

he/ she needs, collects all relevant information;
• Client approaches Bank for Murabaha finance and
promises to buy the commodity from the Bank at a
marked-up price;
• Bank makes payment of base price to supplier;
• Supplier transfers ownership of commodity to
Bank;
• Bank sells it to the Client at marked-up price;
• Client pays marked-up price in full or in parts over
future (known) time period(s).
 4. Leasing (Ijara)

 Ijara in simple terms, implies leasing or hiring

of a physical asset.
 It is a popular product in which the bank
assumes the role of a lessor and allows its
client to use a particular asset that it owns.
 The client or lessee, is in need of the asset.
 Through ijara, it has chance to generate
income using the asset against payment of
predetermined rentals.
 A Simple model of Ijara

1. Client identifies supplier of the asset that

he/she needs, collects all relevant
information;
2. Client approaches Bank for ijara of the asset
and promises to take the asset on lease;
3. Bank makes payment of price to supplier;
4. Supplier transfers ownership of asset to Bank;
5. Bank leases the asset, transfers possession
and right of use to Client;
6. Client pays ijara rentals over future (known)
time period(s).