BBA B&F (2012-16)

HAILEY COLLEGE OG BANKING & FINANCE

Submitted By:
Isma Nizam

M12BBA013

Zartasha Shaukat

M12BBA057

Kehkashan Sakhawat

M12BBA067

Submitted To:
Prof. Riaz Ahmed Mian
Session:
th

BBA B&F 6 semester (2012-16)

Hailey College of Banking & Finance

Table of Content
Sr #

CONTENTS

Page #

Acknowledgement

Dedication

Executive Summary

6-7

Scope of Study

Objective of the study

Methodology

Introduction & Overview of Topic

What is bank

10

History of Banking

11

Islamic Banking

12

Introduction to Islamic Banking

History of Islamic Banking

13
14

Origin, scope & growth

Council for Islamic Ideology

15-16

Global scenario of Islamic Banking

17-20

Modes of Islamic Finance

Murabaha

21

Ijarah

21

Ijarah-Wal-Iqtina

21

Musharakah

22

Musawamah

22

Istisna'a

22

Bai Muajjal

23

Mudaraba

23

Bai Salam

23

Islamic Banking Issues

24-25
2

Conventional Banking
The role of conventional banking

26
27

Products of conventional banking

Transactional account

28

Saving account

29

Certificate of deposit

29

Credit card

30

Debit Card

30

Mortgage Loan

31

Unsecured Debit (personal loan)

31

Loan

31
Islamic Banking VS Conventional Banking

32-43

Similarities & Difference

32

Islamic Banking role in Economic development

44-47

Operational Challenges and Prospects

48

10

The challenges facing individual Islamic banks

49-50

11

The challenge of adopting an Islamic financial system

51-52

12

Motivating Factors for Islamic Banking

53

13

Conclusion

54

14

References

55

Acknowledgement
Thanks and again thanks to Allah Almighty,
who pulled us through the times when every stone was turned against us.
He and only He dawned new horizons for us when the darkest fog made us blind,
who is really the Best Manager of the entire universe.
Without His consent, nothing is possible.
Thank You Allah Almighty.
Thanks from the recesses of our hearts to our to
the Most Respected Teacher, Professor Riaz Ahmed Mian
for his Untiring efforts, His Valuable Guidance and Precious Advices
are rare Assets for Us.

Dedicated to:
Our Honorable Teachers & Loving Parents
Whose,
Love, Affection, Motivation, Patience, Support
&
Spiritual Inspirations
Give us Encouragement,
To all those People who have quenched for Knowledge,
To all those who have dedicated their lives to others,
To all of those who have served and sacrificed for
Sake of Freedom
To all of those people, who may be gone now,
But they will never be
Forgotte....

Executive summary
This study is undertaken to understand the concept of Islamic banking and interest based
banking, the difference between the two systems and their economic implications for an
economy. In general terminologies, a financial institution or a financial intermediary that
accepts deposits and channels those deposits into lending activities, either directly or through
capital markets is given the name of bank. The prime source of revenue and cost of funds to
conventional banks (interest based banks) is charging interest through lending and accepting
deposits for interest respectively. Interest is the major driver of operations of conventional banks
although other valuable services including guarantees, funds transfers, safety of wealth,
facilitation in international trade etc. also form a substantial part of income of banks. Islamic
banking, on the other hand, is a banking system which is in consonance with the spirit, ethos and
value system of Islam and governed by the principles laid down by Islamic Shariah. Interest free
banking is a narrow concept denoting a number of banking instruments or operations which
avoid interest. Islamic banking, the more general term, is based not only to avoid interest -based
transactions prohibited in Islamic Shariah but also to avoid unethical and un-social practices. In
practical sense, Islamic Banking is the transformation of conventional money lending into
transactions based on tangible assets and real services. The model of Islamic banking system
leads towards the achievement of a system which helps achieve economic prosperity.
The origination of term interest dates back to 17th century with the emergence of banking system
at global level. Interest means giving and/or taking of any excess amount in exchange of a loan
or on debt. Hence, it carries the same meaning/value as that of Riba. Further, it is narrated that
the loan that draws interest is Riba. There is consensus among the Muslim scholars of all the
fiqhs that interest is Riba in all its forms and manifestations.
Islamic Financial Institutions (IFIs) are operating in the same society where conventional banks
are operating and perform all those functions which are expected from a financial institution.
IFIs are assisting business world by providing all the services required to run the economy
smoothly, however, the philosophy and operations are different. In this study I will analyze the
operations and products of IFIs in comparison with traditional conventional banks. Any financial
6

system is expected to assist in running the economy by providing the following services grouped
in two headings. First; Savings mobilization from savers to entrepreneurs and Second; Provision
of general utility services including transfer of funds, facilitation in international trades,
consultancy services, safekeeping of valuables, and any other service for a fee. There is no
restriction on provision of such services by IFIs as for the service is not against the Sharia.
However there exists difference in mechanism of funds mobilization from savers to
entrepreneurs as described following. Savings mobilization consists of two phases i.e. accepting
deposits and extending financing and investments.

Scope of the Study

The focus of the study will be on:

Introduction to Islamic banking and interest based banking

Products if Islamic and interest based banking

Difference between interests based and islamic banking.

Major modes of Islamic banking and finance

Practical aspects of Islamic banking and its economy wide implications.

Objectives of the Study

What are Islamic Banking and its philosophy?

What are interests based banking and its philosophy?

What are the basic principles of Islamic banking?

What is the difference between interests based banking and Islamic banking?

Methodology
The material of the study will authentically be obtained from secondary sources such as books,
research reports, and research articles taken from Internet

INTRODUCTION & OVERVIEW OF THE TOPIC

What is bank?
A bank is a financial institution and a financial intermediary that accepts deposits and
channels those deposits into lending activities, either directly or through capital markets.
A bank connects customers that have capital deficits to customers with capital surpluses.
Due to their critical status within the financial system and the economy generally, banks
are highly regulated in most countries. Most banks operate under a system known as
fractional reserve banking where they hold only a small reserve of the funds deposited
and lend out the rest for profit. They are generally subject to minimum capital
requirements which are based on an international set of capital standards, known as the
Basel Accords.

10

History of banking
The History of Banking begins with the first prototype banks of merchants of the ancient
world that made grain loans to farmers and traders carrying goods between cities;
recorded as having occurred at about 2000 BC within the areas of Assyria and Babylonia.
Later on, in ancient Greece and during the Roman Empire, lenders based in temples
made loans and added two important innovations: the accepting of deposits and the
changing of money. Archaeology from this period in ancient China and India shows the
existence also of money lending activity.
Banking, in the modern sense of the word, can be traced to medieval and early
Renaissance Italy, to the rich cities in the north such as Florence, Venice and Genoa. The
Bardi and Peruzzi families dominated banking in 14th century Florence, establishing
branches in many other parts of Europe. Perhaps the most famous Italian bank was the
Medici bank, established by Giovanni Medici in 1397.
The development of banking spread through Europe also and a number of important
innovations took place in Amsterdam during the Dutch Republic in the 16th century and
in London in the 17th century. During the 20th century, developments in
telecommunications and computing resulting in major changes to the way banks operated
and allowed them to dramatically increase in size and geographic spread. The Late-2000s
financial crisis saw significant number of bank failures, including some of the world's
largest banks, and much debate about bank regulation.

11

Islamic banking
Islamic banking is based on the principles of Islamic economics an economic
framework in accordance with Islamic law (Sharia'h).
There are two types of Islamic economics:

Caliphate , the Islamic form of government representing the political unity and
leadership of the Muslim world (Islamic political framework)

Assuming the political framework is non-Islamic, therefore, seeking to integrate

some prominent Islamic tenets into a secular economic framework

Caliphate is the absolute Islamic rule, thus the economy focuses on distribution of
resources in order to meet the basic and luxurious needs of individuals in society, and the
state has a clear role in policing, taxation, managing public assets, and ensuring the
circulation of wealth. Such a political framework in its true form does not exist in today's
world.
Assuming non-Islamic political framework simply proposes two main tenets: no interest
can be earned on loans and socially responsible investing. This is the way interest based
banking is Islamizedthe first step towards an Islamic economic framework.
Modern day Islamic scholars and academics have developed various modes of Sharia'h
complaint financing that are designed to work within the prevailing capitalist economic
framework. In order to achieve this balance numerous concessions have been afforded
to financial institutions that would not apply if a viable interest free economic system
existed. The intention behind making these concessions is to encourage the evolution of
this type of alternative system.

12

Introduction
Islamic banking refers to a system of banking or banking activity that is consistent with
Islamic law (Shariah) principles and guided by Islamic economics. In particular, Islamic
law prohibits usury, the collection and payment of interest, also commonly called riba.
Generally, Islamic law also prohibits trading in financial risk (which is seen as a form of
gambling). In addition, Islamic law prohibits investing in businesses that are considered
unlawful, or haraam.

Islamic finance has been gaining momentum on a global scale for the last 30 years.
Many Islamic Banks have sprung up over the last few years. These changes are occurring
both in Muslim and in western countries, and are driven by a global trend amongst
Muslims to become more observant of their faith. It might have been the reason why
Islamic Banking emerged, however, today Islamic Banking is sought by Muslims and nonMuslims due to the benefits it offers.
Industry size is currently estimated at more than $400 billion, with projected growth of
15% per annum.

Financial institutions around the globe are trying to keep pace with the growing demand
for Shariah compliant products and services.

13

History of Islamic banking

Islamic Banking: Origin, Scope, and Growth
The first modern experiment with Islamic banking was undertaken in Egypt under cover,
for fear of being labeled as a manifestation of Islamic fundamentalism, which was
anathema to the government in power. It took the form of a saving bank based on profitsharing in the town of Mit Ghamr, lasted until 1967, by which time there were nine such
banks in the country. These banks neither charged nor paid interest, invested mostly in
trade and industry, directly or in partnership with others, and shared profits with
depositors. The 1970s heralded the arrival of a new age in Islamic finance witnessing
the establishment of the Nasr Social Bank in 1971 (Egypt), Philippine Amanah Bank in
1973, the Dubai Islamic Bank in 1975, the Kuwait Finance House, the Faisal Islamic
Bank of Sudan, and the Faisal Islamic Bank of Egypt, all in 1977, the Bahrain Islamic
Bank in 1979, and the Qatar Islamic Bank in 1981, to mention a few. By the end of 1996
the number of Islamic banks, IBs, rose to 166 with a total paid-up tier-one capital of $7.3
billion, and total assets of $137 billion. Moreover, if one excludes the Iranian and
Pakistani IBs, the countries that operate under the Islamic system of banking (along
with Sudan), only 40 percent of the paid-up capital and 30 percent of total assets are
commanded by those from other countries. These percentages do not tell the whole
picture. The 19 Gulf Cooperative Council, GCC, states command 18 percent of the total
paid-up capital, and 13 percent of total assets of all IBs. In other words, 10 Iranian, 46
Pakistani, and 19 GCC IBs totaling 75 out of 166, command 78 percent of total paid-up
capital and 83 percent of total assets for the IBs. These numbers appear impressive if
one ignores the size of a single large commercial bank in many developed economies
of the West. Thus, it is quite obvious that IBs are relatively very small and a few of them
are not even profitable

14

COUNCIL FOR ISLAMIC IDEOLOGY

In 1980, a think tank by the name Council of Islamic Ideology (C.I.I.), consisting of 15
eminent jurists, scholars, economist and bankers was formed. Their task was to
recommend to the Federal Government all possible avenues and amendments to bring
the existing laws and practices of the country in conformity with the injunctions of Islam.
C.I.I., after several meetings and extensive brain storming, apart from recommendations
in lieu of other civil and criminal laws, suggested to the Federal Government that an
interest free banking system should be introduced in the country.
Their first recommendation was that Interest, referred to as "Riba" in the Holy Quran,
based on Verses 278 and 279 of Surah Al Baqarah, is Haram. Allah Almighty and his
Messenger (PBUH) have declared war on those who indulge themselves in Riba. C.I.I,
recommended that instead of lending money on basis of interest/ Riba, the financing in
the shape of Islamic financing Bai Muajjal (deferred sale) should be adopted.
In furtherance to the above, the Federal Government adopted the system of mark-up in
January, 1981 and repealed Interest Act, 1839.
On the basis of the foregoing recommendations of the C.I.I., agreed to by the Federal
Government, the State Bank of Pakistan's Banking Control Department, issued Circular
Nos.13 and 32, dated 20th June, 1984 and 26th November, 1984, respectively. Through
the earlier circular, the intention of the government to shift the interest based banking to
Islamic modes of financing was revealed. In that circular, the financial institutions/banks
were barred from receiving any interest bearing deposits from July 1, 1985. As regards
the loaning, it was suggested that the banks should adopt the Islamic mode of financing,
mentioned in the 1st Annexure of the circular, i.e. mark-up (Bai Muajjal), Musharika (profit
loss sharing), Morabaha (hire purchase, leasing etc). The second circular barred the
banks from charging mark-up on mark-up on overdue loans as penalty.

15

The C.I.I., in order to establish interest free/Riba free banking system in Pakistan,
proposed amendments in the following laws:
(a)

The Interest Act of 1839

(b)

The Government Saving Banks Act of 1873 (Section-10)

(c)

The Negotiable Instrument Act of 1881 (Sections-79, 80, 114 & 117)

(d)

The Land Acquisition Act, 1894 (concerned provisions)

(e)

The Code of Civil Procedure, 1908 (concerned provisions)

(f)

The Cooperative Societies Act, 1925 (concerned provisions)

(g)

The Cooperative Societies Rules, 1927 (concerned provisions)

(h)

The Insurance Act, 193 8 (concerned provisions)

(i)

The State Bank of Pakistan Act, 1956 (Section-22(l)

(j)

The West Pakistan Money Landers Ordinance, 1960 (concerned provisions)

(k)

The West Pakistan Money Lenders Rules, 1965 (concerned provisions)

(1)

The Punjab Money Lenders Ordinance, 1960 (concerned provisions)

(m) The Sindh Money Lenders Ordinance, 1960 (concerned provisions)

(n)

The NWFP Money Lenders Ordinance, 1960 (concerned provisions)

(o)

The Baluchistan Money Lenders Ordinance, 1960 (concerned provisions)

(p)

The Agricultural Development Banks Rules 1961 (Rule No. 17 (1) (2) & (3)

(q)

The Banking Companies Ordinance, 1962 (Section 25 (2a&b)) (r)

The Banking

Companies Rules, 1963 (Rule No.9 (2&3)

(s)

The Banks (Nationalization) Payment of Compensation Rules, 1974 (Rule 9)

(t)

The Banking Companies (Recovery of Loans) Ordinance, 1979 (Section 8(2a&b)

(u)

The Constitution of Pakistan 1973 (Article No.203 (a) to 203(j) and 270(a)

16

Islamic Banking Global Scenario

Over the last three decades Islamic banking and finance has developed into a fullfledged system and discipline reportedly growing at the rate of 15percent per annum.
Today, Islamic financial institutions, in one form or the other, are working in about 75
countries of the world. Besides individual financial institutions operating in many
countries, efforts have been underway to implement Islamic banking on a country wide
and comprehensive basis in a number of countries. The instruments used by them, both
on assets and liabilities sides, have developed significantly and therefore, they are also
participating in the money and capital market transactions. In Malaysia, Bahrain and a
few other countries of the Gulf, Islamic banks and financial institutions are working
parallel with the interest based system.
Bahrain with the largest concentration of Islamic financial institutions in the Middle East
region, is hosting 26 Islamic financial institutions dealing in diversified activities including
commercial banking, investment banking, offshore banking and funds management. It
pursues a dual banking system, where Islamic banks operate in the environment in
which Bahrain Monetary Agency (BMA) affords equal opportunities and treatment for
Islamic banks as for interest based banks. Bahrain also hosts the newly created
Liquidity Management Centre (LMC) and the International Islamic Financial Market
(IIFM) to coordinate the operations of Islamic banks in the world. To provide appropriate
regulatory set up, the BMA has introduced a comprehensive prudential and reporting
framework that is industry-specific to the concept of Islamic banking and finance.
Further, the BMA has pioneered a range of innovations designed to broaden the depth
of Islamic financial markets and to provide Islamic institutions with wider opportunities to
manage their liquidity.
Another country that has a visible existence of Islamic banking at comprehensive level
is Malaysia where both interest based and Islamic banking systems are working in a

17

competitive environment. The share of Islamic banking operations in Malaysia has

grown from a nil in 1983 to above 8 percent of total financial system in 2003. They have
a plan to enhance this share to 20 percent by the year 2010. However, there are some
conceptual differences in interpretation and Shariah position of various contracts like
sale and purchase of debt instruments and grant of gifts on savings and financial
papers.
In Sudan, a system of Islamic banking and finance is in operation at national level. Like
other Islamic banks around the world the banks in Sudan have been relying in the past
on Murabaha financing. However, the share of Musharaka and Mudaraba operations is
on increase and presently constitutes about 40 percent of total bank financing. Although
the Islamic financial system has taken a good start in Sudan, significant problems still
remain to be addressed.
Like Sudan, Iran also switched over to Usury Free Banking at national level in March
1984. However, there are some conceptual differences between Islamic banking in Iran
and the mainstream movement of Islamic banking and finance.
Owing to the growing amount of capital availability with Islamic banks, the refining of
Islamic financing techniques and the huge requirement of infrastructure development in
Muslim countries there has been a large number of project finance deals particularly in
the Middle East region. Islamic banks now participate in a wide financing domain
stretching from simple Shariah-compliant retail products to highly complex structured
finance and large-scale project lending. These projects, inter alia, include power
stations, water plants, roads, bridges and other infrastructure projects. Bahrain is the
leading centre for Islamic finance in the Middle East region. The establishment of the
Prudential Information and Regulatory Framework for Islamic Banks (PIRI) by the BMA
in conjunction with AAOIFI has gone a long way towards establishing a legal and
regulatory framework to meet the specific risks inherent in Islamic financing structures.

18

The BMA has quite recently signed MoU with the London Metal Exchange (LME) to pool
assets to develop and promote Shariah compliant tradable instruments for Islamic
banking industry. The arrangement is seen as a major boost for industrys integration in
the global financial system and should set the pace for commodity-trading environment
in Bahrain. BMA has also finalized draft guidelines for issuance of Islamic bonds and
securities from Bahrain. In May 03, the Liquidity Management Centre (LMC) launched
its debut US$ 250 million Sukuk on behalf of the Government of Bahrain.
National Commercial Bank (NCB) of Saudi Arabia has introduced an Advance Card that
has all the benefits of a regular credit card. The card does not have a credit line and
instead has a prepaid line. As such, it does not incur any interest. Added benefits are
purchase protection, travel accident insurance, etc and no interest, no extra fees with
any conditions, the card is fully Shariah compliant. It is more secure than cash, easy to
load up and has worldwide acceptance. This prepaid card facility is especially attractive
to women, youth, self employed and small establishment employees who sometimes do
not meet the strict requirements of a regular credit card facility. Saudi Government has
also endorsed an Islamic-based law to regulate the kingdom's lucrative Takaful sector
and opened it for foreign investors.
Islamic banks have also built a strong presence in Malaysia, where Standard & Poor's
assigned a BBB+ rating to the $600 million Sharia-compliant trust certificates (called
Sukuk) issued by Malaysia Global Sukuk Inc. Bank Negara Malaysia (BNM) has
announced to issue new Islamic Bank licenses to foreign players. The Financial Sector
Master plan maps out the liberalization of Malaysia's banking and insurance industry in
three phases during the next decade. It lists incentives to develop the Islamic financial
sector and enlarge its market share to 20 percent, from under 10 percent now. A
dedicated high court has been set up to handle Islamic banking and finance cases.
In United Kingdom, the Financial Services Authority is in final stages of issuing its first
ever Islamic banking license to the proposed Islamic Bank of Britain, which has been

19

sponsored by Gulf and UK investors. The United States of America has appointed Dr.
Mahmud El Gamal, an eminent economist/expert on Islamic banking to advise the US
Treasury and Government departments on Islamic finance in June 2004.

20

Modes of Islamic Finance

Murabaha
Literally it means a sale on mutually agreed profit. Technically, it is a contract of sale in
which the seller declares his cost and profit. Islamic banks have adopted this as a mode
of financing. As a financing technique, it involves a request by the client to the bank to
purchase certain goods for him. The bank does that for a definite profit over the cost,
which is stipulated in advance.

Ijarah
Ijarah is a contract of a known and proposed usufruct against a specified and lawful
return or consideration for the service or return for the benefit proposed to be taken, or
for the effort or work proposed to be expended. In other words, Ijarah or leasing is the
transfer of usufruct for a consideration which is rent in case of hiring of assets or things
and wage in case of hiring of persons.

Ijarah-Wal-Iqtina
A contract under which an Islamic bank provides equipment, building or other assets to
the client against an agreed rental together with a unilateral undertaking by the bank or
the client that at the end of the lease period, the ownership in the asset would be
transferred to the lessee. The undertaking or the promise does not become an integral
part of the lease contract to make it conditional. The rentals as well as the purchase price
are fixed in such manner that the bank gets back its principal sum along with profit over
the period of lease.
21

 Musharakah
Musharakah means a relationship established under a contract by the mutual consent of
the parties for sharing of profits and losses in the joint business. It is an agreement under
which the Islamic bank provides funds, which are mixed with the funds of the business
enterprise and others. All providers of capital are entitled to participate in management,
but not necessarily required to do so. The profit is distributed among the partners in preagreed ratios, while the loss is borne by each partner strictly in proportion to respective
capital

contributions.

Musawamah
Musawamah is a general and regular kind of sale in which price of the commodity to be
traded is bargained between seller and the buyer without any reference to the price paid
or cost incurred by the former. Thus, it is different from Murabaha in respect of pricing
formula. Unlike Murabaha, seller in Musawamah is not obliged to reveal his cost. Both
the parties negotiate on the price. All other conditions relevant to Murabaha are valid for
Musawamah as well. Musawamah can be used where the seller is not in a position to
ascertain precisely the costs of commodities that he is offering to sell.

Istisna'a
It is a contractual agreement for manufacturing goods and commodities, allowing cash
payment in advance and future delivery or a future payment and future delivery. Istisna'a
can be used for providing the facility of financing the manufacture or construction of
houses, plants, projects and building of bridges, roads and highways.

22

 Bai Muajjal
Literally it means a credit sale. Technically, it is a financing technique adopted by Islamic
banks that takes the form of Murabaha Muajjal. It is a contract in which the bank earns a
profit margin on his purchase price and allows the buyer to pay the price of the commodity
at a future date in a lump sum or in installments. It has to expressly mention cost of the
commodity and the margin of profit is mutually agreed. The price fixed for the commodity
in such a transaction can be the same as the spot price or higher or lower than the spot
price.

Mudaraba
A form of partnership where one party provides the funds while the other provides
expertise and management. The latter is referred to as the Mudarib. Any profits accrued
are shared between the two parties on a pre-agreed basis, while loss is borne only by the
provider of the capital.

Bai Salam
Salam means a contract in which advance payment is made for goods to be delivered
later on. The seller undertakes to supply some specific goods to the buyer at a future date
in exchange of an advance price fully paid at the time of contract. It is necessary that the
quality of the commodity intended to be purchased is fully specified leaving no ambiguity
leading to dispute. The objects of this sale are goods and cannot be gold, silver or
currencies. Barring this, Bai Salam covers almost everything, which is capable of being
definitely described as to quantity, quality and workmanship

23

Islamic Banking Issues

o Human resource for Sharia'h compliance
Users of Islamic financial services assign primary importance to Sharia'h compliance of
the services they use. It is understandable that Sharia'h noncompliance entails a serious
operational risk and can result in withdrawal of funds from and instability of an Islamic
bank, irrespective of its initial financial soundness. Sharia'h compliance is hence a serious
matter for an Islamic bank, in addition to its compliance with other regulatory
requirements.

o Unresolved Fiqh Issues

Lack of standard financial contracts and products can be a cause of ambiguity and a
source of dispute and cost. In addition, without a common understanding of certain basic
foundations, further development of banking products is hindered.

o Legal framework
An appropriate legal, institutional and tax framework is a basic requirement for
establishing sound financial institutions and markets. Islamic jurisprudence offers its own
framework for the implementation of commercial and financial contracts and transactions.
Nevertheless, commercial, banking and company laws appropriate for the enforcement
of Islamic banking and financial contracts do not exist in many countries.
24

o Excess Liquidity
Islamic banks have over 60 % excess liquid funds which cannot be properly utilized due
to non-availability of Sharia'h Compliant products and instruments.
The competitiveness and soundness of financial institutions depend on the availability of
efficient financial products. Islamic banks urgently need Sharia'h compliant products to
meet a number of pressing needs.

25

Conventional Banking
Interest based banking is based on the principle that the more you have, the more you
can get. In other words, if you have little or nothing, you get nothing. As a result, more
than half the population of the world is deprived of the financial services of the interest
based banks. Interest based banking is based on collateral. Interest based banks look at
what has already been acquired by a person Interest based banks go into punishment
mode when a borrower is taking more time in repaying the loan than it was agreed upon.
They call these borrowers defaulters. When a client gets into difficulty, interest based
banks get worried about their money, and makes all efforts to recover the money,
including taking over the collateral. In interest based banks charging interest does not
stop unless specific exception is made to a particular defaulted loan. Interest charged on
a loan can be multiple of the principal, depending on the length of the loan period.

26

The role of Conventional banks

Interest based banks engage in the following activities:
Processing of payments by way of telegraphic transfer, internet banking, or other
means
Issuing bank drafts and bank cheques
Accepting money on term deposit
Lending money by overdraft, installment loan, or other means
Providing documentary and standby letter of credit, guarantees, performance
bonds, securities underwriting commitments and other forms of off balance sheet
exposures
Safekeeping of documents and other items in safe deposit boxes
Sales, distribution or brokerage, with or without advice, of: insurance, unit trusts
and similar financial products as a financial supermarket
Cash management and treasury
merchant banking and private equity financing
Traditionally, large interest based banks also underwrite bonds, and make
markets in currency, interest rates, and credit-related securities, but today large
interest based banks usually have an investment bank arm that is involved in the
mentioned activities

27

Products of conventional banking

Products offered by mostly interest based banking usually called interest based banking
are given below

Transactional account

Savings account

Certificate of deposit

Credit card

Debit card

Mortgage loan

Unsecured debt(personal loan)

Loan

i.

Transactional account

A transactional account is a deposit account held at a bank or other financial institution,

for the purpose of securely and quickly providing frequent access to funds on demand,
through a variety of different channels.
Transactional accounts are meant neither for the purpose of earning interest nor for the
purpose of savings, but for convenience of the business or personal client; hence do they
tend not to bear interest. Instead, a customer can deposit or withdraw any amount of
money any number of times, subject to availability of funds.

28

ii.

Savings account

savings accounts are accounts maintained by retail financial institutions that

pay interest but cannot be used directly as money in the narrow sense of a medium of
exchange (for example, by writing a check). These accounts let customers set aside a
portion of their liquid assets while earning a monetary return. For the bank, money in a
savings account may not be callable immediately and therefore often does not incur
a reserve requirement freeing up cash from the bank's vault to be lent out with interest.
Withdrawals from a savings account are occasionally costly, and they are more timeconsuming than withdrawals from a demand (current) account. However, most saving
accounts do not limit withdrawals, unlike certificates of deposit. In the United States,
violations of Regulation D often involve a service charge, or even a downgrade of the
account to a checking account. With online accounts, the main penalty is the time required
for the Automated Clearing House to transfer funds from the online account to a "brick
and mortar" bank where it can be easily accessed. During the period between when funds
are withdrawn from the online bank and transferred to the local bank, no interest is
earned.

iii.

Certificate of deposit

A certificate of deposit (CD) is a time deposit, a financial product commonly offered to

consumers in the United States by banks, thrift institutions, and credit unions.
CDs are similar to savings accounts in that they are insured and thus virtually risk free;
they are "money in the bank". CDs are insured by the Federal Deposit Insurance
Corporation (FDIC) for banks and by the National Credit Union Administration (NCUA) for
credit unions. They are different from savings accounts in that the CD has a specific, fixed
term (often monthly, three months, six months, or one to five years), and, usually, a fixed
interest. It is intended that the CD be held until maturity, at which time the money may be
withdrawn together with the accrued interest.
29

In exchange for keeping the money on deposit for the agreed-on term, institutions usually
grant higher interest rates than they do on accounts from which money may be withdrawn
on demand, although this may not be the case in an inverted yield curve situation. Fixed
rates are common, but some institutions offer CDs with various forms of variable rates.

iv.

Credit card

Credit card is a small plastic card issued to users as a system of payment. It allows its
holder to buy goods and services based on the holder's promise to pay for these goods
and services. The issuer of the card creates a revolving account and grants a line of
credit to the consumer (or the user) from which the user can borrow money for payment
to a merchant or as a cash advance to the user.
A credit card is different from a charge card: a charge card requires the balance to be
paid in full each month. In contrast, credit cards allow the consumers a continuing balance
of debt, subject to interest being charged. A credit card also differs from a cash card, which
can be used like currency by the owner of the card. Most credit cards are issued
by banks or credit unions, and are the shape and size specified by the ISO/IEC
7810 standard as ID-1. This is defined as 85.60 53.98 mm (33/8 21/8 in) in size.

v.

Debit card

A debit card (also known as a bank card or check card) is a plastic card that provides the
cardholder electronic access to his or her bank account(s) at a financial institution. Some
cards have a value with which a payment is made, while most relay a message to the
cardholder's bank to withdraw funds from a designated account in favor of the payee's
designated bank account. The card can be used as an alternative payment method
to cash when making purchases. In some cases, the primary account number is assigned
exclusively for use on the Internet and there is no physical card.
In many countries, the use of debit cards has become so widespread that their volume
has overtaken or entirely replaced checks and, in some instances, cash transactions. The
development of debit cards, unlike credit cards, has generally been country specific
30

resulting in a number of different systems around the world, which were often
incompatible. Since the mid 2000s, a number of initiatives have allowed debit cards
issued in one country to be used in other countries and allowed their use for internet and
phone purchases.
Unlike credit cards, the funds paid using a debit card are transferred from the bearer's
bank account, instead of having the bearer pay back the money at a later date.
Debit cards usually also allow for instant withdrawal of cash, acting as the ATM card for
withdrawing cash. Merchants may also offer cash back facilities to customers, where a
customer can withdraw cash along with their purchase

vi.

Mortgage loan

A mortgage loan is a loan secured by real property through the use of a mortgage
note which evidences the existence of the loan and the encumbrance of that realty
through

the

granting

of

mortgage

which

secures

the

loan.

However,

the

word mortgage alone, in everyday usage, is most often used to mean mortgage loan.
The word mortgage is a Law French term meaning "death contract," meaning that the
pledge ends (dies) when either the obligation is fulfilled or the property is taken
through foreclosure.
A home buyer or builder can obtain financing (a loan) either to purchase or secure against
the property from a financial institution, such as a bank, either directly or indirectly through
intermediaries. Features of mortgage loans such as the size of the loan, maturity of the
loan, interest rate, method of paying off the loan, and other characteristics can vary
considerably.
In many jurisdictions, though not all (Bali, Indonesia being one exception), it is normal for
home purchases to be funded by a mortgage loan. Few individuals have enough savings
or liquid funds to enable them to purchase property outright. In countries where the
demand for home ownership is highest, strong domestic markets have developed.

31

vii. Unsecured debt (personal loan)

n finance, unsecured debt refers to any type of debt or general obligation that is not
collateralized by a lien on specific assets of the borrower in the case of a bankruptcy or
liquidation or failure to meet the terms for repayment.
In the event of the bankruptcy of the borrower, the unsecured creditors will have a general
claim on the assets of the borrower after the specific pledged assets have been assigned
to the secured creditors, although the unsecured creditors will usually realize a smaller
proportion of their claims than the secured creditors.
In some legal systems, unsecured creditors who are also indebted to the insolvent debtor
are able (and in some jurisdictions, required) to set-off the debts, which actually puts the
unsecured creditor with a matured liability to the debtor in a pre-preferential position.

viii. Loan
A loan is a type of debt. Like all debt instruments, a loan entails the redistribution of
financial assets over time, between the lender and the borrower.
In a loan, the borrower initially receives or borrows an amount of money, called
the principal, from the lender, and is obligated to pay back or repay an equal amount of
money to the lender at a later time. Typically, the money is paid back in
regular installments, or partial repayments; in annuity, each installment is the same
amount.
The loan is generally provided at a cost, referred to as interest on the debt, which provides
an incentive for the lender to engage in the loan. In a legal loan, each of these obligations
and restrictions is enforced by contract, which can also place the borrower under
additional restrictions known as loan covenants. Although this article focuses on monetary
loans, in practice any material object might be lent.

32

Islamic Banking Vs Conventional banking

The main difference between Islamic and interest based banking is that Islamic teaching
says that money itself has no intrinsic value, and forbids people from profiting by lending
it, without accepting a level of risk in other words, interest (known as "riba") cannot be
charged.
To make money from money is prohibited wealth can only be generated through
legitimate trade and investment. Any gain relating to this trading is shared between the
person providing the capital and the person providing the expertise.
At Islamic Bank of Britain, we generate all our profit through Shariah compliant trading
and investment activities. We then share the profits with our customers at a pre-agreed
ratio. In order to share profits you must hold one of our savings or investment accounts
There are two major differences between Islamic Banking and Interest based banking:
1. Interest based banking practices are concerned with "elimination of
risk" where as Islamic banks "bear the risk" when involve in any
transaction.
2. When Interest based banks involve in transaction with consumer they
do not take the liability only get the benefit from consumer in form of
interest whereas Islamic banks bear all the liability when involve in
transaction with consumer. Getting out any benefit without bearing its
liability is declared Haram in Islam.

While the basics of what the business is are the same, the term refers to operating the
business within Islamic law. The main thing that affects this business under that law is
that Islam prohibits the charging of interest. Certainly a problem in modern banking!
33

However, what is considered to be interest has different definitions by different Islamic

scholars...some say it can only be considered on gold and silver...but paying back the
same weight as you borrowed (the same weight of paper money for example), is not
interest. Like in all religious things, there would seem to be some conflict and
differences between followers that may seem strange to outsiders.
So basically, modern Islamic banking may take many forms, each of which strives to
adhere to it understands of Islamic law

34

Similarities and Differences

Islamic Financial Institutions (IFIs) are operating in the same society where interest
based banks are operating and perform all those functions which are expected from a
financial institution. IFIs are assisting business world by
providing all the services required to run the economy smoothly, however, the
philosophy and operations are different. In this section I will analyze the
operations and products of IFIs in comparison with traditional
Interest based banks. Any financial system is expected to assist in running the economy
by providing the following
Services grouped in two headings. First; Savings mobilization services,
Safekeeping of valuables, and any other service for a fee. There is from savers to
entrepreneurs and Second; Provision of general utility services including transfer of
funds, facilitation in international trades, consultancy no restriction on provision of
such services by IFIs as for the service is not against the Sharia. However there
exists difference in mechanism of funds mobilization from savers to entrepreneurs as
described following. Savings mobilization consists of two phases i.e.
Accepting deposits and extending financing and investments.

35

Deposits

Deposits are collected from savers under both types of institutions for reward irrespective
a bank is operating under interest based system or Islamic system. The difference lies in
agreement of reward. Under interest based system reward is fixed and predetermined
while under Islamic deposits are accepted through Musharaka and Mudaraba where
reward is variable. Under interest based banking return is higher on long-term
deposits and lower for short-term deposits. Same is the practice in Islamic banking
to share profit with depositors. Higher weight for profit sharing is assigned to longterm deposits being available to bank for investing in longer term projects yielding
superior returns and lower weight for short-term deposits which cannot be invested in
long term projects. The only difference in interest based and Islamic system lies in
sharing of risk and reward. Under interest based system total risk is born by the bank
and total reward belongs to it after servicing the depositors at fixed rate while under
Islamic system risk and reward both are shared with depositors. Reward of
depositors is linked with outcomes of investments made by IFIs. Under Islamic financial
system only those IFIs will be able to collect deposits who can establish trust in the
eyes of masses hence leading to optimal performance by financial industry. So for
IFIs workings in Pakistan have succeeded in establishing their credibility in the eyes of
savers.

36

Financing and Investments

The second phase in savings mobilization process is extension of credit facility to
business and industry for return. Both types of institutions (Islamic and Interest
based) are providing financing to productive channels for reward. The difference lies
in financing agreement. Interest based banks are offering loan for a fixed reward while
IFIs cannot do that because they cannot charge interest. IFIs can charge profit on
investments but not interest on loans. In interest based banking three types of loans are
issued to clients including short term loans, overdrafts and long-term loans. Islamic
banks

cannot

issue loans except

interest

free loans (Qarz

e Hasna)

for any

requirement however they can do business by providing the required asset to client.
In following paragraphs I present the comparative working of different products (financing
scheme) of both systems.

Overdrafts / Credit Cards

Interest based banks offer the facility of overdrawing from account of the customer on
interest. One of its form is use of credit card whereby limit of overdrawing for customer is
set by the bank. Credit card provides dual facility
To customer including financing as well as facility of plastic money whereby customer can
meet his requirement without carrying cash. As for facility of financing is concerned that
is not offered by Islamic banks except in the
form of Murabaha (which means IFI shall deliver the desired commodity and not
the cash) however facility to shop/meet requirement is provided through debit card
whereby a customer can use his card if his account carries
Credit balance. Under interest based banking a customer is charged with interest once
the facility availed however under Murabaha only profit is due when the commodity
is delivered to the customer. Furthermore in case of
37

default customer is charged with further interest for the extra period under interest
based system however extra charging is not allowed under Murabaha.

Third

under

interest based

system

customer

can

avail

the

opportunity

of

rescheduling by entering into a new agreement to pay interest for extended period
which is not the case under Murabaha. IFIs can claim only the original receivable
amount agreed in initial contract. Another practical issue under Murabaha is how to deal
with intentional defaulters. Different options are lying with IFIs including to blacklist
the defaulter for any further financing facility, to stipulate in the contract that in case of
default all installments will be due at once, to stipulate in the contract a penalty shall be
imposed but the same shall not form income of IFIs rather it will go in charity

38

Short term loans

Short term and medium term loans are provided to customer to meet working
capital requirements of firm by interest based banks. Working capital is required by
firms to invest in inventories and accounts receivables and meet the expenses. As
for inventory investment is concerned that is provided by Islamic banks through
Murabaha. As for meeting of day to day expenses of business is concerned financing
is provided through participation term
certificates where by profit of a certain period (e.g. quarter, six month, one year)
is shared by IFIs on prorate basis. However financing through participation term
certificates is not as easy as a short term loan from
interest based bank due to risk involved for IFIs in the transaction. Firm seeking shortterm facility from IFIs has to prove the viability of the project/business to the
satisfaction of investor. For meeting the working capital requirements of nonprofit
organizations to date there is no arrangement under Islamic financial system. Personal
consumption loans are also not issued by IFIs how ever any individual of sound
financial position can acquire anything for his personal use under Murabaha financing
whereby a certain percentage of profit is added on cost by IFIs. Murabaha financing is
very useful for short to medium term financial requirements of business/nonprofit
organizations and individuals. Murabaha financing is asset based financing and anyone
can request to an IFI for provision of an asset generally used for Halal (lawful)
purposes. By default under Islamic financial system IFIs cannot lend cash for interest
(only exception is Qarz e HasnaCharity loan). One of the features of Murabaha is in
case of delay in payment by customer IFI cannot ask for extra amount as time value of
money like interest based banks. However penalty is imposed on defaulter if stipulated
in original contract of Murabaha duly signed by the customer but same cannot be
included in the income of IFI. This penalty must be spent for charitable purposes.

39

Under Murabaha scheme of financing facility is linked with assets which leads to
economic stability and creates
linkage between real and financial sector. It is not zero sum game because utility is
created through services and products and not by mere building the blocks of wealth
through dealing in paper money. Although Murabaha is being used by IFIs successfully
and have succeeded in meeting short to medium term requirements of firms by
providing a successful replacement of interest based loans yet certain differences
exist in both type of financing. First is one cannot get cash under Murabaha.
Second asset is purchased by IFI initially then transferred to customer hence IFI
participate in risk.
Third refinancing facility is not available under Murabaha. Fourth in case of default
price of the commodity cannot be enhanced however penalty may be imposed if
stipulated in original contract of Murabaha however same
cannot be included in income of IFI. Fifth only those assets can be supplied by
IFIs under Murabaha whose general and/or intended use is not against the injunctions
of Sharia (e.g. supply of a machine to produce liquor)

40

Medium to long term loans

Medium to long-term loans are provided for purchase or building of fixed assets by firms
to expand or replace the existing assets. Under Islamic financial system requirement
of firms and individuals are fulfilled through Murabaha, Bai Muajjal and Istasna
(discussed in appendix B). Another financing option for long-term financing is profit
sharing under Musharaka and Mudaraba (discussed in appendix B). Although financing
under Murabaha, Bai Muajjal and Istasna is very much look like interest based loans
with the only difference of provision of asset and not cash to client however differences
exist in the contracts which alter the nature of risks and returns. Financing under
Musharaka and Mudaraba is challenging for IFIs and firms as well. Under Sharia based
financing
schemes firms have to prove the viability/profitability of the project/business to the
satisfaction of IFIs to get the finance because risk of losing the amount is involved.

Leasing
Leasing is relatively recent source of financing whereby usufruct of an asset is
transferred to lessee for agreed amounts of rentals. Under leasing ownership may or
may not be transferred.
Same facility is provided by IFIs under agreement of Ijara. Under Ijara asset is provided
to customer for use with out transfer of ownership for a specific period of time in
exchange for agreed rentals. Ownership of asset can be
transferred to customer through mutual agreement at the completion of lease term. All
ownership risks are born by IFIs during Ijara tenure. Certain differences exist in the
transaction under both systems. First is rental under
Ijara are not due until asset is delivered to the lessee for use. Second additional rent
cannot be demanded in case of default except a penalty (if stipulated in original contract
of lease) which is not the income of IFI. Third during period of major repair rent cannot be
41

demanded by IFI. Fourth if asset is lost or destroyed IFI cannot claim further installments
hence all risks of ownership are born by IFI

Agricultural Loans
Agricultural loans include both types of loans short-term as well as long-term. Shortterm loans are required by farmers for seeds and fertilizers and long-term loans
are required to develop additional lands and purchase of equipments. Normally
farmers return these loans after selling the finished crops. Interest based banks
are providing credit facility by charging interest. Same facility is provided by IFIs to the
farmers under Bai Slam, Bai Murabaha Musharaka and Mudaraba (discussed in appendix
B). Under Bai Salam cash is provided to farmers for purchase of seeds and fertilizers
however this is not loan rather purchase of finished crops to be delivered by
farmers. For purchase of equipments Murabaha facility is used and for development of
additional land Musharaka and Mudaraba is used by IFIs. To get finance for land
development farmers have to convince the IFIs about profitability of the venture due
to risk involved in the transaction.

House financing
Housing finance/Mortgages is the more secured form of financing for both interest
based banks and IFIs. Under interest based system loan is provided for interest while
under Islamic financial system facility is provided through diminishing Musharaka. Under
diminishing Musharaka house is purchased jointly by IFI and customer. IFI rents out
its share in property to customer for an agreed amount of rent. Share of financier is
divided in units of small denomination. Customer pays the installments to IFI consist
of rentals plus purchase price of a unit. Stake of customer in property is increasing
while of IFI is decreasing with payment of every installment. Finally with the payment
of last installment stake of IFI reaches to zero and property is transferred in the
name of customer.
42

Diminishing Musharaka model can help out in avoiding the real estate crisis (like of 2008)
because

when market value of property decreases both IFI and customer suffers

according to their share in property and whole burden is

not shifted on customer alone. Hijazi, & Hanif (2010) have raised certain questions
about the existing practice of IFIs working in Pakistan and needs to be addressed by
policymakers, Sharia boards and management of IFIs.

Investments
In order to maintain liquidity interest based banks have many avenues including
government securities, shorter term loans and money at call and short notices, leasing
companies bonds, investment in shares

etc.

Interestingly mandatory reserve

maintenance by interest based banks with central banks is also rewarded in the form of
interest. Interest based banks can also create liquidity by issuing the bonds against their
receivables. Commercial banks are also protected by central bank by providing
liquidity in rainy days for interest. Interbank deposits are also rewarded in the form
of interest by commercial banks.For IFIs avenues are very limited to create required
liquidity at the same time to earn some revenue by investing in short term and liquid
securities. IFIs cannot invest in government securities, short term loans, bonds and
money at call and short notices because of interest based transactions.
Mandatory reserve with central bank is maintained by IFIs but they are not
rewarded like interest based banks. Looking towards central bank in rainy days to
maintain liquidity is also not as straightforward due to interest demand of central
bank. IFIs cannot demand interest on interbank deposits.

As for investment in

market able securities are concerned again IFIs are not free to invest in any equity
security due to two reasons. First Halal business of the underlying firm is required.
Second financial operations of underlying firm should be interest free.
Keeping

in view the dominance of interest based banking

and existing business

practices one can conclude safely that a very negligible number of firms meet both
conditions.

The much appreciable job has been done by

43

Almeezan investment management limited (AIML) a subsidiary of leading Islamic

bank in Pakistan (Meezan bank) in this regard. A list of Sharia compliant securities is
being maintained and updated every six monthly out
of which 30 companies are selected for Kse Meezan Index (KMI). KMI was
established in June 2008.IFIs can invest only in those securities which are declared
Sharia compliant securities through filtering of Sharia
compliance criteria.

44

Islamic banking playing role in the economic

development of the world
Islamic banking is unique, but by no means anomalous. It is neither at odds with nor
incomparable to interest based banking. Is it possible to contrast the two models?
I-They are both financial intermediations. A financial intermediary is the institution that
acts as a middleman between cash surplus units (savers) and deficit spending units
(users of fund). It is quite obvious that the main function of interest based banks is
financial intermediation. However, there are those who would like to think that there is
no such thing in the Islamic economic system as financial intermediation and that an
Islamic bank can only be sufficiently Islamic if it can operate like a trader, one who
buys and sells goods and commodities.
The financial intermediary in interest based banking is a borrower-lender institution.
Since such institution will not survive unless it at least covers expenses, then an
income must be generated from such arrangement. This is where interest appears. An
Islamic bank, on the other hand, is based on a multi-tier Mudarabah. A Mudarabah is
a partnership in profit where capital and management may joint together to create
value. The income accruing to the Islamic financial intermediary is coming out of profit
not from interest. The root of such a conception is the fact that Shari'ah doesnt
distinguish between a seller being a trader or a final intermediary, unlike positive law
where civil law is different from commercial law. In Shari'ah all people stand against
one legal code.
II-A case in mind is Murabaha. There are those who say if an Islamic bank does
Murabaha any other form but the traders way of doing things it will not be permissible
from Shari'ah point of view, and an Islamic bank would be in their view a dubious

45

interest based bank. They say: since it is never the intention of the bank, to own there
assets and hold on to them then, such bank is not sufficiently Islamic.
According to this viewpoint, an Islamic bank must have huge warehouses and elegant
stores full of goodies for sale. This is not valid and those who think so miss two
important points:
Intention is of no consequence on the permissibility or otherwise of any exchange
contract in Shari'ah. In an authentic Hadith, the Prophet (PBUH) showed one
companion how to substitute a usurious transaction by another non usurious to reach
the same purpose, He (PBUH) didnt object to the intention nor that he nullified the
contract on the basis of intention. Rather he corrected the form of contract.
If the anatomy of the contract is in line with Shari'ah requirements, then the transaction
is acceptable. Hence, if bank actually buys and then sells, with ownership passing from
seller to buyer and that the subject of contract is a good or commodity then the
transaction is correct. In interest based banking the subject of contract is money hence
any increase is usurious.
III-The way interest based banks render financial intermediation is very simple. They
borrow money and lend money. Both assets and liabilities are one form of lending.
Islamic banking function in a rather elaborate (not perplexing) way. They have to
continuously innovate to satisfy the needs of their clients. It is because of this we see
Murabaha, Musharakah, Mudarabah, Istisnaa, Salam to name just a few Islamic
modes of finance. This makes the job of an Islamic banker not all roses, but certainly
a more interesting one.
IV-A interest based banker is a risk manger. He is concerned with all kind of credit,
market, interest rate, legal and other risk factors. An Islamic banker should be just as
concerned. However, there is one added risk for the Islamic banker, this is what we

46

may call Shari'ah disobservance risk. Risk analysis refer to the forces that may cause
the outcome of investment to be sub optimal. Certainly an Islamic investor
earning non-permissible income is an outcome that is most undesireous, and it may
cause the value of his investment to be reduced.
V-Contrary to popular opinion, being concerned about time value of money is a
similarity not a difference between Islamic and interest based banking. There is no
basis for the current thinking that Shari'ah doesnt allow the attachment of monetary
value to time in the contracts exchange. The contract of Salam and differed-payment
sales fly in the face of this argument. It is only in loans that Shari'ah requires that no
time value of money is considered (but replaced by great rewards in the hereafter).
VI-A major difference, however, remains in the handling of delinquency and default.
When a borrower delays payment of debt, interest will accrue on his delayed portion.
Unless, such borrower defaults and become incapable of paying back his debt, such
interest will compensate the interest based bank for lost business. This cant be done
in Islamic banking as this is considered usurious.
Clearly, this is a disadvantage from two aspects: Firstly, an Islamic bank will not have
the opportunity in a Murabaha transaction for example, to be compensated for lost
profit. But more importantly, it increases significantly, the Murabaha risks. Since bank
clients are rational people who will seize an opportunity when they see one, they will
always delay payment. One major Ijtihad of contemporary Shari'ah scholars, is to allow
the Islamic bank to impose penalties. Rather than accrue such penalties as income,
and hence become usurious, they are disposed off to charity. This way the pressure
will mount on the debtor to pay in time, without falling into Shari'ah impressibility.

47

Operational Challenges and Prospects

Both the theory of Islamic banking and the rapid expansion of Islamic banks recent years
have demonstrated the viability and feasibility of non-interest-based operations. This must
be surprising to those who believed that banks and financial systems could not operate
in a modern economy without reliance on an interest rate mechanism. Indeed, experience
has shown that Islamic banks are powerful means of mobilizing resources. Operationally,
however, both the Islamic financial systems in the three countries that have adopted it as
well as individual Islamic banks face challenges that need to be addressed.
The most important among these challenges is the fact that, while it has been relatively
easy to create a system in which deposits do not pay interest, the asset portfolios of
Islamic banks do not contain sufficiently strong components that are based on profitsharing. The main reasons for this are: (a) lack of a legal and institutional framework to
facilitate appropriate contracts as well as mechanisms to enforce them; and/or (b) lack of
appropriate menus containing a broad range and a variety of maturity structures of
financial instruments. Consequently, a relatively strong risk perception has become
associated with profit-sharing methods in particular and Islamic banking in general. This,
in turn, has led to concentration d asset portfolios of the Islamic banks in short-term and
trade-related assets with inimical effects on investment and economic development. The
problem is exacerbated by the fact that Muslim countries, as is the case in much of the
developing world, suffer from a lack of deep and efficient capital and money markets that
can provide the needed liquidity and safety for existing assets. The absence of suitable
long-term instruments to support capital formation is mirrored in the lack of very shortterm financial instruments to provide liquidity.

48

The challenges facing individual Islamic banks

Impressive as the growth record of individual Islamic banks may be, the fact is that at
present, those banks have mostly served as intermediaries between the financial
resources of Muslims and major commercial banks in the West. In this context, this has
been a one-way relationship, so far. There is still no major Islamic bank that has been
able to develop ways and means of intermediating between Western financial resources
and the demand for them in Muslim countries.
It also appears that individual Islamic banks face difficulties in fund placement because
they have had a major bias towards short-term, secured, low-return but liquid
investments. The challenge for these institutions stems from motivational and technical
factors.
Motivationally, their basic aim appears to have been that of demonstrating the viability of
Islamic banking without taking too many risks. Admittedly, this is a noble and a very
important objective, however, although they have succeeded in this effort and have
managed to create a market niche for Islamic banking, they do not seem to have achieved
the market depth that could ensure long-term profitability and survival. This stems from
the fact that they appear to be far behind in technical innovations and financial market
developments that in recent years have revolutionized finance and capital markets. There
is no evidence that these banks have made any large investment in research and product
development, nor is there any evidence that new financial products developed in recent
years, particularly in equity derivatives, have been utilized to any significant degree by
the major Islamic banks. This is unfortunate because the market opportunities that these
banks have been able to develop, to allow funds from Islamic communities to be placed
in Islamically permissible portfolios, can and will be exploited by more efficient and
innovative Western financial institutions that already have or will discover this market
niche.

49

While there is considerable room for competition and expansion in this field, the long-term
survivability of individual Islamic banks will depend on how rapidly, aggressively, and
effectively they can develop techniques and instruments that would allow them to carry
on a two-way intermediation function. They need to find ways and means of developing
marketable Shariah-based instruments by which asset portfolios generated in Muslim
countries can be marketed in the West as well as marketing Shariah-based Western
portfolios in Muslim communities.

50

The challenge of adopting an Islamic

financial system
The most important challenge for Islamic banking is in its system-wide implementation.
At present, many Islamic countries suffer from financial disequilibria that frustrate
attempts at wholesale adoption of Islamic banking. Financial imbalances in the fiscal,
monetary and external sector of these economies cannot provide fertile ground for
efficient operation of Islamic banking. Major structural adjustments particularly in fiscal
and monetary areas are needed to provide Islamic banking with a level playing field.
Additionally, adoption of a legal framework of property ownership and Contracts that
would clearly specify the domain of private and public property rights as well as stipulation
of legally enforceable rights of parties to contract that fully reflect the requirements of the
Shariah, are necessary to allow an operational framework conducive to efficient
operation of Islamic banking.
An Islamic financial system can be said to operate efficiently if, as a result of its adoption,
rates of return in the financial sector correspond to those in the real sector. In many
Islamic countries fiscal deficits are financed through the banking system. To lower the
costs of this financing, the financial system is repressed by artificially maintaining limits
on bank rates. Thus, financial repression is a form of taxation that provides governments
with substantial revenues. To remove this burden, government expenditures have to be
lowered and/or revenues raised. Massive involvement of governments in the economy
makes it difficult for them to reduce their expenditures. Raising taxes is politically difficult.
Thus, imposing controls on domestic financial markets becomes a relatively easy form of
raising revenues. Under the above circumstances, it is understandable why governments
would have to impose severe constraints on private financial operations that can provide
higher returns to their shareholders and/or depositors. This makes it very difficult for
Islamic banks and other financial institutions to realize fully their potential. For example,
Mudarabah companies that can provide higher returns than the banking system would

51

end up in direct competition with the banking system for deposits that are used for bank
financing of fiscal deficits.
While Muslim countries may, for legitimate reasons, opt for an Islamic financial system,
for the economy as a whole to benefit fully from the operations of such a system, it is
necessary that (a) government expenditures are fully rationalized, (b) revenues from
taxation, and those derived from property legitimately placed within the government
domain by the Shariah, are raised to meet the expenditure needs the government, (c)
the financial sector is liberalized so that returns to this sector reflect returns to the real
economy, (d) equity markets are developed to allow financing of investment projects
outside banking institutions, and, finally, (e) the structure of the banking system should
be such as to allow strong banking supervision and prudential regulation commensurate
with the risks involved in various transactions.* To accomplish the last objective, the
banking structure can be tiered in accordance with principal Islamic financial transactions.
It is reasonable to assume that risks involved in Musharakah or Mudarabah financing, are
different from those involved in trade-type financing. It follows, therefore, that prudential
regulations of these transactions should be different.

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Motivating Factors for Islamic Banking

Motivation and renewed interest in Islamic finance industry stems from its strong
economic, financial and social considerations, backed by its unique features.
Most significant is its appeal to add to financial diversity and innovation being skewed
towards:
(i)

Asset backed and equity based transactions, which promote entrepreneur

friendliness and consideration of project viability

(ii)

Equitable distribution of risks and rewards among the stakeholders;

(iii)

Inculcating market discipline and higher ethical standards given its

emphasis on non-exploitation and social welfare.

In the wake of high Asian domestic savings rates and build up of the regions foreign
exchange reserves as well as oil surpluses of Middle East in the last few years, Islamic
finance is now also emerging as a way to wealth management, both of richer nations and
high net worth individuals.

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Conclusion
Hence we conclude that the interest based banking is totally dependent upon the
interest in every aspect of banking while the Islamic banking is totally against the interest
in every aspect of banking so due to the interest the Islamic banking and the interest
based banking have very differences which are mainly in product that they are offering
just like the interest banks offers credit cards, debit cards, loans on interest ,leasing on
interest etc but the Islamic banking offer different products which are totally on the Islamic
halal rules Murabaha ,Ijarah ,Ijarah-Wal-Iqtina ,Musharakah ,Musawamah ,Istisna'a ,Bai
Muajjal etc.so these products are totally different from that of interest based banking

54

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Ahmad, M., Business Ethics in Islam, Academic Dissertations-5, Islamabad, Pakistan,

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Ali, A.Y., The Holy Qur'an: Text, Translation Commentary, Washington, D.C., The
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