CIMA launches Islamic Finance

Qualification
December 20, 2007 Certification in Islamic Finance islamic finance certification

The islamic finance industry is growing at the rate of 20 percent

per year with $500 billion worth. This has created in new job opportunities in
islamic finance market. To meet this market the Chartered Institute of
Management Accountant (UK) and International Institute of Islamic Finance
launched first qualification in Islamic Finance in December 2007.

This will be valuble for those who seeking accrediated qualification in Islamic
Finance. This will be called as Certificate in Islamic Finance (Cert IF). The
certificate has four compulsory study modules. Each is covered by a detailed
study guide that will take you through to the final assessments.
Cert IF is a self study, distance learning qualification, and is available for study
across the globe. Each module is independent. We recommend that you
complete the Islamic Commercial Law module first as it includes knowledge
and skills you will require for the three remaining modules.
Robert Jelly, Director of Education at CIMA, says:
CIMA has identified that there is considerable demand from the global
business community to develop the knowledge and skills required to service
this increasingly important market. The CIMA Islamic Finance qualification is
the first to be created in conjunction with an Advisory Group made up of
academics, practitioners and scholars of Shariah, and will assist employers in
the City of London and other major financial centres throughout the world in
equipping their employees to develop financial products.'.

The growing importance of Islamic

finance in the global financial
system
December 12, 2007 Banking , Islamic Finance BIS and BCBS support for the IFSB ,corporate governance in
islamic finance , islamic banks growth , islamic finance growth , Islamic Financial Services Board (IFSB) , risk
management , risk management in islamic banks

Remarks by Mr Malcolm D Knight,

General Manager of the BIS, at the
2nd Islamic Financial Services
Board Forum, Frankfurt, 6
December 2007.
Abstract
Although there are differences between Islamic banking and conventional
banking, there are some fundamental principles that apply equally to both. In
particular, rigorous risk management and sound corporate governance help to
ensure the safety and soundness of the international banking system. In the
light of the growing importance of Islamic banks and Sharia-compliant
financial innovation, the increasing integration of Islamic financial services
into global financial markets serves to strengthen this point.
The Basel II framework improves the risk sensitivity and accuracy of the
criteria for assessing banks' capital adequacy. This framework is
fundamentally about stronger and more effective risk management grounded
in sound corporate governance and enhanced financial disclosure, the
importance of which has been underscored by the recent problems that have
arisen in the banking industry worldwide. The guidance provided by the
Islamic Financial Services Board (IFSB) is a useful contribution to the

realisation of these global goals. It will support the establishment of resilient

financial market infrastructures and sound and robust core Islamic financial
institutions operating according to safe and sound risk management practices.

Full speech
Introduction
Good morning. I am pleased and honoured to address the 2nd Islamic
Financial Services Board Forum today. As the General Manager of the Bank
for International Settlements, I am particularly pleased to be here today to
discuss Islamic finance and its growing importance in the global financial
system. But let me start by commending Professor Rifaat Ahmed Abdel Karim
of the Islamic Financial Services Board and Josef Toovsk of the BIS
Financial Stability Institute for putting together such a comprehensive
programme. It is entirely appropriate that the IFSB and the FSI should join
forces to organise this conference. After all, the IFSBs mission is to promote
the soundness and stability of the Islamic financial services industry. It does
so by issuing global prudential standards for the industry. Likewise, the FSIs
mission is also to promote sound supervisory standards and practices globally.
BIS and BCBS support for the IFSB
As an associate member of the IFSB, the BIS has been actively supporting the
IFSBs mission and initiatives since the Board began operations in 2003. The
Basel Committee on Banking Supervision, which is hosted by the BIS, is
increasingly looking beyond its membership to enhance cooperation with nonmember countries and organisations with related interests and similar goals.
The Committees outreach to non-member countries is part of an initiative to
promote the development of sound supervisory practices and to accommodate
the growing importance and sophistication of non-member banks.
The BIS and the Basel Committee have been strong supporters of the IFSB
through participation in IFSB working groups, such as the capital adequacy
group, and by providing speakers for conferences and other events. I believe

that the active and productive dialogue between the Basel Committee and the
IFSB will continue to benefit both of our organisations. Professor Rifaat and
members of the Basel Committees Secretariat have recently held fruitful
discussions, and continue to strengthen the cooperation between the IFSB and
the Committee.
In my remarks today, I will not address the specifics of Islamic finance and
how it differs from conventional banking. Instead, I would like to focus on two
elements of banking supervision that Islamic and conventional banking have
in common. That is, appropriate levels of risk management and corporate
governance, which help to ensure the safety and soundness of the
international banking system.
Growth in Islamic finance
As I am sure you heard yesterday and will also hear today, there has been
significant growth in Islamic financial services in recent years and there is
every reason to expect that this growth will continue at a rapid pace. Clearly,
there is expanding demand for these products, and a closely associated desire
on the part of banks, including non-Islamic banks, to provide Islamic financial
services.
Although it is still modest in size relative to conventional retail banking,
Islamic retail banking is rapidly becoming more visible. This is particularly
true in the Middle East and Asia Pacific regions, where a number of Islamic
banks and banking units have been opened in recent years. There are also
Islamic banks and asset managers in key international financial centres of the
United Kingdom and the United States.
The growth in Islamic finance is also visible in the expanding range of services
and products that comply with the basic precepts of Sharia law. One example
is the burgeoning global market interest in Islamic bonds Sukuks many of
which are increasingly being issued and bought outside the Islamic world.
This suggests that non-Islamic investors in general are becoming comfortable
with Sukuks. The broadening appeal of Islamic finance is also evident in the
move by large international banks and other private sector financial

institutions to provide Islamic financial services. This includes the

establishment of exchange-traded funds that are screened to ensure their
conformity with Islamic investment principles, as well as offering takaful
or Islamic insurance.
Although the elements that are usually emphasised at conferences like this are
differences between Islamic banking and conventional banking, there are
some fundamental principles that apply equally to both. For example, I can
point to the necessity of strong corporate governance, rigorous risk
management and sound capital adequacy requirements as essential
ingredients to ensure the safety and soundness of any financial system. The
increasing integration of Islamic financial services into the global financial
fabric only strengthens this point.
What about risk management and corporate governance?
The issuance of the revised Basel II framework for bank capital adequacy not
only improves the risk sensitivity and accuracy of the criteria for assessing
capital adequacy, but it is fundamentally about stronger and more effective
risk management grounded in sound corporate governance and enhanced
financial disclosure. I should acknowledge that the special features of Islamic
banking may not always be adequately addressed by broad international
standards for conventional banking contained in the Basel II framework.
Nonetheless, the IFSB considers carefully the global banking standards that
have been and are being developed for conventional banking. The IFSBs
capital adequacy standard, for instance, draws to a large extent on Pillar 1 of
the Basel II framework (the minimum capital adequacy requirements). It has
also released an exposure draft on the supervisory review process (consistent
with the principles of Basels Pillar 2) and another on disclosure and market
discipline (Pillar 3).
As interest in Islamic finance grows, the importance of the IFSBs role
increases. The importance of the fundamental elements of banking
conventional or Islamic cannot be emphasised enough. Topics such as
corporate governance, risk management and capital adequacy are key
elements that underpin sound financial practices. The guidance provided by

the IFSB in these areas helps to ensure that there are resilient financial market
infrastructures and robust core financial institutions operating according to
safe and sound risk management practices. It is important that the same
degree of supervisory oversight is applied to Islamic financial institutions, to
ensure the continuing acceptance of their instruments and services in
international markets and conventional banking systems . In addition, the
guiding principles and standards developed by the IFSB are assisting
supervisors globally to better understand and supervise institutions providing
Islamic financial services.
This is why I am particularly pleased to see the issuance by the IFSB, over the
last couple of years, of its capital adequacy standards and guiding principles
on corporate governance and risk management. The issuance of these
prudential standards and guiding principles helps to enhance the soundness
and stability of the Islamic financial services industry and helps fill an
important niche, as will the recent exposure draft on market discipline.
The importance of robust risk management systems and corporate governance
cannot be overstated. Many of the recent problems that have arisen in the
banking industry worldwide, such as losses due to accounting improprieties,
low underwriting standards and inappropriate valuation methodologies
particularly when applied to complex financial instruments, are primarily due
to poor corporate governance and inadequate risk management. Given these
shortcomings, what then are the implications for banks and supervisors?
Risk management
First and foremost, with respect to risk management banks must have policies
and procedures in place that enable them to identify, measure, control and
report all material risks. Bank management is primarily responsible for
understanding the nature and degree of the risks being undertaken by the
institution. This was not necessarily the case with respect to subprime
residential mortgages, mainly packaged by conventional banks in the United
States, which were then securitised and resold as mortgage-backed securities
and collateralised debt obligations. Investors at large, and the managements of
even some of the largest internationally active banks, did not fully appreciate

the risk inherent in the subprime mortgages embedded in the structured

securities they had purchased. Instead, many relied too heavily on the credit
ratings that the specialised credit rating agencies established for the various
branches of the resulting structured products. While Basel II provides a better
framework for supervisors to focus discussions with banks on the robustness
of their risk measurement and management of complex financial instruments,
banks risk management systems need to be constantly adapted to better
address the effects of innovation in the financial markets and increased
complexity and opacity of financial activities in which banks are engaged.
While weaknesses in these areas have focused on conventional banking
instruments and institutions, Islamic instruments are not immune to them.
Strong risk management is a critical component of a banks ability to
withstand adverse conditions. And this is certainly as important for Islamic
banks as for other types of financial institutions. One element that is essential
is comprehensive stress testing that can capture the effects of a downturn on
market and credit risks, as well as on liquidity. This helps ensure that banks
have a sufficient capital buffer to carry them through difficult periods. In the
events of last summer and this autumn, it became clear that many banks
stress tests did not anticipate the degree and breadth of illiquidity that
resonated throughout the credit markets. Stress tests must consider the effects
of prolonged market tensions and illiquidity, and must reflect the nature of
institutions portfolios and realistic assumptions about the amount of time it
may take to hedge out risks or manage them in severe market conditions.
Corporate governance
The necessity of a robust corporate governance framework has long been
recognised by bank supervisors around the world. Indeed, supervision would
not be possible without sound corporate governance in place. Over the years,
experience has highlighted the need for banks to have the appropriate levels of
accountability, as well as sufficient checks and balances. In general, sound
corporate governance effectively addresses the manner in which the decisionmaking process in the organisation is structured, the respective
responsibilities and accountability of senior management and the board of

directors, and the control functions that ensure the accuracy of the monitoring
processes.
Of course, when supervisors review an institutions risk management system
and corporate governance framework, they must consider the systems
appropriateness in relation to the banks size, its risk exposures and the nature
and complexity of the financial instruments it deploys.
Market disclosure
I have already noted the IFSBs exposure draft on disclosure and market
discipline that was released for comment late last year. This interest in
promoting increased transparency and market discipline is especially
important, particularly given the recent difficulties experienced by banks and
investors alike with respect to complex structured products. Much of the
current turmoil in the credit markets has related to questions about the
soundness of certain types of collateralised debt obligations (CDOs) and assetbacked commercial paper. These problems might well have been avoided or at
least mitigated if there had been greater transparency both about the products
themselves and the commitments made by the banks that originated them.
Again, this problem has thus far been concentrated in conventional banks in
the key financial countries. A crucial area where more transparency has
proved necessary has been in the exposures of some large financial
institutions to CDOs of securities backed by subprime mortgages in the United
States.
Basel II and the IFSBs exposure draft on transparency both seek to raise the
bar on the quality of financial disclosures by providing clearer industry
benchmarks. Enhanced financial disclosure that improves the transparency of
banks and complex structured products, valuation, and the measurement of
risk exposure can certainly help to improve overall risk management. In
addition, requiring enhanced qualitative disclosures will permit all banks to
put their quantitative disclosures into better context and assist them in
explaining their approach to risk management.
Conclusion

Let me conclude by emphasising that rigorous risk management and sound

corporate governance are key elements of any banks ability to understand and
manage its risks. With the growing importance of Islamic banks and Shariacompliant financial innovation, it will be increasingly important to ensure
sound Islamic financial institutions going forward. Supervisors must work
together to encourage all banks to improve their risk management systems,
controls and transparency. Such improvements will help ensure the stability
and soundness of the international banking system. Thank you very much.

Mudaraba-based Investment and

Finance
December 9, 2007 Investment

by
A.L.M. Abdul Gafoor
Groningen, the Netherlands
CONTENTS :

In any economy, private investment occurs in two different ways: active investment, where one or more
persons put their own capital into a project, manage it themselves and enjoy the fruits of their labour
and capital themselves; and passive investment, where the investor provides the capital and receives a
return but takes no further part in the project. Broadly speaking, a passive investor has three options:
one, buy shares in a company and receive a dividend; two, buy bonds or securities and receive interest;
three, deposit in a bank and receive interest. In an Islamic economy, active investment and the first
option are permissible while the last two options would be regarded as riba (interest) income and
therefore prohibited. On the entrepreneur side, he may finance his project using his own capital, by
selling shares in his enterprise, or by borrowing on interest (from a bank or by issuing

bonds/securities). In an Islamic setting, the first two methods are permissible while the last is not. For
clarity the scenarios are depicted in Tables 1 and 2.

Table 1. Investment options for capital-holders

Type of investment
Active investment

Passive investment

Mode of investment

Type of return on capital

Islamic position

In own enterprise

Profit or loss from the

enterprise

Allowed

Shares in a company

Dividend (profit or loss) from

the company

Allowed

Bonds/securities

Fixed positive return ( riba )

Prohibited

Bank deposit

Fixed positive return ( riba )

Prohibited

Table 2. Financing options for entrepreneurs

Type of financing

Mode of financing

Type of return on capital

Islamic position

Own funds

Profit or loss from the

enterprise

Allowed

Share capital

Dividend (profit or loss) from

the company

Allowed

Bonds/securities

Fixed positive return ( riba )

Prohibited

Bank loans

Fixed positive return ( riba )

Prohibited

Active finance

Passive finance

Both conventional and Islamic systems permit and encourage active

investment, which rewards labour and capital from realised profits. Both also
permit and encourage passive investment in shareholder companies, which
too reward capital from realised profits in the form of dividends. In both
cases any realised loss is borne by the capital-providers. But any investment
that brings in riba income or financing that involves the payment of riba is
prohibited in an Islamic system. This leaves the Muslim passive investors
who cannot or will not buy shares in a company and Muslim entrepreneurs
who do not have their own capital or cannot raise share capital but need seed
capital and/or additional funds in a difficult situation. If not for their
religious convictions, they would resort to bonds and securities or fixed
deposits and bank loans. Since this category of investors and entrepreneurs
form a large section of the Muslim investor-entrepreneur community, it is
necessary to address their difficulty. This essay explores the options available
to this group within an Islamic setting. Participatory Financing explained in
the following paragraphs is a system developed to address this special concern
of Muslims. It is based on the ancient concept of mudaraba .

Brief history
Mudaraba is an ancient form of financing practised by the Arabs since long
before the advent of Islam. It suited the Meccan Arabs because of their
location at the cross roads of the ancient trade caravans. They themselves
were merchants carrying goods north to Syria in the summer and south to the
Yemen in winter. They took goods from their homeport to sell at their
destination, and with the proceeds bought other goods and brought them back
to sell at home and/or to re-export to another destination. When a trading
caravan is organised it was the practice of the Meccans either to join it with
their own goods and money or to send such through agents who did the
business on their behalf. When a caravan returned home and the goods were
all sold, the mission was complete and it was time to prepare the balance
sheet and calculate the profit/loss.

Traders who took their own money and goods assessed the success of the
mission by the profit/loss they made and enjoyed the fruits of their labour or
mourned their loss on their own. Those who combined their fortunes with
that of one or more of their colleagues and undertook the project together had
to go one step further and divide the fortune or loss among the partners,
according to a pre-agreed pattern. The rules of this pattern had long been
established by custom and had been known by the namemusharaka. The
agents who carried others goods and/or money had to give accounts to their
principals and claim their share of the profit/loss according to a pre-arranged
pattern. This too had rules assigned by custom and was known by the
name mudaraba.
When Muhammad (Peace be upon him) began his prophetic mission he did
one of three things with regard to the practices of the Arabs: 1) if it involved
the denial of the existence or the uniqueness the one God (Allah) or
associating anything or anyone with Him or was against any command of God,
he prohibited it outright; 2) if it did not involve any such action he did not
interfere with it; 3) if some useful or essential practice involved some
elements of the first, and if that could be removed, he removed the offending
elements and allowed the modified version to be
practised. Mudarabaand musharaka belonged to the second group.
Nabil A. Saleh in his authoritative and very readable book, Unlawful Gain and
Legitimate Profit in Islamic Law (1986), gives detailed descriptions of the
rules relating to mudarabaand musharaka , including the differences of
opinion in the interpretation of these rules by the later schools of Islamic
Law. A recent (1999) publication by Justice Taqi Usmani is a very useful
contribution to Islamic finance. It is useful to students and teachers of
Islamic banking and finance on account of the authoritative definitions given
of the terms and concepts used in the field, and because of the detailed
explanations and background information provided. It also describes how
these concepts are currently implemented, and points out the shortcomings
and gives suggestions for improvements. Though the present author does
not, with all respects, agree with all the suggestions, the book is perhaps a
must in the library of every student of Islamic banking and finance. In it he

singles out mudaraba andmusharaka as the only true modes of

financing. The others such as murabaha, ijara, salam, istisna are modes of
trade which are presently being used as modes of financing.
Islamic financial institutions assume the role of traders and use the modes of
trade but remain financiers. This metamorphosis is achieved by legal
documentation and some self-persuasion. It does not, however, convince
many; and the root of the problems faced by Islamic banking and finance
today lies in this split personality. The theme of this article is: let the
financiers be financiers, and the traders and entrepreneurs be traders and
entrepreneurs.

Social context: past and present

The Mecca of 1400 years ago was a small city (of possibly a few thousand
inhabitants), practically everyone of any significance was known to everyone
else, and the assembling of a trade caravan was a great public event that took
place twice a year. The Whos Who? of the financiers and the agents, their
character and abilities, who took what, what was sold for what price, what was
bought for what price and the sale price were all public knowledge. There was
little room for misbehaviour and the price for it in terms of social ostracism
was very high.
Today, in the modern world, especially in large cities, practically everyone is a
stranger to his neighbour. Financial affairs are strictly private. Who has
money, who needs it, and to do what are all generally unknown to any
other. But the bank has become privy to this information, including the
amounts, and has established itself as an intermediary between the owner of
funds and the entrepreneur who needs it.
The reality today is that there are many capital-holders who wish to earn an
income from their capital but have neither the time nor the skills necessary to
embark on a project. They may range from simple wage earners who have
saved some money, pensioners, widows or orphans who have received a lump
sum payment, trusts and institutions with whom some capital has been
entrusted, to insurance companies and individuals who have inherited a

fortune. The size of their capital too may vary from hundreds and thousands
to millions. They need to invest their capital in a profitable undertaking, but
may not know any entrepreneurs who wish to embark on a project and are
looking for financiers. Even if they find one they may not have the necessary
skills to assess the viability of the project or the ability and integrity of the
entrepreneur. On the other hand, entrepreneurs who have viable project
proposals may not know those who have the required funds and are willing to
invest in their projects.
This is where, in the context of the present-day, the need arises for a financial
intermediary who could bring the investor/financier and the entrepreneur
together. Conventional banks do perform this role very effectively and
efficiently. Capital holders deposit their funds with the bank, and
entrepreneurs submit their project proposals to the bank, the bank examines
the business plan and if it is satisfied that the project could bring in sufficient
income to allow the repayment of the principal and interest, and provided
sufficient collateral is also available, the bank advances a loan. The bank does
not get involved in the project; whether the entrepreneur/borrower makes a
profit or loss he pays the principal and interest on due dates, or the bank has
recourse to the collateral. The bank accepts the depositors capital,
guarantees its full return, and pays him an interest (or return on his
investment) at a fixed rate, and uses the capital to grant loans to
borrowers. But the interest rate given to the depositor is always smaller than
the rate the bank charges the borrower, and the difference goes to cover its
own expenses and profits.
This seems to work very well if people have no qualms about paying or
receiving interest, despite the built-in injustice to both the entrepreneurs and
the depositors.[1] But some people are beginning to have qualms, and
Muslims are prohibited from earning an income in this fashion. [2] Islamic
banking is a response to their concernan alternative method to address the
need, minus the injustice.

Islamic banking
Mudaraba is essentially an agreement between a financier and an
entrepreneur the principals. However, taking account of the modern social
structure and context, the pioneers of Islamic banking brought in an
intermediary between the principals and created a two-tier mudaraba . This
modified form of mudaraba was introduced into conventional commercial
banking in the form of profit-and-loss-sharing (PLS) investment accounts and
financing arrangements. The earned profit (which is an uncertain and
unpredictable return on capital) was to replace the interest (a pre-determined
fixed return) in the conventional setting. This, however, was not acceptable to
the conventional banking authorities. Therefore, except in a few countries
where rules were relaxed or special banking laws were enacted, it was not
possible to establish and operate Islamic banks in most countries of the
world. In such countries Islamic financial institutions, which did not come
under deposit bank regulations, were introduced. In both cases, while the
deposit/investment side worked on mudaraba basis, mudaraba was only one
of several modes used for financing. Though a preferred one in theory, in
practice it became one of the least used. The most used forms are modes of
trade, and this has led to questions of morality and ethics. In addition, Islamic
banks are unable to provide all the financing services expected of a
commercial bank. [3]
One of the very serious consequences of using modes of trade as modes of
financing is that Islamic financial institutions are confined to financing shortterm trade, and are unable to finance long-term projects in industries,
agriculture, services, etc. [4] The latter are equally important, if not more, to
any country except perhaps for some few raw materials exporting countries
which import all other products. But this situation too cannot continue for
long. Many, including Dr. Ali Yasseri in a recent (August 2000) article, cry
out for a new approach. The question is: is there a viable alternative
methodology? A comprehensive new methodology has been developed in a
series of three books published in the last few years, and an overview of the
salient features of the new approach is given in a recent publication. [5]

The author argues that, In Islam, there is a clear difference between lending
and investing lending can be done only on the basis of zero interest and
capital guarantee, and investing only on the basis
of mudaraba . Conventional banking does not and need not make this
differentiation. But a system catering to Muslims has to take this into
consideration and provide for two sub-systems one to cater to those
who would lend and another for those who wish to invest. The first subsystem would cater to those who wish to put their money into a bank for safety
and transaction convenience; and the bank would provide all current account
facilities and short-term loans and advances. This is explained in a 1995
publicationInterest-free Commercial Banking . The 1996
publication Participatory Financing through Investment Banks and
Commercial Banks describes the second sub-system,
where both investment and financing are strictly on the basis
of mudaraba . Though the title mentions only banks, the methodology can
be used by investment companies as well. In this article we propose to bring
out the salient features of the second sub-system. [6]
[In the present era inflation is an important consideration where money is
involved, and this has serious consequences in a riba-free system. An attempt
at dealing with it in the context of banking and finance is presented in the
third book: Commercial Banking in the presence of Inflation (1999).]

Participatory financing
The central idea in the concept of mudaraba is that two parties, one with
capital and the other with know-how, get together to carry out a project. The
financier provides the capital and plays no further part in the project;
specifically, he does not interfere in its execution, which is the exclusive
province of the entrepreneur. If the project ends in profit they share the
profit in a pre-arranged proportion. If it results in loss the entire loss is borne
by the financier, and the entrepreneur gains no benefit out of his effort, which
was his part of the investment. There are many variations of this simple
model but this is the basic concept. Mudaraba is usually translated as profit-

and-loss-sharing but, as far as the financier is concerned, it is in fact profitsharing-and-loss-absorbing.

In participatory financing, as envisaged in the present discussion, there are
three important additions to this basic concept. One, there are many
investors and many entrepreneurs. Two, an intermediary comes in with
whom investors deposit their funds and the intermediary finances projects put
forward by entrepreneurs. In this investors-intermediary-entrepreneurs
triangle, the investor is essentially a sleeping partner. He provides capital and
then shares the profit or absorbs the loss. It is the responsibility of the
entrepreneur to present a good proposal, convince the financier that it is
viable and profitable, and provide proof that he is able, qualified and
experienced to carry out the project successfully. The intermediary is both an
entrepreneur and a financier. When he accepts funds from an investor, he is
an entrepreneur; and when he finances a project submitted by an
entrepreneur, he is a financier.
Three, individual investors and individual entrepreneurs have no direct
contact/relationship with each other. The investor does not know which
project is financed by his capital, and the entrepreneur does not know whose
money is financing his project a pool of funds from several investors
finances a series of projects from several entrepreneurs. When it comes to
profit/loss sharing too it is the net profit/loss from all the projects that is
shared among the investors (and the intermediary). The individual
entrepreneur, however, shares with his financier (the intermediary, in the first
instance) the profit/loss from his own project only.
It is appropriate at this point to state that in the above scenario, the
financiers both the investors and the intermediary operate purely on the
basis of mudarabawhile the entrepreneur is free to choose any mode of
practice (such as murabaha, ijara, salam, istisna, etc.) appropriate to his
trade, business, industry, agriculture, etc. to run his enterprise. Thus the
proposed method simply avoids the need to devise dubious financial
instruments which have brought the very concept of Islamic banking and

finance into disrepute. This also nullifies the need for Sharia Boards in
these institutions.
Another important characteristic of ancient mudaraba was that it was a oneproject, time-limited contract. That is, the contract (between the two
principals) began with the assembling of a particular caravan and ended with
its return each new caravan started with new contracts, whether with the
same partners or with new ones. Today no trade caravans ply between distant
lands, assembling anew and dismantling each season; but businesses,
industries and all kinds of other enterprises are established and run on a longterm basis. Therefore, in the modified version this time-limited, singleproject characteristic has also been removed. This enables the basic concept
of mudaraba to be applied to all kinds enterprises on a long-term basis.
The function of the intermediary is very important. He is responsible for
identifying good projects for financing as well as for monitoring their progress
and ensuring proper accounting and auditing. But he (the intermediary)
plays no part in managing the project or in making policy decisions that is
the exclusive domain of the entrepreneur. The intermediary is a separate
physical and legal entity, independent of both the investors and the
entrepreneurs. But he (she/it) is an equal partner in every project he finances
so that he has full legal right to the physical and financial assets of all the
projects and has full access to all the books. This is very important, and it is
here that participatory financing differs from conventional financing
practices; in this respect it differs from the current practices of Islamic banks
too. This allows the intermediary to have a true picture of the health of the
projects at all times. He can then take any preventive or corrective action (in
extreme cases), and, in the event of failure of a project, he can recover
whatever is left of it. This possibility gives assurance to the investors that
their investment is safe, albeit within limits which they are aware of, and that
the profit and loss account given to them is reliable and transparent. The fact
that the investors confidence in the intermediary and the intermediarys own
profit depend on the number and size of successful projects should ensure that
the intermediary seeks out good projects and closely monitors their progress.

One important feature of participatory financing is that the entrepreneur need

not provide security for the financing he receives. The project itself is the
security, and the intermediary, being an equal partner in the enterprise, is its
guardian. This should play a very constructive role in discovering and
developing new entrepreneurial and other talents in the society, especially at
the micro level, otherwise unearthed on account of the unavailability of
collateral/security.
The proposed scheme provides for two types of investments: one called
Participatory Financing (PF) stocks and the other PF shares. These are
essentially stocks and shares in the intermediarys PF scheme (which is a
collection of all (or a group of) the projects financed by the intermediary). PF
shares correspond to unit shares because every PF share contains a tiny
portion of every project in the scheme. PF stocks roughly correspond to fixed
deposits in a bank. [7] The main difference between the conventional fixed
deposits and the PF stocks is that the return in the latter is computed from the
profit and loss statements of all the projects in the PF scheme (and the
profit/loss shared among the participants) at the end of the accounting
period. Therefore the profit/loss is a realised one, and not an anticipated or
pre-fixed one. Thus neither speculation, nor uncertainty, nor riba is involved
in the operation. But the PF stockholders will have to wait till the end of the
accounting period to collect their returns.
The status of each of the three participants in this scheme is as follows. The
intermediary (an investment bank or an investment company) is a holding
company with the legal status of a (public) limited liability company. The
investor may either hold a PF Share or a PF Stock. The PF shareholders are
like ordinary shareholders in the holding companys PF scheme. The PF
stockholders are like the time-deposit holders in a bank. Each project is a
partnership limited liability company where the entrepreneur and the holding
company are the two partners. PF shares provide the equity capital for the PF
projects, while the PF stocks cater to the short-term cash requirements (which
are normally met by loans and advances from commercial banks).

In essence, participatory financing combines features of time deposits,

business organisations (partnerships, shareholder companies and holding
companies), and unit trusts on the one hand, and equity capital and
commercial bank loans and advances on the other. It makes use of wellknown rules and techniques of financing, company laws and accounting
procedures. That makes it easy to implement, but the combination of all
these in one single system within an entrepreneurial environment is a new
formulation. That makes it a challenging one, requiring new attitudes and a
comprehensive approach. We will briefly touch on these issues in the next
section.
The theory of participatory financing has been fully developed and presented
in the book. The depth of the theory can be gauged from the details given in
the appendices, one of which is reproduced below (with slight explanatory
modifications to suit this article) to help better understand the system.

Issues in implementation
The implementation of this system requires the cultivation of new attitudes on
the part of all the participants. This is a tall order but is an absolute necessity
if we are to create a truly riba -free economy. It requires more from each
participant, but it also offers more both to the individual and to the society as
a whole. From the investor it requires the full understanding that he/she/it
may incur loss and that he will have to wait longer to know the results, but it
promises a truly riba -free income and possibly better profits. From the
entrepreneur it requires complete and accurate bookkeeping and full
disclosure of all his/her/its accounts and the sharing of his bounty with his
financiers, but it provides him with capital without collateral and the
guarantee that in case there is a loss he will not be required to make it up,
provided he had been honest in his dealings and his books will substantiate
it. The intermediary is both a banker and an entrepreneur. As an
entrepreneur, he too is required to be honest in his dealings, and accurate and
transparent as to his bookkeeping and accounts.

Bankers are trained to be very cautious, because their first concern is to

guarantee the safety of the funds deposited with them. But in this system
they are relieved of that concern because the investors have agreed to take the
risk, and therefore if they persist with the bankers attitude they will miss
many opportunities at the investors expense. On the other hand, too much
adventurism can bring about low profits or even loss, and that may lead to the
loss of customers. They must have an entrepreneurs natural talent to spot
profitable projects and to avoid bad ones, and should develop it into a
professional tool. The intermediarys staff will have to be carefully picked and
trained to bring out inherent entrepreneurial talent. Such intermediaries will
have ample reward, as they will share in the profits. It requires a new culture,
a culture of entrepreneur-financiers and of professionally run partnership
companies.
The system is heavily dependent on proper and accurate bookkeeping,
accounting and auditing. That requires the availability of trained
bookkeepers and their wide use, as well as professionally responsible and welltrained accountants and auditors. They are the bedrock of the system. The
system requires a high level of integrity from these personnel, and it is in the
interest of all the participants in the system to respect it. Substantial
investment is necessary in the training of such personnel, and legal protection
is necessary to safeguard the independence of the auditors.
The comprehensive system presented in the four books groups the entire
spectrum of business activities into three broad categories: at one end is the
one-man-owned-and-operated small enterprises, including the ones financed
or supported by loans and advances from commercial banks, and at the other
end are the large enterprises financed entirely by shareholders and managed
by professionals. In between are the proposed participatory-financed
enterprises. The size of the enterprise is an important factor in this
categorisation, and the type of financing and the type of organisation must
generally match the size. Presently in all developing countries to which
group most of the Muslim economies belong the distribution is highly
skewed towards the smaller end. To achieve a better and stable economy, it is
necessary to bring about a more even distribution.

The mudaraba principle is applicable to a range of situations, from a simple

local two-person partnership to a multiparty international corporation. A
shareholder company works essentially on the mudaraba principle. But the
participatory financing scheme envisaged in this article aims at the middle
section of this range. It brings in the intermediary, and provides the investors
with a unit trust type of investment opportunity. The scheme is ideally suited
to medium scale newenterprises. However, it is possible to modify it slightly
and bring in some of therunning businesses too into the participatory
financing system. This will help expedite bringing about the even distribution
mentioned earlier.
This can be done as follows. There are two possibilities. One, the enterprise
is a running business and has no debts, and wishes to expand its activities. In
this case, first the present worth of the enterprise (property, equipment,
stocks, receivables, etc. including goodwill) must be determined. This is the
capital of the enterprise in monetary terms. The investment bank/company
brings in the necessary additional capital, and both go into a partnership
(preferably by establishing a new private limited liability company) as
before. However, in the present instance the original enterprise has two roles,
as an entrepreneur and as a financier, while the investment bank/company is
only a financier. Accordingly, when the profit/loss is computed, the
financiers (both the enterprise in its role as a financier and the investment
bank/company) will first share the profit/loss with the entrepreneur
on mudarabaterms. Next, the two financiers will share the financiers share
between themselves in proportion to their capital contribution. Finally, the
bank/company will credit its share from this project to the bank/companys
PF pool of profit/loss. The procedure from here on is the same as previously
described.
Two, the enterprise is a running business and has debts owing to, say, a
commercial bank. In this case, the investment bank/company will pay up all
the debts and go intopartnership with the enterprise, as in the first case, with this
amount as its capital contribution. [8]

In establishing the new institution of mudaraba -based investment and

finance, using the participatory financing scheme as described above, it is
preferable to start with medium size running businesses. This will provide a
stable base for the new institution to test the theory and to gain experience.

Conclusion
In order to bring about a riba free economy, the countrys banking system hasto be riba free, its commercial enterprises have to be financed by equity capita
l,and its investments have to be on a profit and loss sharing basis.
This articlehas dealt with investment and financing, and has introd
uced a mudaraba -based system called participatory financing that takes into
account present-day realities. This is a new institution specifically developed
to address the concerns of Muslims. It has no parallel in the conventional
economy, but the individual tools and techniques it uses are ones tested and
proved in the conventional setting. Thus, while re-invention of the wheel has
been avoided, proving the viability of the new institution and benefiting from
it are challenges specific to Muslims. It is for the Muslim intellectuals,
professionals, investors, entrepreneurs, and other concerned individuals,
institutions and organisations to take up the challenge.

Appendix
Terms and procedures relating to PF stocks and shares

In this appendix we present working definitions of some terms and

procedures, which can be used as a basis for the development of an
operational model. The main purpose here is to indicate the many issues that
should be addressed in devising such a model.
The definitions of stocks and shares have not remained unchanged over time,
the distinctions have become blurred, and they have acquired different

meanings and connotations in different countries. For example, what were

known as stocks in the UK are now bonds in the USA, and shares have become
stocks. The stocks and shares under the PF scheme have much in common
with the original British definitions of the terms, but they have also some
special characteristics of their own. Therefore we have to define what we
mean by PF shares and PF stocks.

1. PF Shares
Participatory Financing Shares are ordinary shares in the company, which
consists of all the PF projects the bank [9] is currently financing or hopes to
finance in the near future. Funds obtained by selling new PF shares are to be
used as venture capital for new projects. On account of the fact that every
project will have a gestation period, the company will not be able to post a
profit or loss statement on these projects until they
become operational . Therefore PF shares cannot expect to earn a profit or
loss during this period. However, since different projects will have different
gestation periods and because the PF shares are not directly connected to any
particular project, we have to find a way of saying when a PF share begins to
earn a profit or loss. One way of doing it is for the bank to determine a
common average gestation period for the projects expected to come under the
PF scheme and to announce this period when the PF shares issue is
advertised. The shares will not earn any profit or loss in this period of, say,
one to three years. The PF shares will mature at the end of this gestation
period. And all mature PF shares will be entitled to a share in the profit/loss
of all the operational projects of the company. The dividend on these
shares is determined on the basis of the net returns of all the PF projects of the
companyoperational during the banks accounting period, say, annually.
Profit and loss accounting is done at the end of the year. Therefore the final
dividend awarded to PF shareholders is a realised profit/loss and not an
estimated or pre-fixed one. Hence there is no room for uncertainty,
speculation or riba . This is very important.

PF shares are transferable and have no termination points. PF shares will

also have a stake in the assets of the projects. However, since the investors
have no direct connection with any particular project, the claims of the PF
shares are on all the projects of the company. Thus, if, for example, a
project ends and the assets are sold off or the bank sells off its shares in a
project (perhaps to the entrepreneur or to an outside investor) the proceeds
from such sales will accrue to all the PF shares of the company (providing
interim dividends, additional PF shares or increasing their value).
Whether the PF shares are issued periodically, as and when necessary or are
available throughout the year, are all operational concerns and are matters for
individual banks decision. The bank may also consider issuing separate shares
to different groups of projects. In this instance each group will come under
the purview of a separate company.

2. PF Stocks
Participatory Financing Stocks are funds deposited with the bank for a fixed
period of time, to be invested in their Participatory Financing projects. The
return on these investments are determined on the basis of the net returns of
all the PF projects of the bank operational during the banks accounting
period, as computed at the end of that period. And the bank will use these
funds mainly to advance further credits tooperational projects. In effect, PF
stocks are like fixed-term deposits except that neither the capital nor the return
are guaranteed or fixed in advance.
The special characteristics of the PF stocks would be that: 1) PF stocks will not
bear any fixed rate of return or interest, 2) the return will be determined at the
end of each accounting period, and no attempt will be made to make any
estimates in advance, 3) PF stocks are for a defined period, but they may be
reinvested for another defined period, 4) PF stocks have no priority claims
over PF shares, and 5) PF stocks share in profit and loss, but they have no
claims on the assets of the projects.

3. PF Projects, the PF Company and

profit/loss sharing
Now we have to explain what we mean by projects and the company in the
foregoing paragraphs, in the context of participatory financing. Also how the
profit/loss from the projects is shared among the participants.

3.1 PF Projects
Each PF Project is an independent business entity whose legal status in the
eyes of the Company Law may be a private limited liability company. The
project can be anything from a large manufacturing concern to a small
medical laboratory. There are two main and essential partners in each
project: the participate-financing bank and the concerned entrepreneur. The
entrepreneur is the active partner and the bank is the sleeping partner.

3.2 PF Company
The PF company is an internal arrangement within the bank in order to keep
PF funds and profits separate from the banks own capital and profits. Thus
the PF company consists of all the PF projects of the bank and all the PF
investors whose funds are financing these projects. When the bank has more
than one group of projects, each group (with its own investors) will form a
separate PF company.

3.3 Profit/loss sharing

The net profit/loss of each PF project operational during the accounting
period is obtained from its Profit and Loss accounting statement. Each PF
project is a mudarabapartnership with the bank as the financier. Therefore,
if there is profit it is shared between the bank and the entrepreneur according
to the pre-agreed proportion. If there is loss, the entrepreneur neither
receives nor pays anything, while the bank takes the entire loss. This is the
first stage of the profit/loss sharing process.

The PF company consists of all the PF projects of the bank. Therefore the
total net profit/loss of the company is obtained by summing up the banks
share of the net profit/loss from all the individual projects.
Two observations need be made here. 1) All the projects both profit-making
and loss-making will have their capital investment intact, because the loss of
the loss-making ones would be made up by the financier (this is the meaning
of loss absorbing) using the profits accruing to the company from the profitmaking projects. This means that the value of the PF shares of the company
will remain unaffected at this stage. 2) Since fewer projects are expected to
make loss, the net result for the company is likely to be positive. However,
there is always the possibility that the net result can turn out negative.
The next stage is the sharing of the net profit/loss of the company between
the bank and the investors. Their relationship is also
a mudaraba partnership. But here the investors are the financiers and the
bank is the entrepreneur. Hence when there is a profit it is shared between
the bank and the investors according to the pre-agreed ratio. If there is loss
it is absorbed entirely by the investors PF shareholders and PF stockholders
and the bank pays or receives nothing. The investors share of the
companys profit/loss is the PF dividend, and it can be positive or negative.

4. PF Dividends
The dividend we have been talking about has one major difference as
compared to other conventional company dividends. Unlike them, as seen
above, the PF dividend can be positive or negative. This needs some
explanation, but it is important to note the difference. Its computation and
disbursement are also different. Therefore we will examine them below in
some detail.

4.1 Disbursement
The entire net profit or loss of this company will be first distributed as
dividends to all mature PF shares and all the PF stocks immediately after the
announcement of accounts. If the outcome is a net profit, it will be credited to

the account of the shares and stocks. No part of this profit will be held
back at this stage for future investment or as buffer against future
losses. That is, there is no retained profits or reserves at this stage. If the
outcome is negative, it will, similarly, be debited from the account of the
shares and stocks. This is necessary because in the PF scheme both the stocks
and shares participate in the profit/loss of the enterprises, unlike in the case of
conventional companies where only the shareholders participate in the
companys profit/loss while the stockholders (preference shares, bonds,
debentures, etc.) capital and return are guaranteed. Otherwise, if, for
example, some (or all) of the profits were held back, the PF shares would rise
in value at the expense of the profits of PF stocks. On the other hand, if a loss
is realised and it is compensated by previously held profits, the PF stocks will
escape loss at the expense of PF shares, which will fall in value.
However, while the PF shareholders and the PF stockholders will be treated
equally in the computation of their dividends they will find themselves in
different situations when it comes to the disbursement of it. If the dividend
is positive the PF stockholder will find his capital increased; but decreased if
negative. He is free to do what he will with his capital reinvest it or take it
away. On the other hand, the PF shareholders may not be so free. For the
bank may decide to retain all or part of the dividend due to them. If the
dividend was positive and part of it is held back, they will receive some profit
out of their investment and, at the same time, the value of their shares would
rise. If negative, they would receive no profits and, in addition, their shares
would fall in value.

4.2 Computation
The net profit/loss of each PF project operational during the accounting
period is obtained from its Profit and Loss account. The total net profit/loss
of the company is obtained by summing up the profit/loss of all the
individual projects. So far so good. The problem is how do we distribute the
profits among the shareholders and stockholders? Do the stocks and shares
have equal standing? Suppose the answer is yes, then what is the relationship

between a stock and a share? Are they counted in terms of units or in terms
of currency? Some meaningful solution has to be found.
One way of doing it would be to first count the stocks in terms of units as we
do of the shares, and equate one unit of stock to one unit of share. Then every
unit of stock will earn profit/loss the same as one unit of share. Now how do
they stand in terms of currency? Is the price of a stock the same as that of a
share? Which price are we talking about? The nominal value of a share, its
market value or its book value? Without going into the details of why the
former two are not quite suitable, let us settle down for the third the book
value of a share and see how this can be computed and fixed in advance.
When the annual (or quarterly, half-yearly) account is made up and the
dividends are disbursed, the shares of the company will have a book value
as at the beginning of the next year. The price of one stock in that year can be
fixed equal to this book value of one share. Thus the stocks in the company
will be sold in integer multiples, their unit price will be the same throughout
the current year (or accounting period), and every unit of stock will earn the
same dividend as a unit of share. The price of a stock, however, may vary
from year to year depending on the performance of the company but will be
equal to the book value of the share at the beginning of the year and will
remain the same throughout that year.
Consequently, as far as the computation of dividend is concerned, the
company has a total of this many units of shares and the dividend per unit
is obtained by dividing the total net profit/loss of the company by this
number of shares. This dividend per unit is then the same for both PF
shares and PF stocks.

5. Inflation and value erosion of capital

Inflation is currently a fact of life and it erodes the value of capital as time passes. Since the capital
involved in Participatory Financing projects are long-term investments we have to take into account the
value erosion of capital in computing profit/loss. Considering the space and time limitations, we need to
mention here only that the value loss of the projects capital due to inflation will be separately
computed (using the methodology described in the third book, Gafoor (1999)) and deducted from the

projects gross profit/loss and credited to the project, before the resulting net profit/loss is shared
between the financier (the bank) and the entrepreneur. Thus the capital of the enterprise will be
restored to its original real value at the end of each accounting period. This also means that the paid
out dividend would seem less, because it will not include the amount eroded from the value of capital,
but the value of the PF shares will appreciate in monetary terms. The rationale for this approach is
presented in Chapter 5 of the second book, Gafoor (1996).

*****

References
1.

Ahmad, Ausaf, Contemporary experiences of Islamic banks: a survey. In: Elimination of Riba from
the Economy . Islamabad: Institute of Policy Studies, 1994. pp.369-393.

2.

Gafoor, A.L.M. Abdul, Interest-free Commercial Banking . Groningen, the Netherlands: Apptec
Publications, 1995.

3.

, Participatory Financing through Investment Banks and Commercial Banks . Groningen, the
Netherlands: Apptec Publications, 1996.

4.

, Commercial Banking in the presence of Inflation. Groningen, the Netherlands: Apptec

Publications, 1999.

5.

, Islamic Banking and Finance: Another Approach . Groningen, the Netherlands: Apptec
Publications, 2000.

6.

Saleh, Nabil A., Unlawful Gain and Legitimate Profit in Islamic Law . Cambridge, UK: Cambridge
University Press, 1986.

7.

Usmani, Taqi M., An introduction to Islamic Finance . Karachi: Idaratul Maarif, 1999.

8.

Yasseri, Ali, Islamic banking contracts as enforced in Iran: Implications for the Iranian banking
practices. Paper presented at the Fourth International Conference on Islamic Economics and
Banking, held at the Loughborough University, UK, August 13-15, 2000.

A.L.M. Abdul Gafoor 2001

January 2001.
Revised October 2001

Note: 1. A shorter version of this article appears in New Horizon (the monthly
publication of the Institute of Islamic Banking & Insurance, London), Issue no.
119, July 2001.

Note: 2. A modified version of his article is also to be presented at The First

International Conference on: The Role of Islamic Banking & Finance in Socioeconomic Development & The Introduction of Innovative Financial
Instruments, 29-30 October 2001, Kuala Lumpur, Malaysia.
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Developing Islamic money market

December 6, 2007 Islamic Finance Market

Interest-free liquidity management is the major concern for Islamic

banks. The State Bank of Pakistan (SBP) requires Islamic banks and
conventional banks to maintain the same Cash Reserve Requirement (CRR) of
five per cent and Statutory Liquidity Requirement (SLR) of eight per cent.

Islamic banks can hold their required reserver in special current accounts with
SBP or with the National Bank of Pakistan. Any return on these accounts is the
absolute discretion of the SBP. Recently, the SBP has introduced new SLR
policy for the Islamic banks allowing them to invest in Wapda Sukuk but not
exceeding five per cent of their investment potfolio.
Efforts are being made since 1979 to Islamise the financial system for which .
the SBP initially introduced 12 Islamic modes of financing to replace interestbased instruments. The Council of Islamic Ideology (CII) in a separate report
in 1980 advised the SBP to replace the money market discount rate with the
arrangement whereby the SBP would be empowered to finance the banks
on profit and loss sharing basis.Among other recommendations one was
to set up interest-free common pool of funds on cooperative basis to replace
the existing interest bearing government securities.
The SBP initially took drastic steps towards the development (and
implementation) of financial instruments based on Islamic principles. Later
the whole process came to a standstill. No effort had been made towards the
elimination of interest from inter bank transactions; inter-government
transactions and foreign currency accounts.
Pakistan has witnessed the second wave of Islamisation of financial system
since 1999. This time the Supreme Court of Pakistan asked the government to
take steps towards the elimination of interest from the economy. A meeting
held under the chairmanship of the president of Pakistan decided to allow
Islamic banks to operate parallel to conventional banks. In addition,
conventional banks were also allowed to offer Islamic banking services
through dedicated Islamic windows.
Now, six Islamic banks and 13 conventional banks with a total network of 200
branches offer Islamic banking products and services. In addition, non-bank
financial institutions such as Islamic Mutual Funds, Takaful companies,
Mudaraba companies, House Building Finance Corporation etc. are also the
active participants. Efforts are also been made for the development of Islamic
Sukuk (bond) market. Islamic banking is targeting to capture 10 per cent of
the total financial sector in the years to come.

Islamic banking is asset-based banking. History proves that assets prices

increase with the increase in GDP while the interest rate decreases at the same
time. In other words, interest rate and the assets prices have inverse
relationship with each other. Concerns are raised then how can the Islamic
money market operate as efficiently as the interest based money market under
the current parallel banking concept. Here an attempt has been made to
develop a conceptual framework to address this important issue.
Conventional banks operate under the concept of lender-borrower
relationship where interest is considered as the rental income on capital. The
depositors are assumed to be capital providers. Profits of the banks are
distributed at the discretion of the bank managements.
But the Islamic banks follow the concept of Mudaraba (profit sharing) based
on investor-entrepreneur relationship. Here Islamic banks consider depositors
as entrepreneurs. The profits generated through this relationship are divided
between the two parties as per agreed ratio.
Further, researchers divide Islamic bank customers into three broader
categories (a) religiously motivated customers (b) high profit motivated
customers (c) customers who are religiously motivated but also expect returns
at least similar to conventional banks. Customers of second and third
categories generally dominate in terms of numbers in any Islamic bank. They
expect returns on deposits similar to conventional banks.
In the money market, the main objective is to meet short-term liquidity
requirements. The market facilitates banks with deficit in cash to borrow from
the banks having surplus money. Islamic money market conducts a similar
function of meeting the short-term liquidity needs. Instead of interest, it
allows Islamic banks to share surplus capital on profit -sharing basis.
Islamic and conventional money markets can be assumed to offer similar
returns on investments. Low returns in Islamic money markets may badly
affect the overall profitability of Islamic banks in the initial stages of their
development. Even if, Islamic money market offers returns higher than

conventional market, the Islamic banks may still not enjoy an advantageous
position.
The present parallel banking set-up allows conventional banks to transact in
the Islamic money market through their separate Islamic branches and earn
returns equal to Islamic banks. Existing Islamic banking arrangement thus
puts Islamic banks in a disadvantageous position as they would transact only
in the Islamic money market. But at the same time, other banks through their
Islamic and conventional branches can deal in both Islamic and the
conventional money markets. The scenario leaves the SBP with no option but
to manage the Islamic and conventional money markets returns at the same
level.
Special attention should also be paid for developing Islamic money market
instruments to meet the liquidity requirements plus to match the current
market financing rates on constant basis. Current available Islamic financial
instruments are either long-term or fixed in nature which create funding
mismatch problem.
At present, Islamic banks use short- term deposits on variable rates to finance
medium and long-term projects. The situation leads Islamic banks either to
maintain high liquid ratios or to avoid long-term financing that can affect the
overall profitability.
Various Islamic countries have developed Islamic money market instruments
under the concepts of Wakala (agent), short-term Sukuk (bonds), and
securitisation of assets etc. There are many others short- term instruments
which are acceptable in one Muslim country but are subjected to some
restrictions in other Muslim countries especially those issued under the
concept of buy-back agreements and Bai Al-Inah (sale of debt).
Likewise, Islamic money market is also facing serious research deficiencies in
the area of oversight of financial instruments. Innovations are needed to
facilitate Islamic banks to manage their liquidity gap as efficiently as the
conventional banks.

By Dr Ahmad Kaleem
The writer is an Associate Professor at Lahore School of Economics, Lahore.
source : dawn.com
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Islamic Banking: Problems and

Prospects
December 1, 2007 Banking problems and prospects

Definition:
An Islamic Banking is a financial institution that operates with the objective to
implement and materialise the economic and financial principles of Islam in
the banking arena.
The Organisation of Islamic conference (OIC) defined an Islamic Bank as a
financial institution whose statutes, rules and procedures expressly state its
commitment to the principles of Islamic Shariah and to the banning of the
receipt and payment of interest on any of its operations.
According to Islami Banking Act 1983 of Malaysia, an Islamic Bank is a
company which carries on Islamic Banking business. Islamic Banking
business means banking business whose aims and operations do not involve
any element which is not approved by the religion Islam.
Objectives:
The objective of Islamic Banking is not only to earn profit, but to do good and
bring welfare to the people, Islam upholds the concept that money, income
and property belong to Allah and this wealth is to be used for the good of the
society.
Islamic Banks operate on Islamic principles of profit and loss sharing and
other approved modes of Investment. It strictly avoids interest which is the

root of all exploitation and is responsible for large scale inflation and
unemployment.
An Islamic Bank is committed to do away with disparity and establish justice
in the economy, trade, commerce and industry; build socio-economic
infrastructure and create employment opportunities.
History and Present Status of Islamic Banking around the World
The History of Islamic Banking :
The History of Islamic Banking could be divided in to two parts. First When it
still remained an Idea, Second-When it become a reality-by private initiative
in some counties and by law in others.
Islamic Banking as an Idea :
The scholar of the recent past in early fifties started writing for Islamic
Banking in place of Interest Free Banking. In the next two decades Islamic
Banking attracted more attention.
Early seventies saw the institutional involvement. Conference of the Finance
Ministers of the Islamic Countries was held. The involvement of institutions
and Government led to the application of theory to practice and resulted in the
establishment of the Islamic Banks. In this process the Islamic Development
Bank (IDB) was established in 1975.
The coming into being of Islamic Banks:
The first private Islamic Bank, the Dubai Islamic Bank was also set up in 1975
by a group of Muslim businessmen from several countries. Two more private
banks were founded in 1977 under the name of Faisal Islamic Bank in Egypt
and Sudan. In the same year the Kuwaiti Government set up the Kuwait
Finance House.
In the ten years since the establishment of the first private commercial bank in
Dubai, more than 50 Islamic Banks have come into being. Though nearly all of

them are in Muslim countries, there are some in Western Europe as well : in
Denmak, Luxembourg, Switzerland and the UK.
In most countries the establishment of Islamic banking had been by private
initiative and were confined to that bank. In Iran and Pakistan, however, it
was by government initiative and covered all banks in the country. The
Governments in both these counties took steps in 1981 to introduce Islamic
Banking.

Problems being faced by Islamic Banking in the world in general

Most of the Islamic Banks operate on Bai- Murabaha, Bai Muazzal, BaiSalam, Istisna, Hire Purchase/ Leasing mode of Investment i.e. Islamic Banks
always prefer to run on markup/ guaranteed profit basis having Shariah
coverage. For this reason some times the conventional Economists and
General people failed to understand the real difference between Islamic
Banking and conventional Banking.
Mudaraba and Musharaka modes of Investment are ideal but Islamic Banks
are not going in these two modes, the reasons for the above are as follows:
i) There is no systemic analysis and research and no real efforts to introduce
above mentioned two modes but the practitioners blame the following
factors:a) There is lack of committed entrepreneur
b) There is lack of committed professional who can create new
c) instruments.
d) There is lack of committed sponsors who can pressurize the professionals
e) There is shortage of skilled professionals.
2. The problem of forward contact/booking of foreign currency.

The value of US Dollars ($), Pound Sterling, Euro and others are not fixed in
Bangladesh, they are fluctuating from time to time Most of our imports and
exports are made in USD and USD being a strong currency always moves
upward and the exporters are in better position than the importer in our
country. In Bangladesh Forward Booking is required to check the exchange
fluctuation for import of heavy/project Machineries where it take long time
say one year or six months to produce the same.
But due to the restrictions of Shariah we can not cover the risk of Exchange
fluctuation by forward contract as Forward Booking is not permitted by
Shariah. As per Shariah, currency, transaction is to be made under certain
terms and conditions laid down for sarf by Shariah, such as spot possession
of both the currencies by both the parties which is not available in forward
Booking. It is also prohibited to deal in the forward money market even if the
purpose is hedging to avoid loss of profit on a particular transaction effected in
a currency whose value is expected to be declined. This problem requires a
solution by Shariah experts.
3. Inland Bill Purchase/Foreign Bill Purchase :
This is another problem of Islamic Bank where the exporters immediately
after export of the goods approach to the bank for fund before maturity of the
bills to meet their daily needs. Here the Bank has to deploy billions of Taka
each year but how and on what mode of investment ? The Bank can not take
anything by providing fund to the exporter except collection fee for collection
of the Bill, which is very poor.
4. Unfamiliarity with the Islamic Banking System
The first problem, is that despite the growth of Islamic banks over the last 30
years, many people in the Muslim and non-Muslim world do not understand
what Islamic banking actually is. The basic principle is clear, that it is contrary
to Islamic law to make money out of money and that wealth should
accumulate from trade and ownership of real assets. However, there does not
appear to be a single definition of what is or not an Islamic-banking product;
or there is not a single definition of Islamic banking. A major issue here is that

it is the Shariah Councils or Boards at individual Islamic banks that actually

define what is and what is not Islamic banking, and what is and what is not the
acceptable way to do business, which in turn can complicate assessment of
risk for both the bank and its customer. More generally, the uncertainty over
what is, or is not, an Islamic product has so far prevented standardization.
This is difficult for regulators as they like to know exactly what it is they are
authorising. It is also an added burden on the banks that have to educate
customers in new markets.
5. Portfolio Management :
The behavior of economic agents in any country is determined partly by past
experience and present constraints. The Islamic banks are still growing in
experience in many countries. Regarding constraints, Islamic banks in
different countries do not freely choose arrangements, which best suit, their
need. As a result, their activities are not demand-oriented and do not react
flexibly to structural shifts in the economic setting as well as to changes in
preferences It is known to the bank management that a certain portion of the
short-term fund is normally not withdrawn at maturity; these funds are used
for medium or long-term financing. However, a precondition for this maturity
transformation is that the bank be able to obtain liquidity from external
sources in case or unexpected withdrawals. Islamic banks, without having an
interest-free Islamic money and capital market, have no adequate instruments
to meet this pre-condition for effective maturity transformation. On the other
hand, Islamic banks can enhance term transformation if there is an interestfree bond market or a secondary market for Islamic financial papers. Adequate
financial mechanism still has to be developed, without which financial
intermediation, especially the risk and maturity transformation, is not
performed properly.
6. The Regulatory environment
The relationship between Islamic banks and monetary authorities is a delicate
one. The central bank exercises authority over Islamic banks under laws and
regulations engineered to control and supervise both traditional banks.
Whatever the goals and functions are, Islamic banks came into existence in an

environment where the laws, institutions training and attitude are set to serve
an economy based on the principles of interest. The operations of Islamic
banks are on a profit and loss share basis (PLS), which actually do not
come fully under the jurisdiction of the existing civil laws. If there are disputes
to be handled, civil courts are not sufficiently acquainted with the rationale of
the operations of Islamic Banking. Regarding the protection of depositors,
Islamic Banks are required to let the authorities know the difference between
money paid into current accounts and money paid into investment accounts.
Islamic banks operate two broad types of deposits:
a) Deposits, which cover transaction balance. These have a 100 percent
reserve requirement and completely safe, thus satisfying the needs of risk
averters, and
b) The PLS or equity account, in which depositors are treated exactly as if they
were shareholders in the bank. There is no guaranteed rate of return or
nominal value of the share.
In non-Muslim counties (i.e., the countries with less than 50% Muslim
population) the central banks are very stringent in granting licenses for
Islamic banks to operate. In order to be established in those countries Islamic
banks must also meet the additional requirements of other government and
non-government authorities. (So, apart from legal constraints there are
economic measures that result operations of Islamic banks in the non-Muslim
world difficult). In Muslim countries also they face economic restrictions.
Besides funding, acceptable investment outlets is a major challenge for Islamic
financial institutions.
7. Absence of Liquidity Instruments
Many Islamic banks lack liquidity instruments such as treasury bills and other
marketable securities, which could be utilised either to cover liquidity
shortages or to manage excess liquidity. This problem is aggravated since
many Islamic banks work under operational procedures different from those
of the central banks; the resulting non-compatibility prevents the central
banks from controlling or giving support to Islamic banks if a liquidity gap

should occur. So the issue of liquidity management must come under active
discussion and scrutiny by the authorities involved is Islamic banking.
8. Use of Advanced Technology and Media
Many Islamic banks do not have the diversity of products essential to satisfy
the growing need of their clients. The importance of using proper advanced
technology in upgrading the acceptability of a product and diversifying its
application cannot be over emphasized. Given the potentiality of advanced
technology, Islamic banks must have to come to terms with rapid changes in
technology, and redesign the management and decision-making structures
and, above, all introduce modern technology in its operations. Many Islamic
banks also lack the necessary expertise and institutional capacity for Research
and Development (R & D) that is not only necessary for the realization of their
full potential, but also for its very survival in this age of fierce competition,
sophisticated markets and an informed public. Islamic banking cannot but
stagnate and wither without dynamic and ongoing programmes. In addition,
Islamic banks have so far not used the media appropriately.
Even the Muslims are not very much aware that the Islamic banking is being
practiced in the world. Islamic banks have not ever used an effective media to
publicise their activities. The authorities concerned in Islamic banks should
address these issues on a priority basis.
9. Need for Professional Bankers
The need for professional bankers or managers for Islamic banks cannot be
over emphasized. Some banks are currently run by direct involvement of the
owner himself, or by managers who have not had much exposure to Islamic
banking activities, nor are conversant with conventional banking methods.
Consequently, many Islamic banks are not able to face challenges and stiff
competition. There is a need to institute professionalism in banking practice to
enhance management capacity by competent bankers committed to their
profession. Because, the professionals working in Islamic banking system have
to face bigger challenge, as they must have a better understanding of industry,
technology and the management of the business venture they entrust to their

clients. They also have to understand the moral and religious implications of
their investments with the business ventures. There is also a need for banking
professionals to be properly trained in Islamic banking and finance. Most
banks professionals have been trained in conventional economics. They lack
the requisite vision and conviction about the efficiency of the Islamic banking.
10. Blending of Approach of Islamic Scholars with the Approach of the
Conventional Bankers
Bankers, due to the nature of their jobs have to be pragmatic or applicationoriented. There is and will be tendency in the bankers practicing in Islamic
banks to mould or modify the Islamic principles to suit the requirement for
transactions at hand. Additionally, being immersed in the travails of day to
day banking, they find little time or inclination to do any research, which can
make any substantial contribution to the Islamic banking. Islamic Scholars
active in researching Islamic Banking and finance, on the other hand, typically
have a normative approach, i.e. they are more concerned with what ought to
be. A very few of them are knowledgeable about banking or the needs of the
customers.
(ii) Problem Specific to Islamic Banking in Bangladesh
1. Absence of Islamic Money Market
In the absence of Islamic money market in Bangladesh, the Islamic banks
cannot invest their surplus fund i.e., temporary excess liquidity to earn any
income rather than keeping it idle. Because all the Government Treasury Bills,
approved securities and Bangladesh Bank Bills in Bangladesh are interest
bearing. Naturally, the Islamic banks cannot invest the permissible part of
their Security Liquidity Reserve and liquid surplus in those securities. As a
result, they deposit their whole reserve in cash with Bangladesh Bank.
Similarly, the liquid surplus also remains uninvested. On the contrary, the
conventional banks of the country do not suffer from this sort of limitations.
As such, the profitability of the Islamic banks in Bangladesh is adversely
affected.

2. Absence of Suitable Long-term Assets

The absence of suitable long term assets available to Islamic banks is mirrored
by lack of short term tradable financial instruments. At present there is no
equivalent of an inter-bank market in Bangladesh where banks could place,
say, over night funds, or where they could borrow to satisfy temporary
liquidity needs. Trading of financial instruments is also difficult to arrange
when rates of return are not know until maturity. Furthermore, it is not clear
whether Islamic banks in Bangladesh can utilise more exotic instruments,
such as derivatives, that are becoming increasingly popular with conventional
banks. Obviously, these factors place Islamic banking in Bangladesh at a
distinct disadvantage compared to its conventional banking counterpart.
3. Shortage of Supportive and Link Institutions
Any system, however well integrated it may be, cannot thrive exclusively on its
built-in elements. It has to depend on a number of link institutions and so is
the case with Islamic banking. For identifying suitable projects, Islamic
banking can profitably draw the services of economists, lawyers, insurance
companies, management consultants, auditors and so on. They also need
research and training forums in order to prompting entrepreneurship
amongst their clients. Such support services properly oriented towards Islamic
banking are yet to be developed in Bangladesh.
4. Organizing Relationship with Foreign Banks
Another important issue facing Islamic banks in Bangladesh is how to
organise their relationships with foreign banks, and more generally, how to
conduct international operations. This is, of course, an issue closely related to
the creation of financial instruments, which would be simultaneously
consistent with Islamic principles and acceptable to interest-based banks,
including foreign banks.
5. Long-term Financing
Islamic Banks stick very closely to the pricing policies of the government. They
can not benefit from hidden costs and inputs, which elevate the level of prices

by certain entrepreneurs without any justification. On the other hand, Islamic

banks as financial institutions are even more directly affected by the failure of
the projects they finance. This is because the built in security for getting back
their funds, together with their profits, is in the success of the project.
Islamically, it is not lawful to obtain security from the partner against
dishonesty or negligence, both of which are very difficult if not impossible to
prove.
Prospects
In my understanding the prospect of Islamic Banking is very bright. Muslim
people everywhere want Islamic Banking. In Bangladesh, to give an example,
4/5 conventional Banks have opened separate Islamic branches recently. Five
hundred applications are pending with Islamic Bank Bangladesh Ltd. for
opening of new braches. IBBL has already 132 branches in the country.
The position may not be same in all countries. But if Islamic Banking succeeds
in any country, the position will same in every Muslim country in my
judgment. This means, that first Islamic Bank in any country should be well
managed and successful so that people have faith in this system. Established
Islamic Banks should co-operate by lending competent officials in setting up
new Islamic Banks.
The problems mentioned in the preceding pages are not insurmountable. Most
of them can be solved with more research and dedicated efforts. IDB, OIC
Fiqh Academy, Internatinal Islamic Banking organizations and individual
Islamic banks should put more resources in research in Islamic Banking,
Finance and Economic issues. Cooperation of Central Banks and the
Governments. will be needed in some areas. I have no doubt in mind that
Islamic banking will expand more and more in the entire world.
source : shah aabdullah foundation