2.

1 Islamic Banking
Islamic banking has been defined as banking in consonance with the ethos and value
system of Islam and governed, in addition to the conventional good governance and
risk management rules, by the principles laid down by Islamic Shariah.[1]
The objective of Islamic banking system is to make a positive contribution to the
fulfillment of socioeconomic objectives of the society in all spheres, including trade,
industry & agriculture etc.[2] in general, is to promote, foster and develop the
application of Islamic principles, law and tradition to the transaction of financial,
banking and related business affairs and to promote investment companies. Islamic
banks accept deposits which they can either commit to investment or general deposits.
They also have investment accounts with or without authorization. Banks engage in
investment activities based on Musharakah (equity
participation) Mudarabah or Qirad (agencies), Murabaha, Bai' Salam (post delivery
sale) and/or leasing arrangements especially for equipment. On the lending side,
Islamic banks issued a number of new lending instruments such as Al
Muqarada profit bonds to finance large projects and Al-Mudarabah certificates which
were not issued for specified projects. Islamic banks practice conventional short term
financing on a profit/loss basis.[3]
2.2 PHILOSOPHY OF ISLAMIC BANKING AND FINANCE

The prohibition of interest by Islam is the base of the development of Islamic Banking
Phelosopghy. The Islamic system order based on a set of principles constituting the
concept and philosophy as enunciated explicitly in the Quran.This philosophy
provides what can be understood as the Islamic system of social justice. [4]In Islamic
law some gain has been prohibited which are generally fixed or if there is no concept
of risk shearing. Conventional Finance believes in return without risk, whilst Islamic
Finance prohibits the latter and enforces the opposite.[5]
Islam prohibits interest but it does not means, that it prohibits all gains on capital. The
only increase stipulated or sought over the principle loan or debt is prohibited in
Islamic sharia law. Islamic principles simply require that performance of capital
should also be considered while rewarding the capital. The prohibition of a risk free
return and permission of trading, as enshrined in the Holy Quran [1], makes the
financial activities in an Islamic set-up real asset-backed with ability to cause ‘value
addition’.[6]
Islam deems profit, rather than interest, to be closer to its sense of morality and equity
because earning profits inherently involves sharing risks and rewards. [7] Islam
encourages shearing of risk among lender and borrower, Islamic financing system is
based on this principle, it has also another character of owing and handing of real
assets, its involvement in trading, construction and leasing using Islamic mode of
financing. As such, Islamic banks deal with asset management for the purpose of
income generation. They will have to prudently handle the unique risks involved in
management of assets by adherence to best practices of corporate governance. Once
the banks have stable stream of Halal income, depositors will also receive stable and
Halal income.[8]
Profit has been recognized as ‘reward’ for (use of) capital and Islam permits gainful
deployment of surplus resources for enhancement of their value. However, along with
the entitlement of profit, the liability of risk of loss on capital rests with the capital
itself; no other factor can be made to bear the burden of the risk of loss. Financial
transactions, in order to be permissible, should be associated with goods, services or
benefits. At macro level, this feature of Islamic finance can be helpful in creating
better discipline in conductive of fiscal and monetary policies.[9]
All such things/assets corpus of which is not consumed with their use can be leased
out against fixed rentals. The ownership in leased assets remains with the lesser that
assumes risks and gets rewards of his ownership. The institution may either rent the
equipment or receive a share of the profits earned through its use; Islamic leasing
(Ijara wal Iqtina) are the same as Ijarah except that the lessee can acquire ownership
of the asset by making installment payment.[10]
2.3 MAJOR MODES OF ISLAMIC BANKING AND FINANCE

Following are the main modes of Islamic banking and finance:

1. 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.[11]
2. Ijara
Ijara 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, Ijara 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.[12]
3. 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 principle sum along with
profit over the period of lease.[13]
4. Istisna
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.[14]
5. 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.[15]
6. Mudarabah
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.[16] Murabaha in tandem with Bai Muajjal is a
useful means of financing in the Islamic Mortgages arena. It allows the Bank to
purchase the house at spot price and then sell it to the client over a deferred period
thereby generating a profit for the Bank.[17]
7. 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 pre-agreed ratios, while the loss is borne by each partner strictly in
proportion to respective capital contributions.[18]
8. 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.[19]
9. Qard Hassan (Good Loan)
This is a loan extended on a goodwill basis, and the debtor is only required to repay
the amount borrowed. However, the debtor may, at his or her discretion, pay an extra
amount beyond the principle amount of the loan (without promising it) as a token of
appreciation to the creditor. In the case that the debtor does not pay an extra amount to
the creditor, this transaction is a true interest-free loan. Some Muslims consider this to
be the only type of loan that does not violate the prohibition on riba, since it is the one
type of loan that truly does not compensate the creditor for the time value of
money.[20]
2.4 RATIO OF PROFIT

There is a difference of opinion among the Muslim jurists about the Ratio of Profit.
In the view of Imam Malik and Imam Shafii, it is necessary for the validity of
Musharaka that each partner gets the profit exactly in the proportion of his investment.
Therefore, if A has invested 40% of the capital, he must get 40% of the profit. Any
agreement to the contrary which makes his entitled to get more or less than 40% will
render the musharkah invalid in Shariah.
On the contrary, the view of Imam Ahmad is that the ratio of profit may differ from
the ratio of investment if it is agreed between the partners with their free consent.
Therefore, it is permissible that a partner with 40% of investment gets 60% or 70% of
the profit, while the other partner with 60% of the investment gets only 40% or 30%.
The third view is presented by Imam Abu Hanifah which can be taken as a via media
between the two opinions mentioned above. He says that the ratio of profit may differ
from the ratio of investment in normal conditions. However, if a partner has put an
express condition in the agreement that he will never work for the musharkah and will
remain a sleeping partner throughout the term of musharkah, then his share of profit
cannot be more than the ratio of his investment. [21]
2.5 ISLAMIC FINANCING AND ITS GLOBAL EVOLUTION

As with all things Islamic, the origination of Islamic finance goes back to the time of
Prophet Muhammad (Peace be upon Him). The Qur’an and the example of Prophet
Muhammad (Peace be upon Him) provide direct behavioral guide and represent
bedrock of Islamic faith to over one billion Muslims globally. The Prophet
Muhammad (Peace be upon Him) happened to be a businessman serving as a trader
for Khadija (May Allah be pleased with Her). The Prophetic example was the very
epitome of fair-trade. Refraining from usury, ensuring transparency in transactions,
and total honesty entitled him Al- Amin (The trustworthy) in pre-Islamic Arabia[22]
During the Islamic Golden Age, early forms of proto-capitalism and free
markets were present in the Caliphate; the first modern experiment with Islamic
banking was undertaken in Egypt under cover, without projecting an Islamic image,
for fear of being seen as a manifestation of Islamic fundamentalism which was
anathema to the political regime. The pioneering effort, led by Ahmad El Najjar, took
the form of a savings bank based on profit-sharing in the Egyptian town of Mit Ghamr
in 1963. This experiment lasted until 1967[23], by which time there were nine such
banks in the country. These banks, which neither charge nor paid interest, invested
mostly by engaging in trade and industry, directly or in partnership with others, and
shared the profits with their depositors.[24]
But some views whows that the first modern Islamic modern banking institution
stablished in Pakistan in 1950. As a former credit Union. This was first Islamic
financing movement. Using this idea Mit Ghamr saving Bank emerged as a rural
institution in Egypt in 1963. [25] At meeting of Foreign minister of Islamic countries
in Karachi Pakistan in 1970, Pakistan and Egypt jountly proposed for the
establishment of international Islamic Bank for trade and development this again
discussed in 1973 with Banghzi (Libya) in a meeting which further suggested for
constituting a committee of experts for designing this international Islamic Bank. This
was finally established in 1972 as Islamic Development Bank in Jeddah Saudia
Arabia.[26] The IDB was established in 1974 by the Organization of Islamic Countries
(OIC), but it was primarily an intergovernmental bank aimed at providing funds for
development projects in member countries. The IDB provides fee based financial
services and profit-sharing financial assistance to member countries. The IDB
operations are free of interest and are explicitly based on Shariahprinciples. [27]
In the seventies, changes took place in the political climate of many Muslim countries
so that there was no longer any strong need to establish Islamic financial institutions
under cover. A number of Islamic banks, both in letter and spirit, came into existence
in the Middle East,[28]. After that, numbers of Islamic Bank established in different
Islamic countries. Dubai Islamic Bank in 1975 in Dubai, Faisal Islamic Bank in Egypt
and Sudan in 1972, Kuwait Finance House in 1977. Jordan Islamic Bank in 1978 and
Bahrain Islamic Bank in 1979[29]
Islamic banking made its debut in Malaysia in 1983, but not without antecedents. The
first Islamic financial institution in Malaysia was the Muslim Pilgrims Savings
Corporation set up in 1963 to help people save for performing hajj (pilgrimage to
Mecca and Medina). In 1969, this body evolved into the Pilgrims Management and
Fund Board or the Tabung Haji as it is now popularly known. The Tabung Haji has
been acting as a finance company that invests the savings of would-be pilgrims in
accordance with Shariah, but its role is rather limited, as it is a non-bank financial
institution. The success of the Tabung Haji, however, provided the main impetus for
establishing Bank Islam Malaysia Berhad (BIMB) which represents a full fledged
Islamic commercial bank in Malaysia. The Tabung Haji also contributed l2.5 per cent
of BIMB's initial capital of M$80 million. BIMB has a complement of fourteen
branches in several parts of the country. Plans are afoot to open six new branches a
year so that by 1990 the branch network of BIMB will total thirty-three [30]
Reference should also be made to some Islamic financial institutions established in
countries where Muslims are a minority. There was a proliferation of interest-free
savings and loan societies in India during the seventies. [31] The Islamic Banking
System (now called Islamic Finance House), established in Luxembourg in 1978,
represents the first attempt at Islamic banking in the Western world. There is also an
Islamic Bank International of Denmark, in Copenhagen, and the Islamic Investment
Company has been set up in Melbourne, Australia.[32]
2.6 HISTORY OF ISLAMIC BANKING IN PAKISTAN

Pakistan now recognized one of the Islamic finance industries in the World.
Muhammad Ali Jinnah as early 1948, emphasized on Islamic principles in his address
at inauguration of State Bank of Pakistan he said.
“I shall watch with keenness the work of your Organization in evolving banking practices compatible
with Islamic ideas of social and economic life. We must work our destiny in our own way and present
to the world an economic system based on true Islamic concept of equality of manhood and social
”
justice. [33]

Pakistan has a protracted history of Islamic banking with the initial attempt to
Islamize banking system in 1980s2, leading to sweeping changes in the Banking
Companies Ordinance, 1962 (BCO’62) and associated laws and regulations to
accommodate non-interest based banking transactions[34]. The Islamization measures
included the elimination of interest from the operations of specialized financial
institutions including HBFC, ICP and NIT in July 1979 and that of the commercial
banks during January 1981- June 1985.[35]
Separate Interest-free counters started operating in all the nationalized commercial
banks, and one foreign bank (Bank of Oman) on January 1, 1981 to mobilize deposits
on profit and loss sharing basis. Regarding investment of these funds, bankers were
instructed to provide financial accommodation for Government commodity operations
on the basis of sale on deferred payment with a mark-up on purchase price. Export
bills were to be accommodated on exchange rate differential basis. [36]
In March, 1981 financing of import and inland bills and that of the then Rice Export
Corporation of Pakistan, Cotton Export Corporation and the Trading Corporation of
Pakistan were shifted to mark-up basis. Simultaneously, necessary amendments were
made in the related laws permitting the State Bank to provide finance against
Participation Term Certificates and also extend advances against promissory notes
supported by PTCs and Mudarabah Certificates. From July 1, 1982 banks were
allowed to provide finance for meeting the working capital needs of trade and industry
on a selective basis under the technique of Mishawaka.[37]
As from April 1, 1985 all finances to all entities including individuals began to be
made in one of the specified interest-free modes. From July 1, 1985, all commercial
banking in Pak Rupees was made interest free.[38]
From that date, no bank in Pakistan was allowed to accept any interest-bearing
deposits and all existing deposits in a bank were treated to be on the basis of profit
and loss sharing. Deposits in current accounts continued to be accepted but no interest
or share in profit or loss was allowed to these accounts.
However, foreign currency deposits in Pakistan and on-lending of foreign loans
continued as before. The State Bank of Pakistan had specified 12 modes of non-
interest financing classified in three broad categories.
However, in any particular case, the mode of financing to be adopted was left to the
mutual option of the banks and their clients. The procedure adopted by banks in
Pakistan since July 1 1985, based largely on ‘mark-up’ technique with or without
‘buy-back arrangement’, was, however, declared un-Islamic by the Federal Shariat
Court (FSC) in November 1991. However, appeals were made in the Shariat
Appellate Bench (SAB) of the Supreme Court of Pakistan.[39]
The Commission for Transformation of Financial System (CTFS) was constituted in
January 2000 in the State Bank of Pakistan under the Chairmanship of Mr. I.A. Hanfi,
a former Governor State Bank of Pakistan.[40]
A Task Force was set up in the Ministry of Finance to suggest the ways to eliminate
interest from Government financial transactions. Another Task Force was set up in the
Ministry of Law to suggest amendments in legal framework to implement the Court’s
Judgment. The CTFS constituted a Committee for Development of Financial
Instruments and Standardized Documents in the State Bank to prepare model
agreements and financial instruments for new system.
The House Building Finance Corporation had shifted its rent sharing operations to
interest based system in 1989.[41] The Task Force of the M/O Law proposed
amendments in the HBFC Act to make it Shariah Compliant. Having vetted by the
CTFS, the amended law has been promulgated by the Government. Accordingly, the
HBFC launched in 2001 Asaan Ghar Scheme in the light of amended Ordinance based
on the Diminishing Musharaka concept. A Committee was constituted in the Institute
of Chartered Accountants, Pakistan (ICAP), wherein the SBP was also represented,
for development of accounting and auditing standards for Islamic modes of financing.
The Committee is reviewing the standards prepared by the Bahrain based Accounting
and Auditing Organization for Islamic Financial Institutions (AAOIFI) with a view to
adapt them to our circumstances and if considered necessary, to propose new
accounting standards.
It was decided in September 2001 that the shift to interest free economy would be
made in a gradual and phased manner and without causing any disruptions. It was also
agreed that State Bank of Pakistan would consider for:

1. Setting up subsidiaries by the commercial banks for the purpose of

conducting Shariah compliant transactions;
 2. Specifying branches by the commercial banks exclusively dealing in
Islamic products, and

3. Setting up new full-fledged commercial banks to carry out exclusively

banking business based on proposed Islamic products.[42]
Accordingly, the State Bank issued detailed criteria in December 2001 for
establishment of full-fledged Islamic commercial banks in the private sector. The
Meezan Bank was granted a ‘Scheduled Islamic Commercial Bank’ license on
January 31, 2002, and formally commenced operations as a Scheduled Islamic
Commercial Bank with effect from March 20, 2002, on receiving notification in this
regard from the State Bank of Pakistan (SBP) under section 37 of the State Bank of
Pakistan Act, 1956. Currently, the Bank is engaged in corporate, commercial,
Consumer, investment and retail banking activities. Further, all formalities relating to
the acquisition of Societies General, Pakistan by the MBL were completed, and by
June, 2002 it had a network of 5 branches all over the country, three in Karachi, one in
Islamabad and one in Lahore.[43]
The Government as also the State Bank is mainly concerned with stability and
efficiency of the banking system and safeguarding the interests, particularly, of small
depositors. With this concern in mind it has been decided to operate Islamic banking
side by side with traditional banking. The approach is to institute best practice legal,
regulatory and accounting frameworks to support Islamic banks and investors alike.
The year 2002-2003 witnessed strengthening measures taken in the areas of banking,
non-bank financial companies and the capital markets.
2.7 ROLE OF ISLAMIC BANKING IN THE DEVELOPMENT OF THE COUNTRY

Islamic banks and financing performing according to the sharia law, those are helpful
for mobilization of resources, and their use in right manner. PLS (Musharaka and
Mudarabah) and non-PLS (trading & leasing) based categories of modes and
strengthening the payments systems to contribute significantly to economic growth
and development.[44] Islamic mode of financing system offering finance in short tem,
long term, and different type of instrument for liquidity management, asset
management etc, for enterprises and projects. This creates employment opportunities
in the economy. It would be necessary to create an environment that could induce
financiers to earmark more funds for Musharaka/Mudarabah based financing of
productive units, particularly of small enterprises.[45]
The non-PLS techniques, as acceptable in the Islamic Shariah, not only complement
the PLS modes, but also provide flexibility of choice to meet the needs of different
sectors and economic agents in the society. Trade-based techniques like Murabaha
with lesser risk and better liquidity options have several advantages vis-à-vis other
techniques but may not be as fruitful in reducing income inequalities and generation
of capital goods as participatory techniques. Ijarah related financing that would
require Islamic banks to purchase and maintain the assets and afterwards dispose of
them according to Shariah rules, require the banks to engage in activities beyond
financial intermediation and can be very much conducive to the formation of fixed
assets and medium and long-term investments.
On the basis of the above it can be said that supply and demand of capital would
continue in an interest free scenario with additional benefit of greater supply of risk-
based capital along with more efficient allocation of resources and active role of
banks and financial institutions as required in asset based Islamic theory of finance.
Islamic banks can not only survive without interest but also could be helpful in
achieving the objective of development with distributive justice by increasing the
supply of risk capital in the economy, facilitating capital formation, and growth of
fixed assets and real sector business activities.
Salam has a vast potential in financing the productive activities in crucial sectors,
particularly agriculture, agro-based industries and the rural economy as a whole. It
also provides incentive to enhance production as the seller would spare no effort in
producing, at least the quantity needed for settlement of the loan taken by him as
advance price of the goods. Salam can also lead to creating a stable commodities
market especially the seasonal commodities and therefore to stability of their prices. It
would enable savers to direct their savings to investment outlets without waiting, for
instance, until the harvesting time of agricultural products or the time when they
actually need industrial goods and without being forced to spend their savings on
consumption.
Small and medium enterprises (SME) sector has a great potential for expanding
production capacity and self-employment opportunities in the country. Enhancing the
role of financial sector in development of SME sub-sector could mitigate the serious
problems of unemployment and low level of exports. The banks may introduce ‘SME
Financing Funds’ with various geographical locations. The corporate sector and the
commercial banks may set up a network of such Funds under the aegis of SECP by
establishing institutions under syndicate arra