Islamic Finance Imtiaz A. Pervez Arab Law Quarterly, Vol. 5, No. 4. (Nov., 1990), pp. 259-281. Stable URL: http://links.jstor.org/sici?sici=0268-0556%28199011%295%3A4%3C259%3AIF%3E2.0.CO%3B2-9 Arab Law Quarterly is currently published by BRILL.
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ISLAMIC FINANCE Imtiaz A Pmez*
ISLAMIC BANKING
Introduction Islamic banking has only recently emerged in the contemporary financial world. From the first example of Egypt's Mit Ghamr Savings Bank in 1963 it has grown steadily to today's 100or so Islamic financial institutions worldwide. However, we must question whether this growth necessarily reflects the system's complete maturity or even its wider operational scope. There are still a large number of unanswered questions and Islamic banks are faced with several unresolved problems. However, the conventional banking system has evolved over a period of time on the basis of research and experience and stands institutionalised. It is supported by sophisticated infrastructure and regulated by coherent legislation. To address the questions posed, it would be pertinent not only to examine and explain the nature and ingredients of the system's processes, the rationale behind the prohibition of interest ("riba"), but also to obtain an overview of the Islamic religion itself from which the principles of Islamic economics, and in turn of Islamic banking, are basically drawn. Samuel Butler ( E l m t a y Mmality, 1902) believed that the true laws of God are the laws of our own well-being. And well-being of humanity, in its individual or collective form, remains the ultimate objective of all religions. To prevent injustice, deliberate or otherwise, religion identifies and separates the lawful from the prohibited. This concept has been known to all mankind since ancient times. However, people have differed, in relation to superstition and myths, in the definition of the scope, variety and causes of taboos and prohibitions. The divinely-revealed religions that followed spelt out clearly the laws and injunctions through which to ensure the rights of individuals and thereby allow dignity to humanity. Islam enumerates these in great detail. Muslims believe this was the mission of all prophets and messengers in human history and it was the same fundamental faith revealed to Moses, Jesus and Mohamed (peace be upon them). According to Godfrey Jansen, Islam is not merely a religion. It provides for Muslims a complete code catering for all areas of human existence; individual and social, material and moral, economic and political, legal and cultural, national and international. *General Manager, Faysal Islamic Bank of Bahrain E.C. Paper submitted to the International Bar Association Seminar, on "International Finance and the Arab World in the 1990's"' Paris, France, 20-22 June 1990. Other papers presented at the seminar are available from: lBA, 2 Harewood Place, Hanover Sq., London WIR 9HB.
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It is a comprehensive way of life, religious and secular; it is a set of beliefs and a way of worship; it is a vast and integrated system of law; it is a culture and a civilisation; it is an economic system and commercial norm; it is a polity and a method of governance; it is a society and a family conduct; it prescribes for inheritance and divorce, dress and etiquette, food and personal hygiene. It is a spiritual and human totality; thus worldly and other-worldly. The Holy Qu'ran and the Sunnah (word and tradition of the Holy Prophet-peace be upon him) together are the source for these laws. Qiyas, Ijma, and ijtitrad are meant to provide interpretation, and thereby facilitate future development and implementation of the Islamic judicial system. Qiyas is a deductive analogy by which a jurist applies to a new case a ruling made previously in similar cases. Ijma is the consensus of the Islamic community, umma. It is through this principle that democracy makes its impact on the conduct of Islamic polity. While it opens up law to popular opinion, it is a conservative exercise as the consensus has to be by a very large proportion of the umma. The Holy Prophet's firm belief in his umma is evident from his famous saying, "my community will not agree on what is wrong". Ijtihad, on the other hand, is independent judgment provided by scholars of Islamic laws for which clear principles and procedures are stipulated in the Qu'ran and Sunnah. It is an extremely important tool that provides development and adaptation through research. Some visible developments in the world of Islam in the past couple of decades synchronise with the so-called Islamic revival that has taken place at about the same time, attributed mainly to the following reasons: Muslim populations discovering identity of their selves and religious values following independence from colonial rigimes; Dissatisfaction of Muslims with the materialist ideologies of capitalism and communism; (3) The recent unprecedented boost in the oil-related income of many Muslim Arab nations giving them economic recognition.
An outcome of this revival is the emergence of a new academic discipline, i.e., Islamic economics. This discipline is based on the knowledge and application of the injunctions and norms of Shari'a which prevent injustice in the acquisition, management and disposal of material resources. The Islamic economic system encourages trade and enterprise but is inimical to self-interest and undue profiteering. It is non-discriminatory to human society and builds a relationship between the individual and the community through co-operation, integration and duty. Being largely humanitarian in character and socially orientated, it provides satisfaction for human beings by enabling them to perform their obligations to Allah and Society. This is contrary to the dictates of modem economics that have, over time, become more or less a value-free empirical social science akin to applied
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mathematics without much relevance or regard to the needs of individuals. Islamic Shari'a provides rules that cover the allocation of resources, property rights, management, production, consumption, the functions and working of markets and the distribution of income and wealth. It also defines, in broader terms, the framework for the design of monetary and banking systems. Since the Islamic economic system was not implemented in its entirety in a diversified environment for a significant duration in the past, its analysis, the requirements respecting its implementation in the present-day environment, and its economic consequences, are not as yet well elaborated or verified. As Creator, God is The Owner of the Universe. Man is His Vice-Regent and must, therefore, carry out his duties as prescribed by the Creator. Wealth is a trust from the Owner and is best used in a manner which will lead to the enlarging of the interests and welfare of humanity, in accordance with the rules laid down for the purpose. Islam is not an ascetic religion. Neither miserliness nor prodigality are encouraged. It advocates an healthy balance between the material and spiritual aspects of life. While it dictates strictly for the periodic, even quotidian, performance of spiritual duties, it provides for, and in fact details dispensation for, materials things. It permits humanity to avail themselves of the bounties provided by God but in a manner whereby others are not deprived either by discrimination or exploitation, and that the prescribed values are maintained. When the prayer is ended, then disperse in the land and seek of God's bounty. . .(Qu'ran 62.10) Zakat, an obligatory tax on the wealth of Muslims, is a mechanism that forces productive use of wealth since cash or near-cash accumulation is fully taxable on an annual basis while deferral is permitted for most long-term productive investments. It provides for the equitable distribution of wealth, and ensures subsistence for the needy. Coupled with other taxes and charges which an Islamic state may levy, it meets the needs of the state for the welfare of its people. Private enterprise is given full approval. Application of money in asset-related commercial activities is meant to allow for the generation of real wealth, and in turn the fdtering through of the benefits of such additional capital generation to all the human factors of production, including the grower, labourer, trader, user and the investor etc. Doubts have been expressed as to the ability of the Islamic economic system to effectively respond to the challenges of such a fast changing time. The example given is that of today's Muslim countries generally lagging behind the advanced nations in industrialisation and technology. Against the Industrial Revolution that transformed North America, Europe and the Far East in the past two centuries, no comparable development took place in Muslim countries. To Western observers, the Ottomans' inability to evolve and implement the economic policies needed to promote industrialisation are attributed to the inadequacies of the system. While it is true that Islamic countries have not kept pace in industrialisation and technology with developed non-Muslim nations, it is not justifiable to ascribe this failure to the Islamic system itself for the following reasons: (1) The Islamic economic system was never implemented extensively in the
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past except for a short time in the very early period of Islam. During that time, Muslims actually obtained phenomenal social, political, economic and geographical development and expansion; (2) "Ijma" and "ijtihad" which provide the ability to meet challenges of changing times were not fully utilised by Muslims. These are two major aspects of Islamic religion that ensure that it is widely acknowledged as the most modem of the religions; (3) It was the political and administrative failure of Islamic regimes in the past that resulted in most of their population being subjugated for long periods to colonial or other inimical regimes during which time their development on all counts remained ignored.
Prohibition of Interest The prohibition and elimination of interest is the core of the Islamic fmancial system. God's immense disapproval of interest is evident from some of the verses from the Holy Qu'ran: 0 you who believe, fear Allah and give up what remains due to you of interest if you are indeed believers. And if you do not, then be warned of war (against you) by Allah and His Messenger, while if you repent you shall have your capital. Do not do wrong and you shall not be wronged. (2.278-279)
Those who swallow usury cannot arise except as he arises whom the devil prostrates by (his) touch. That is because they say trading is like usury. And Allah has allowed trading and forbidden usury. (2.275)
In Judaism, interest was prohibited or not encouraged as per the following: If you lend money to any of My people with you who is poor, you shall be to him as a creditor, and you shall not exact interest from him. (Ex.22:25) He that hath not given this money upon usury; nor taken reward against the innocent. He that doeth these things: shall never fall. (Psalm 15) To a foreigner you may lend upon interest, but to your brother you shall not. (Deut. 23.19)
The moral teaching of Jesus in this direction was clear and absolute: Love your enemies and do good, lend, expect nothing in return. (Luke 6.35)
Aristotle rejected interest on the basis that "money is sterile". Cato even compared it with homicide. In biblical times all payments for the use of money were forbidden. In 340 B.C., Lex Genucia prohibited interest in Republican Rome. When the Roman Empire became Christianised in the fourth century, the Church forbade the clergy from taking interest. In 594 B.C., Solon cancelled all private and public debts when he reformed the Athenian constitution. In the eighth century, Charlemagne made usury a criminal offence. St Thomas Aquinas believed that money was invented chiefly for the purpose of exchange and that its principal use was its consumption and alienation whereby it is sunk in exchange. Hence, it was unlawful to make payment for the use
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of money lent. In the early Middle Ages, Popes and Councils continued to fulminate against it and civil governments passed laws forbidding interest. The anti-usury movement reached its height in 1311 when Pope Clement V made the prohibition of usury absolute and declared all secular legislation in its favour null and void. By the 1700s, interest had become an acceptable business practice but still most people opposed it until 1945 when King Henry VIII changed national laws to permit charging some form of interest. According to Dr Mahmoud Abu Saud, money, under Islamic laws, is considered as a means of exchange. It cannot be equated with commodity for the following reasons: (1) Money has a technical (or artificial) property of yielding its owner real income simply by holding it, i.e., without exchanging it against other goods; (2) It is liquid and has no carrying cost, no production cost (almost), and no substitute; (3) Demand on money is not genuine as it is derived from demand for goods that money can buy; (4) Money is exempt from the law of depreciation to which all goods are subjected; and (5) Money is the product of social convention having a purchasing power derived mainly from the sovereignty as against the intrinsic value of other goods. Interest is construed by Islamic economists as only a theoretical concept that does not correspond to or is representative of real growth of capital. Any excess of money paid by the borrower to the lender over and above the principal amount for the use of the lender's liquid money over a certain period of time will count as interest. In more precise terms, Dr Mohsin S Khan defines interest as: (1) That which is positive, fmed ex-ante and tied to time-period and amount of loan; (2) That its payment is guaranteed regardless of the outcome of the venture in which the capital is invested; and (3) That the state apparatus provides for and enforces its collection. According to him, Islam recognises two types of individual claims to property: (1) The property rights that are a result of the individual's labour and natural resources; and (2) The property that is obtained through exchange, remittance of the rights of those less able to utilise the resources to which they are entitled, outright grants and inheritance.
Money represents the monetised claim of its owner to property rights created by assets that were obtained either by (1) or (2) above. Lending money is a transfer of these rights from the lender to the borrower. All that can be claimed in return for it is, therefore, its equivalent. Interest on money loaned, therefore, represents an unjustifiable property rights claim because it is outside the legitimate framework of individual property rights recognised by Islam.
ARAB LAW Q U A R T E R L Y
Bohm-Bawerk tried to explain the rationale of interest and the rate of interest in terms of time preference, i.e., the concept of technical superiority of present over future. According to him, an average person prefers present over future and if he is required to forego the present comfort or use of his funds, he should be entitled to some remuneration, i.e., interest. However, it is not clear what rate of remuneration. Some argue that the nominal interest rate is justified being a fair compensation for inflation, otherwise value of money is depreciated by time. According to the Fisher equation, nominal rate of interest is the real rate of interest plus inflation rate. While it is practically impossible to accurately predict an inflation rate for a reasonable subsequent period of time, or is customary to do so, there is much more to it than compensation for inflation alone. How much above inflation is something depending on priorities? Monetary authorities use interest as a tool to control the demand and supply of money, to influence currency exchange rates and inflow or otherwise of international investments. In these circumstances, the proportions to which the nominal rate extends itself are unlimited. The following example of a situation that so often appears in today's environment will illustrate the discriminatory properties of arbitrary nominal interest rate and in turn its devastating effects on certain sectors of society.
Example To tackle high inflation persisting for some time, acute anti-inflationary measures are in effect. Inflation is down to 7% but interest base rate is still high, say at 15%. Market demand has declined considerably and recession set in. Due to reduced demand, the borrower's earnings from the use of borrowed funds have declined to say 8%, i.e., much lower than at a time when demand was high or even normal. Banks are committing on average-say-14% interest to depositors and charging 18% to borrowers, i.e., 11% above the inflation rate. The borrower ends up paying 10% (interest rate of 18% less 8% increment obtained on the borrowed funds) from his personal assets. If this situation persists, the borrower will have, over time, exhausted all his personal assets. Meanwhile, to safeguard the depositor's interests, the bank calls in receivers and initiates bankruptcy proceedings against the borrower well before his assets are exhausted. Since the interest rate offered on deposits did not have any relevance to the rate of actual capital generation, the system discriminates in favour of the cash-surplus section of society at the expense of the producerlprovider of goodslservices. Under this example, it is the user of the funds who ends up discriminated against despite the fact that it is he who provides immense benefit to society by creating employment, adding value, and thereby creating real wealth, which eventually contributes to the general welfare of society. After a f ~ e dpre-determined return has been guaranteed to depositors, the conventional bank is forced to charge the borrower a nominal rate to cover the
ISLAMIC FINANCE
cost of funds and to provide return to its shareholders. When the actual generation of wealth is higher, it is tantamount to discrimination against the investor and when lower, against the user. Socio-economic justice in Islam is not an isolated phenomenon but a way of life. Islam considers interest in its present form as unjustified and hence injurious to the health of society. For conwmption loans, interest violates one of the basic functions for which God created wealth, i.e., so that the needy can be supported with surplus wealth. In the case of production loans, pre-determined nominal rate of interest is unjust because of the uncertainty surrounding the entrepreneurial profits. At the same time, interest encourages creation of an idle class of people who receive income without having to put in any labour for it. Society is, therefore, deprived of their labour and enterprise.
Islamic Finance The Islamic financial system allows for the replacement of interest by a return obtained from investment activities and operations that actually generate extra wealth. Under this system, capital, or any income thereon, is guaranteed in advance to the depositor. As such, the Islamic bank has no pre-determined cost of funds and is not under pressure to put up an arbitrary price on the cash that it leds. The income generated from the assets underlying the invested funds is passed to investment depositors ("Investors") after deducting the Islamic bank's management fee. When higher return is obtained from investment activities, Investors in terms of their risk-sharing relationship with Islamic banks receive the relevant higher benefits of such investments. In the event of loss, however, the bank loses its fees while the Investors absorb the loss unless such loss was due to gross negligence on the part of the bank, proved as such. To a classical banker, business is first and foremost an economic activity that converts resources into goods andlor services which meet the needs of society. In certain aspects, financial institutions, in their capacity as trustees of others' assets have over time, moved away to some extent from their classical role and approach. Today's aggressive fund manager has overtaken traditional investors, i.e., pension funds and insurance companies. T o conservativeness and produce of the classical investment banker, has been added certain speculative aspects and high leveraging which has given rise to volatility. Too many instruments move across trading floors without adequate inherent economic substance. In the options market, a fraction of the whole business is actually concluded by delivery while so many make and lose money in the meantime. Leveraging is one of the key factors facilitating take-overs, mergers and acquisitions to alarming proportions. A corporate entity on its own today finds it hard to stave off acquisition-friendly or hostile-whether such acquisitions are for genuine and fair economic reasons or merely aimed at erasing competition or stripping of assets. Today's financial institutions in their typical form are generally quite vulnerable for the following reasons:
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(1) Their capital is at great risk due to high leveraging with their liabilities generally 12 to 30 times their capital. This is well opposed to their own yardstick under which a corporate gearing of even 2 is deemed unhealthy. (2) The definition of a bank has undergone many changes. The modem-day commercial banks are no longer operating in their classical form by c o n f ~ g their operations mainly to short-term. Against their shorter term liabilities, a part of their assets are of longer maturities. While, these guarantee repayment of deposit plus interest, some of their assets may be of unsound quality. Upon forced sale, these could deteriorate in value or be unconvertible quickly. Should unusual payment calls be received from depositors due to any negative developments or rumours, it may be impossible for these financial institutions to easily convert all their assets into cash and honour their commitments. With the liberalising of and opening of domestic banking and capital markets, the increasing range of borrowers as well as the instruments, regulatory authorities continue tightening policies and making stringent prudential ratios. However, it cannot be denied that even today, should a general crisis develop, it may not always be effectively possible for an authority to bail out the country's entire financial sector despite its commitment, best efforts and intentions. Mini crises have occurred in the recent past and continue to occur while there are fears of major crises looming. Too much financial, rather than commercial and economic, consideration of these operations renders the markets inherently weak, prone to high volatility, which could contribute to future crisis. Within the scope of the existing basis of the relationship, Investors have no stake or commitment with the financial institutions or the assets acquired against their investment funds. A small crisis could, therefore, grow by their panic withdrawals. As a consequence, such financial assets will depreciate in value shattering the economic order of society. Islamic banks generally perform the same functions as conventional banks. They act as financial intermediaries, mainly in a trust capacity, as well as administrators of the economy's payments and transfer system. While conventional banks exploit market imperfections (surplus, deficits, information, transaction costs, search and acquisition, financial claims etc.) solely to obtain maximum results for the benefit of their shareholders, the Islamic bank maintains a greater balance between the interests of the Investor, shareholder, user and society. This is because it is required to contribute to socio-economic justice within the framework of its functions of financial intermediation. Due to the very nature of its contractual relationship with the Investors, the Islamic bank is not exposed to the same vulnerability on the following grounds: (1) For the Islamic bank, the Investors' deposits ("Investment Funds"), being on a trust basis, do not count as its own liabilities. Since the Islamic bank is liable only in the case of gross negligence in the performance of its trust functions, if proved as such, Investment Funds may count only as its contingent liability. In this sense, the Islamic bank is not a highly leveraged institution unless
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current account balances in its books are several times its capital base, which is not normally the case. (2) Certain ratios such as Gearing Ratio and Return on Assets ("ROW) have no particular relevance to the Islamic bank, Gearing Ratio for the reason that Investment deposits do not constitute the Islamic bank's liabilities. Lower ROA of a conventional bank reflects weakness and vulnerability in the case of volatility of conditions on both sides. Even a slight negative interest-rate mismatch between those guaranteed to depositors and obtained from assets could erode profitability. In the case of the Islamic bank, there are no guarantees to investors and, therefore, no fixed cost of funds. Variation in income from assets remains to be for the account of the Investors whose funds are originally employed for the acquisition of such assets. This provides for automatic and, in fact, natural adjustment of assets with liabilities without the need for any external intervention. (3) The Islamic bank as trustee has full discretion on the application of the Investment funds under its mutual contractual relationship with the Investors. On the other hand, Investors as, more or less, equity holders or sleeping partners, have natural commitment in the trustee's decisions, and in turn to the underlying assets.
R A I S I N G OF C A P I T A L
As in the case of all developed economies, capital remains one of the key resources in the Islamic economy in that there are not many commercial activities which can be carried out without capital. However, it requires the financial intermediary to allocate capital in a manner which will provide socio-economic justice to society by the creation of wealth and avoidance of discrimination, exploitation or any other form of injustice. Monopoly, unfair price manipulation and hoarding are some of the anti-social practices opposed by Islam, as is interest as a pre-determined nominal rate. Funding is raised by Islamic banks basically through two vehicles, current accounts and investment accounts. Current accounts Current Accounts with the Islamic bank do not earn any income for the depositor directly or indirectly. The Islamic bank receives these funds as a loan and their repayment to the current account customers is absolute and unconditional on its part. If these funds are used by the Islamic bank for productive purposes, the Islamic bank and not the customer bears the risk and reward, and the former assumes full responsibility for all consequences of their use. The Islamic bank may, if conditions require, charge fees to cover expenses to service current account customers. Balances in current accounts are direct liabilities of the Islamic bank. Accordingly, these balances are reported above the line of the Islamic bank's balance sheet as its own direct liabilities and are guaranteed by its capital resources.
ARAB LAW QUARTERLY
Investment Accounts In these accounts are the amounts received from Investors to be invested by, and generally under the full discretion of, the Islamic bank, on a trust basis strictly in conformity with the terms and conditions of the relationship between the Investor and the Islamic bank. The Investors assume all the risks and rewards relevant to such investments. As trustee, the Islamic bank receives a fured percentage of the profit earned as its management fees, the maximum extent of which is provided for in the relationship contract, although the Islamic bank may, at its sole discretion and without any obligation whatsoever, forego a part of its share of profit for the benefit of the Investors. If at any time, assets acquired by the Islamic bank for the benefit of the Investors through their Investment Funds obtain a net loss, it is borne by Investors on a pro rata basis. For that time, the Islamic bank is deprived of its management fee since such fee can only be a percentage of the profits obtained. The Islamic bank is liable for loss only in the event of its gross negligence in the performance of its trust functions, if it is proved as such.
Reserve Account It is also customary within the provisions of the contractual relationship between Investors and the Islamic bank to permit the bank to deduct and provide up to a maximum of a certain percentage from the profits earned as a donation to a reserve account. The balances in this account are meant to offset any unforeseen losses that may be caused to existing assets or those to be acquired in the future. The reserve account provides a safety net and enhances stability to income stream for the Investors. Reserve Account bdances are maintained only for the benefit of the existing and future Investors and the Islamic bank is barred from obtaining any benefit and comfort for its own capital unless it was invested along with investment accounts under the same conditions as for investment accounts. In the event of winding up of the portfolio of Investment accounts, unappropriated balances in a reserve account after meeting all claims of the Investors may be donated to recognised charities.
Modaraba Investment Accounts It is a pool of funds similar to conventional mutual funds. Investment Funds are received into the Modaraba which are generally represented in units. Periodically, the assets underlying the Modaraba are revalued and any increment in value thus obtained is indicated by a relevant change in the unit price of the Modaraba. If the Modaraba terms permit, new Investors enter the Modaraba by buying units at the latest price prevailing at the time of their entry. The existing Investors leaving the Modaraba receive the latest value of the units held by them. The difference between their initial deposit and the value received according to the new unit price will represent the Investor's profit or loss from the relationship.
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The Investor's risk in the Modaraba is confined to the extent of his individual amount of participation. Should losses in a Modaraba exceed the total capital resources there is no recourse against the Investor's personal assets outside the Modaraba. Islamic banks, as trustees, manage the Modarabas with the utmost care, using prudent policies and conservative practices diversifying risk in such a manner that any unfavourable development in any one investment sector will have minimum overall effect on the Modaraba profitability. In many countries, Modarabas are established as separate companies under special laws and are listed on stock exchanges. These marketable securities are an essential part of Islamic financial markets. Many scholars of Islamic economics consider Modaraba as the major instrument contributing to the replacement of interest. Theories have been produced under which the Modaraba instrument can be used as a tool for market operations and hence the main instrument for effecting monetary policies of Islamic states. If an Islamic bank has also committed its own funds along with other investment funds, such funds are subject to the same terms and conditions as are applicable to Investment Funds. In order to provide liquidity, Islamic banks do commit their own funds on the basis of unit value and accept all the risk and rewards relevant to such amounts under the principles of Islamic banking. Under the relationship contract Investors have no voting rights or say in the management of the Modaraba which rests with the Islamic bank under the provisions of the relationship contract. Depending on the terms of the Modaraba, the Islamic bank may raise financing for the benefit of the Modaraba to conduct profitable transactions which cannot otherwise be undertaken within the capital resources of the Modaraba. In countries where Modaraba companies exist under special local statutes, such conduct for the benefit of the Modaraba Investors is duly regulated by local laws.
Leasing Certificates Leasing in the conventional form with a few modifications is an acceptable mode of investment for Islamic banks. A striking difference of the lease contract from other financing vehicles is that rental can be periodically fmed by mutual consent for each subsequent period. Secondary markets can be created for certificate which carry the ownership of good assets, and when external financial institutes providing redemption facilities for such certificates are satisfied with the quality and health of such assets, their proper use and maintenance, since it provides liquidity and is conducive to the development of Islamic financial markets, such an instrument meets the specific needs of the Islamic bank and Investors. A brief outline is discussed under the Use of Funds section below.
Use of funds On the one hand, the use of funds under the Islamic mode of financing is expected to meet socio-economic objectives. On the other, it is imperative that the interests of
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the Investors are duly safeguarded by a sound and efficient decision-making process as well as a management process that governs careful maintenance and monitoring of assets to minimise losses and enhance increment in value of investments. The healthy balancing of these two objectives is obviously a monumental task facing Islamic banks. It requires a full understanding of the economic needs of society at all levels, of various sectors and factors, an excellent grasp of credit assessment techniques and closer involvement through sustained exercise of financial analysis of the enterprise receiving funds well, and to ensure that the use of funds is proper and timely. The Islamic bank is, therefore, expected to perform the dual functions of: i) an investment bank, in the sense that it performs trust, corporate managerial, financial planning, advisory and consultative functions along with the provision of medium-to-longer term equity and project finance: and ii) a commercial bank in relation to its short-term investments, financing functions, as well as providing customer services of varied type and scope. Against the wider scope of its financing responsibilities and operations, the Islamic bank even now has access to very limited forms of financing. major forms of financing follow. FORMS O F FINANCING
Modaraba financing Modaraba is a contract between an Islamic bank and a Client whereby the Islamic bank provides a specific amount of funds to the Client for an enterprise for defined purposes in exchange for a reasonable and highly predictable profit. The Client receives a share in the profit as compensation or a fee for his know-how and management. Entrepreneurs with strong technical and managerial skills but without adequate fmancial strength find it extremely difficult in the contemporary financial world to raise capital for the establishment of viable economic units, or execution of contracts which provide for such sufficient cash flows and earning capability as will allow attractive return on the Investors' capital, in addition to permitting reasonable compensation to the entrepreneur for his know-how and management. Under this contract, the entire capital is provided by the Islamic bank who looks to the user of funds ("Client") for the management and technical know-how and basically to the feasibility (technical, commercial, financial and legal) of the economic unit providing adequate cash flows and earnings that will permit the repayment of principal, return on investment, and in addition, incentive to the entrepreneur within a reasonable time-frame. Depending on the viability of the enterprise, this form of financing is highly conducive to the creation of new entrepreneurs who are technically proficient and have the ability to efficiently run specific enterprises to the highest levels of efficiency and productivity but have no cash resources of their own. In fact, it encourages conversion of know-how and services into capital. The Islamic bank allows all costs of production including management expenses of the Client himself and his labour as deductible expenditure. In addition, the Client
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is permitted a fured percentage of profit as a fee for his know-how and management without which the economic unit would not be in existence and producing. It is normally 15-30% of the profits, depending on the extent and quality of technology, management efforts and expertise involved. This form of remuneration provides considerable incentive to the Client to earn high income and buy out the Islamic bank from the management fees earned out of net profits of such enterprise. However, it remains a high risk method of financing. Alhough the Client has sufficient incentives to make the unit a success, he has no capital committed to the enterprise. The Islamic bank, therefore, puts in extraordinary efforts to carefully scrutinise feasibility and projections provided by the Clients using the most sophisticated credit risk evaluation, analysis techniques and criteria for its decision-making process. Following credit approvals, the Islamic bank takes necessary steps to guard, as far as possible, against completion and operational risks and such common causes of project failures as completion delays, cost-overrun, technical obsolescence and failures, changes in regulatory risk factors, raw material shortages and ineffective marketing while it requires the enterprise to be managed to the highest standards to ensure that the projections are achieved. After the project's completion, the Islamic bank maintains a strict check on operational risks such as the quality, quantity, availability and price of raw materials, any changes in the regulatory and environmental conditions, productivity and effective output at desirable cost levels, adequacy of infrastructure and continued availability of qualified and skilled labour and managerial personnel. If required, Islamic banks may put a member on the Client's board of directors to keep abreast of the developments within the unit. Cross-border Modaraba financing entails varied types of risks. Political and regulatory risks are among the most important as are tax burdens. Consequently, this most desirable form of Islamic finance has not found favour in taxable societies in the West and in unstable environments of developing countries. Local laws in certain countries do not permit banks to take equity stake in the manner prescribed. The following are some of the characteristics of the Modaraba relationship: (1) The relationship is entered into between the parties for a certain duration in which the repayment of capital is provided for on the basis of mutual agreement. (2) Determination of profit distribution and principal repayment is mutually agreed for a certain fixed duration and the date on which such determination is carried out. On such date of determination, audited financial accounts including balance sheet and income statements are submitted to the parties for necessary determination. (3) From the net profit after payment of all costs including management costs (including the salary of the Client himself) the Client is paid his management Fee at the rate prescribed under the relationship contract. The balance of the profit goes to the Islamic bank for distribution to Investors.
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(4) While fued ratios are permissible, fued amounts of profit for either party are not permitted uuder this form of fmancing. (5) Liability for loss rests solely with the Islamic bank unless it is proved that the Client was grossly negligent in the performance of his trust functions in which case the entire loss will have to be borne by the Client. (6) If two or more Islamic banks are involved in providing capital for the Modaraba, the distributable part of the profit, i.e., after payment of management fees, will be distributed between them pro rata to the amount invested by each. (7) Each party exercises business discretion strictly in terms of the relationship contract and discretionary authorities so approved. This avoids confusion and provides clear-cut functional process. (8) The Modaraba capital is only consumed for the purposes approved under the relationship and the Client has no authority to invest such capital in other ventures without prior approval of the Islamic bank. (9) During the relationship, the Client is not permitted to introduce his personal and any other external capital in the unit unless provided for and previously approved by the Islamic bank. (10)It is expected that the Client achieves the projections provided to the Islamic bank at the time of the initiation of the relationship on the basis whereby the Islamic bank decided to enter such a relationship. Should the actual results fdl far short of these projections, the Islamic bank will be within its rights to seek full explanation for such variance and the Client is obliged to provide the same. Should such explanation be found unsatisfactory, the Islamic bank may seek recourse against the Client for misrepresentation. (1 1)The Client is not allowed to appoint another management for the enterprise unless it is provided/approved by the Islamic bank as being necessary for the success of the enterprise. (12)The Modaraba is not permitted to obtain financing from third quarters without prior express permission of the Islamic bank. However, the client may engage in normal trade credit operations which are normal for such a type of business and were duly provided for in the feasibility smdy previously submitted to the Islamic bank. (13)Liabilities of the Islamic bank under the Modaraba are limited to the extent of its capital provided to the Client under the Modaraba contract. Creditors have no recourse to other assets of the Islamic bank should any of their claims remain unsettled against the resources of the enterprise. (14)Either party in the Modaraba contract has the right to terminate the contract. If there be more than two partners, the contract may continue in favour of the remaining partners. Many Islamic jurists agree that at the time of termination of the contract, all the goods and capital should have been converted into cash. Even in the case of a fued-period contract, it will not be legitimate to bind the partners not to terminate the contract until the date of maturity. The Modaraba also terminates upon the death of any one of the partners.
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This principle renders the Modaraba contract relationship weak, particularly when the Modaraba contract covers a long-term project. Modern scholars of Islamic economics have recommended review of certain principles, including this one, in order to eliminate such weaknesses whereby undue advantage or disadvantage to either party is eliminated. Conventional equities are one of the most desirable Islamic financing vehicles. However, all the equities are not approved for Islamic banks for the following reasons:
(1) The main line of business of a number of corporate entities such as banks, insurance companies, other conventional financial institutions, alcohol manufacturing/trading etc., is itself prohibited under Islam. (2) A number of corporate entities themselves issue interest-based debt instruments. Since equity adding, howsoever small, of such entities means part ownership, the same is permitted. Investment in equities is generally risky due to volatility of markets and acute fluctuation in prices. To cover such volatility through diversification, equity portfolios comprise a large number of selected equities picked from diverse business sectors. Some of these may belong to the above-mentioned two groups. Sometimes, even when an entity was not engaged in issuing a debt instrument at the time an Islamic bank joins such portfolio, there is no guarantee that it will not opt to do so while the Islamic bank is still involved in the equities portfolio and leaving at the time may not be in the interest of the portfolio. Due to these constraints, it has not been possible for Islamic banks to freely engage in equity-related investments. Besides, certain types of operations such as "puts" without ownership of the equity are not permitted in Islam. Constraints in the selection of equities and transactional processes due to strict stipulations of Islamic law do not allow diversification, a vital essence for such investment type. These factors have rendered equity investment unsafe and hence unattractive to Islamic banks.
Accounting Treatment Income from a Modaraba relationship is entered in the books of the Islamic bank when cash representing the same is actually alised, It may also be booked when it is recognised or when there is reasonable certainty of its realisation after it has been duly determined and quantified. Musharaka Financing Musharaka financing is the same financing contract as Modaraba except that the Client also provides a part of the capital, in addition to providing management and know-how. On the other hand, the Investor may provide a part of the management and know-how, in addition to capital. In that case, the sharing of the profit from the unit is adjusted accordingly on both sides and the discretionary authority of each
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paruler and a relationship framework is clearly defined. It has also the same relevant implications as listed under Modaraba Financing.
Morabaha Financing Under this contract, the Islamic bank as Investor purchases goods, raw materials, equipment, machinery or any other items of economic significance from a third party at the request of a Client and sells such goods to the Client on a spot or deferred payment basis at its own price. The difference between the purchase cost of the Islamic bank and the sale price to the Client forms the profit available to the Islamic bank from the relationship. The contract normally caters for short-term financing requirements of Clients through legitimate trading practices. Without the financing from the Islamic bank, it will not be possible for the Client to undertake his trading activities to the required extent of his business proportions. Following the Islamic bank and the Client entering into a contract for such a relationship, the bank issues a letter of credit or any other relevant document ordering the purchase of the goods in question from the manufacturer or supplier for onward delivery to the Client. Since Morabaha entails a fured pre-determined rate of return to the Islamic bank, arguments have been raised as to its similarity with conventional interest. However, since the Islamic bank bears several risks until the completion of the delivery which equates it with actual trading, such transactions are considered as legitimate under the provisions of Islamic banking. This contract has the following implications: (1) The customer has the right to reject the goods should these not conform to the required quality. (2) The Islamic bank is not permitted to assign the benefits of, and recourse under, the manufacturer's warranty to the Client. The Islamic bank is responsible for providing services under such warranty to the Client and may, therefore, have to act as an intermediary between the Client and the manufacturer and/or supplier. (3) The Islamic bank is obliged to provide the break-down of its cost and profit and all other expenses involved as are charged to the Client under the sale price. (4) The Client only promises to purchase the goods and is not legally bound to necessarily take delivery of the goods upon arrival at the port of destination should it have a reasonable and justifiable excuse for such refusal. (5) The Islamic Bank always obtains title to the goods before passing these on to the Client. ( 6 ) In countries where imports are subject to duties and taxes, the Islamic bank's profit is treated as a part of the purchase price and is, therefore, subject to such levies and taxes as are charged on imported items thereby increasing the cost of import to the Client. This is because financing by the Islamic bank is treated as trading and not recognised as "debt". Due to this difficulty, trade financing by
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Islamic banks with such countries where import taxes and duties on imported goods are charged, has not developed satisfactorily. The Morabaha contract provides mostly for short-term financing needs of Clients. Due to the inherent liquidity element that this form of financing carries with it, Morabaha financing has been quite widespread with Islamic banks. Unfortunately, due to the non-existence of the inter-Islamic bank market, Islamic banks are hard-pressed to maintain higher liquidity positions than their conventional counterparts. This is one of, the main reasons why a large part of the Islamic banks financing portfolio comprises morabaha. Accounting Treatment
Where the ultimate income is both contractually determinable and quantifiable at the commencement of the transaction, the same is accrued on a straight-line basis over the period of the transaction. Qard Hassan Financing This type of financing is a benevolent type of loan provided free of any charge to certain Clients. This form of Islamic financing for commercial purposes is normally made to an enterprise in difficulty which is separately receiving financing for defined purposes. Such a loan provides financial assistance to the enterprise at no extra cost whereby the viability and profitability of such enterprise itself is considerably enhanced. After the enterprise has reverted to profitability and the two parties agree, Qard Hassan may be converted into equity but not with retrospective effect. This type of financing is also used to provide loans to the needy on humanitarian grounds if the resources of the Islamic bank allow the provision of such loans without unduly affecting its profitability for the Investors and shareholders. This is one form of Islamic finance which incorporates an unconditional obligation on the part of the Client to repay the amount loaned. The Islamic bank has the right to ask for collateral as security. It may also seek full recourse against the client for the recovery of amounts due from him. Ijara Financing This is a contract whereby the Islamic bank purchases an asset and leases it to a Client. The lease contract specifies the leasing period, the amount and timing of lease payments and the responsibilities of both parties during the life of the lease. Leases can be simple rentals or more elaborate contractual arrangements committing the parties to future actions. Islamic principles of finance permit the purchase of an asset for subsequent rental which may include certain profit to the Investor. A commercial or individual Client wishing to acquire the use of capital equipment may request the Islamic bank to purchase such asset and oblige itself to rent such asset from the Islamic bank.
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Subject to the fulfilment of certain conditions, the Client has the option to purchase the asset during the term of the lease. The optional purchase price declines over the term of the agreement. As the customer is not obliged to purchase the asset financed under the Ijara contract at the expiry of the lease, the Islamic bank will not normally take a substantial risk with respect to its residual value at the expiry of the lease. Two most frequently used types of leases are the operating lease and the financing lease. Full amortisation of cost differentiates the financing lease from the operating lease, both of which are acceptable under Islamic principles of finance under specific conditions. The Islamic bank's standard Ijara contract differentiates between the operating and financing lease with regard to its own responsibilities and liabilities. In the former, the Islamic bank is essentially acting as warrantor of the asset leased although the Client makes undertakings as to the utilisation of the asset and its maintenance etc. In the financing lease, the Client must deal directly with the manufacturer or supplier in all matters relating to the leased assets and assumes risk of loss on receiving possession in terms of the stipulations of the lease contract. The Ijara Wa Iktina type lease is a variation of the standard financial Ijara agreement. The Islamic bank purchases the equipment and leases it to the Client but the Client is obliged to purchase the equipment at the end of the lease term. Ijara financing is ideal for the securitisation of the Islamic financial paper, provided that the paper carries adequate redemption underwriting support from financial institutions facilitating redemption on demand. On the other hand, the underlying asset should be easily convertible into cash and so it is imperative that the asset is of high quality, is marketable, is used and maintained to high international standards which are specified, maintains demand and therefore normally adds its market value above its book value, is movable and easily repossessable in the event of default. The instrument also permits some mismatching of short-term liabilities with longterm assets because:
(1) The instrument is marketable and is convertible into cash on demand. (2) Periodic rent reviews are permitted. Accordingly, even though it is a longerterm form of financing, the Investor will never be tied down to a fned type of return which may not meet its investment objectives. Rent review can be tied by mutual consent to any international index that reflects relevant market conditions. If the asset is of high quality, the Islamic bank may not have to rely so much on the credit risk of the client as on the asset itself. This allows a relatively weaker credit risk Client to obtain Ijara financing. These considerations make leasing an attractive type of finance for Islamic banks and there is growing interest on their part in this form of financing. However, the main question is the selection of the assets which meet the criterion. At present, Islamic banks tend to opt for commercial passenger aircraft although it is a very big ticket item and financing for such an asset involves very long periods. Also important is the question of taxation since the Islamic bank's income from this form of financing is taxable in many developed and under-developed countries.
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Islamic Syndication It is usually a large financing facility granted to a key industrial or trading organisation lead-managed by an international bank of standing which is also often the "agent". Since the amount involved is large, a number of financial iXIStituti0n~participate by lending money andlor by taking one of several different management functions. It is impossible for Islamic banks to participate in conventional syndicated transactions since these are mostly interest-related or involve such other forms as are prohibited by Islamic principles. The first ever Islamic syndicated transaction was recently launched by Faysal Islamic Bank of Bahrain E.C. through a composite structure which has now found considerable interest among many Islamic and conventional financial institutions worldwide.
Special Modaraba A Special Modaraba is floated by the Agent bank ("Modareby') in which other financial institutions-Islamic and conventional-participate with their participation amounts. The Special Modaraba conditions stipulate not only the conditions of participation but also clearly spell out the relevant use of funds, the contract documentation used for such use of funds, the Client, the guarantor to the Client's obligations and all other legal documentation required in the relationship from the parties to the transaction.
Agent The Agent performs his functions strictly in accordance with the terms of the Special Modaraba contract.
Morabaha Agreement Being normally short-term, it is normally under the Morabaha contract, as provided for under the Special Modaraba contract, and is signed between the Agent and the Client for the transaction relationship.
Guarantee Document The stipulated guarantee on the approved legal form is obtained by the Agent from the guarantor to the Client's obligations before releasing the syndicated facility.
Other Legal Documents The Agent obtains legal opinions from his own international lawyer, his lawyer in the country of the Client, the Client's own lawyer, and the guarantor's lawyer
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relevant to the covenants, conditions precedent and other relevant terms of the relationship requiring legal opinions for the satisfaction of the Agent and participants. Upon completion of this documentation, the Agent proceeds accordingly and maintains the relationship. The participating banks do not have any direct relationship with the Client as the Agent acts for them for all purposes under his own name. The entire management responsibilities are carried out by the Agent except in the beginning when the participant banks decide on the credit risk and legal documentation. Thereafter, there is very little administrative work, and in turn administrative costs, involved for the participants. Therefore, the instrument is very popular among Islamic and conventional banks alike. Seven syndicated transactions for a total amount of US$600 million offered by the Faysal Islamic Bank of Bahrain E.C. were all immediately consumed. The last transaction for US$100 million was 100% oversubscribed within a week of the first solicitation. This experience indicates the viability of Islamic financial products among Islamic and conventional financial instruments. Provided that legal requirements of today's complex environment are met effectively and loopholes adequately plugged, there is no reason why other forms of Islamic finance should not be accepted by the financial institutions and the financing clients. On the other hand, Islamic banks also look to conventional financial institutions for instruments and portfolios that meet their objectives and are within the prescribed bounds of the principles of Islamic banking. Islamic banks are also willing to join hands with conventional institutions in order to produce such instruments and portfolios in which Islamic financial institutions can participate. There are already a number of examples in h s respect and it is hoped that this co-operation will grow further in the due course of time. Meanwhile, from experience Islamic banks are endeavouring to iron out problems and weaknesses-operational, structural and legal-in order to make their own instruments viable. In this regard, Islamic economists and jurists are meeting together at various forums trying to investigate the considerations of Shari'a in this respect. General Problems Faced by Islamic Banks Islamic banks suffer from a number of problems-operational, legal, and infrastructural. Some of these follow.
Loss of Opportuni~ In the event of failure on the part of the Client to repay its fured obligations to an Islamic bank on the due date, damages are permitted under Islam for payment to the Islamic bank. However, these are subject to the following conditions:
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(1) Several warning letters are issued in a certain time to the client asking him to repay the amounts overdue. (2) The first occurrence of non-payment will not count as admissible for charging damages. (3) It is to be ensured that the Client has the fmancial capacity to meet his commitment. A temporary cash flow problem will not be regarded as the Client's genuine inability to repay but rather be treated as financial mismanagement on his part. (4) Such damages will be equal to the rate of profit which the Investors under the relevant Modaraba would have otherwise received had the repayments been made on time. These conditions, being protracted, contribute to inefficiency in the collection of dues from customers. Particularly in the retail trade, this process will considerably increase costs of the Islamic bank. When larger amounts are involved, a remission in the first period of default will be substantial in monetary terms. Since margins of profit in international trade are highly competitive and thin, Islamic banks cannot afford any opportunity loss. Accordingly, this subject needs considerable further study, discussion and review by Islamic jurists.
Shari'a Law's Admissibility in International Courts The matter of admissibility of legal contracts bound by Shari'a laws in international courts has many implications. Even when contracts between two parties may be acceptable in certain courts, in the event of a dispute, local law will prevail should any of the Shari'a provisions violate the relevant provisions of the local law. Should such provisions of the local law mean violation of the Shari'a law itself, the same will not be acceptable to the Islamic bank. This leaves the Islamic bank in a great quandary as it may not be able to obtain full recourse against the Client under the contract that was prepared in accordance with the provisions of the Shari'a.
Manpower Shortage Unwillingness on the part of many to move away from the mainstream of conventional banking is a situation that Islamic banks are faced with today which is hampering the building of their manpower resources and further development. This is because Islamic banking as an alternative financial system is not considered by many in conventional banking as a well established phenomenon. Nor do Islamic establishments have such a wide network and scope so that a professional in conventional banking may comfortably look towards a future career in the same sense as he looks to the conventional ones. Opting to change over to Islamic banking for a conventional banker amounts to him sacrificing his interests unless he is religiously committed to the concept. Accordingly, manpower development within Islamic banking is faced with added difficulties on that account alone.
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Track Record Only a couple of decades old, Islamic banking in practice is relatively very young. The lack of a long established track record in Islamic banking does not give investor an adequate sense of comfort. Even a slight negative movement in results can, therefore, induce this lack of comfort and may lead to a run on deposits. Islamic banks are, therefore, forced to maintain an unusually high level of liquidity which adversely affects their profitability.
Undeveloped Interbank and Financial Markets Inter-Islamic-bank markets are almost non-existent so that Islamic banks cannot place or raise funds from among themselves on an established pattern. Only in Pakistan and Iran do such markets exist, but these are relevant to the local currencies only. On the other hand, financial markets as exchange systems that allow for trading of financial instruments are not yet well developed in the Islamic financial world. These markets comprise persons, agents, brokers, institutions and intermediaries who operate under laws, contracts and extensive communication networks, all of which are not ideal for Islamic financial instruments or else ideally developed within the Islamic world. Islamic financial institutions are, therefore, hard-pressed to produce instruments which will function and achieve their objectives within the contemporary situation, or in a more restricted environment such as limited secondary trading within a certain group of financial institutions supporting a certain instrument. The development, over time, of Islamic banking in general, and their instruments in particular, as well as a change of regulation within Islamic countries, will in the long run contribute to the development of Islamic financial markets. Stock exchanges are coming into existence in many Islamic countries, as are certain instruments, but there is still a long way to go before Islamic financial markets attain maturity.
Lack of Unifnvn Accounting Standards for Islamic Banking Among Islamic financial institutions, there is generally no uniformity in accounting policies and standards. As a result, there is no consistency in the accounting treatment of various operations; even the presentation of their financial statements. In this situation, the reader of financial accounts of an Islamic financial institution finds it hard to relate the results of one institution with another. For example, the Invesunent Funds in one institution are expressed as the Funds Under Management and reported below the line of its balance sheet on the premise that according to the Shari'a, such funds are invested for the benefit and at the risk of the customer and being fiduciary in nature do not form pan of the bank's liabilities. Another bank will report the same above the line within its balance sheet because the relevant regulatory authority in whose jurisdiction it operates requires it to do so for reserve and other prudential ratio evaluation purposes. Similarly, the treatment of accrual of morabaha profit over the period of the transaction also differs. While one Islamic financial institution may book
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the entire transaction profit on the day of the sale, the other may amortise it over the transaction period on "straight line" basis to provide relevant income on investment throughout the period. Islamic banks have recently agreed to establish an accounting standards board in Bahrain which should ultimately solve this problem. CONCLUSION
Despite the weaknesses, handicaps and problems faced by Islamic banks, they have proved themselves by their viable operational existence in the past over two decades. The future looks promising for them if only they adhere to the ethical codes of their trust functions and hold dearest to them the objectives of Islamic banking. As Henry Kaiser said, "problems are only opportunities in work clothes" which Friedrich Durrenmatt describes, in his "21 Points", as "what concerns everyone can be resolved by everyone". BIBLIOGRAPHY
Abu Saeed, Dr Mahmud; Money, Interest and Qirad.
A1 Qaradawi, Dr Yousuf; "The Lawful and the Prohibited in Islam", I.I.F.S.C.
Kuwait.
Anwar, Dr Muhammad; "Modelling Interest-Free Economy", The Institute of Islamic
Thought, Herndon, Va.22070, USA.
Chopra, M. Umar; "Towards a Just Monetary System", The Islamic Foundation,
Leicester, UK.
International Monetary Fund; "Islam Banking".
Jansen, G.H.; Militant Islam.
Khan, Dr Moshin S.; "Monetary Policy in an Islamic Economy", Islamic Banking
Conference, Bahrain 1990.
Montefiore, Hugh, Bishop of Birmingham: "Banking World December 1984".
Siddiqui, Dr Muhammad Nejatullah; "Partnership and Profit-Sharing Islamic Law",
The Islamic Foundation, UK.
