Monday, November 23, 2009

FAQs in Islamic Banking

FAQs (source

Q1. What is Islamic Banking?
Q2. What is the philosophy of Islamic banking and finance?
Q3. What is the Islamic Banking Global Scenario?
Q4. What are the Major modes of Islamic banking and finance?
Q5. Can Islamic banks play any role in economic development of the Country?
Q6. What are the features of State Bank’s Islamic Export Refinance Scheme?
Q7. Is it permissible for an Islamic bank to impose penalty for late payment?
Q8. Can Islamic banks claim solatium or liquidated damages on account of late payment/default by the clients?

Q1. What is Islamic Banking?
Ans. 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. Interest free banking is a narrow concept denoting a number of banking instruments or operations, which avoid interest. Islamic banking, the more general term is expected not only to avoid interest-based transactions, prohibited in the Islamic Shariah, but also to avoid unethical practices and participate actively in achieving the goals and objectives of an Islamic economy.

Q2. What is the philosophy of Islamic banking and finance?
Ans. Islamic Shariah prohibits ‘interest’ but it does not prohibit all gains on capital. It is only the increase stipulated or sought over the principal of a loan or debt that is prohibited. 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 Verse 2:275 of the Holy Quran, makes the financial activities in an Islamic set-up real asset-backed with ability to cause ‘value addition’. Islamic banking system is based on risk-sharing, owning and handling of physical goods, involvement in the process of trading, leasing and construction contracts using various Islamic modes of finance. 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. The forms of businesses allowed by Islam at the time the Holy Quran was revealed included joint ventures based on sharing of risks & profits and provision of services through trading, both cash and credit, and leasing activities. In the Verse II:275, Allah the Almighty did not deny the apparent similarity between trade profit in credit sale and Riba in loaning, but resolutely informed that Allah has permitted trade and prohibited Riba. Profit has been recognized as ‘reward’ for (use of) capital and Islam permits gainful deployment of surplus resources for enhancement of their value. However, alongwith 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 conduct of fiscal and monetary policies. Besides trading, Islam allows leasing of assets and getting rentals against the usufruct taken by the lessee. 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 lessor who assumes risks and gets rewards of his ownership.

Q3. What is the Islamic Banking Global Scenario?
Ans. Over the last three decades Islamic banking and finance has developed into a full-fledged system and discipline reportedly growing at the rate of 15percent per annum. Today, Islamic financial institutions, in one form or the other, are working in about 75 countries of the world. Besides individual financial institutions operating in many countries, efforts have been underway to implement Islamic banking on a country wide and comprehensive basis in a number of countries. The instruments used by them, both on assets and liabilities sides, have developed significantly and therefore, they are also participating in the money and capital market transactions. In Malaysia, Bahrain and a few other countries of the Gulf, Islamic banks and financial institutions are working parallel with the conventional system. Bahrain with the largest concentration of Islamic financial institutions in the Middle East region, is hosting 26 Islamic financial institutions dealing in diversified activities including commercial banking, investment banking, offshore banking and funds management. It pursues a dual banking system, where Islamic banks operate in the environment in which Bahrain Monetary Agency (BMA) affords equal opportunities and treatment for Islamic banks as for conventional banks. Bahrain also hosts the newly created Liquidity Management Centre (LMC) and the International Islamic Financial Market (IIFM) to coordinate the operations of Islamic banks in the world. To provide appropriate regulatory set up, the BMA has introduced a comprehensive prudential and reporting framework that is industry-specific to the concept of Islamic banking and finance. Further, the BMA has pioneered a range of innovations designed to broaden the depth of Islamic financial markets and to provide Islamic institutions with wider opportunities to manage their liquidity. Another country that has a visible existence of Islamic banking at comprehensive level is Malaysia where both conventional and Islamic banking systems are working in a competitive environment. The share of Islamic banking operations in Malaysia has grown from a nil in 1983 to above 8 percent of total financial system in 2003. They have a plan to enhance this share to 20 percent by the year 2010. However, there are some conceptual differences in interpretation and Shariah position of various contracts like sale and purchase of debt instruments and grant of gifts on savings and financial papers. In Sudan, a system of Islamic banking and finance is in operation at national level. Like other Islamic banks around the world the banks in Sudan have been relying in the past on Murabaha financing. However, the share of Musharaka and Mudaraba operations is on increase and presently constitutes about 40 percent of total bank financing. Although the Islamic financial system has taken a good start in Sudan, significant problems still remain to be addressed. Like Sudan, Iran also switched over to Usury Free Banking at national level in March 1984. However, there are some conceptual differences between Islamic banking in Iran and the mainstream movement of Islamic banking and finance. Owing to the growing amount of capital availability with Islamic banks, the refining of Islamic financing techniques and the huge requirement of infrastructure development in Muslim countries there has been a large number of project finance deals particularly in the Middle East region. Islamic banks now participate in a wide financing domain stretching from simple Shariah-compliant retail products to highly complex structured finance and large-scale project lending. These projects, inter alia, include power stations, water plants, roads, bridges and other infrastructure projects. Bahrain is the leading centre for Islamic finance in the Middle East region. The establishment of the Prudential Information and Regulatory Framework for Islamic Banks (PIRI) by the BMA in conjunction with AAOIFI has gone a long way towards establishing a legal and regulatory framework to meet the specific risks inherent in Islamic financing structures. The BMA has quite recently signed MoU with the London Metal Exchange (LME) to pool assets to develop and promote Shariah compliant tradable instruments for Islamic banking industry. The arrangement is seen as a major boost for industry’s integration in the global financial system and should set the pace for commodity-trading environment in Bahrain. BMA has also finalized draft guidelines for issuance of Islamic bonds and securities from Bahrain. In May 03, the Liquidity Management Centre (LMC) launched its debut US$ 250 million Sukuk on behalf of the Government of Bahrain. National Commercial Bank (NCB) of Saudi Arabia has introduced an Advance Card that has all the benefits of a regular credit card. The card does not have a credit line and instead has a prepaid line. As such, it does not incur any interest. Added benefits are purchase protection, travel accident insurance, etc and no interest, no extra fees with no conditions, the card is fully Shariah compliant. It is more secure than cash, easy to load up and has worldwide acceptance. This prepaid card facility is especially attractive to women, youth, self employed and small establishment employees who sometimes do not meet the strictrequirements of a regular credit card facility. Saudi Government has also endorsed an Islamic-based law to regulate the kingdom's lucrative Takaful sector and opened it for foreign investors. Islamic banks have also built a strong presence in Malaysia, where Standard & Poor's assigned a BBB+ rating to the $600 million Sharia-compliant trust certificates (called sukuk) issued by Malaysia Global Sukuk Inc. Bank Negara Malaysia (BNM) has announced to issue new Islamic Bank licences to foreign players. The Financial Sector Master plan maps out the liberalisation of Malaysia's banking and insurance industry in three phases during the next decade. It lists incentives to develop the Islamic financial sector and enlarge its market share to 20 percent, from under 10 percent now. A dedicated high court has been set up to handle Islamic banking and finance cases. In United Kingdom, the Financial Services Authority is in final stages of issuing its first ever Islamic banking license to the proposed Islamic Bank of Britain, which has been sponsored by Gulf and UK investors. The United States of America has appointed Dr. Mahmoud El Gamal, an eminent economist/expert on Islamic banking to advise the US Treasury and Government departments on Islamic finance in June 2004.

Q4. What are the Major modes of Islamic banking and finance?
Ans. Following are the main modes of Islamic banking and finance:

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

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

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

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

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.

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.

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.

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.

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.

Q6. Can Islamic banks play any role in economic development of the Country?
Ans. Islamic banks, while functioning within the framework of Shariah, can perform a crucial task of resource mobilization, their efficient allocation on the basis of both PLS (Musharaka and Mudaraba) and non-PLS (trading & leasing) based categories of modes and strengthening the payments systems to contribute significantly to economic growth and development. Sharing modes can be used for short, medium and long-term project financing, import financing, pre-shipment export financing, working capital financing and financing of all single transactions. In order to ensure maximum role of Islamic finance in development of the economy it would be necessary to create an environment that could induce financiers to earmark more funds for Musharakah/Mudarabah based financing of productive units, particularly of small enterprises. 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 interestfree scenario with additional benefit of greater supply of risk-based capital alongwith 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 marketespecially 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 ofagricultural products or the time when they actually need industrial goods and without being forced to spend their savings on consumption. Banks might engage in fund and portfolio management through a number of asset management and leasing & trading companies. Such companies/entities can exist in the economy on their own or can be an integral part of some big companies or subsidiaries, as in the case of Universal Banking in Europe. They would manage Investors Schemes to mobilize resources on Mudarabah basis and to some extent on agency basis,and use the funds so collected on Murabaha, leasing or equity participation basis. Subsidiaries can be created for specific sectors/operations, which would enter into genuine trade and leasing transactions. LowriskFunds based on short-term Murabaha and leasing operations of the banks in both local as well as foreign currencies would be best suited for risk-averse savers who cannot afford possible losses, in PLS based investments. Under equity based Funds, banks can offer a type of equity exposure through specifiedinvestment accounts where they may identify possible investment opportunities from existing or newbusiness clients and invite account-holder to subscribe. Instead of sharing in the bank’s profit, the investors would share the profits of the enterprise in which funds are placed with the bank taking a management fee for its work. Banks can also offer open-ended Multiple Equity Funds to be invested in stocks. 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 arrangements or otherwise.

Q7. What are the features of State Bank’s Islamic Export Refinance Scheme?
Ans. State Bank of Pakistan has introduced a Musharakah-based Islamic Export Refinance Scheme (IERS) to meet the export financing requirements of banks conducting operations under Islamic Modes. IBIs can avail this facility under both parts of SBP’s Export Finance Scheme (EFS). The framework of the IERS is based on the concept of Profit & Loss Sharing. The State Bank shares the actual profit of the Musharakah pool of the Islamic Bank. However, in case the actual profit of the pool is more than ongoing rates under conventional EFS, the excess profit so received by SBP would be credited to the Takaful fund, a reserve fund to be maintained by SBP under Islamic modes for risk mitigation that would be used to meet future losses arising on implementation of IERS. Salient features of the Scheme are as under:
1. The facility is allowed only against transactions, designed on the basis of Islamic Modes of financing approved by the Shariah Advisor/Board of the concerned bank.
2. 2. Each Islamic bank shall be under obligation to create a Musharakah pool (having a minimum of 10 companies - to be achieved in first year of operations) consisting of financing to blue chip companies on Islamic modes. The blue chip companies shall mean such companies involved in the export business or other business or both, or a manufacturing concern marketing their products in Pakistan or abroad, who have i) good track record on the stock exchange or ii) have a rating of minimum B + or equivalent by the rating agencies approved by the State Bank for rating banks in Pakistan, such rating should be acceptable to the bank as per its own lending policies, for advancing loans, or iii) companies having Return on Equity (ROE) during last three years which should be at least higher than the rates of finance prescribed by the
State Bank during those years on its conventional EFS. In case of a company which is in operation for less
than three years, the ROE of the available number of years shall be considered. The Islamic Bank shall
ensure that companies selected for Musharakah Pool under the above criteria does not have adverse Credit
Information Bureau report as also export overdues of more than one year.
3. The State Bank will share in the overall profit (gross income less any provision created under Prudential
Regulations during the period plus amount recovered against prior periods’ losses and reversal of provision)
earned by the Islamic bank on the Musharaka pool under the provisions of the IERS calculated on daily
product basis.
4. If, on the basis of the annual audited accounts of the Islamic Bank, the profit accruing to the SBP is more
than the profit paid to the SBP on quarterly basis as per un-audited accounts of earnings of the pool, the
difference shall be deposited by the Islamic bank, within 7 days of its determination, in a special non
remunerative reserve fund viz. “Takaful Fund” to be maintained at the office of the SBP BSC (Bank), where
the head office/country office of the concerned bank is situated. This arrangement shall remain effective for
all intents and purposes for the duration of the agreement.
5. If, on the basis of the annual audited accounts of the pool, the share of the State Bank in the profit
works out to be less than the amount, which has already been paid to the State Bank on provisional basis,
the State Bank will refund the excess amount involved out of balance held in the Takaful Fund, if any.
6. In the event of loss suffered on the Musharakah pool on the basis of annual audited accounts, the Islamic
bank and the State Bank shall share the loss in the proportion of their share of investment in the
Musharakah Pool expressed on daily product basis. The share of loss to State Bank will first be met out of
credit balance in the Takaful Fund, if any. The loss not met from the Takaful Fund shall be borne by the
State Bank.
7. In case of loss, the Islamic bank shall be entitled to claim refund on account of share of profit paid by it
to SBP on provisional basis, alongwith SBP’s share in the loss of principal amount extended to the
Musharakah pool.

Q8. Is it permissible for an Islamic bank to impose penalty for late payment?
Ans. In Islamic law it is permissible to penalize a debtor who is financially sound but delays payment of debt without any genuine reason. Such act of the debtor is unjust as the Prophet (PBUH) has said, "A rich debtor who delays payment of debt commits Zulm". A heavy non-performing portfolio and default on part of the clients is a serious problem confronting the financial institutions all over the world including Pakistan. This problem could be a threat to success of Islamic banking system. If clients do not honor their commitment in respect of timely payment of a debt created in installment sale, Murabaha, leasing or do not pay banks’ share of profit in participatory modes or do not deliver goods at stipulated time in Salam and Istisna’a, it could cause irreparable loss to the system, the banks and financial institutions and ultimately to savers and the economy. The jurists allow punishment (T´azir) to such borrower in the form of fine. In the opinion of some Maliki jurists a delaying borrower would be obliged to pay for charitable activities. In view of the severity of the problem, all Shariah bodies like Islamic Fiqh Academy of the OIC, Shariat Appellate Bench of the Supreme Court of Pakistan, etc. have approved the provision of penalty clause in the contractual agreements that keeps a balance between the requirement in view of severity of the problem and that of the Shariah conditions/principles to keep the fine difference between interest and Murabaha profit intact. However, the penalty proceeds would be used for charity because penalty on default in repayment cannot become an automatic source of income for the creditor.

Q9. Can Islamic banks claim solatium or liquidated damages on account of late payment/default by the clients?
Ans. The contemporary Shariah scholars have evolved a consensus that banks are authorized to impose late fees on the delinquent. But proceeds of such penalty are to be used for charity purposes. Only the court or any independent body can allocate any part of the penalty as liquidated damages / solatium for the banks. Liquidated damages can be given to banks in case of default on the part of banks’ clients provided it is based on actual financial loss. The court may reasonably adjust the amount of compensation. The ‘actual financial loss’ cannot be the loss in terms of conventional ‘opportunity cost’. It has to be proved by the bankers themselves to the satisfaction of the court or any arbitrator. However, some Shariah Boards allow Islamic banks to charge from the defaulter the rate realized by them on their Murabaha portfolio during a specific period. They also recommend that the financial condition of the client be taken into account.

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