dynamic model of islamic bank profitability

Journal of Islamic Banking and Finance April – June 2013 1

2 Journal of Islamic Banking and Finance April – June 2013

IN THE NAME OF ALLAH, THE BENEFICENT,

THE MERCIFUL

O ye who believe Fear God and give up what remains of your demand for usury if ye are indeed believers.

If ye do not, take notice of war from God and His Apostle. But if ye turn back ye shall have your capital sums. Deal not

unjustly, And ye shall not be dealt with unjustly.

SURA AL BAQARA II VERSE 278-279

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The articles published in this Journal contain references from the

sacred verses of Holy Qur’an and Traditions of the prophet (p.b.u.h) printed for the understanding and the benefit of our

readers. Please maintain their due sanctity and ensure that the pages on which these are printed should be disposed of in the

proper Islamic manner


Journal of Islamic Banking and Finance

Volume 30 April – June. 2013 No. 2 Founding Chairman Muazzam Ali (Late) Former –Vice Chairman Dar Al-Maal Al-Islami Trust, Geneva, Switzerland

Board of Editorial Advisors

Ahmed Ali Siddiqui Mufti Bilal Qazi S. A. Q. Haqqani Dr. Hasan uz Zaman Dr. Mohammad Uzair Altaf Noor Ali (ACA)

Chairman Basheer Ahmed Chowdry

Editor Aftab Ahmad Siddiqi

Co-ordinator Research & Marketing Mohammad Farhan Business Executive A. N. Haqqani Published by International Association of Islamic Banks Karachi, Pakistan. Ph: 35837315 Fax: 35837315 Email: ia _ ib @ yahoo.com Follow us on Facebook: http://www.facebook.com/JIBFK

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International Advisory Panel

Professor Dr. Mohd. Ma’sum Billah Chairman, Middle Eastern Business World (MBW) Group of Companies, Kuala Lumpur Malaysia.

Professor Dr. Rodney Wilson School of Government and International Affairs, Durham University, UK

Dr, R. Ibrahim Adebayo Department of Religions, University of Ilorin, Nigeria Prof. Dr. Zubair Hasan The Global University of Islamic Finance, Kuala Lumpur, Malaysia Dr. Waheed Akhtar Assistant Professor, Comsats Institute of Information Technology (CIIT), Lahore, Pakistan Dr. Manzoor Ahmed Al-Azhari, PhD Legal Policy (Shariah Law) Chair, Department of Islamic Studies, Institute of Religious Education & Research, (IRER) HITEC University Taxila Cantt, Pakistan. Professor Dr. Khawaja Amjad Saeed FCA, FCMA Hailey College of Banking & Finance University of Punjab, Lahore, Pakistan Dr. Mehboob ul Hassan Professor, Department of Business Administration Sindh Madarsatul Islam University, Karachi, Pakistan Mr. Salman Ahmed Sheikh External Reviewer Bankers Academy USA, Research Associate & Faculty Member IBA Karachi and also Heads of Islamic Economics Project Prof/ Dr. Habib ur Rahman Head Business Administration Deptt Sarhad University of Science & Information Technology, Peshawar, Pakistan

Dr Muhammad Zubair Usmani Jamia Daraluloom Karachi


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Journal of Islamic Banking and Finance

Volume 30 April – June 2013 No. 02

C O N T E N T S 1. Editor’s Note ----------------------------------------------------------------------------------5 2. Sub prime crises and the lessons for the Islamic Financial Industry -------------9 By Suleman Muhammad Ali 3. A Competitive Analysis of Islamic and Conventional Banks In Pakistan during Global Recession------------------------------------------------------------------ 22 By Syed Farhan Najum and Ifran Anjum 4. Non-Interest Banking System in Nigeria: Shari’ah Perspective ---------------- 28 By Dr. Huud Shittu 5. Analysis of Promise in Islamic Law, Definition and the Opinions of Muslim Jurists with regard to Binding Nature of Promise ---------------------------------- 43 By Dr. Mohammad Nawaz (Al Hassani) 6. Firm’s Behavior in Islamic Economics ------------------------------------------------ 59 By Salman Ahmed Shaikh 7. Adoption of AAOIFI Shariah Standards: Case of Pakistan ---------------------- 68 8. Islamic Finance in a Multipolar World: Traversing the Complexities of a New World----------------------------------------------------------------------------- 75 By Abbas Mirakhore and Mughees Shaukat 9. Dynamic Model Of Islamic Bank Profitability -------------------------------------- 85 By Titi Dewi Warninda 10. Efficiency and Performance of Islamic Banks in Bangladesh -------------------- 92

By Muhamad Abduh, Sidratul Mahabub Hasan and Alfatih Gesan Pananjund

11. Country Models ---------------------------------------------------------------------------105 ° Bangladesh 12. News Monitor ------------------------------------------------------------------------------107


Editor’s Note

Islamic finance has witnessed substantial growth globally over the last four decades. The Islamic financial system has gained worldwide acceptance, the demand for Islamic finance is not just confined to Muslim countries but many western counties is also acknowledging the significance of Islamic finance as an alternate and viable financing mechanism. The asset backed nature of Islamic financial transaction, coupled with prohibitation as speculative activity makes Islamic finance stable and prudent system than its conventional counterpart. The Islamic financial sector less affected than the conventional banking system during the global financial crisis.

This issue of Journal of Islamic Banking & Finance documents scholarly contributions from authors around the globe. Scholarly contributions in this current issue discuss the theoretical underpinnings of an Islamic economy, contemporary issues in Islamic finance and performance based empirical studies on Islamic banking and finance.

The article “Subprime crises and the lessons for the Islamic Financial Industry” by Suleman Muhammad Ali stresses on the need to learn important lessons from the subprime crises. The paper diagnoses the reasons that caused the subprime crises and then goes on to suggest various factors that need to be taken care of and measures to be taken by the IFI industry players to avoid the chaos experienced by interest based financial system.

The author notes that since Shariah compliance requirements deter it from investing in products which are based on gambling (Maiser) and trading of debts (Bai al Dayn), the IFI and its players have not been exposed to instruments such as CDS and debt based MBS. However, most of the Islamic Banks have been graced with excess liquidity; generated through retail deposits; which the Islamic banks have been unable to place efficiently due to limited availability of Shariah compliant liquidity management products.

The Second article “A Competitive Analysis of Islamic and Conventional Banks in Pakistan during Global Recession” by Syed Farhan Najum & Irfan Anjum Manarvi analyzes the performance of Islamic and conventional banks in Pakistan during and after the recession period. Using financial ratios such as ADR, ROI, D/E, current ratio and WC ratio were used to carry out this analysis. Both the types of banks were found to be hit by the recession, however the effect on Islamic banks was observed to be lower than the conventional bank. The results revealed that old banks performed better than new entrants.

Their results depict that even though Islamic banks are doing interest free banking to avoid uncertainty but still they got affected by the global recession. The banks in


Pakistan neither conventional nor Islamic remained unaffected except the effect on ROI. The crisis could not affect it because of different operational nature and secure interest free investment in Islamic banks.

The next article “Non-Interest Banking System in Nigerian: Shari’ah Perspectives” By Dr. Huud Shittu using primary and secondary data examines the objectives of the non-interest banking system. It surveys some countries where pilot projects on Islamic banking system were carried out and subsequently substantiated. The author argues that one of the main selling points of Islamic banking, at least in theory, unlike conventional Banks, is about the viability of the project and the profitability of the operation but not the size of the collateral. Good projects which might be turned down by conventional Banks for lack of collateral would be financed by Islamic Banks on a profit-sharing basis. It is especially in this sense that Islamic Banks can play a role in stimulating economic development. In many developing countries, of course, development Banks are supposed to perform this function. Islamic Banks are expected to be more enterprising than their conventional counterparts. In practice, however, Islamic Banks have been concentrating on short-term trade finance which is the least risky. The paper encourages increased use of partnership modes and government’s support for promotion of Islamic banking in Nigeria.

In the next paper “Analysis of Promise in Islamic Law Definition and the Opinions of Muslim Jurists with Regard to Binding Nature of Promise”, Dr. Mohammad Nawaz explained the meaning of promise {al Wad} and discussed about the opinions of Muslim scholars with regard to the binding nature of promise in Islamic law and analyzed their evidences on their view points and provided the preference in this regard. The article described the opinion of Muslim jurists with regard to validity of contract concluded on the bases of promise and analyzed their arguments in detail and provided the preference in this regard. This article analyzed the opinion of contemporary scholars who hold that promise is binding and enforceable by court and the contract which based on such promise is also valid and the article rejected their opinion with strong evidences and mentioned that the opinion of contemporary scholars does not have any conformity with the opinion of classical jurists neither Hanfi, Shafei and Hanbli Jurist nor Malki jurists and proved that the opinion of contemporary jurists is combined from the clashes.

The fifth article “Firm’s Behavior in Islamic Economics” by Salman Ahmed Shaikh attempts to explain the distinctive features of Islamic Economics that guide the equitable distribution of resources in an economy. Prohibition of interest and institution of Zakat encourage investment, spending and circulation of wealth. It is discussed that how Islamic principles help in achieving both efficiency and equity. Islam does not disallow market and price mechanism, but compliment them with rules and institutions that ensure distributive justice, equity and social welfare. The paper also discusses how Islamic principles help moderate greed, pursuit of self-interest and how ethical principles and afterlife accountability result in including externalities and marginal social cost in firm’s economic accounting of profits and costs. In the final section, it is argued that the Islamic ethical principles have far reaching effects on corporate governance.

Following fifth article, the next article is “Adoption of AAOIFI Shariah Standards: Case of Pakistan”. AAOIFI is one of globally recognized international bodies that prepare Shariah based accounting, auditing, governance, ethics and Shariah Standards for


the Islamic financial industry. AAOIFI based standards are generally considered to be globally acceptance and are adopted in various jurisdictions of the world.

Moving ahead, the next article is on “Islamic Finance in a Multi-polar World: Traversing the Complexities of a New World” by Abbas Mirakhor and Mughees Shaukat discusses that the recent financial developments have given rise to a developing consensus that the Uni-polar economic growth regime dominated by U.S, Japan and few European centers, is under great stress. The consensus takes into consideration the present financial stresses and strains, and uncertainty surrounding the sustainability of the Uni-polar regime, which has given way to a shift towards a Multi-polar economic setup. Continuation of debt-based financing regime (the hallmarks of which are risk transfer and risk shifting) will not necessarily allow the benefits of emerging Multi-polarity to accrue to the world economy. The new system can be more effective with a new regime of financing. Indications are that almost all emerging countries in Asia are actively considering risk sharing via Islamic finance as a possible alternative.

The eight article is on “Dynamic Model of Islamic Bank Profitability” by Titi Dewi Warninda quantitatively analyzes profitability determinants in Islamic banks in the short and long run. Using data of Indonesian Islamic banks, it applies dynamic model of Error Correction Model (ECM) to find several internal and external factors that influence Islamic bank profitability in the short and long run. This research shows that Total Financing becomes dominant variable in the short run and has positive effect. In the long run, Loan Loss Provision becomes dominant variable but has negative effect. Markup Financing has significant influence in the short and long run, but Equity Financing only has significant influence in the long run. Surprisingly, this research indicates that Equity Financing has stronger influence than Markup Financing in the long run.

Based on ECM result analysis above, Total Financing, Money Supply, Markup Financing, and Bank Size become variables that positively influence Islamic banks profitability in the short run. But no variable has negative influence in the short run. Total Financing, Equity Financing, Mark up Financing, Money Supply, Bank Size, and Mudarabahh Time Deposit become variables that positively influence Islamic banks profitability in the long run. While Loan Loss Provision becomes variable that has negative effect in the long run.

The last paper talked about “Efficiency and Performance of Islamic Banks in Bangladesh: Evidence from the period of 2006-2010” by Muhamad Abduh, Sidratul Mahabub Hasan & Alfatih Gesan Pananjung investigates the efficiency and performance of five Islamic banks in Bangladesh using ratio analysis and data envelopment analysis. The study established that with regard to banks’ efficiency, all Islamic banks have shown an improvement in their efficiency level.

Disclaimer

The authors themselves are responsible for the views and opinions expressed by them in their articles published in this Journal.


OBITUARY

The Management of JIBF is deeply grieved on the sad demise of our Associate Editor Syed Mazhar Ali, who passes away on May 11, 2013. May Allah Almighty rest the soul in peace. (Ameen)

(Please recite Surah-e-Fatiha)

Syed Mazhar Ali was born in Delhi in Nov’ 1923. He worked at sessions court and Sindh secretariat Karachi. He left the country to go to Saudi Arabia in year 1975 to work in Aramco. Later he returned from Saudi Arabia in the year 1984 and joined Journal of Islamic Banking & Finance, he remained attached with the organization till his death.

He was a great man made out of the finest blend of experience and literary. He had been an extremely down to earth person with an immensely soft heart for all of those who surrounded him.

Teaching was his passion, he also taught many of children and students living in neighbour hood and did it for free. He was an ardent reader. Reading books, newspapers and discussing current affairs and talking about history were a few things he always enjoyed.

He was a man of great courage and will power. At the age of 80 he was diagnosed with throat cancer but due to his determination and will power, he survived the harsh treatment to cure the disease and finally got up healthy eradicating the disease from its roots. 10 years later, he was again diagnosed with a secondary form of Cancer and this time in the food pipe. Unfortunately he succumbed to it in this instance and met the Almighty in good Faith on May 11th 2013 at the age of 93.

He has been a fatherly figure for all the family and his death has posed a state of enormous grief to all.


“Sub prime crises and the lessons for the Islamic Financial Industry”

By Suleman Muhammad Ali*

ABSTRACT The Islamic Financial Industry (IFI) and its players including the regulators need to learn important lessons from the sub prime crises; especially since the industry at present is in its initial stages and is some what indirectly linked to the global conventional financial system. The paper discusses the sub prime crises and digs deep into the factors that led to this mayhem which has affected the global financial markets triggering a global recession on a scale unmatched since the great depression. The paper then goes on to suggest various factors that need to be taken care of and measures to be taken by the IFI industry players to avoid the chaos experienced by interest based financial system.

Key Terms: Adjustable Rate Mortgages (ARM); Moral Hazard; Mortgage Backed Securities (MBS); Limited Recourse Financing; Regulation; Securitization.

1.0 Introduction: The Sub prime mortgage crises is an ongoing crises; which started in the United

States; characterized by evaporating liquidity in the world’s credit markets; declining asset prices specially in the housing sector; high rate of foreclosures on mortgage assets; failure of mortgage backed securities; etc. Although the crises started in the United States (US) its effects have been contagious and have extended to other financial markets around the globe.

2.0 Reasons and Factors Leading to the Financial Crisis: The crises started when the US Housing Asset Price Bubble started to burst. The

US housing asset prices had risen sharply during the preceding five years up till 2006.

* Author: Mr. Suleman Muhammad is an MBA (Finance) Chartered Islamic Finance Program

(CIFP) from INCEIF, Kuala Lumpur. Presently working with Meezan Bank Limited as Manager-Product Structuring & Research. Participated in Structuring, Pakistan’s First ever short-term. KAPCO Sukuk and the development/presentation of proposal regarding the launch of ISLAMIC Interbank Benchmark Rate (IIBOR) in Pakistan to SPB. He is also Islamic Banking trainer, visiting speaker at NIBAF (SBP).


During the period of the bubble (2002-2006) the rising housing asset prices more and more people were encouraged to borrow money at low interest rates by various financial institutions. Adjustable Rate Mortgages (ARM) were offered by numerous banks under which mortgage loans at very low initial interest rates were offered; the interest rates were pre-agreed to be increased after a certain period for instance after two to three years. Similarly the mortgage loans were offered at very easy terms or with little credit appraisal requirements. Mortgage loans were also disbursed with minimum or no requirements of adequately checking the assets or the existing / future income streams of the borrowers. All such efforts were geared towards encouraging more and more borrowing for acquiring residential property. Along with this factor we also look at other major factors in the following section which have contributed to the crises that has rocked the world

2.1 Long Term Trend of Rising Prices: The long term trend of rising housing prices encouraged the borrowers to avail the

cheaply priced easy terms mortgage financing in the hope of getting the loan refinanced at a lower rate once the interest rates are increased under the adjustable rate mortgages.

2.2 High Consumption mindset: Similarly more and more home owners started using the increased value of their

housing property as a security for getting a second mortgage or credit for financing their consumption expenditures or for financing investments in the stock market. The average US House hold debt in 2008 was around 134% of the disposable income and the total nationwide household debt was $14.5 trillion in 20081. All these figures show that the average American was consuming more than what he or she was earning. Then how is it possible that one spends more than what he or she earns? The answer lies in incurring debt to finance the consumption expenditure. All this was due to low credit rates; easy or zero credit application terms and increasing value of the underlying mortgaged assets.

2.3 Bad Credit Practices and Sub Prime Lending: The years leading up to the crises the US economy had seen and unprecedented

growth this in return had resulted in high capital inflows from the growing economies of Asia and from elsewhere around the world as the US was seen as a safer investment haven. The money that was coming in resulted highly supply of liquidity this coupled with lower interest rates and the high rate of origination of mortgage backed securities forced a mindset in which banks were more eager to service large volumes of credit applications in shorter span of time rather than focusing on ensuring the quality of the credit. Hence various schemes allowing credit to individuals with impaired or no credit history sprang up. Automated Credit application schemes based on concepts such as NINA (No Income No Assets) basically allowed borrowers to apply and avail credit without showing any employment and assets proof. Thereby credit was given without taking into consideration the ability of the borrower to pay back the borrowed money. This was also partly prompted by the greed and short sightedness of the bank managers to inflate the performance by showing high credit disbursements in the hope of getting short term benefits and high performance bonuses.

1 http://www.federalreserve.gov/releases/z1/Current/z1r-5.pdf


2.4 The case of Mortgage Backed Securities (MBS): The Mortgage Backed securities are backed by the earnings or the cash flows of

various mortgage loans. The payment, return and the security are all tied up to these mortgage loans. It is a product created through modern financial engineering which allows various banks to pass on their credit exposures to other banks and financial institutions or individuals by repacking the originated mortgage loans into securities or bonds representing an ownership or security interest in these mortgage loans. The previous mortgage or lending model envisaged the banks to originate and hold the loan till its maturity; however with the engineering of securitization banks are able to originate and distribute the originated loan to entities by repacking them into securities. This had two detrimental effects on the US financial market; firstly it resulted in availability of excess liquidity to the credit markets. Banks were able to originate the loans through their deposits and then sell these loans by repacking them into securities through out the world thereby releasing their liquidity tied up in the originated for yet further mortgage and loan originations.

Secondly the policy of originate and distribute lead to the Moral Hazard problem and encouraged the banks and investment banks to originate high volume of mortgage loans with little emphasis on the credit quality of such loans since their focus was of short term in nature that is to earn large profits through origination fees; fees on structuring of complex mortgage backed securities and profits from the sale of such securities. These banks and investment banks were least bothered with the long term quality and results of such securities or the defaults which would arise if housing prices started to fall. The structuring Managers were appraised and were paid heavy bonuses on the basis of the various complex securitization structures of MBS they were able to innovate and sell successfully and the amount of origination of mortgage loans done by the bank managers.

2.5 MBS and the role of Investment Banks: Apart from the Moral Hazard issues mentioned above; the Investment Banks such

as Bear Sterns, Lehman Brothers etc. were not subject to the regulations created fro conventional banks. Such Investment banks in view of profiteering through short term gains borrowed hefty sums of money at low interest rates from the short term interbank market and invested in high earning long term assets such as mortgage backed securities. Since these Investment banks are not allowed to generate low cost deposits from retail consumers in form of Current Accounts and Savings Accounts they normally rely on issuance of bonds or securitization of their originated assets to fund their liquidity requirements. But as observed prior to the crises the major investment banks pursued a policy of making quick profits by borrowing short term at a lower interest rate and investing the proceeds at a higher interest rate thereby making a financial leverage. Most of the low cost borrowed money ended up in investments in long term high yielding mortgage backed securities. Such investment strategies were effective and yielded high profits only till the stage when there were no defaults on the high yielding mortgage backed securities and the housing prices were high and the credit was easily available from the wholesale markets at lower rates.

Similarly many Investment Banks by following the mentioned policy had indulged in excess leverage since the required capital adequacy standards applicable to conventional banks were not applicable in case of these Investment banks. Similarly


many conventional banks in the US as well as in Europe used financial innovations such Special Purpose Vehicles (SPVs) to avoid financial regulation and create mortgage back securities and transferring there risky assets to the SPV and issuing the mortgage backed securities thereby creating room on their balance sheets for availing more leverage which would have other wise been restricted due to the prevailing capital adequacy standards.

2.6 Naked Credit Default Swaps (CDS): A CDS in its simplest form is a type of credit insurance contract under which a

creditor or bondholder buys protection against credit default from an entity selling credit protection or insurance for an agreed fee or premium. In case the bond issuing entity or the debtor defaults on the debt the protection seller shall make the par value of the bond to the protection buyer. The mechanism of the bond seems to be harmless in this simplest form; however these swap instruments were also being used as a speculation vehicle by investors not holding any bond. These investors were betting on whether a particular creditor or bond issuing entity will default or not; hence for a single debt obligation Insurance companies like AIG issued numerous Naked CDS to speculators who didn’t hold the actual bond issued. When the market collapsed and the defaults started; people started investing more heavily in the Naked CDS hoping for winning the debt in case there is a default. Increasing defaults caused a strain on AIG and other insurance companies who were not able to honor their insurance commitments to a large volume of investors making a claim. This forced the American government to announce a relief package for AIG; since the failure of AIG would have caused widespread losses in the Financial System due to systemic risk.

2.7 Speculative Housing Investments: With the constant increase in housing prices over the long term; the housing assets

and real estate residential properties were largely being sought as effective and high yielding investment avenues. According to certain reports nearly 40% of the Housing purchases in 2005 were not made by those primary purchasers who required housing as a residential requirement. This led to an increase in demand and thereby increases in price of the housing estates.

2.8 Underlying Assumptions: All the factors and the behavior of various stakeholders as mentioned above were

based on the following assumptions as described by Warren Buffet; a renowned American investor, industrialist and CEO of Berkshire Hathaway;:

1) Housing prices would not fall dramatically.

2) Free and open financial markets supported by sophisticated financial engineering would most effectively support market efficiency and stability, directing funds to the most profitable and productive uses.

3) Concepts embedded in mathematics and physics could be directly adapted to markets, in the form of various financial models used to evaluate credit risk.

4) Economic imbalances, such as large trade deficits and low savings rates indicative of overconsumption, were sustainable.


5) Stronger regulation of the non banking financial system and derivatives markets was not needed2.

2.9 The Bubble Bursts: The prevalence of above assumptions and the increase in demand for housing and

cheap supply of credits resulted in the boom in the construction industry to increase the supply of housing to meet the demand. The increase in supply resulted in the decrease in prices at the start of 2006. With this decrease in prices the real estate housing lost its spark as speculative investment thereby the speculative investors started to withdraw from the market by selling their long positions. This resulted in further increase in the supply of homes to be sold in the market. This factor along with the boom in construction resulted in high number of remaining unsold houses in the market. Thereby further depressing the price of homes throughout the US economy. The depressing of prices was far higher in certain states. This decrease in price was coupled with the increasing interest rates of the mortgage loans after the initial lower rates under the Adjustable Rate Mortgage (ARM) schemes. This meant that people with lower or sub prime credit ratings started to default on their periodic mortgage payments. Individuals who had availed such financing with a mindset that they would be able to refinance their ARM loans at lower rates weren’t able to do that once the underlying housing assets started diminishing in value. As a result there were foreclosures on mortgages with sub prime or no credit history; this resulted in more properties available for sale in the economy thereby further decreasing the prices of real estate.

With such decreasing values of houses; defaults in periodic payments by mortgage borrowers and diminishing values of the underlying mortgage/security the mortgage backed securities whose underlying values were directly related to the cash flows of these mortgaged assets started to feel the pinch of the housing bubble bursting from the core. The value of the MBS started to fall along with the periodic profit payments and the redemption value. The investment banks which had invested heavily in these investments by borrowing extensively from the short term interbank market or through the issuance of bonds were unable to fulfill their repayment requirements under these obligations when these fell due. The liquidity for such investment banks was squeezed to a complete standstill since they were not able to sell their long term MBS assets in the market due to the fallout in the mortgage market and neither were they able to generate enough liquidity through borrowing due to their constantly decaying credit standing and the cautious approach of the other lenders. These institutions also were unable to generate liquidity through further securitizations. As a result such investment banks and non banking financial institutions which had played a major role in flushing the market with excess liquidity completely dried up their resources to generate the liquidity. This resulted in the shortage of liquidity in the market thereby pushing the interest rates upwards.

With the interest rates pushing upwards the housing prices fell more sharply as is the tendency of the assets to move in the opposite direction from the interest rates. This further resulted in failure of mortgage borrowers to get the planned refinancing; the higher rates also resulted in higher profit payments to be made on the loan. The decrease in pricing of homes resulted in negative equity of the mortgaged home owners under the 2 http://www.reuters.com/article/idUSTRE51R16220090228?pageNumber=3&virtualBrandChannel=0


mortgage loan i.e. the value of the underlying asset financed by the loan is less than the amount of the loan outstanding. This situation resulted in encouraging the home owners to default on the loans since the loans were limited recourse mortgages under which the liability of the borrower is restricted to the enforcement value of the security.

Hence the crises resulted in a vicious cycle under which a fall in pricing of housing led to default in payments on the mortgage loans and resulted in diminishing of value of MBS which further decreased the availability of credit in the market resulting in further defaults and foreclosures which further resulted in decrease in housing prices due to increase in supply of unsold housing units and which in turn further dampened the availability of credit and the values of MBS and mortgage loans. Since the world’s financial markets are more integrated and many financial institutions had invested in the US MBS the fall out of this crisis also engulfed the financial markets around the globe especially western Europe where Iceland as a nation was on the verge of bankruptcy due to high exposure to US MBS and there was a bank run on Northern Rock a British Bank which was nationalized by the British government.

3.0 Lessons for Islamic Financial Industry: The Islamic Financial Industry (IFI) and its players including the regulators need to

learn important lessons from the sub prime crises; especially since the industry at present is in its initial stages and is some what indirectly linked to the global conventional financial system. In the following sections we discuss the various factors to be taken care of and measures to be taken by the industry players to avoid the chaos experienced by interest based financial system.

3.1 Limited Recourse Financing and Shariah Compliance: One of the main reasons that encouraged mortgage borrowers during the sub prime

crises to default on their loans was the Limited Recourse nature of the financing provided by the banks. This meant that once the value of the underlying asset decreased below the value of the loan the customer was better off handing over the asset back to the financier rather than make the payments for a house which was less than its payment value. Under Shariah this form of financing in which the debt obligations are restricted to the realization of the security is not appropriate according to some scholars; since under Shariah there are references that a person is obligated for his debts even after his death from his property which is left behind. The division to the heirs is also secondary after the distribution is made to the creditors. There are evidences which state that a person will be liable for his unpaid debts till the Day of Judgment.

Hence restricting the debt obligations to the amount of the security by putting such a condition to this effect in a sale or a murabaha contract is a void condition and contrary to the principles of Shariah. Hence Islamic Financial Institutions would most likely be safe from such conditions if their contracts have gone through the required Shariah screening. However this plus point is only applicable where the transactions involve a debt obligation for instance a Murabaha contract. In cases where the contract does not involve a debt obligation like Ijarah, Musharakah Mutnaqissa, Musharakah or Mudarabah then as per the rules of Shariah the underlying contract by its nature only allows a Limited Recourse to the Financier. For these contracts Islamic Banks and Financial Institutions (FIs) need to build appropriate mechanisms under the contract


which restrict the customer from taking advantage of this limited recourse and discourages him from making a default or removes the Moral Hazard situation. In certain circumstance appropriate Shariah compliant mechanisms through the use of the concept of Wa’d (Undertaking) appropriate caluses can be built like the Charity clause which can deal with such issues of Moral Hazard at the client’s end.

Hence the IFI and its players need to revisit their contracts and legal agreements and reengineer their contract to safeguard their interests in a manner which is also compliant to Shariah

3.2 Diversification of the Asset Base: Another major contributing factor for the collapse of various Financial Institution

during the crises was the fact that these institutions had invested heavily in Mortgage Market either through direct credit disbursements or through investing in the MBS or both. The underlying assumption for this behavior was the belief that the housing prices would not reverse over the long periods. This defied the age old risk management lesson of ‘do not put all your eggs in one basket’ and once the housing market reversed the financial institutions were heavily exposed to one sector. As a lesson the IFI and its players must diversify their asset base across sectors and industries so that a reversal in one sector does not effect the overall health of the concerned FI and the FI is able to sustain the losses by banking on its other assets.

3.3 Diversification of the Funding Sources: Similarly the funding sources should be diversified not only for the Islamic Non

Banking FIs but also for Islamic Banks; since as the crises has shown that some institutions had relied very heavily on wholesale funding source or the short term interbank market to get cheap funding. The failure of Northern Rock is a classic case of limited funding sources. The bank relied heavily on the wholesale and money markets for generating liquidity. About 75 % of the total funding came from this source. Since the bank was in a high growth mode increasing its market share in 2007 to 18.9% in the mortgage market from 14.5% reliance on this mode of funding increased. The bank had changed its funding strategy from ‘originate to hold’ to ‘originate to distribute’ by packaging a pool of mortgage loans and selling the securities to other investors, thereby creating instant liquidity for the bank. This process of securitization was done through an independent special purpose vehicle (SPV) called ‘Granite’ which issued these securities, thereby enabling Northern Rock to manage its risk by passing it on to the SPV. Similarly the wholesale funding also included the direct issuance of bonds against the security of mortgage loans without involving the SPV, in this case the risk remained with Northern Rock. Other sources of wholesale borrowing were the Inter Bank Money market, funding mainly short term in nature. While the bank was in a high growth mode and increased its funding from the wholesale markets to fund that growth, the bank continued to decrease its reliance on the retail funding sources. The proportion of deposit and retail funds to the total liabilities and equity of Northern Rock fell from 62.7 % in 1997 to 22.4 % in 2006.3 Besides the massive decrease in proportion, the proportion was also very low when compared to that of other banks. These figures show the extent of increasing reliance that

3 House of Commons’, Treasury Select Committee report. January 2006


the bank was placing on wholesale sources of funding. This strategy of high expansionary growth through increasing reliance on wholesale markets was had the potential to lead severe crises once there was a liquidity crunch in these markets. Things turned out to be so when the US mortgage markets hit snag due to defaults and foreclosures in the sub prime mortgage market. Increasingly the wholesale institutional investors became averse to invest in the mortgage based sector. Generally on the backdrop of concerns regarding the slowdown in US economy due to the sub-prime mortgage crisis the confidence of lenders in the wholesale and money markets was low in taking big exposures, specially on institutions heavily reliant upon the mortgage assets. The result was the failure of Northern Rock’s funding policy of generating sufficient liquidity at competitive prices.

The availability of healthy level of retail deposits or retail funding oriented policy would have helped the bank whither the crises in which almost all banks were feeling the liquidity pinch, especially since Northern Rock always had sufficient assets to cover its liabilities but found hard to convert its assets to generate liquidity since they were largely based on declining quality mortgages. A higher level and long term natured retail deposits and deposit generation oriented policy would have helped the bank effectively manage its liquidity at a time when the wholesale sources were quickly drying up. The banks with good level of retail funding were able to survive the storm.

Relying to heavily on retail deposits like Current and Savings Deposit is also not a good strategy either since these deposits normally to do not have any restrictions on withdrawals from the customers. Hence IFI and its players need to maintain an efficient mix of wholesale and retail deposits to manage both sides of the risk.

3.4 Corporate Governance and the Moral Hazard Problem: Slack Corporate Governance also played its role in contributing to the triggering of

the crisis. The bank mangers and investment banking executives were more concerned with the short term goals of high volume originations of the mortgage assets pursuant to the policy of ‘originate and distribute’ through various SPVs. Similarly investment banks were also more concerned with the short term goals of devising complex structured financial derivatives and MBS which would bring them structuring and advising fees. All this short term focus meant that the originating and structuring entities were least concerned with the long term quality and results of loans and structured securities. By focusing on shirt term originate and distribute strategies the banks and investment bank managers were able to inflate their short term performances in the hope of enjoying fat bonuses. Larry Tabb, founder and chief executive of the TABB Group, a capital markets research and advisory firm sums this up in the following words: ‘In the record year of 2006, Wall Street executives took home bonuses totaling $23.9 billion, according to the New York State Comptroller's Office. Wall Street traders were thinking of the bonus at the end of the year, not the long-term health of their firm’4

Islamic Banks and FIs need to be wary of such factors and need to build appropriate Corporate Governance measures to restrict such behavior to earn short term profits at the cost of long term losses for the investors, customers and the financial system at large. The bonuses and appraisals should be linked to long term performance of the underlying structure and the products outlined especially in cases when such products are 4 http://www.businessweek.com/investor/content/oct2008/pi20081017_950382_page_4.htm


financial in nature and can pose systemic risk for the financial system at large. In this regard the bonuses can be announced on deferred terms that is the amount of the bonus can be announced based on short term performance but should be payable on deferred basis based on the long term performance of the employee and the structured product. Hence appropriate accountability measures are necessary in Islamic Financial Institutions to safeguard against such practices.

3.5 Prudent Credit Appraisal and Credit Management Regime: Credit risk refers to the possibility of default and delay in repayment of debts. This

type of risk is faced by all financial institutions since all enter into transactions involving debts. This type of risk can seriously affect the performance of the financial institution resulting in high Non Performing Loans, liquidity crises and other costs. The level of seriousness of these issues could have major consequences for the concerned Financial Institution (FI) for instance insolvency, bankruptcy there by causing blow to the public’s confidence in the bank. Core factor instigating the sub prime crises was that there was almost no or very little credit risk measurement and management techniques in place to manage the credit risk; as mentioned before credit was based automated credit approvals and easy terms like NINA and to individuals with bad or no credit history.

The mitigation of credit risk requires prudent credit management techniques and appropriate systems to be appropriately in place to measure the risk involved in various transactions. For Islamic Banks (IB) appropriate measures should also be in place to measure the risk involved with various types of different modes that are employed. Secondly proper due diligence in credit evaluation of the clients should be done before extending the facility this again involves that proper evaluation systems are in place. This involves evaluating past credit history and ability to pay the debt on time which involves evaluating the income of the client. For Islamic Banks it is also essential that in case of profit sharing modes proper analysis and viability of the client’s business or the project is done. An important technique to mitigate the credit risk is to acquire the collaterals against the financings. This requires that the proper valuation of the collateral is done furthermore its also essential to conduct follow up evaluations of the collateral as well as of the client’s creditworthiness to ensure that collateral and the client’s ability top pay does not diminish thereby risking default. For IBs it is also essential that the collateral is Shariah compliant and separate contract for rahn (collateral) is entered into at the time of executing the facility. Conventional banks also mitigate against the delay in payment by charging a heavy penalty as interest if the repayment is delayed beyond the due date. Islamic Banks under certain jurisdictions are not allowed to charge any payments, but they mitigate the risk by giving away the penalty amount as charity. All regulatory requirements as required by the regulatory regime and communicated from time to time by the concerned regulator should be followed by the bank. Another important source to mitigate the credit risk is to diversify the asset base of the bank and since the majority of the assets of the banks consist of loans or Shariah compliant financial transactions it is important to diversify the credit base. That is the credit exposure should not be excessively taken against one sector as was in the case of Northern Rock and Lehman Brothers but should be spread among the various sectors in the market. Similarly exposure should also not be excessively taken against a small number of clients. This is mostly taken care of by the sector limit and per party limit guidelines issue by the regulatory authority, which is linked to the size of the concerned bank. It is necessary to


follow these guidelines to hedge against the credit risk and improve the quality of the assets on the balance sheet. IBs in this regard must also ensure that they do not take excessive exposure on one or two Shariah compliant modes but effectively diversified among various modes as far as the situation permits since each mode has its own inherent risks which can be mitigated by effective diversification.

Furthermore it is also necessary for Islamic Banks and FIs that at least 10% to 20% down payments are made mandatory on the customers requiring mortgage financing this would result in inclusion of customers equity at the out set and if the underlying property declines there would still be room and time for the financier to manage the credit before the value of the assets decrease below the outstanding amount of the finance.

3.6 Regulation of Non Banking Financial Sector and Systemic Risk: Non Banking Financial Sector has increased around the globe in the past few years.

Major players of this sector are the Investment Banks which act as wholesale finance houses and play a very important role quite similar to normal conventional banks. However up till now these institutions are normally subject to much lighter regulations be it related to regulatory equity ratios; leverage restrictions or per party limits. However the crisis has taught us one important lesson which can be summed up in the following words of Paul Krugman; Professor of Economics and International Affairs at the Woodrow Wilson School of Public and International Affairs at Princeton University; “As the shadow banking system expanded to rival or even surpass conventional banking in importance, politicians and government officials…………..Influential figures should have proclaimed a simple rule: anything that does what a bank does, anything that has to be rescued in crises the way banks are, should be regulated like a bank."5

Hence any of the players in the Islamic Financial Industry which acts like a bank and provides financing and takes deposits either through partnership structure of Mudarabah or through debt financing thereby resulting in Systemic Risk should be regulated through the same tight regulatory mechanism as the normal Islamic Commercial banks are. They should be subject to same regulatory and reserve requirements and the necessary Capital Adequacy ratios.

3.7 Restricting the Leverage and Increasing Regulatory Capital during Boom periods: The ownership structure refers to the strength of the sponsors as well as the level of

equity involved in the capital composition. The targets of the Capital Adequacy Ratios (CAR) as suggested by the Basel II committee for all the conventional banks and the IFSB CAR standards for Islamic Banks should be strictly adhered to. The regulatory capital requirements should be increased in case of high growth stages of the organization especially if this growth is being undertaken through high level of leverage due to availability low rate finance in the market and high growth in the value of assets. As is evident from the crisis normally during the high growth stages increased leverage is not taken as a siren since the good results on the assets side; availability of excess and cheap

5 http://www.nytimes.com/2010/04/02/opinion/02krugman.html?_r=1


liquidity in the market and high bottom line results usually hide the inherent leverage risks present existing in the strategy.

Increased level of equity not only increases the stake of the shareholders in the organization which would automatically result increased oversight by the Board of Directors (BOD) but also augurs well for the reputation of any financial institution. Strong sponsors with worldwide holdings and recognition results in good image among the public. Similarly a government’s stake in the institution up to a certain level may also result in healthy reputation however excessive govt. stake might result in a negative image.

3.8 Securitization and Derivatives Instruments: The IFI is maturing with each year passing by and the market has seen new

complex structures being involved in form of Shariah compliant mortgage backed securities. The regulators of IFI need to be attentive to such developments and learn from the lessons of the sub prime crises and restrict such tendencies ‘Originate and distribute’ strategies at this initial juncture. The issuance of the mortgage backed securities by Tamweel; a UAE based provider of home finance is a case in point6. Although securitization of housing assets results in the supply of required liquidity in the market and assists the consumers requiring low cost housing; the situation can get out of hand if the securitization process goes overboard and the speculative investors jump in to cash in from the availability of low cost financing to gain financial leverage. Thereby creating an artificial demand for housing which results in increased pricing of housing which ultimately is detrimental to the initial goal of providing low cost housing finance to the primary and real consumers.

Hence regulators while allowing for such securitization must also build appropriate regulatory restrictions to deter speculative practices of investors. Secondly they must also restrict the ‘Originate and Distribute’ strategies Islamic Financial Institutions and Banks which would lead to an unwarranted focus on short term gains at the expense of long term asset quality. This can be done by putting a limit to the amount of distribution that an entity can indulge in as a percentage of origination. Similarly speculative investors can be restricted by requiring a high level of initial down payments for mortgage applicants who already own a residential property.

The CDS types of derivatives are inherently contrary to the principles of Shariah and it is highly unlikely that any Islamic Bank or financial institution would be allowed to invest in such products by their Shariah Advisors. However recent developments have shown that products such as Shariah compliant cross currency swaps and other products such as call and put option products based on Aurbon (Commitment Fee) and Wa’d (Undertaking) are being designed. Although such products have been discarded by majority of the Shariah scholars; such developments must be seen as alarming signs by the regulators since if they are accepted by the majority at any stage, they have the potential to disrupt the industry due to increased systemic risk.

4.0 Conclusion: The Islamic Financial Industry is in its initial stages and due to its inherent attribute

of compliance with Shariah has been able to withstand the global financial meltdown 6 http://www.ameinfo.com/140520.html


triggered by the sub prime crises; since Shariah compliance requirements deter it from investing in products which are based on gambling (Maiser) and trading of debts (Bai al Dayn). Hence the IFI and its players have not been exposed to instruments such as CDS and debt based MBS. At the same time most of the Islamic Banks have been graced with excess liquidity; generated through retail deposits; which the Islamic banks have been unable to place efficiently due to limited availability of Shariah compliant liquidity management products. However apart from these positive attributes the IFI and its players need to learn from the lessons of the global crises and need to focus on all they key factors as discussed above and other issues to plug the weaknesses in the system. At the same time the IFI regulators need to play an important role by studying the speculative nature of human behavior and the tendency to make huge short term gains without acknowledging the risks of long term detrimental effects of financial structuring and opportunistic behavior. Most importantly they need to learn the lesson that free markets with very little or non existing regulation would not necessarily result in efficient distribution of financial resources into productive channels. The human psychic or the invisible hand would always result in opportunistic behavior which can have detrimental effects. Hence appropriate and efficient regulation is required to streamline the market behavior.

References: Islamic Financial Services Board (IFSB). 2005. “GUIDING PRINCIPLES OF RISK

MANAGEMENT FOR INSTITUTIONS (OTHER THAN INSURANCE INSTITUTIONS) OFFERING ONLY ISLAMIC FINANCIAL SERVICES. December 2005. Available at: www.IFSB.com. Accessed on: March 15, 2008

Islamic Financial Services Board (IFSB). 2005. “GUIDING PRINCIPLES OF RISK MANAGEMENT FOR INSTITUTIONS (OTHER THAN INSURANCE INSTITUTIONS) OFFERING ONLY ISLAMIC FINANCIAL SERVICES” December 2005. Available at: www.IFSB.com. Accessed on: March 15, 2008

Diwany, El Tarek. 2007. “Lessons to be learned from Northern rock”. Euromoney Islamic Finance Information Service. December 11, 2007. Also available at: www.islamic-finance.com.

Sub Prime Mortgage Crises. Article. http://en.wikipedia.org/wiki/Subprime_mortgage_ crisis#cite_note-63 Accessed on: October 28, 2010

ENSEC completes first Shariah-compliant home finance securitization for Tamweel. Article http://www.ameinfo.com/140520.html Accessed on: October 28, 2010

Corrigan, Gerald E. “Central Banks and the Financial System”, in Central Banking Issues in Emerging Market-Oriented Economies. Kansas City: Federal Reserve Bank of Kansas City, 1990.

“FACTBOX: Highlights of Warren Buffett's annual investors' letter”. February 28, 2009 Available at: http://www.reuters.com/article/idUSTRE51R16220090228? pageNumber=1 Accessed on: October 30, 2010

INCEIF. 2006. “Risks and Returns”, in Islamic Economics and Finance: Theory and Ethics Kuala Lumpur: INCEIF Ben Steverman and David Bogoslaw. “The Financial Crisis Blame Game” Available at:


http://www.islamic-finance.com/

http://en.wikipedia.org/wiki/Subprime_mortgage_

http://www.reuters.com/article/idUSTRE51R16220090228

http://www.businessweek.com/investor/content/oct2008/pi20081017_950382.htm Accessed on: October 30, 2010

King, Mervyn. 2007. “Turmoil in Financial Markets: What can Central Banks Do?”. Paper submitted to the Treasury Committee. September 12, 2007.

Paul Krugman. “The Financial Reform 101” Available at: http://www.nytimes.com/2010/04/02/opinion/02krugman.html?_r=1 Accessed on: October 30, 2010

House of Commons’, Treasury Select Committee Fifth Report. January 2006. Available at: http://www.publications.parliament.uk/pa/cm200708/cmselect/cmtreasy/56/5602.htm. Accessed on: October 29, 2010 http://www.federalreserve.gov/releases/z1/Current/z1r-5.pdf Accessed on: October 28, 2010


A Competitive Analysis of Islamic and Conventional Banks in Pakistan during

Global Recession By

Syed Farhan Najum, Irfan Anjum Manarvi*

ABSTRACT

International financial institutions especially the banks were seriously hit by the global recession and the period after it. A large number of conventional and Islamic banks were operating in Pakistan at that time, though with slightly different practices and strategies. This research was focused on analyzing their performance during and after the recession period. Financial ratios such as advanced deposit ratio return on investment, debit to equity, current and working capital ratios were considered appropriate tools to carry out this analysis. Data from published yearly reports of various conventional and Islamic banks such as Bank Al Habib, Alfalah, Islami, Muslim Commercial and Meezan bank was collected and analyzed by evaluating these ratios for each bank. A comparative analysis was also carried out through time series during the period from 2006 to 2011. Both the types of banks were found to be hit by the recession, however the effect on Islamic banks was observed lower than the conventional bank. A review of the history of a bank’s operations showed that those with longer operational period performed better than the new entrants in Pakistani market.

Keywords: Islamic Banks, Conventional Banks, Global Recession, Pakistan.

1. Introduction: Global recession had a significant effect on performance of financial institutions

especially banks all over the world. It started in 2006, became worst in 2007 and followed towards recovery gradually in various parts of the world after that. While it affected the economies of countries, researchers found it a serious area for exploration during this and the following period. It was investigated that how 123 banks U.S commercial banks got pushed into bankruptcy during this period while affecting the global economies as well including countries such as UK, U.S and China [1]. Its effects * Authors: Syed Farhan Najum and Irfan Anjum Manarvi are MBA Student of Iqra

University Islamabad Campus, Pakistan, HITEC University Taxila.


were subsequently observed to spread towards South Asian Region and Pakistani banking sector was observed as no exception to it [2]. Research reported a decline in total deposits from Rs 3.77 trillion to 3.67 trillion (equivalent to 37.7 to 36.7 billion USD approximately) and provision for losses moved up from Rs 173 billion to Rs 179 billion (17.3 to 17.9 billion USD approximately) [3]. Like anywhere else in the world, banks tried to increase their efficiency, services and lending capabilities over the years to continue being major source of financing. Islamic banking activities were initiated in early 2000 in Pakistan and a result of it Meezan Bank started working in 2002 followed by many others in years to come. Right from the outset, Islamic banks started competing with conventional banks and enhanced its operations [4]. As a result these banks also started channelling the monetary policy of the governments for contribution to economy [5]. Though Islamic banking had a humble start in various countries through much lesser number of branches, these institutions somehow managed to compete with conventional banks in efficiency [6]. Similar trends were observed in Pakistan where a total number of over 30 commercial banks had hundreds and thousands of branches all over the country. There were only 6 Islamic banks with counted number of branches in major cities only [7].The primary difference of the two was interest free banking offered by Islamic banks [8].

Present research was therefore focused on conducting similar analysis through data collection of various Islamic and conventional local and foreign banks in Pakistan. It was envisaged that this research could bring out significant lessons and results through quantitative analysis of balance sheet, horizontal and vertical analysis. Additionally bank’s operating efficiency could also be measured through financial ratios such as return on investment, debt to equity, current advance deposits ratios and working capital ratio for both types of banks. A total of five such banks were selected including Meezan bank, Bank Islami, Muslim

2. Overview of Banks: At this stage it is considered appropriate to provide a brief introduction to the banks

under study for better understanding of the analysis and results for the academics, researchers and industry leaders.

• Meezan bank was the first Islamic bank that started its operations in Pakistan in 2002. It is the 9th largest bank in Pakistan in term of branches that are approximately over 290 and has A-1+ short term and AA- long term credit rating as a financial institution.

• Islami bank started its operations in 2003 in Pakistan. It has A1 as short term and A as long term credit rating. It reported to have over 120 branches in 2011.

• Alfalah bank was incorporated in 1992. The bank has A1+ short term and AA long term credit rating and has more than 400 branches network in Pakistan.

• Bank Al Habib launched its operations in Pakistan immediately after the partition of United India i.e. somewhere in 1947. It reported to have over 380 branches and A1+ and AA+ short term and long term credit rating respectively.

• Muslim Commercial Bank was also incorporated in 1947. It has the largest branch network with numbers over 1209 branches in Pakistan and A1+ and AA+ short term and long term credit rating respectively.


3. Financial Ratios Analysis: The performance of banks was analyzed on the basis of various financial ratios

such as Advance Deposit Ratio, Return on Investment, debt Equity Ratio, Current Ratio and Working Capital Ratio for a period of five years starting from 2006 to 2011. Its results are given in figures 1 to 4 as shown below.

Fig. 1: Advanced Deposit Ratio.

Fig. 2: Return on Investment.

Fig. 3: Debt to Equity Ratio.


Fig. 4: Current Ratio

Fig. 5: Working Capital

• It may be seen from Fig. 1 that the degree to which the banks have used their available resources to meet the customer’s credit needs. A drastically downward trend is visible in the available resources after 2008 in all banks, which explains that the banks have utilized its maximum resources to fulfill customer credit needs. All banks have similar trends except Bank Alfalah which showed minor increase in 2010 but that was small and temporary. Meezan and Muslim Commercial Banks had rapid decrease after 2008. This decline was the aftermath of financial crisis. To recover from that all of the banks massively used their resources to meet the customer credit needs.

• Fig. 2 shows profitability levels of banks on invested capital. All of the banks have same profitability levels expect Muslim Commercial and Islami bank. MCB showed higher profit as compared to all others. Whereas Bank Islami showed negative trend from 2006-2008, rapid decline in 2009 and rapid increase after that. It could have been the result of Bank Islami having invested much lower than others. Increase after 2009 could be considered as a sign of recovery due to the interest rates increase after 2008 from 9.09% to 14%; which was a step taken by State Bank of Pakistan (SBP) to boost banking industry [3].


• Fig. 3 shows the proportion to which extent any of these banks used its equity and debt to finance its assets. Bank Alfalah and Bank Al Habib had higher levels than others which mean the two banks aggressively used their debt to finance growth. Meezan and Bank Islami rapidly moved toward growth by taking high risk. This also showed high dependency on debts rather than equity. This increase in debts was due to the increase in loans taken by banks to meet its customers’ needs shown in fig. 1.

• Fig. 4 shows results of a bank’s ability to pay short term debts and payables. All banks had almost the same trend except Bank Islami, which a showing was gradually decreased after 2006 confirming that the bank liabilities were rapidly increasing. A reduction was the ability to meet short term obligation as a result of financial crisis.

• Fig. 5 indicates a banks short term ability to meet its liabilities. Its analysis can is based on comparing the current years with previous years. Both the Islamic banks lacked capital. MCB showed the highest trend even during global recession, while the other conventional banks came below MCB but they had higher values as compared to Islamic Banks.

4. Findings: This research was conducted to investigate the performance of Islamic and

Conventional banks operating in Pakistan during global recession especially in relation to each other.

5. Ratios Analysis: Advance deposit ratio showed a declining trend immediately after 2008 which was

the last year of global recession. It could be inferred that the global crisis not only affected the conventional banks but also the Islamic banks. A decrease in available resources shows that the banks utilized their resources to maximum levels to cope up with financial crisis and could not meet their customer credit needs. Return on investment showed totally different trend as compared to advance deposit ratio. Different trends for different types of banks may be observed from this ratio i.e. the conventional banks showed a slightly declining trend after 2007. Whereas the two Islamic banks showed decreasing trends during 2007-2008. Meezan bank results had a consistently rising trend where Islamic bank showed a temporary negative decline in 2009 and rapid upward movement after that. It could be inferred from these results that global crisis slightly affected the conventional banks but could not have dominating effect on operations of Islamic banks.

Debt to equity ratio confirmed the outcome of financial crisis clearly. Islamic banks used their debts higher than the conventional banks. This increase was due to increase in loans taken by Islamic banks to handle their operation during the aftermath of global financial crisis. It was also noticed that the banks which were operating since longer period used less debt such as the Islamic banks established in 2002. Current ratio showed the ability to pay short term debts and payables. The Islamic and conventional both types of banks had consistently decreasing trend.


6. Conclusion: The study was aimed at investigating the performance of Islamic and conventional

bank during and after the global recession. The results depict that even though Islamic banks are doing interest free and providing secure lending to avoid uncertainty but still they got affected by the global recession. The banks in Pakistan neither conventional nor Islamic remained unaffected with an exception of return on investment. The crisis could not affect it because of different operational nature and secure interest free investment in Islamic banks.

References: 1. M. K. Hassan. The global crisis and Islamic finance. 2. B. A. Khilji, M. U. Farrukh, M. Iqbal. The impact of recent financial recession on

the banking sector of Pakistan. 2010. 3. F. Saleem. Pakistan and the global financial crisis. Center for research and security

studies. 2009. 4. A. Ahmad, M. I. Malik, A. A. Humayoun. Banking development in Pakistan: A

journey from conventional to Islamic Banking. European journal of social sciences. vol. 17, 2010.

5. R. Sukmana, S. H. Kassim “Roles of the Islamic banks in the monetary transmission process of Malaysia” International journal of Islamic and middle Eastern finance and management. 2010. pp. 7-19.

6. M. H. Yahya, J. Muhammad, and A. R. A. Hadi. A comparative study on the level of efficiency between Islamic and conventional banking system in Malaysia. International journal of Islamic and middle Eastern finance and management. 2012, pp. 48–62.

7. R. Ghayad. Corporate governance and the global performance of Islamic banks. vol. 24. Humanomics. 2008, pp. 207-217.

8. A. Chazi, L. Syed. Risk exposure during the global financial crisis: the case of Islamic banks. International journal of Islamic and middle eastern finance and management. vol. 3. 2010. pp. 321-333.


Non-Interest Banking System In Nigerian: Sharĩ‘Ah Perspectives

By Dr. Huud Shittu Ph.D *

ABSTRACT Endless queues and congestion, wary and unsympathetic cashiers, ineffective Automatic Transaction Machine (ATM) and other inconveniences are the major traits of the Nigerian Banks resulting to dilly-dally economy of Nigeria. Exploitation and economic corruption in the blood stream of Nigeria citizenry worsen economic responses. This altogether precipitates, recently, the apex Bank in Nigeria to announce its determination to float non-interest banking. This proposal has indeed grouped Nigerian Societies into two based on religions: Islãm and Christianity; it influences responses of stakeholders towards changing Nigeria to an Islamic country while others welcome the step because their religion accepts it. Some Nigerians have not believed that Sharĩ‘ah has its system of banking. This work, therefore, is not examining the position of stakeholders but it brings to the fore the concept of non-interest banking as it relates to Sharĩ‘ah perspective. Two methods are used: historical and survey. Secondary sources are used in establishing historical data. The paper further examines the objectives of the non-interest banking system. How would Islamic banking work to benefit every customer irrespective of religious background? Against this background, this paper has reviewed extant works and examined what constitute Islamic banking? It surveys some countries where pilot projects on Islamic banking system were carried out and subsequently substantiated. Major features of Islamic banking are highlighted; the policies and modes of trading within and outside the Bank are also explained. Benefits that could be derived from Islamic banking are comprehensively stated. The paper puts together all the salient points as summary, recommendation and conclusion.

Key Word: Islamic Banking work to benefit every customer irrespective of religious background

* Author – Dr. Huud Shittu, Ph.D - Department of Religion and Philosophy (Islamic Unit)

Specialized in Islamic Law (Shari’ah), University of JOS Nigeria. E-mail: [email protected]


Introduction: A number of hitches are noticed in Nigerian Banks which has serious effect on the

economy. Among the problems are endless queues and congestion, wary and unsympathetic cashiers, ineffective Automatic Transaction Machine (ATM) and other inconveniences resulting to dilly-dally economy of Nigeria. Exploitation and economic corruption in the blood stream of Nigeria citizenry worsen economic responses. This altogether influences the apex Bank in Nigeria to announce its determination to float non-interest banking.

Non-interest banking phenomenon has polarized Nigerian societies into two main religious camps: Muslims and Christians. The proponents and opponents have questions to answer. Are the proponents having interest of the country at heart? Similarly, are the opponents defending the economic status of the country? Let the responses be personal or provided by the individuals.

Traditional form of banking was popular in various communities: in Southwest, it is called Ajọ or Eesu, in Northern Nigeria, it is called Adace and in the East, it is Itokpọ ego. It means ‘contributions’. The practice is not popular in the Eastern Nigeria like other regions. Co-coordinator of the contribution used to put duration to the payment and distribution; it may be on daily, weekly or monthly bases. However, method of documenting it was the same. It was by writing an arrow or slash usually by charcoal on walls for a contribution on daily basis or weekly depending on the arrangement.

Above six decades when modern banking in Nigeria was first initiated by the colonial masters to service only the administrative and commercial interests of the metropolitan authorities, so the promotion of the indigenous entrepreneurship was very low in the priority list of the colonial masters. This explains that they care a little for economic development of the masses. It is on this premise and exploitation through undisclosed interest and deceit manner of entangling customers into interest-motivated loans and deposits the commercials Banks in Nigeria are operating. Salisu Ishaku laments on major economic hardship the existing banks create on the society; he notes that banks take more profit of the business from the borrower while customers burden all loss in case of eventuality in his project and miss the collateral security used in getting the loan.1 He also explains his fear on morally status of Nigerians to live up to the required standard of honesty and justice which Islamic banking demanded. This work notes with responsiveness that comprehensive advocacy is imperative.

Objective of examining non-interest banking is to intensify awareness of the populace on the veracity of non-interest banking to resuscitate the dilly-dally economy. It is also to educate people that Islãm has effective banking system, which does not cause any financial problem. Ab initio in Sharĩ‘ah, usury and unlawful trading are not only condemned but also prohibited, which are the sources of trading for conventional banks. The significance of this work is that, some people who do not believe that Sharĩ‘ah has a system of banking will be informed and testified to the efficacy of it. To achieve this, historical and survey methods will be applied, and secondary sources of information will be used in gathering data. This paper is afraid of repetition, therefore permit me to interchange the word non-interest with either Islamic or Sharĩ‘ah banking based on the submission of Quadri that Sharĩ‘ah and Islãm is inseparable.2 The three terms will be used interchangeably to qualify nature of the Bank in the discourse.


However, an attempt is made in this paper to define concisely Islamic banking, trace the background to it, survey some countries operating Sharĩ‘ah system of banking and highlight salient features of Islamic banking. Also, modes of trading with policies involved are explained. Some reasons are advanced for the government to enhancing funding of non-interest banking / Islamic Bank. Summary, recommendations and conclusion ensued.

Definition and nature of Banks in Discourse: Interest free banking is otherwise known as Islamic banking because it is consistent

with the stipulation of Sharĩ‘ah principles. Interest free banking is a fundamental economic system in Islãm because all trades involving unlawful elements, though considered profitable by the conventional banks, are prohibited by Islamic injunctions: Qur’ãn and Hadĩth, hence it is Sharĩ‘ah compliant system of banking. Islamic banking is an economic aspect of finance and accountability based on the principles of Sharĩ‘ah. Prophet Muḥammad (SAW) was the accounting officer in his lifetime when his companions were keeping valuable materials with him. He also worked with His uncle, Abi Tãlib and Khadijah; his trust influenced his marriage in 595 A.D. After his demise, history explains that ‘Umar bin Khatab ensure effective management and accountability of public funds under the Baytul-Mãl institution, which therefore performed some banking functions, such as depositing and withdrawing by using teller and cheque leaf respectively; transfer of money. Allusion to works establishing use of cheques is reiterated in Yaqubi’s work; Harun Rashid drew a cheque by his hand to withdraw money; and money of Muslim armies was paid by cheque.3 The first set of Muslim scholars that agitated for Islamic banking after they have noticed corrupt attitudes in banking sector includes Abdullah Ali Hassan an-Nadwi, Abdullah al-Maudud from India, Hassan al-Bannah, Sayed al-Qutub and Rasheed Rida from Misra (Egypt). The concerted efforts of the forenames influenced the first International conference on Islamic economic in 1970 under the leadership of King ‘Abdul ‘Aziz University, Jeddah; it was thereof recommended establishment of financial institution based on Islamic philosophy and the fruit was Islamic banking.4

Nonetheless, the emergence and growth of the Islamic finance industry is a phenomenon that has generated considerable interest in the financial world in recent years because it has ability to offer innovative financial solutions to an under-served market; many believe that it functions as a community banking niche with considerable growth potentials because Nigerian Banks are described as “torture chambers”,5 which explains sort of inconveniences in modern Banks. The operation system of Banks in Nigeria is obviously devoid of any ethical and religious philosophy; it rather subjected to profit maximization system presented by the colonial masters. This explains that none of the Banks is operating on any morally value because their ultimate goal is to ascertain profit. This influences the opinion of Olashore who notes that Banks in Nigeria lost confidence in their customers.6 Banks are now clapping their hands at various organizations for members to come for loan because people have noted their corruptive system. Roshash submits that the investment philosophy that African Banks and Companies adopted concede elements of deceit and exploitation because hoarding and forms of usurious dealing are found to be the idea instrumentally underlying investment ventures embarked upon in Nigeria and Africa with exception of some countries that have allowed non-interest system of investment and banking.7 He postulates that the


investment modes are integral components of the inherited economic system. These are suggested to be some of the factors responsible for the resurgence of non-interest banking. The observation is proved to be right by the submission of Gusau who notes that colonialists left indelible marks on the strata of life, particularly economic outlook.8

However, Ngozi Okonjo-Iweala, World Bank Managing Director (former), and current finance minister acknowledged non-interest banking as another efficient form of banking during her screening session at the National Assembly. She says: “We need to look at non-interest banking without emotions. It is another form of banking. We just need to unpack the elements of this system of banking in order to understand it. From the evidence, it seems to be functioning relatively well in various parts of the world”.9

The apex Bank issued the Islamic banking guidelines first since application for non-interest banking that has been received over the years were for firms interested in operating as Islamic Banks. Deputy Governor of the apex Bank reiterated that other models of non interest banking would be done when applications are received for such variants. He disclosed that Islamic banking model is introduced as part of the reform agenda to improve access to capital and advance financial inclusion in the country. He explained further on the need for non-interest banking, that financial inclusion is a major challenge, as almost fifty percent (50%) population of adult Nigerians do not have access to capital; and this was keeping these groups of individuals out of banking practices.10 Which group? This paper suspects, Muslim is one of the groups because Islamic doctrine does not compromise principle of interest Riba and dishonesty. As a result, he declared:

I like to clearly reassure Nigerians that non interest banking is part of our plans to increase the inclusion into the financial system of those who have stayed out of the banking system for various reasons. I like to assure Nigerians very clearly that there is no agenda. It is simply finance, it is not about religion.11

He noted that the Central Bank of Nigeria (CBN) is open to receive applications from other firms that wish to operate other variants of non-interest banking.12

Nigerian Experience of non- Interest Banking: Nigerians are people of unstable principle but of political and economic

imbalances, the reason behind this observation is not farfetched. Non- interest banking that the Central Bank of Nigeria (CBN) is championing the course recently has been floated in the dawn of Independence but truncated by the then Federal commissioner for finance, Chief Obafemi Awolowo in 1960; he revoked the license granted to the Muslim Bank in West Africa to carry out Islamic banking. Nobody heard anything about it until 1990 when General Ibrahim Badamosi Babangida enacted a decree that provide establishment of profit and loss sharing banking, but it did not see light of the day. Platinum Habib Bank was granted a license to operate in 1999, which was patronized by Muslims and was successful. Again, Olusegun Obasanjo, former President of Nigeria approved in 2002 the establishment of full operation of Islamic Bank under the supervision of CBN.13 This work foresees serious need for awareness and enlightenment in nooks and cranny of Nigeria.

Legal Provision for Islamic Banking: Although the fallacious judgment passed by some people that Sharĩ‘ah lacks

provision for banking and other economic provision but it is full of spiritual engagements


has been exhaustively refuted by the decision of the apex Bank in Nigeria. This explains that, Sharĩ‘ah concerns every stratum of life and this is the reason it is a way of life.14 It has been reiterated that Islamic economic system is devoid of corruption, cheating and hardship but it ensures material satisfaction through lawful means.15. Chapra equally states that Sharĩ‘ah is a complete guide for everything; it is interested in avoiding macro-economic ecological imbalances.16 Glorious Qur’ãn, Hadĩth and Ijtihãd are the major sources to and in support of non-interest banking, and that is what makes it Islamic banking.

It is treated under the concepts Sharikah meaning partnership and Mudãraba partnership in skill and capital. However, Sharikah connotes a contractual agreement or business consent in between two or more persons. Glorious Qur’ãn reveals, thus: “… truly many are the partner (in business) who wrong each other not so do those who believe and work deeds of righteousness, and how few are they?” (Q. 38:24).17 Many scholars have conducted a lot of research into this verse, for instance, Imam al-Zamakhashri contends that Allãh does not condole unlawful eating of property, dishonesty, gambling and usurious acts but cherish mutual trading.18 This is also repeated in another verse that mutual consent on trade is permitted and all forms of usurious acts are prohibited. Hence act of buying and trading is cherished to Allãh (Q. 2:275). A dictum of Prophet Muḥammad (SAW) reported by Abu Hurayra, thus: “Almighty Allãh said: I am a third party to every two partners so long as neither of them betrays the other, if anyone of them cheats the other, I would depart their company”.19 These are the authentic proofs which endorse the legality of Sharikah – partnership and Mudãraba - profit and loss sharing principle in business.

Banking System in Sharĩ‘ah: Some of the early scholars and writers have been thinking aloud rather than

presenting well-thought-out ideas and they put their views in copious works on Islamic banking, but with some gaps. Qureshi postulates that banking is a social service that the government should sponsor like public health and education, since the Bank could neither pay any interest to account holders nor charge any interest on loans advanced. He also encourages Sharikah al- Muḍãraba partnership on skill and capital partnerships between Banks and businessmen as a possible alternative, sharing losses if there is any.20

Ahmad envisages that it would be advantageous for the Muslims if Islamic Banks are established on the basis of a joint stock company with limited liability. He suggests, in addition to current accounts on which no dividend or interest is paid, let there be an account in which people could deposit their capital on the basis of partnership, with shareholders receiving higher dividends than the account holders from the profits made. He agrees with Quresh on possibility of partnership arrangements with the businessmen who seek capital from the Banks.21 However, the partnership principle is not defined, and there should be an explanation on who bears the loss.

Uzair suggests that Mudãraba is the main premise for interest-free banking.22 He argues that the Bank should not make any capital investment with its own deposits that will render his analysis somewhat impractical. Al-Arabi suggests banking system with Mudãraba policy as the main pivot. He is actually advancing the idea of a two-tier Mudãraba which would enable the Bank to mobilize savings on a Mudãraba policy.23


Irshad speaks of Mudãraba as the basis of Islamic banking, but his concept of Mudãraba is quite different from the traditional one in that he thought of capital and labour (including entrepreneurship) as having equal shares in output, thus sharing the losses and profits equally.24 This actually means that the owner of capital and the entrepreneur have a fifty-fifty share in the profit or loss as the case may be.

Siddiqi proposes that Islamic banking model should be based on Mudãraba.25 Chapra's model of Islamic banking, like Siddiqi's, is based on the Mudãraba principle.26 Muhsin has presented a detailed and elaborate framework of Islamic banking in a modern setting. His model incorporates the characteristics of commercial, merchant, and development Banks, blending them in novel fashion. It adds various non-banking services such as trust business, factoring, real estate, and consultancy, as though interest-free Banks could not survive by banking business alone. He envisages that Islamic Banks should be distinct from those of conventional Banks in nature, outlook and operations.27 The point is that there is more to Islamic banking than mere abolition of an interest. This takes the discourse to survey some Islamic Banks.

Existing non- Interest / Islamic Banks: The first modern experiment with Islamic banking was undertaken in Egypt under

cover, without projecting an Islamic image, for fear of being seen as a manifestation of Islamic fundamentalism which was anathema to the political regime. In the seventies, changes took place in the political climate of many countries so that a number of Islamic Banks, both in letter and spirit, came into existence in the Middle East, for example, the Dubai Islamic Bank came to being in l975, the Faisal Islamic Bank of Sudan in l977, the Faisal Islamic Bank of Egypt in l977, the Bahrain Islamic Bank sprang up in l979 and Islamic Development Bank in Egypt emerged in 1974 and many others. The Nasir Social Bank, established in Egypt in l97l, was declared an interest-free commercial Bank, although its charter made no reference to Islãm. Nigeria is not exceptional; JAIZ and Platinum Habib Bank (PHB) are noted for their effort at establishing a free interest banking services.

Siddiqi reports the pioneering effort of Ahmad al Najjar who established a savings Bank based on profit-sharing in the Egyptian town of Mit Ghamr in l963. It was an experience that lasted for four years (1963-1967).28 Ready affirms that there were Nine such Banks in the country, which neither charged nor paid interest.29 These Banks invested mostly by engaging in trade and industry, directly or in partnership with others, and shared the profits with their depositors. Thus, they functioned essentially as saving investment institutions rather than as commercial Banks.

It is pertinent to state that the Islamic Development Bank (IDB) was established by the Organization of Islamic Countries (OIC), but it is primarily an inter-governmental Bank aiming at providing funds for development projects to member countries. The IDB provides fee based on financial services, profit-sharing and financial assistance to member countries. The IDB operation is free of interest and explicitly based on Sharĩ‘ah principles. Sharĩ‘ah provides that Muslims must not part take in any business of interest based (riba) regardless of the purpose for which such business or loans are made and regardless of the rates at which interest is charged. Though attempts were made to distinguish between usury and interest, and between loans for consumption and for production but this paper could not say vividly what happens elsewhere.


Nigeria concept, however, people mostly believe that riba refers to usury practiced by petty money-lenders and not to interest charged by modern Banks and that no riba is involved when interest is imposed on productive loans, but these arguments have not gained sympathy of Islamic scholars but the consensus of Islamic scholars holds no difference between riba and interest; it is just a matter of language employed to diffuse the concept.

The prohibition of riba being the fundamental issue is re-emphasized in four different verses in the Glorious Qur'ãn. The first revelation condemns it, placing interest in juxtaposition with wrongful appropriation of property belonging to others, thus: Those who devour usury will not stand except as stands one whom the Evil one by his touch hath driven to madness. That is because they say: Trade is like usury but God hath permitted trade and forbidden usury …” (Q.2:275). The second verse emphasizes that interest deprives wealth of God's blessings, thus: “God will deprive Usury of all blessing, but will give increase for deeds of charity …” (Q. 2:276). The third injunction enjoins Muslims to stay clear of interest for the sake of their own welfare, “O ye who believe! Devour not Usury, doubled and multiplied; …” (Q. 3:130). The fourth place establishes a clear distinction between interest and trade, urging Muslims to take only the principal sum and forgo the interest, even this sum, if the borrower is unable to repay for a very serious and obvious reason; “O ye who believe! Fear God and give up what remains of your demand for usury, …” (Q. 2: 278); “ If the debtor is in a difficulty, grant him time, till it is easy for him to repay. But if ye remit it by way of charity, that is best for you if ye only knew” Q. 2 280). It is further declared in the Glorious Qur'ãn, that those who disregard the prohibition of interest are at war with God and His Prophet (SAW). At this juncture, traits of Islamic Bank should be identified.

Features of Sharĩ‘ah Banking System: Scholars put forward economic reasons to explain prohibition of interest, at any

form, in Islãm.30 Khan argues, for instance, that interest, being a pre-determined cost of production, tends to prevent full employment.31 In the same vein, it has been contended that international monetary crises are largely due to the institution of interest, and that trade cycles are in no small measure attributed to the phenomenon of interest.32 Although lawful profit in Islãm can equally be exploitative, the exploitative character of the institution of interest is the strain.

The objection that rent on property is considered Halãl (lawful) is then answered by rejecting the analogy between rent on property and interest on loans, since the benefit to the tenant is certain, while the productivity of the borrowed capital is uncertain. Besides, property rented out is subject to physical wear and tear, while money lent out is not. The question of erosion in the value of money; Islamic jurists have ruled out compensation for erosion in the value of money, or, according to Ḥadĩth, a tangible good must be returned by its like (mithl): 'gold for gold, silver for silver, wheat for wheat, barley for barley, dates for dates, salt for salt, like for like, equal for equal, and hand to hand. However, Muslims need no proofs before they identify the riba and the institution of interest since no human mind can fathom a divine order hence it is a matter of belief (Imãn).

The Islamic ban on interest does not mean that capital is costless in an Islamic system. Sharĩ‘ah recognizes capital as a factor of production but it does not allow the factor to make a prior or predetermined claim on the productive surplus in the form of


interest. This obviously poses the question as to what will then replace the interest rate mechanism in an Islamic framework. There have been suggestions that profit-sharing can be a viable alternative.33 In Islãm, the owner of capital can legitimately share the profits made by the entrepreneur. What makes profit sharing permissible in Islãm, while interest is not, is that in the case of the former it is only the profit-sharing ratio, not the rate of return itself that is predetermined.

It has been argued that profit-sharing can help in allocating resources efficiently, as the profit-sharing ratio can be influenced by market forces so that capital will flow into those sectors which offer the highest profit sharing ratio to the investor, other things being equal. This occurs in the Muḍaraba. In conclusion, it emerges that Islamic banking has three distinguished features: it is interest-free; it is multi-purpose and not purely commercial, and it is strongly equity-oriented. There is a consensus among the Scholars of Islãm and finance/bank-expertise that Islamic Banks can function well without interest.

Categories of Partnership in Sharĩ‘ah Banking System: Islãm does not deny the fact that capital is a factor of production; it therefore

deserves to be rewarded. Islãm allows owners of capital a share in a surplus that is uncertain, so the investors in the Sharĩ‘ah order have no right to demand a fixed rate of return. However, four distinctive policies are identified and any other policy finds its way in between the four. The four includes Sharikah al-amwãl partnership in capital, Sharikah al-abdãn professional partnership, Sharikah al- Mudãraba partnership in skill and capital and Sharikah al-Wujũah partnership in/on credibility or representation. Jurists in Sharĩ‘ah have agreed on the viability and legality of the four categories of partnership.

Sharikah al-Mudãraba Partnership on Skill and Capital concurrently: This partnership involves two or more parties that one or some of them provide

capital and others contribute skill with which the investment will survive. Of course, they have decided to float an investment and agreed on the term of operation and profit sharing between them; it involves travelling or movement for business reasons, the movement could be limited as designed in the term of business agreement. In passing, this policy covers the taxi cab drivers and their car’s owners. Bank may enter partnership with one or many transporters and other traders with this policy. However, two conditions are formulated by the Jurists of Sharĩ‘ah:

a. Mudãraba Muṭlaq Open Partnership, this allows the workers to invest on any kind of business and travel to any place of his choice. He can equally deal with any person of his desire at all rate and level.

b. Mudãraba Muqayyad Restricted Partnership stipulates that workers has limit to which they can deal. Memorandum spells out areas of operation, places and class of people, and the companies they can deal with. It is on this agreement the partnership survives.

Mudãraba and Mushãraka are inter-related terms that constitute, at least in principle if not in practice, the twin pillars of Islamic banking. It means partnership in equity capital. Mushãraka principle is invoked in the equity structure of Islamic Banks and is similar to the modern concepts of partnership and joint stock ownership. In so far as the depositors are concerned, an Islamic Bank acts as a Mudãrib which manages the


funds of the depositors to generate profits subject to the rules of mudãraba. The Bank may in turn use the depositors' funds on a mudãraba basis in addition to other lawful modes of financing. In other words, the Bank operates a two-tier mudãraba system in which it acts both as the mudãrib on the saving side of the equation and as the owner of capital rabbulmãl on the investment portfolio side. The Bank may also enter into mushãraka contracts with the users of the funds, sharing profits and losses.

Sharikah al-Amwãl Partnership on Capital: This is a partnership entered into by two or more parties who contributed together

some capitals with the intention of undertaking an investment and sharing the profit or loss incurred in the proportion of ratio each contributed, and agreed upon by the time the partnership is sealed. Further explanation here is that the capital must be recognized and valued in the Sharĩ‘ah. This partnership is one of the policies the conventional Banks employed to raise their capitals. All the orthodox schools of thought consented to the fact that the capital must be valued and popular in recognition. Jurists have submitted that sharing of the profit and power to dispose or contract the business rest upon their agreement at the time of initiating the partnership.34 It is a legitimate partnership that Islamic bank can develop based on equity participation (mushãraka); in which the partners use their capital jointly to generate a surplus. Profits or losses will be shared between the partners according to the agreed formula depending on the equity ratio.

Sharika al-Abdãn Professional Partnership: Gusau equates Sharika l-abdãn as nominally the same with Sharika l-Sannã‘a. This

work agrees with him in defining this policy as one that involves two or more parties in partnership of profession. This explains that people of the same or different profession can come together based on their profession, and they agree to carry on an investment in particular terms with regards to ratio of profit and loss sharing. Abu Daud explains that Prophet Muhammad (SAW) tacitly approved this type of partnership entered by ‘Ammar bn Yasir, Sa’ad bn Abu Waqqa and Abdullahi bn Mashud during the battle of Badar that the three will jointly benefit from captives of war each and every one of them was able to catch.35

Position of this paper therefore is that in as much the parties aware and agreed on the term stated; the partnership is legally formed and recognized. Hence, Banks and other companies can equally be formed based on this policy. This paper advocates that if the partnership could be jointly established it is alright.

Sharika al-Wujũh Partnership in Credibility: Principle of Sharika al-Wujũh rests on the credibility of each party in the

investment. However, it involves two or more persons who have no capital; cash or kind but agreed to set up a business venture. The company rests on their credibility, prestige and confidence they could enjoy from the capitalists or business men. Their operation is based on reputation so that after the sales, money is remitted to the owner of the capital and the gain is shared between the partners as the agreement endorsed stipulates. The legality is analogical since the legality behind the representation or delegation to either buy or sell something; or as Waliyy in marriage or delegation to give divorce notice to a wife is adequate, then, this partnership is equally legal and recognized. Sharing of profit


or loss must have been stipulated in the terms of agreement. The above mentioned partnerships are recommended for Banks to enter with the interested companies and individuals.

Accounts Operation in Sharĩ‘ah Banking System: Islamic Banks normally operate three broad categories of account: current, savings,

and investment. The current account, as in the case of conventional Banks, gives no return to the depositors. It is essentially a safekeeping (al-Wadĩ‘ah) arrangement between the depositors and the Bank, which allows the depositors to withdraw their money at any desired time and permits the Bank to use the depositors' money. Cheque books are issued to the current account deposit holders but with charges. The Sharĩ‘ah Banks provide the broad range of payment facilities clearing mechanisms; Bank drafts; bills of exchange’ travelers-cheque; et cetera. More often than not, no service charges are made by the Banks in this regard. The savings account is also operated on a safekeeping (al-Wadĩ‘ah) basis, but the Bank may at its absolute discretion pay the depositors a return periodically depending on its own profitability. Such payment is considered lawful in Islãm since it is not a condition for lending by the depositors to the Bank, nor is it predetermined. The savings account holders are issued with savings booklets and are allowed to withdraw their money as and when due.

The investment account is based on the Mudãraba principle, and the deposits are term deposits, otherwise called fixed deposit, which cannot be withdrawn before maturity. The profit-sharing ratio varies from Bank to Bank and from time to time depending on supply and demand conditions. In theory, the rate of return could be positive or negative, but in practice the returns have always been positive and quite comparable to rates conventional Banks offer on their term deposits. A difference in between the conventional and Sharĩ‘ah Banks is that the former determines the profit by percentage and gives out immediately, more so it is negotiable, This is purely unlawful and it is not done in Islamic Banks. The profit, in Islamic Banks, is shared when the profit accrued; it is not immediately and depends on the available profit. The investment account, Islamic Banks employ a variety of instruments. The Mudãraba and Sharika al-Amwãl or Mushãraka policies earlier referred to are supposedly the main conduits for the outflow of funds from the Banks. In practice, however, Islamic Banks have shown a strong preference for other policies which are less risky.

Profit Sharing Murãbaha Trading Mode: This is a policy which two or more parties entered with an agreement to buy

products on behalf and sell to the second party in the trade. The agreement is made and sealed earlier before the goods are purchased. It is the most commonly using policy of financing that seems to be the 'mark-up' device which is termed Murãbaha. In a Murãbaha transaction, the Bank finances the purchase of a good or asset by buying it on behalf of its client and adding a mark-up before reselling it to the client on a 'cost-plus' basis. It may appear at first glance that the mark-up is just another term for interest as charged by conventional Banks, interest thus being admitted through the back door. What makes the murãbaha transaction legitimate is that the Bank first acquires the asset and in the process it assumes certain risks between purchase and resale. The Bank takes


responsibility for the good before it is safely delivered to the client. The services rendered by the Islamic Bank are therefore regarded as quite different from those of a conventional Bank which simply lends money to the clients to buy the good. Hence, certain modes of trading are identified and recognized in Sharĩ‘ah.

Deferred Payment Trading Mode (Bai‘ Mu’ajjal): Islamic Banks have also been resorting to purchase and resale of properties on a

deferred payment basis, which is termed Bai' mu’ajjal. It is considered lawful in fiqh (Jurisprudence) to charge a higher price for a good if payments are to be made at a later date. According to fiqh, this does not amount to charging interest, since it is not a lending transaction but a trading one.

Leasing Mode of Trading Bai‘l-‘Ijãra: Leasing or ‘Ijãra is also frequently practiced by Islamic Banks. Under this mode,

the Banks would buy the equipment or machinery and lease it out to their clients who may opt to buy the items eventually, in which case the monthly payments will consist of two components, that is, rental for the use of the equipment and installment towards the purchase price.

Pre-Paid Purchase Bai‘ sSalãm: Reference must also be made to pre-paid purchase of goods, which is termed Bai'

sSalãm, as a means used by Islamic Banks to finance production. Here the price is paid at the time of the contract but the delivery would take place at a future date. This mode enables an entrepreneur to sell his output to the Bank at a price determined in advance. Islamic Banks, in keeping with modern times, have extended this facility to manufactures as well.

It is clear from the above that Islamic banking goes beyond the pure financing activities of conventional Banks. Islamic Banks engage in equity financing and trade financing. By its very nature, Islamic banking is a risky business compared with conventional banking. To minimize risks, however, Islamic Banks have taken pains to distribute the eggs over many baskets and have established reserve funds out of past profits which they can fall back on in the event of any major loss.

Prospects of non-Interest (Sharĩ‘ah) Motivated Banks: Muslims and other faiths’ adherents will certainly benefit from the Sharĩ‘ah

motivated banking because it does not discriminate religion, ethnic or race but it is for the development of the people and the nation as well as the world entirely. What Muslims need to do is to strive and ensure that, even one is established, though some investments are noted for their roles in the society which comply with the Sharĩ‘ah policy as stated in this work. However, the following advantages abound in the society:

Soft loan benefit is guaranteed to the general public without payment of an interest but there must be fulfillment of the payment at the right time as agreed on. Farmers enjoy more as the Bank will extend soft loan of short and long term to them and other business intended people. It is going to strengthen and build the social economic infrastructure of this very great country.


The Islamic banking will enhance installment sale of assets where legal system does not allow such sale for individuals. This is in line with one of the policies discussed above- Mudãraba – a contract between the Bank and the purchaser.

Leasing of assets and finance are a sort of advantage for every member of the society; this is where Bank provides financial assistance to potentially revenue yielding development projects whether in industry, agro-industrial sectors and otherwise. The Bank can only sustain the ownership pending the time the payment of the assets is made after which the Bank will transfer title of ownership to the beneficiaries.

A lawful profit sharing is available for those who come together to initiate interest free Bank, otherwise called Sharĩ‘ah policy motivated Bank. Though the profit can only be shared when profit is made and it is divided upon the ratio of the contributed capital.

Technical assistance will equally be rendered to the public when so required; this plays a significant role in the economic and social development of the society. This involves scholarship enhancement but it is mainly for the Muslims with a view to develop scholarship Bank experts.

There are severally benefits this paper cannot mention because of the space. However, one outstanding gain is the eternal reward for fulfilling the requirement of Sharĩ‘ah. Allãh is rewarding one who lives his life in accordance to Sharĩ‘ah. This leads the discourse to challenges involved.

Challenges of Islamic/non-interest banking: The major challenge in Nigeria for the operation of non-interest banking rests on

the mechanism, that is, man power. The efficiency of the banking operation is guaranteed by the presence of experienced bankers in both ways; conventional and Islamic banking. This explains that trained staffs in this direction are required. Part of the explanation is that long-term financing requires expertise which is not always available.

Another challenge is that there are no backup institutional structures such as secondary capital markets for Islamic financial instruments. It is possible also that the tendency to concentrate on short-term financing reflects the early years of operation: it is easier to administer, less risky, and the returns are quicker. The Banks may learn to pay more attention to equity financing as they grow older.

It is sometimes suggested that Islamic Banks are rather complacent. They tend to behave as though they had a captive market in the Muslim masses that will come to them on religious grounds. This complacency seems more pronounced in countries with only one Islamic Bank. Many Muslims find it more convenient to deal with conventional Banks and have no qualms about shifting their deposits between Islamic Banks and conventional ones depending on which Bank offers a better return. This might suggest a case for more Islamic Banks in those countries as it would force the Banks to be more innovative and competitive. Here, the paper makes concluding remark.


Concluding Remark: The preceding discussion makes it clear that non-interest banking, otherwise known

as Islamic banking, is not a negligible or merely temporary phenomenon. Islamic Banks are here to stay and there are signs of prospect and challenges.

One of the main selling points of Islamic banking, at least in theory, unlike conventional Banks, is about the viability of the project and the profitability of the operation but not the size of the collateral. Good projects which might be turned down by conventional Banks for lack of collateral would be financed by Islamic Banks on a profit-sharing basis. It is especially in this sense that Islamic Banks can play a role in stimulating economic development. In many developing countries, of course, development Banks are supposed to perform this function. Islamic Banks are expected to be more enterprising than their conventional counterparts. In practice, however, Islamic Banks have been concentrating on short-term trade finance which is the least risky.

Recommendation: Based on the foregoing, this paper encourages the Muslims, particularly the well to

do people to float any possible category of the partnership in Islamic banking, and the less privileged also implored to give wholesome and handsome patronage with honesty. As a matter of seriousness, If Muslim organizations, such as the Supreme Council for Sharĩ‘ah, the Supreme Council for Islamic Affairs, the Muslim Students Society and early Muslim Organizations like Ansar-Ud-Deen, Ansarul Islãm, Nawair-Ud-Deen and Nur-Ud-Deen Societies, could float Islamic Banks and honestly manage it well, certainly the non-Muslims will overwhelmingly patronize it. However, the staff of the non- interest Banks should be prepared to face the challenges involved and determined to ensure the success of the Bank.

Government is also encouraged not relent its effort towards ensuring that non-interest banking as an alternative and opportunity for groups that could not assess conventional Banks’ policies is sustained.

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Saturday July 16 2011. 2. Quadri, Yasir A. Sharĩ‘ah; The Islamic way of Life. Ilorin: Shebiotimo, 2000. 3. Saleh, Auwal. An Introduction to Islamic Economics and Banking System. Abuja:

Gidan Dabino Publishers, 2002. 4. Ibid. 5. Roshash, A.A, Mustafa. “The Islamic Alternative to the Present Mode of

Investment in African Banks and Companies”, Ed. Nuru Alkali, Islãm in Africa. Ibadan: Spectrum, 1993.

6. Olashore, O. Policy Issues in Nigeria: Banking and Economic Management: A Collection of Essays. Ilorin: Atoto, 1986.

7. Roshash, op.cit 8. Gusau Ahmad. Economics of Islãm, Lahore: n.d., 1952


9. Ngozi Nweala, “Ngozi Okonjo Iweala supports non-interest banking at confirmation hearing” www.proshareng.com/new/14179; http://www.nairaland.com/nigeria/topic-708147.0.html, retrieved May 25th 2012.

10. Acheme Jack, “Nigeria’s Apex bank allays fears on Islamic Banking”, www.businessdayonline.com, retrieved on May 25th 2012

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Monetary and Fiscal Economics of Islãm. Jeddah: International Centre for Research in Islamic Economics, 1982.

17. Ali, A.Y. The Holy Qur’an Text, Translation and Commentary. London: Islamic Foundation, 1975).

18. al-Zamkhashari, Mahmud bn ‘Umar Jarullahh Abi Qasim, Al-Kashaf. 1:502. Caira: Dar Ihyah al Turath al Arabi 1, n.d.

19. Isma’il, Muḥammad al-Khalani. Subul as-Salam-Sharh Bulugh Marãmi 3:15. N.p. n.d.

20. Qureshi, Anwar Iqbal. Islãm and the theory of interest. Lahore: n.p., 1946. 21. Ahmed, Sule and Gusau. “Prospects and Problems of Islamic Banking in Africa”.

Ed. Nuru Alkali. Islãm in Africa. Ibadan: Spectrum, 1993. 22. Uzair, Mohammad. An Outline of `Interestless Banking. Karachi: Raihan

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23. al-Arabi, Muḥammad Abdullah. 'Contemporary Banking Transactions and Islãm's views theory', Islamic Review. London: l966.

24. Irshad, S.A., Interest Free Banking. Karachi: Orient Press of Pakistan, 1964. 25. Siddiqi. Banking without Interest. Leicester: The Islamic Foundation, 1983a. 26. Chapra, M. Umer. 'Money and Banking in an Islamic Economy'. M. Ariff, Ed.,

Monetary and Fiscal Economics of Islãm. Jeddah: International Centre for Research in Islamic Economics, 1982.

27. Muhsin, M., 'Profile of Riba-free Banking'. M. Ariff, Ed., Monetary and Fiscal Economics of Islãm. Jeddah: International Centre for Research in Islamic Economics, 1982.

28. Siddiqi, M.N. 'Islamic Banking: theory and practice'. M. Ariff, Ed., Monetary and Fiscal Economics of Islãm. Jeddah: International Centre for Research in Islamic Economics, 1988.

29. Ready, R.K., 'The March toward Self determination'. Paper presented at the First Advanced Course on Islamic Banks, International Institute of Islamic Banking and Economics, Cairo, from 28th August to l7th September, 1981.


http://www.proshareng.com/new/14179

http://www.nairaland.com/nigeria/topic-708147.0.html

http://www.businessdayonline.com/

30. Mannan, M.A., Islamic Economics. Lahore: n.d., 1970.

31. Khan, Muḥammad Akram. 'Theory of Employment in Islãm', Islamic Literature. Karachi, XIV (4): 5l6, 1968.

32. Ibid; Su'ud, M. Abu. 'The Economic Order within the General Conception of the Islamic Way of Life'. Islamic Review. London. 55 (2): 2426 and (3): lll4. n.d.

33. Kahf, Monzer. 'Saving and Investment Functions in a Two Sector Islamic Economy'. M. Ariff, Ed., Monetary and Fiscal Economics of Islãm. Jeddah: International Centre for Research in Islamic Economics, 1982a.; - - - . 'Fiscal and Monetary Policies in an Islamic Economy'. M. Ariff, Ed., Monetary and Fiscal Economics of Islãm. Jeddah: International Centre for Research in Islamic Economics, 1982b.

34. Al-Dasuqi, Muḥammad Arafah. Hashiyat Dasuqi 3:248. N.p, n.p., n.d.

35. (Abu Daud 2: 23; al-Shawkani 5: 299).


Analysis of Promise in Islamic Law Definition and The Opinions of Muslim Jurists with

Regard to Binding Nature of Promise By

Dr Mohammad Nawaz {al Hassani}*

ABSTRACT The Article explained the meaning of promise {al Wad} and discussed about the Opinions of Muslim scholars with regard to the binding nature of promise in Islamic law and analyzed their evidences on their view points and provided the preference in this regard.

The article described the opinion of Muslim jurists with regard to validity of contract concluded on the bases of promise and analyzed their arguments in detail and provided the preference in this regard.

This article analyzed the opinion of contemporary scholars who hold that promise is binding and enforceable by court and the contract which based on such promise is also valid and the article rejected their opinion with strong evidences and mentioned that the opinion of contemporary scholars does not have any conformity with the opinion of classical jurists neither Hanfi, Shafei and Hanbi Jurist nor Malki jurists and proved that the opinion of contemporary jurists is combined from the clashes.

Key Word: Promise (al wad) in Islamic law Binding nature, Muslim jurist opinion, Evidance

Introduction: The Islamic banking system is new arrangement of banking in against to

conventional banking system and it is growing day by day in the world.

The Islamic system of banking some time required explanation or change in the rules according to the requirement of Islamic law.

When any client requires finance he contacts to Islamic bank to provide help to him in importing such and commodity from abroad according to Islamic law then Islamic * Author: Dr. Mohammad Nawaz (al Hassani) is an Assistant professor, Faculty of Shariah

and law, International Islamic University, Islamabad – Pakistan. E‐Mail: [email protected]


mailto:[email protected]

bank takes undertaking from such customer that when bank bought this commodity from abroad the customer will buy this commodity from Islamic bank.

This undertaking and promise is binding as contract is binding as contract is enforceable or this undertaking and promise is not binding and enforceable, so it was the requirement of Islamic banking to explain the meaning of promise and undertaking and to mention the rule of promise that it is binding or not and also to provide the rule of contract which based on such promise and elaborate the opinions of Muslim jurists with regard to the validity of contract concluded on the bases of promise.

Definition Of Promise {al Wad}: The promise is defined in following words: it is to inform other person that

promissory provides his desired thing to him in future fixed or non fixed date.1

Threat {al Waeed} is apposite to promise and threat is providing information to other party that threatening person will injure him in future fixed or non fixed date.2

The promise is binding or not there is different opinion of Muslim jurists.

Opinions Of Muslim Jurists With Regard To Binding Nature Of Promise: There are two opinions of jurists as follows:

The majority of Muslim jurists Such as Hanfies, Shafeis and Hanblies, hold that promise is unilateral binding {lazim}and it is not bilateral binding{Mulzam} and it means the promissory person is required by his religion to fulfil his promise but any other party cannot enforce him to fulfil his promise and when promise is not bilateral binding then any contract based on it is considered valid such as the compound murabahah 3 because compound murabaha at the level of promise is not contract.

Malki jurists and some other hold that promise is bilateral binding {mulzam} in the matter of contracts based on promise as some promised with other: If you buy this house i 1 Al Majallah / legal maxim; 84 2 The same source. 3 Compound murabahah: it is compound due to two reasons. {1} one of them is that: it is

component of three people : a- supplier the original business man from whom the bank wants to purchase a commodity and he is actual seller b-Bank which is going to purchase this commodity from original seller and to sell it to client c-The client who is original purchaser of commodity. {2}Second reason is that the compound murabahah is comprised from promise of contract and then from contract because the client comes to bank and submits his willingness to purchase specific commodity from bank and Bank takes undertaking from purchaser and bank also promises with client to sell this commodity to him after purchasing it from market and when bank bought this commodity from abroad or from anywhere else by its own representative or by appointing a real purchaser as a agent of bank to check the market and value of the commodity and inform about a proper situation to the bank and when bank is informed and satisfied about all prerequisite of purchasing a property then bank concludes the contract with supplier and pays the price to him and comes with this commodity and asks the client to fulfil his promise then the contract of murabahah sale is concluded between bank and client,


support you in the payment by providing specific amount and now the promissory is enforced by court to fulfil the requirement of his promise and it is explained by Abu Bakr Ibn al Arabi al Malki and Ibn al Shat al Malki: They said the promise is binding for person who made it and he is enforced to fulfil his promise by court.4 Ibn Shubramah is more strict in this regard and said the promise is bilateral binding though it is caused for any expenditure or not. 5

Conclusion: There are three situations:

i- If the promise is neither binding for bank nor for client in such manners that the promissory is enforced by anybody to fulfil the requirement of his promise then the compound murabahah is valid6 in Islamic law and it is according to all those jurists who hold that promise is not binding as Hanfi, Shafei and Hanbli jurists.

ii- If the promise is binding to any one of the bank or client as Siddique al Darir the contemporary scholars said or {iii}the promise is binding for both bank and client as Malki jurists hold then the contract of compound murabahah is void.7

View point of contemporary scholars: There are two opinions of contemporary scholars:

FIRST OPINION: majority of contemporary scholars hold that promise is not binding and they also hold that: the contract of compound murabahah is valid.8

Evidences: They argued on their opinion with evidences mentioned below.

1- Almighty Allah commanded: Do not say about anything that i do it in the morning except you say: If Almighty Allah wants it. 9

Ibn Hazam said: it is obligatory for promissory to add the exemption to his promise because the promise without exemption is prohibited by this verse and 4. Abdul Hameed al Sahey / Ahkam al Aqud wa al Buyu /17-18, And Dr Yusuf Al Qardavi /

Bay al Murabahah lil Aamir bil shira/ 151 5 I(bn Hazam al Dahiri / al Muhallah / Maktabah al Jamhuriyah al Arabiyah / 1969 – 1389

/section: 1125/8:377 6. It is view point of Hanafi, Shafei and Hanbli jurists. See: coming discussion. 7. It is view point of Malki Jurists and cotemporary scholars who adopted the opinion of Malki

jurists that the promise is binding and enforceable but they declared: that the murabahah contract is valid.

8. Some of them are as: Dr Rafique al Misri, Abdul Rahman Abdul Khaliq, Dr Mohammad Suleman al Ashqar and Dr Hassan Abdullah al Amin. See: Majallat al Muslim al Muasir / no: 32: 1402 A H and no: 35 / 1403 AH and Majallat al Jamiah al Islamiyah / no: 59 and Dr Mohammad Suleman al Ashqar / Bay al Murbihah Kama tajrebohu al Masarif al Islamiyyah / al Kuwait: Maktabah al Falah.

9 Surah al Kahf / 23-24


prohibited could not be obligatory because both are opposite to each other and the promise with exemption is not binding and it is agreed upon.10

2- Tradition of Prophet {blessing of Allah and peace be upon him} and he said: When any one promised with other and he intended to fulfil his promise but he cannot fulfil his promise then there is no harm for him.11

It is known from this tradition that if promissory is intending by his promise that he will not fulfil his promise it is prohibited for him because it is simultaneous to lying and lying is prohibited in Islamic law.

3- If the promise is binding and enforceable then this promise will be contrary to text of tradition of Holy Prophet {blessing of Allah and peace be upon him} that the sellers are with their option until they do not separate from each other.12 And here promissory is not given any option after promising thought the session is not terminated and it becomes binding on bank and client both.

4- The promise is analogous to oath and when anything is better than the fulfilment of oath and the breach of oath is valid and it is proved by the tradition of Prophet {Blessing of Allah and peace be upon him} Bye god i do not take oath on any matter and i think anything else better than oath i adopt the better thing and come out from the binding of oath.13

The promise is given rule of oath by analogy and analogy is valid evidence in Islamic law according to majority of Muslim jurists.14

5- If the promise is binding and enforceable as in compound murabahah then it is contract of sale and the selling a commodity which does not exist is prohibited due to the tradition of Holy Prophet {blessing of Allah and peace be upon him} Do not sell whatever is not with you. 15 It means do not sell

10 Ibn Hazam al Dahiri / al Muhallah/ section:1125/8:379-380

11 It is narrated by Abi Dawood and al Tirmidi / Sunan e Abi Dawood / hadeth: 4995 and Jame al Tirmdi/ hadeth:2633.

12 It is narrated by Immam al Bukhari and Muslim, See: Sahih al Bukhari / 3: 83 and Sahih Muslim / 5: 9.

13 It is narrated by Imam al Bukhari / Sahih al Bukhari / Hadeth: 4385 14 Oath is divided in three types: {1} }{Yameen Laghve} meaningless oath as Arab people say in

their conversation among themselves as their habits: bye God and bye God. This type of oath is not given any rule and it is useless oath. {2} oath on event occurred in past: there are two situations {a} the person took oath on the event and he is truthful in his oath such oath is valid and accepted in court and judgment is given on the basis of this oath provided there is no testimony {b}the person took oath on the event and he is liar as murderer took oath and said bye God I did not kill this innocent person while he killed that innocent person in fact, though this oat is also accepted in court but this oath is called {yameen ghamoos}it means this oath dips him in the hell fire after the day of judgment. {3} oath on the event which will occur in future and this type of oath is concluded oath {Yameen Munaqidah}this oath is taken for the strengthens of future matter and it is binding: now there are two situations: {a} if this oath is not fulfilled then expiation becomes obligatory on that person who has taken this oath.{b} if it is fulfilled then the person who has taken this oath made himself free from the liability of oath.

15 It is narrated by Termzi, Abu Dawood and Haithami: See: Jamie al Tirmizi /3: 534 /Hadeth no: 1232 and Sunan e Abu Dawood / 3: 383 / Hadeth no:3503 and Majma al Zawaid / 4:80


whatever does not exist and the commodity at the time of promise does not exist in compound murabahah.

6- If the promise is binding as mentioned above in compound murabahah then it is contract of sale and selling a commodity which is not owned still is prohibited due to tradition of Holy Prophet {blessing of Allah and peace be upon him} Do not sell whatever is not with you. It means: which is not owned by you.

7- If promise is binding then the contract of compound murabahah is not valid due to tradition: Do not sell whatever is not with you and it means: Do not sell whatever is not deliverable at the time of contract.

8- If promise is binding then the contract of compound murabahah becomes bay al einah16 because client requested to bank to purchase for me such and such commodity and then he demanded from bank to sell same commodity to me 17 and bay al einah is prohibited due to two traditions of Holy Prophet {blessing of Allah and peace be upon him}. a- One of them is that: When you exchange the property according to eina sale, and hold the tails of cow and please with cultivation and leave struggle implement the wishes of Almighty Allah{Jihad}18 then Allah exalted appoints over you insults until you come

16 Bay al einah is selling a commodity on cash price and then buying it back at the higher price

than cash price which should be paid in future fixed date and both transactions take place at the same time and same session of contract and it is named einah because the same substance{ayn} is sold and bought back.

17 See: Dr Mohammad Suleiman / Bay al murabahah wa Tatbiqatuhu fi al Masarif al Islamiyyah / 128

18 There are three different word used in Holy Quran which stand for different meaning {1} Jihad and it is not in the meaning of war as West and some Muslim scholars understood but it is struggle for the application of divine and revealed education of Almighty Allah in the world and Jihad is struggle for the application of wishes of Almighty Allah which are given in divine educations against to wishes of people individually and collectively by which they can violate the right of anyone else as Prophet {blessing of Allah and peace be upon him} said: He who harms any non Muslim who is citizen of Muslim country I will stand against to him on the day judgment and when I stand against to any one on the day of judgment the judgment will be given in my favour and there is another tradition of Prophet {blessing of Allah and peace be upon him}and he said: when he was returning from battle of Ahzab: we came back from little Jihad for big jihad and companions asked: What is big Jihad? Prophet said: It is Jihad against to himself. It means scarifying own wishes against to the wishes of Almighty Allah is also Jihad and it is first stage of pious person who became capable to be called vicegerent of Almighty Allah. {2} {Harb} It stands for war between the nation and nation and tribe and tribe. {3} {Muharabah} Terrorism and it is causing disturbance in the world without any justification and it is causing harm for others without differentiation between innocent and criminal.


back to your Din. 19 implement the wishes of Almighty Allah{Jihad}20 then Allah exalted appoints over you insults until you come back to your Din. 21

b- Second is that: Aysha {Allah be pleased with her}said: when Umm Mohibbah told her that she sold one slave girl to Zaid bin Arqam al Ansari by 800 Dirham and still he did not pay anything to me he decided to sell her to any one, so I bought her back from Zaid bin Arqam by 600 Dirham, {instead of that he sells her to anybody else} Aysha {Allah be pleased with her}said: that it is bad what you sold and it is bad what you bought and tell to Zaid that his battle{Jihad}alongside of the Holy Prophet {blessing of Allah and peace be upon him}is nullified unless he repents and then she asked to her, what should I do? I just take my capital back from him Aysha{Allah be pleased with her} replied: Those who after receiving direction from their Lord {exalted} shall be pardoned for their past.22

5- If the promise is binding and enforceable then compound murabahah will be component of two sales in one sale because the bank promises with client that I buy this commodity and bank promises with client that I sell you this commodity.23 And two sales in one sale is prohibited by tradition of Holy Prophet {blessing of Allah and peace be upon him} who sold two sales in one sale he is entitled for sediment or riba. 24

9- If the promise is binding and enforceable then this promise will be contrary to text of tradition of Holy Prophet {blessing of Allah and peace be upon him}

19 It is narrated by Imam Ahmad in his Musnad, See: al ZAilai / Nasab al Rayah Li Ahadith al

Hidayah/ 4:17. 20 There are three different word used in Holy Quran which stand for different meaning {1}

Jihad and it is not in the meaning of war as West and some Muslim scholars understood but it is struggle for the application of divine and revealed education of Almighty Allah in the world and Jihad is struggle for the application of wishes of Almighty Allah which are given in divine educations against to wishes of people individually and collectively by which they can violate the right of anyone else as Prophet {blessing of Allah and peace be upon him} said: He who harms any non Muslim who is citizen of Muslim country I will stand against to him on the day judgment and when I stand against to any one on the day of judgment the judgment will be given in my favour and there is another tradition of Prophet {blessing of Allah and peace be upon him}and he said: when he was returning from battle of Ahzab: we came back from little Jihad for big jihad and companions asked: What is big Jihad? Prophet said: It is Jihad against to himself. It means scarifying own wishes against to the wishes of Almighty Allah is also Jihad and it is first stage of pious person who became capable to be called vicegerent of Almighty Allah. {2} {Harb} It stands for war between the nation and nation and tribe and tribe. {3} {Muharabah} Terrorism and it is causing disturbance in the world without any justification and it is causing harm for others without differentiation between innocent and criminal.

21 It is narrated by Imam Ahmad in his Musnad, See: al ZAilai / Nasab al Rayah Li Ahadith al Hidayah/ 4:17.

22 al Qurtabi / Jami le Ahkam al Quran / 3 : 359 - 360 23 Abdul Rahman Abdul Khaliq / Shareiyyat al Muamlat allati taqumo biha al Bunuk al

Islamiyyah / Majallat al Jamia al Islamiyya no: 59 /102 24 It is narrated by Abu Dawood and al Baihaqi: See: Sunan e Abi Dawood / 3: 273/ no: 3461and al

Sunan al Kubra / 5: 345


that the sellers are with their option until they do not separate from each other.25 And here promissory is not given any option after promising with bank or with client.

10- If the promise is binding then it is selling debt against to debt and it is prohibited by tradition of Holy Prophet {blessing of Allah and peace be upon him} while forbidding from the sale al kali by sale al kali.26 because the bank while promising with client it is selling a commodity to client on deferred payment before purchasing of it and it is selling debt in against to debt and it is prohibited.

11- If the promise is binding for both it is contingent sale because client said to bank: if you purchase the said commodity I buy it from you, and contingent sale is prohibited. by tradition.27

SECOND OPINION: Some contemporary scholars hold that promise is binding and enforceable as the view point of Malki jurists but Malki jurist hold that compound murabahah is not valid while these contemporary scholars hold the compound murbahah is valid and Mowlana Taqi Usmani from Pakistan and Dr Yusuf al Qardavi are from this group of contemporary scholars. 28

Evidences Of This Group Of Scholars On The Binding Nature Of Promise:

Mowlana Taqi Usmani said: A number of Muslim jurists are of the view that fulfilling a promise is mandatory and a promissory is under moral as well as legal obligation to fulfil his promise, According to them, promissory can be enforced through courts of law and this view ascribed to Samurah bin Jundub {Allah be pleased with him} the well known companion of Holy Prophet {blessing of allah and peace be upon him} Umer bin Abdul Aziz, Hassan al Basari, Said bin al Ashwa, Ishaq bin Rahvaih and Imam al Bukhari.29 And further he said: The same is the view of Malki jurists, and it is preferred by Ibn al Arabi, Ibn al Shat and it is endorsed by al Ghazzali the famous Shafei jurist who says: the promise is binding if it is made in absolute term and the same is the view of Ibn Shubramah. 30

This group of scholars argued on their view point as follows:

Mowlana Taqi usmani argued on the binding nature of promise by the text of Quran and Hadeth31 these texts of Holy Quran and Sunnah related to the importance and obligation of promise are as follows:

25 It is narrated by Immam al Bukhari and Muslim, See: Sahih al Bukhari / 3: 83 and Sahih Muslim

/ 5: 9. 26 It is narrated by Hakim in his Musnad. See: Showkani / nail al Aowtatr / 5:156. 27 These are the prohibitions applied on the compound murabahah while promise is binding. 28 this group of contemporary Muslim scholars are as Dr Sami Hmud, Dr Abdul Hameed al Bali, Dr

Yousuf al Qardavi, Dr Mohammad al Badavi, al Shaikh Abdul Hameed al Sayeh, Ibrahim al Dabu and Molana Taqi Usmani from Pakistan.

29 See: Molalna Taqi usmani /Islamic Finance /Idaratul Maarif : Karachi / 122 30 Islamic Finance / 122 31 Islamic Finance / 124


1- And {you} fulfil the covenant, surely the covenant will be asked about {in the hereafter}. 32

2- O who believed: why do you say what do you not to do; it is big angriness of Almighty Allah that you preach to others to do so but you do not act accordingly. 33

Abu bakr al Jassas said: This verse of Holy Quran indicates that one undertakes to do something, no matter whether it is worship or a contract, it is obligatory on him to do. 34

3- - Holy Prophet {blessing of Allah and peace be upon him} said: there are three signs of hypocrite person: when he spoke he lied and when he promised he did not fulfil it and when he is trusted he breaches the trust.35

4- Holy Prophet {blessing of Allah and peace be upon him} said: Four qualities are found in any one he is hypocrite and if one of them is found then there is one quality of hypocrisy until leave them, when any one talked he lied and when he promised he did not fulfil it and when he litigated he abused and when he covenanted he betrayed.36

The Answer Of These Evidences: The two answers of these evidences can be given here:

a- if we accept that these texts of Quran and Hadeth denote to the binding nature of promise as being enforce able then the promise of sale will be the sale contract as Malki jurists hold and such sale contract is void and this is verdict of Abdullah bin Umer {Allah be pleased with him} and it is verdict of all Malki jurists who hold that promise is binding and it renders the compound murabahah to be invalid and there are so many prohibitions with regards such type of contract as these are mentioned under the opinion of scholars who hold that promise is not binding.

b- All these and other texts of Quran and Hadeth explain the importance of promise that the fulfilment of promise is obligatory but it does not mean: that it is enforce able by court as a group of contemporary scholars hold but it is obligatory as an integrity of promissory person and it is called unilateral binding {Lazim}.

5- Mowlana Taqi Usmani argued on the binding nature of promise with the principle which is legal maxim according to him and it is {qad Tujalo al Maweido Lazimatn le hajate al nnas} Some time the promise is made binding to fulfil the requirement of people 37

I would like to disagree with this evidence due to reasons mentioned below: 32 surah Bani Israiel / 34 33 Sura al Saff / 2 - 3 34 Ahkam al Quran / 3: 420 35 It is narrated by Imam al Bukhari / Kitab al Iman 36 It is narrated by aql Tirmidi / al Jame al Tirmidi / hadeth: 2632 37 Islamic Finance / 88.


FIRST: it is not capable to be doctrine, how is it possible to be principle?,

SECOND: it is not a legal maxim 38 and all those scholars who studied the legal maxim they know the nature of legal maxim and they can differentiate among the construction of this sentence which is totally different from the construction of legal maxim.

THIRD: when the word {qad} comes on the present tense it gives the meaning that the promise is considered binding in rare cases while common rule is that the promise is not binding and enforce able by court and it is contrary to legal maxim because legal maxim explains such rule which is common for general cases.

FOURTH: the legal maxim mentioned above is in the structure of passive voice tense {Tujalo} {Majhul} and it shows that it is very weak view point that the promise is binding and enforceable. 39

FIFTH: the word {lazimatn} does not give the meaning of word {Ilzam}which means enforceable but it gives the meaning of unilateral liability and it is the meaning of {Iltizam}which means being liable and it means the promissory is liable to do by his own self but no one can enforce him to do so because there is no {ILZAM}.40

SIXTH: the word {le hajate al nnas}is objected by reasons as follows: a- this portion of sentence is not complete but there is another word which is not mentioned here and that is {ilaihe} b- the {hajah} means need and the promise in compound murabahah is not need but it is only complementary matter which facilitate the client and bank,

c- if we assume that promise is need as Mowlana Taqi Usmani said: then need does not convert the prohibited act to permissible 41 and it does not change the rule of invalidity to validity unless it is covered by three conditions: i- It is public need. ii It is definitive. iii There is no other solution to fulfil the requirement of this type of need.

The Second and last conditions are not found in compound murabahah. a- second condition is not found in compound murabahah here because it is not definitive that bank and client do not fulfil their promises but there is probability and possibility and whatever is based on probable it is also probable not definitive.

b- the last condition is also not found in this need because there are so many other solutions to fulfil the requirement of such need of client as i- Diminishing musharakah and the ratio of capital participated by client in partnership is nominal. ii- considering a promise non binding as Hanfi, Shafei and Hanbli Jurists hold. 42

38 the scholars who studied the legal maxim they know the nature of legal maxim.

39 It is only view point of Malki jurists. 40 The word{Luzum}is taken from {Thulathi Mujarrad}so where ever is {Iltizam} there is

{Luzum}and where ever a {Ilzam}there is also Luzum but it is not necessary that where ever is {iltizam} there is {ilzam} and where ever is {Ilzam} there is {iltizam}and ratio propotion between both is {umoom and khusoos min Wajhn}according to schplars of logic.

41 It is only necessity which converts the forbidden things to permissible. 42 This group of contemporary scholars while trying to satisfy the banking sector by claiming

that the promise is binding by its nature and compound murabah is valid tool of Islamic


OBJECTION: If someone says that there is possibility of risk and it is that the client does not fulfil his promise and he does not buy the commodity bought by bank for him.

ANSWER: it is answered that it is possible not definitive and possibility of risk is always found in business transactions and it is not bar from the validity of contract.

So the sentence mentioned above is neither principle nor legal maxim of Islamic jurisprudence. 43

6- Another evidence provided by Mowlana Taqi Usmani: if promises are not enforceable in the commercial transaction it may seriously jeopardise commercial activities and if anybody orders to trader to bring for him a certain commodity and import it and promises to purchase it from him on the basis of which the trader imports from abroad by incurring huge expenses, how can it be allowed for the former to refuse to purchase it? 44

I would like to disagree with it and it is due to two reasons: a- It is evidence for the binding nature of promise and there is no bar to consider the promise binding and enforce able because there are so many other jurists who hold that the promise is binding and enforce able but the question about such promise is that it gives rise to sale contract and it means: it is sale contract and such sale contract is void according to all Muslim jurists who hold that promise is binding, and compound murabahah is based on such promise which is void and whatever is based on void it is also void.

b- It is not necessary that the compound murabahah is applied for the import and export transaction which are causing for huge expenses but there are so many other Islamic tools of financing and modes of investment which can be applied here and these are more suitable for this type of transaction without any prohibition as diminishing partnership and bank asked the client to pay some amount according to his capacity as a partner to purchase this commodity from abroad though the amount participated by client is nominal and bank buys this machine from abroad and bank came with it and handed over to client on the basis of diminishing musharakah and it is very clear and easy for those who are working in the banking sector and it is best solution for the problem of huge expenses instead of compound murabahah which is prohibited according to all those classical jurists who hold that the promise is binding and enforceable.

Conclusion: This group of scholars hold: that the promise between bank and client is binding

and enforceable as contract and it can be challenged in court as contract can be challenged in court.

finance, they entered in to room which is closed in the front of them because the murbihah sale now will be definitely prohibited due to many reasons mentioned in the verdict of Abu al walid al Baji al Malki who hold that compound murabahah is invalid.

43 I am at that time in Brussel, and the books related to Islamic jurisprudence are not available otherwise I deduct the original source from which this sentence is taken.

44 Islamic Finance / 125 and same is discussed by Dr yusuf al Qardavi in his book namely bay al murabahah lil Aamir bil Shira / 24 - 26


It is based on misconception related to difference between binding nature of contract and binding nature of promise and this group of scholars understood that there is no difference between these two bindings while there is difference between binding nature of contract and binding nature of promise and the binding nature of sale is component of two things:1- {Iltizam}being a liable and 2-{Ilzam}being enforceable 45 and each party in sale contract is liable to fulfil the obligation of contract as well as he can enforce other party to fulfil the requirement of obligation of contract because it is bilateral binding while the binding nature of promise is only {Iltizam}being liable by his own integrity and it is only unilateral obligation as Hanfi, Shafei and Hanbli jurists declared, so the promissory is not enforced to fulfil the requirement of his promise by anybody else while seller is enforced to fulfil the requirement of sale and if subject matter is not existing or it is not owned by him he cannot provide the requirement of sale contract, so due this reason it is prohibited for him to sell such subject matter which does not exist and which is not owned by him and which is not deliverable while the person who promises is not enforced by anybody else due to lack of {Ilzam}bilateral obligation, otherwise this promise will be the contract which will be prohibited due to reasons mentioned above as Malki jurists hold.

The Validity Of Contract Which Based On Promise Such As Compound Murabahah:

There are three view points:

1- The compound murabah is valid according to all jurists who hold that promise is not binding though they are classical jurists as Hanfi, Shafei and Hanbli or contemporary scholars.

2- All those classical jurists who hold that promise is binding and enforceable said that compound murabahah is not valid.

3- Some contemporary scholars who hold that promise is binding and enforceable said that compound murabahah is valid and Mowlana Taqi Usmani and Dr Yousuf al Qardavi are from this group of scholars and they argued on the validity of compound murabahah by following evidences.

1-Original rule for Sale is that: it is permissible except those which are prohibited by text of Quran or hadeth and murabahah sale is permissible even though the bank promised with client to purchase required commodity and to sell it to client with profit and the client promised with bank to purchase said commodity from bank while bank bought it.46

45 Imam Abu Hanifa said: when a person has given surety ship from deceased person who died

without paying debt which was obligatory on him till his death, this person is only liable {multazim} by his own option to pay the debt which is obligatory on deceased person but it does not give the right to creditor to demand his debt from this type of surety person. See: Shabbir Ahmad Usmani / Iela al Sunan/ Chapter Surety ship with regard to deceased.

46 Dr Yusuf al Qardavi also mentioned here the principle which is that: the origin in contract and disposition is permissibility except there is any explicit text of Quran or Hadeth which


I would like to disagree with this argument because the evidence is that {all things are permissible in their origin}: this is legal maxim and acceptable but it means the situation which needs rule of permissibility on the basis of this legal maxim, is not coming under the scope of this legal maxim because the rule of such sale is already given tradition of Prophet {blessing of Allah and peace be upon him} and there are three traditions of prophet {blessing of Allah and peace be upon him} which declared such contract prohibited and these are as follows:

a-{Do not sell whatever is not with you}and it is interpreted by three ways:{1} Do not sell whatever is not existing and it means when subject matter is not existing you cannot sell it. {2} Do not sell whatever is owned by you. {3} Do not sell whatever is not deliverable. If we say that promise is binding then the compound murabahah will not be valid because the subject matter is not existing at the time of promise between the bank and client and it is not owned by bank and it is not deliverable also at that time so it will be prohibited due to tradition mentioned above..

b- Prophet {blessing of Allah and peace be upon him} forbade bay al Kali bil kali. It means selling a debt by debt and here the bank at the time of promise is selling debt and client is purchasing debt by debt.

C- Prophet {blessing of Allah and peace be upon him} forbade the sale with condition and there is sale with condition because bank told to client: if you buy it then i purchase it from abroad and client told to bank when you buy this commodity from abroad i purchase it from you. If promise is binding then the compound murabahah will be prohibited according to these three traditions and the compound murabahah comprises from binding promise according to these contemporary scholars and it will be prohibited on the basis of their view point.

2- the contract of manufacturing, sale of salam are valid contracts according to Hanfi jurists even though the subject matter is not existing and it is to fulfil the need of people and compound murabahah is also concluded to fulfil the demand of client though the subject matter is not existing, so it is similar to above mentioned contracts because of that each one of them is concluded to fulfil the demand and need of society even thought the subject matter is not existing at the time of conclusion of contract, so the compound murabahah will be valid contract due to analogy {Qiyas}.47

I would like to disagree with this evidence due to two reasons as follows: a- the contract of Salam and contract of manufacturing are allowed in Islamic law as a

forbidden it and the origin in worship is prohibition. Bay al Murabihat lil Aamir bil Shira /13.

Note: the first part of the stating of al Qardavi, is a legal maxims: The origin in contract and disposition is permissibility and it is accepted but second part of his saying: the origin in the worship is prohibition, is rejected because it is neither legal maxim nor a verdict of any reliable jurist but it is saying of Ibn Taimiyyah and his followers and saying of Ibn Taimiyyah does not have any weight in against to many traditions mentioned by al Qardavi himself in his book namely: {bay al murabahaht li alAamir bil Shira} in these three pages: 13 -15.

47 See: Dr Yusuf al Qardavi/ Bay al Murabahah lil Aamir bil Shira / 23 and Rafique al Misri / Bay al Murabahah lil Aamir bil Shira / Majallat al Ummah / no: 61: 27


exceptional case and analogy {Qiyas}is not allowed in exemption according to majority of jurists.48

b- the contract of salam and manufacturing are permissible in Islamic law because these both contracts individually fulfil such requirement and need of society which cannot be fulfilled by any other contract while requirement of compound murabahah can be fulfilled by single murabahah or by compound murabahah without binding nature of promise or by bay al Muajjal and it also can be fulfilled by diminishing partnership and fulfilment of need by any permissible way or by diminishing partnership is obtained without any sale which is prohibited, so there is no need for compound murabahah which based on binding nature of promise.

3- Dr Yusuf al Qardavi argued on the justification of compound murbahah and said: there is specially text of Quran revealed in the book of Almighty Allah and it is justifying the sale and rejecting the view point of Jews 49 who assumed that sale is similar to riba or riba is similar to sale and no difference between both, and they said: the sale is similar to riba and almighty Allah permitted the sale and prohibited the riba 50 this Quranic sentence advantages the permissibility of each type of sale weather it is barter trade or money exchange or bay al salam or general sale or it is sale without explaining the cost of commodity or with explaining the cost of commodity as trust sale and it includes bay al murabahah which is selling by cost plus profit, bay al towliyyah which is selling with no profit no loss, and bay al wadiah which is selling with loss{...}All these and other types of sale are permissible because these are the types of sale which Almighty Allah permitted and sale is not prohibited without the prohibition of Almighty Allah and his Prophet {blessing of Allah and peace be upon him} with strong text {muhkam}where is no doubt. 51

I would like to disagree with the argument of Dr Yusuf al Qardavi because of two reasons: i- Saying of Dr Yusuf al Qardavi that Allah Almighty permitted the sale and prohibited the riba, it is muhkam text of Quran while it is not muhkam but the verse as whole is Dahir in rule of sale and riba and Nass {text} in the difference between them and it is neither mufassar nor Muhkam because Muhkam always attaches with the word

48 all scholars of Usool al Fiqh discussed about said matter in their books in detail under the

topic {Ma la yageri fihe al Qiyas}See: my thesis of LLM in Shariah with title: the controversial issues in the enforcement of analogy and their applications in Islamic jurisprudence. Note: this thesis is written in Arabic and it is submitted to Umm al Qura university for the completion of LLM {Islamic law} degree.

49 this verse revealed after the conquest of Makkah while Bnu Saqif raised this question that the sale is similar to riba and they demanded their debts from Bnu Mughirah with interest and Bnu Mughiirah refused to pay any type of interest after its prohibition and dispute among them came to Itab bin Asyad who was the governor of Makkah al Mukarramah in these days.

50 Sura al Baqarah / 275 51 Bay al murabahah lil Aamir bil Shira / 15. Note: Dr yusuf al Qardavi said in the last of

above mentioned paragraph: Text muhakam which is pure from doubt in it: it is strange thing because the student of Usool al fiqh knows what is the standard and level of muhkam particularly muhkam al Quran in texts of Quran and Hadeth and this saying of al Qardavi shows also that some time text muhkam is doubt full.


Khalidan or Khlidien or Abdan or word of any number of counting as one hundred and it is discussed in detail by scholars of Usool al Fiqh in the chapter of interpretation. 52

ii- the justification of compound murabahah is not established by this evidence because it is stipulated for the lawfulness of sale contract that the elements of sale are found and conditions are met and when it does not fulfil the basic requirement of sale contract it is not lawful sale and the compound murabahah at the level of promise according to all those scholars who hold: that promise is binding, does not fulfil so many conditions of validity of sale contract such as: 1- The subject matter is not existing. 2- The subject matter is not owned. 3- The subject matter is not deliverable. 4- It is selling debt against debt {bay al Kali bil Kali}. It is bay al einah as Baji hold. 6- There are two sales in one sale. 7- There is bay with condition and these prohibitions are mentioned in the verdict of Abul Walid al Baji al Malki {blessing of Allah be upon him}

Dr Yusuf al Qardavi quoted saying of Ibn Hazam al Dahiri in the favour of his opinion and said: I quote the strong saying of Ibn Hazam al Dahiri in his book al Muhall: the promising with each other by selling gold with gold or with silver and selling silver with silver and same in other four types by selling one of them with other, it is permissible even though they conclude contract of sale after that or not, because promises among them is not sale {...} because there is no prohibition about any one of them and whatever is prohibited and it is explained by its name as Almighty Allah said: whatever is prohibited for you it is explained in detail 53 and whatever is not explained as a prohibition for us, it is permissible for us by the text of Quran because there is nothing in Dean except the Fard, or Haram, and Fard is demanded from us in Quran and in Sunnah and Haram is explained in detail with its name in Quran and Sunnah and whatever is except to it, it is neither Fard nor Haram but it is halal on the basis of necessity because there is no fourth type{of rule} in Islamic law. 54

I would like to disagree with this argument due to three reasons: a- the promise is not binding according to Ibn Hazam al Dahiri while it is binding according to Dr Yusuf al Qardavi and other Muslim scholars who belong to this group, because of that Ibn Hazam said: After coming with promise to each other that they are {free} to conclude the sale contract or not while it is not allowed according to the contemporary Muslim scholars.55

b-Dr al Qardavi said: strong saying of Ibn Hazam al Dahiri and strong saying of Ibn Hazam al Daheri is that the promise is not binding.56

c- Saying of Dr al Qardavi that: there are only three rules explained by Quran and Sunnah such as Fard, Haram and Halal and there is no fourth type {of rule} in Islamic

52 The word riba and bay these both are mujmals when word { AL}is for genus or for Istighraq

and only one situation in which these words are specific when {AL} is for mahud khargi. 53 Sura al Anam / 119 54 Bay al murabahah / 15. Note: Saying of Ibn Hazam al Dahiri in the last of the paragraph

quoted by al Qardavi here: and it is permissible due to necessity: it is strange sentence also from Ibn Hazam al Dahri and I do not know why he wrote such sentence because there is nothing in Islamic law which will be remained prohibited after the requirement of necessity while murabahah is not allowed on the basis of necessity.

55 Ibn Hazam al Dahiri / al Muhallah / section: 1135/ 8: 377- 380 56 See: Ibn Hazam al Dahiri /al Muhalla /8: 377-380


law, it is totally contrary to whatever is explained by Muslim jurists in Usool al Fiqh that there are five types of rules according to majority of Muslin jurists while these are seven types in short according to hanfi jurists.

Conclusion: It is very important and interesting point that many contrary things are seen in the

view point of contemporary scholars who hold that promise is binding as follows::

1- The contemporary scholars have taken the concept of binding nature of promise from Malki jurists who are the founder of this theory and their theory based on the verdict of Abdullah bin Omer {Allah be pleased with him}which is narrated by Imam Malik {blessing of Allah be upon him}and Abdullah bin Omer{Allah be pleased with him}was asked about the case mentioned above and he forbade such sale contract which based on promise and all Malki jurists hold that such promise is sale contract and such sale contract is void, while contemporary scholars hold that the promise is binding and enforce able as sale is binding and compound murabahah which based on such promise is also valid.

2- The internal matter which is known as difference between the opinion of Malki jurists and opinion of contemporary scholars is that the enforceable promise is sale contract according to malki jurists while contemporary scholars could not understand this saying of Malki jurists and they remain repeating again and again that promise is binding and enforceable

3- Malki jiurists hold that such sale contract is void due to many reasons while this group of contemporary scholars hold that such sale contract is valid.

Theories With Regard To Promise And Compound Murabahah: There are three theories with regard to promise and compound murabahah: 1-

Theory of Malki jurists is that the promise is enforceable and compound murabahah is not valid. 2- theory of some contemporary scholars namely Mowlana Taqi Usmani and Dr Yusuf al Qardavi that promise is binding and enforceable and compound murabahah is valid. 3- theory of majority of classical jurists as Hanfies, Shafeis Hanblies and some contemporary scholars that promise is not binding and compound murabahah is valid.

a- The first theory is not applicable in Islamic banking because compound murabahah is not valid according to this theory. b- Second theory is also not applicable in Islamic banking because it is baseless and it is causing for many prohibition declared by Islamic law and it is also rejected by all classical Muslim jurists Hanfi, Shafei, Hanbli and Malki.

c- Third theory is the theory of Hanfi, Shafei and Hanbli jurists and this theory is applicable in Islamic banking sector and this theory is discussed in the beginning and the verdict of Imam Mohammad bin Hassan al Shebani and Imam al Shafei and Ibn al Qayyim{blessing of Allah be upon them} is mentioned with regard to non binding and non enforceable nature of promise and with regard to validity of compound Murabahah

The banking sector should be pleased due to practicing according to the verdict of majority of Muslim Jurists {blessing of Allah be upon them}.


Conclusion Of Whatever Is Discussed In Article: It is as follows:

a- The compound murabahah is disputed not due to itself but due to basing on promise which is binding.

b- The promise creates only unilateral obligation {iltizam} according to Hanfi, Shafei and Hanbl {blessing of Allah be upon them} while promise creates bilateral obligation and it is enforce able according to Malki jurists {blessing of Allah be upon them}

c- The compound murabahah is valid contract according to those jurists who hold that: the promise is not binding and enforce able as Hanfi, Shafe and Hanblie jurists while it is prohibited according to those jurists who hold that the promise is binding as Malki jurists.

e- The contemporary scholars as Dr Rafique al Misri, Dr Mohammad Suleman al Ashqar, Dr Hassan Abdullah al Amin Abd al Rahman Abd al Khaliq hold that the promise is not binding and enforce able and they also inclined that the compound murabahah is lawful and valid.

f- The contemporary scholars as Dr Yusuf al Qardavi, Dr Sami Hamood, Dr Abdul Hameed al Bali, Dr Mohammad al Badavi, al Shaikh abd al Hameed al Sayeh, Ibrahim al Badu and Mowlana Taqi Usmani from Pakistan hold that promise is binding and the compound murabahah is lawful and valid.

g- The compound murbahah should be applied in those commodities which are available in side of the country as cars and houses and other material. But those commodities which are required to be imported or needed to be exported and required huge expenses before sale and purchase the other modes and tools of Islamic law of financing should be applied as diminishing musharakah or compound murabahah provided that the promise is not binding and enforceable such as the opinion of Hanfi, Shafei and Hanbli jurists.


Firm’s Behavior in Islamic Economics By

Salman Ahmed Shaikh*

Abstract This paper attempts to explain the distinctive features of Islamic Economics that guide the equitable distribution of resources in an economy. Prohibition of interest and institution of Zakat encourage investment, spending and circulation of wealth. It is discussed that how Islamic principles help in achieving both efficiency and equity. Islam does not disallow market and price mechanism, but compliment them with rules and institutions that ensure distributive justice, equity and social welfare. The paper also discusses how Islamic principles help moderate greed, pursuit of self-interest and how ethical principles and afterlife accountability result in including externalities and marginal social cost in firm’s economic accounting of profits and costs. In the final section, it is argued that the Islamic ethical principles have far reaching effects on corporate governance.

Keywords Production, Distribution, Financial Markets, Equity, Markets, Agency Conflict, Externality, Price Mechanism, Profit Maximization

JEL Codes L38, D21, D40, B5

1. Distribution of Resources and Islamic Economics: In Economics, the four broad categories of resources include land, labor, capital

and entrepreneurial ability. It is the entrepreneurial ability which helps in capital formation with improvement in quality and quantity of capital which in turn also enhances the productivity of land as well as labor.

The institutional and structural impetus to entrepreneurial ability comes from:

1. Prohibition of earning solely through lending of money without putting money at risk.

* The Author, Salman Ahmed Shaikh is a Research Associate and Full Time Faculty Member

(Economics & Finance) at Institute of Business Administration, Karachi, Pakistan. He heads “Islamic Economic Project, written several dozen research papers and articles in the area of Islamic Economic and Finance. E-Mail: [email protected]



2. By banning other means of earning money where the resource or asset that is the subject of trade either does not have any intrinsic value or the mode of earning involves no risk taking.

With introducing wealth Zakat and prohibition of interest, the households who have surplus income left after consumption expenditure cannot expand their wealth other than:

i. By putting their wealth in entrepreneurial pursuits

ii. Else, by investing in productive and scarce resources, i.e. land and capital and earn income by transferring the use of these productive resources to some other entrepreneur.

In line with the natural observation and evidence that not all people have same preference with regards to risk, there remains a risky way of earning sustenance, i.e. entrepreneurship with higher expected returns and less risky way of earning sustenance by providing one’s labor and productive assets in ownership on lease to the other entrepreneurs.

Islamic injunctions put huge emphasis on making best use of the resources provided by Allah. Cultivating barren land and dignity of labor is given significant value and regarded as virtues. The demand for economic resources, i.e. land, labor and capital comes from the interest free and productive asset/activity based voluntary exchanges in a market economy.

Thus, the market economy with these unique characteristics has desirable balance of equity and efficiency.

Efficiency: There is inbuilt control mechanism to efficiently use resources as the economic

agents, the firms and households, both receive divine encouragement and admonishment to make the best use of resources and refrain from waste and extravagance.

Moreover, using economic theory, we know that efficiency is achieved in more competitive markets. Competition is achieved in an Islamic economy by banning the potential barriers to entry through disallowing arbitrary compensation to money capital and encouraging capital formation through productive investments and entrepreneurship.

Equity: Equity is ensured through encouraging: 1) circulation of wealth, 2) direct wealth

Zakat and production Zakat, 3) intergenerational transfer of inheritance wealth and 4) inculcating ethical checks in a person’s overall conduct with deterministic justice promised in afterlife.

1. Role of Markets in Islamic Economy: As per Islamic principles, within certain bounds, the market forces can operate and

will determine which goods should be produced and offered at what price. Through private sector investment and production, resource markets and product markets will function to enable households to obtain purchasing power by providing factors of production like labor or land in the production process and earn compensation in terms of wage and rent, respectively.


The distinctive features which enrich the market mechanism in an Islamic economy include:

Guiding preferences through divine injunctions: Rather than complimenting humans in their animalistic instincts to keep having

one-eyed focus on material well-being only, Islam inculcates piousness, kindness, cooperation and communal responsibility in humans. In some instances, Islam guides explicitly to avoid extravagance, lavishness & using certain products and services which harm a human’s ethical existence and well being either individually and/or harm the society in the process.

Explaining this, Samad (2008) notes that the conventional market is an exchange of goods and services of an open ended production set. Production and consumption in an Islamic market are not unrestricted sets of goods and services. A seller or buyer is not permitted to exchange goods or services which are not approved by Shariah.

Afterlife accountability in all economic agents: With the concept of afterlife accountability, Islam immensely influences

intertemporal choice behavior. It helps in private economic agents (consumers, producers etc.) modifying their actions in such a way that takes into consideration externalities and welfare (individual and social), both in this world and afterwards.

Elaborating this further, Azid (2007) stressed on the need to transform the market into an ethicized market by means of endogenizing the moral element in all of the socioeconomic institutions and interactions.

Complimenting Material with Spiritual Rationality: Islam does not deny private property rights, private rational choices and individual-

specific preferences that do not contradict Islamic injunctions. Islam enriches God given material rationality with God given spiritual rationality. It suggests some institutional changes in economic environment that alter choices for more optimal intertemporal outcome and social welfare.

2. Firm’s Behavior: Islamic Economics Perspective: Amin et al (2003) explained that in the Islamic framework, it is assumed that

economic agents are guided by Islamic values. Thus, an Islamic producer, being accountable to Allah, treats the resources at his command as a trust and the production of goods as a duty, and he will base his production decisions on the concept of ‘maslaha’.

The author opines that a producer in an Islamic market could still be profit-driven; but, being governed by the Shariah, the Islamic producer’s valuation of economic costs will be modified. Hence, the producer will internalize the externalities in its utility and cost functions.

Discussing the goal of the firm in an Islamic economy, Hasan (2002) argued that it is important to understand what is being maximized, how, and for what purpose. He cites examples and said that maximizing survival, employment, equity, or the pleasure of God would probably be welcome to most of the people. Hence, according to the author, maximizing behavior in Islamic economics is untenable.


The author opines that if the firms fulfill their Islamic duties towards the consumers, the employees, and the society in general in arriving at their total revenue curves, then profit maximization is not objectionable. He argues for internalizing social costs and benefits and Islamic principles to enable the use of profit maximization with requisite modifications and restrictions.

In mathematical modeling of a firm’s behavior, Metwally (1997) describes an Islamic firm as one that would seek the maximization of utility which is a function of the amount of profits and the amount of spending on charity or good deeds. The author suggests using utility as a broad function which includes net profits as well as charity as parameters. However, the amount of profit would, after the payment of all imposed taxes (Zakat and other dues) be no less than a minimum level which is ‘safe’ to keep the firm in business.

In another mathematical formulation, Bendjilali and Taher (1990) argue that even in imperfect market structure like a monopoly, if the monopolist is concerned about the social welfare, then he will be willing to partially sacrifice his profits in order to attain efficiency and minimize social welfare loss.

Hence, it could be appreciated that several authors have emphasized on the ethical and spiritual rationality in the firm’s behavior. In a value neutral framework, there is no cap or mechanism to solve problem of a human's greed. In fact, a value neutral framework provides a cover to follow, pursue, harness and practice greed. On the other hand, Islam addresses hearts and first of all, it purifies the heart, encourages compassion, responsibility and gives concept of shared responsibility, afterlife accountability and restricted not absolute property rights.

3. Production Function in Islamic Economy: Production function in economics explains the functional relationship between

inputs and output. Whatever mathematical form the production function takes, i.e. Cobb Douglas, Constant Elasticity of Substitution etc, the basic ingredients of any production function are inputs and how they relate with output. The most commonly taken inputs are Labor (N) and Capital (K). Total Factor Productivity (TFP) is the summary measure of the impacts of other inputs, social and legal infrastructure and the technological change. Below, we summarize the impact of Islamic Economics principles on the production function in an economy.

Factors of Increase in Capital

4.1.1. Ban on interest increases investable capital: Tax on cash and capital at 2.5% will force the people to invest their money capital

in productive uses. With prohibition of interest, rational households will use the money capital in their own business or invest with equity participation in Mudarabah and stocks etc.

4.1.2 No tax beyond Zakat increases investable capital: With a lenient rate of Income Zakat, i.e. Khums (5%) and Ushr (10%), the

productive sector is provided with incentive to ensure achieving potential output with


lenient fiscal levies and circulation of capital through prohibition of interest. This could bring about increase in output per person in an economy and could bring stability in prices.

Besides this, a consistent and credible low Zakat rate policy (0.05 < Production Zakat Rate < 0.10) with broader Zakat base would ensure: 1) minimum distortions, 2) boost aggregate demand and 3) encourage investment by decreasing costs of doing business. This could also simultaneously solve microeconomic problems of imperfection in markets by increasing competition and helping to reduce market power.

4.1.3. Disallowance of risk free return on money: Money itself has no intrinsic value and is neither a rentable asset nor a tradable

commodity as per Islamic principles. If capital is combined with labor, it “could” produce profit, but if money alone is lent, the interest it earns is not permissible as per Islamic principles. Interest is neither a justifiable reward of money nor capital. Money holder/owner has to convert it in one of the other factors of production, namely 1) land with natural resource, 2) physical capital stock and 3) or become an investing entrepreneur to have any justifiable compensation out of the production process.

Factors of Increase in Labor Supply Encouragement to be self-dependent:

Islam encourages people to avoid indebtedness and dependency. A Hadith says:

“Narrated Hakim bin Hizam: The Prophet said, “The upper hand is better than the lower hand (i.e. he who gives in charity is better than him who takes it). One should start giving first to his dependents. And the best object of charity is that which is given by a wealthy person (from the money which is left after his expenses). And whoever abstains from asking others for some financial help, Allah will give him and save him from asking others, Allah will make him self-sufficient.”

(Sahih-Al-Bukhari: Book 24, No. 508) Increase in employment level:

If people do not invest, their wealth would shrink and distributed among poor masses of the society through Zakat. If they want to avoid erosion in wealth, they are obliged to either enter in productive activities themselves or invest in such venture with their capital contribution. This will increase productive investment in the economy, bring more employment opportunities and make markets more competitive.

Factors of Increase in Total Factor Productivity: With higher levels of investment, circulation of wealth and competitive markets,

innovation and quality enhancement will be the only means of sustaining the edge for firms. Hence, there will be more focus on innovation, customer satisfaction and hence speed of innovation and productivity is expected to increase. The supply side of innovation, which is the human capital, will also be encouraged and incentivized through employment creation as a result of removing concentration and idleness of wealth.

Factoring in Externality: Highlighting the limitations of free markets to factor-in externalities, Mortazavi

(2004) states that the concern over the tragedy of the commons emanates from the fact


that Western economics has become a discipline devoid of values. Exploitation of the natural environment can be abated when individuals consider intergenerational welfare and justice to be important factors in their economic decisions. Islamic economics, unlike its Western counterpart, is a value-driven discipline replete with moral values that limits individual’s consumption, and imposes significant social and religious responsibilities on individuals as guardians of the natural environment for future generations.

On the same lines, ASTRÖM (2011) explains that one of the problematic points of view of today’s generation is that they have the rights of limitless ownership without taking into account the responsibilities towards society and humanity.

With the concept of afterlife accountability, Islam immensely influences intertemporal choice behavior. It helps in private economic agents (consumers, producers etc.) modifying their actions in such a way that takes into consideration externalities and individual and social welfare, both in this world and afterwards. Afterlife accountability stimulates positive change in behavior in a much more comprehensive and permanent manner than any regulation or material incentive could possibly do.

In light of this, Na’iya (2007) also suggests that the effective solution to the environmental problems lies on the overall worldview which spells out the relationship between man, nature and his Creator as well as the implications of one’s actions in the hereafter.

5. Corporate Governance & Agency Conflicts: Agency conflict arises when the various parties have different incentives or

objectives in a mutual relationship. Two main agency conflicts in commercial context are:

• Between shareholders and managers • Between shareholders and creditors

In the first agency conflict, the managers appointed by the shareholders may work in a manner that increases their own welfare, but which may harm the interests of shareholders in the long run. For instance, excess leveraging, loose credit sales policy, avoiding necessary repair, inventory investment and capital investment to show higher short term profits and liquidity. As a result, managers can sanction higher perks and bonuses in the short run for themselves when they are engaged with the firm and before they switch to other firms.

In the second agency conflict, shareholders represented by managers may take on excessive borrowing which increase the capital provided by creditors at excessive risk afterwards. Higher returns will magnify return on equity and lower returns or losses will only hurt shareholders up to the amount of limited capital they invested in the business. Moral of the story is that when accountability can be avoided in presence of authority, moral hazard may occur.

Chapra (2007) mentions that in an interest based relationship, the lender may tend to take risks which are not worthwhile if the arrangement was based on risk sharing basis. The fixed contractual compensation encourages less prudence, carelessness, unsound risk analysis and hence may contribute to losses and macroeconomic imbalances and crisis.


Indeed, the frequency of the crises in recent past has increased alongside more sophisticated and complicated interest based financial architecture.

Some of the ways to counter the first agency problem include i) Linking compensation with profits, ii) ESOP (Employee Stock Ownership Plans), iii) Threat of management firing or replacement etc. But, there are ways by which managers counter the ‘management replacement’ concern from takeovers. These include i) Poison pill, ii) Golden parachute etc.

Some of the ways to counter the second agency problem include i) Negative covenants, ii) Including representatives in BoD, iii) Cap on credit limit/financial ratios etc.

However, as can be anticipated, human beings after all have greed and often, the innovations in counter strategies resulting from the greed bypass and out speed regulation.

In this context, it will be interesting to discuss the Islamic Economics perspective on this issue.

First, Islam places huge emphasis on documentation to avoid conflicts. (See Al-Baqarah: Verse 282)

Second, Islam encourages equity financing over debt financing in which payoffs are linked to productive enterprise. The source of payoffs is the same for all equity partners and the distribution mechanism is agreed among them at the outset. This brings equity in a customized way incorporating the utility functions and independent choices of partners rather than trying to bring equity by a regulator using an arbitrary mechanism or an inefficient or distortionary taxation.

Third, with regards to first agency conflict (between shareholders and managers), we need to recognize that the first agency conflict can exist even in a completely unleveraged firm as well since not all small and large shareholders can be participating in all of the mundane activities of business simultaneously. In this regard, the Islamic ethical injunctions are very important devices to affect the economic behavior. Below, we discuss these ethical injunctions.

Islam places huge emphasis on trust. Breach of trust is a serious crime in Islam. Holy Quran says:

• “…and he who eats unfaithfully shall bring that in respect of which he has acted unfaithfully on the Day of Resurrection; then every soul be paid fully what it has earned, and they shall not be dealt with unjustly.” (Surah Ali-Imran: Verse 161-162)

• You believers! Do not betray Allah and the Messenger, nor knowingly, betray your trusts. (Surah Anfal: Verse 27)

Ahadith also shed light on this:

• The Muslims are bound by their stipulations. (Abu Da’ud, No: 3120)


• Definition of a hypocrite: “If he makes a promise, he breaks it, and if he makes a compact, he acts treacherously.” (Bukhari, No: 32)

Furthermore, firm belief in afterlife accountability and deterministic justice and rewards promised in life hereafter affects the intertemporal behavior of every economic agent in every economic and non-economic relationship. It affects the behavior even where regulation fails. It is because nothing is hidden from Allah who knows not only the actions, but the intentions behind the actions.

Finally, with regards to second agency conflict (between shareholders and creditors); Islam discourages taking on debt unnecessarily. Prophet Muhammad (pbuh) used to ask salvage from mishappenings and debt was one of them.

It is narrated by Abu Musa Ashari that the Prophet said: “After the major sins which must be avoided, the greatest sin is that someone dies in a state of debt and leaves behind no asset to pay it off.” [Darimi]

Conclusion: In this paper, we made an attempt to explain the distinctive features of Islamic

Economics that guide the equitable distribution of resources in an economy. The paper discussed that prohibition of interest together with institution of Zakat encourage investment, spending and circulation of wealth. With no source to earn risk-free money on interest based loans, people with surplus funds will either spend or invest to avoid decrease in wealth.

With circulation of wealth and investment in productive sectors, utilization of resources will increase and result in efficiency. Institution of Zakat and circulation of wealth will also address issue of equity in resource distribution.

It was highlighted that Islam does not disallow market and price mechanism, but compliment them with rules and institutions that ensure distributive justice, equity and social welfare. The paper also discussed how Islamic principles help moderate greed, pursuit of self-interest and how ethical principles and afterlife accountability result in including externalities and marginal social cost in firm’s economic accounting. In the final section, we showed that the Islamic ethical principles and equity based financial intermediation have far reaching effects on corporate governance and effectively handle agency conflict and problem of moral hazard.

References: Amin, M. Ruzita & Yusof, A. Selamah (2003), “Allocative Efficiency of Profit

Maximization: An Islamic Perspective”, Review of Islamic Economics, No. 13, pp. 5-21.

ASTRÖM, Z. Hafsa (2011). ‘Paradigm Shift for Sustainable Development: The Contribution of Islamic Economics’. Journal of Economic and Social Studies. Vol 1 (1), pp. 73-82.

Azid, Toseef et al. (2007), Theory of the Firm, Management and Stakeholders: An Islamic Perspective, Islamic Economic Studies, Vol 15 (1), pp. 1 - 30.


Bendjilali, Boualem, and Farid B. Taher (1990) “A Zero Efficiency Loss Monopolist: An Islamic Perspective”, The American Journal of Islamic Social Sciences, 7(1): 219-32.

Chapra, M. Umer (2007). “The Case Against Interest: Is It Compelling?” Thunderbird International Business Review, Vol 49 (2), pp. 161-186.

Hasan, Zubair (2002), Maximization Postulates and Their Efficacy for Islamic Economics, The American Journal of Islamic Social Sciences, Vol 19 (1), pp. 95 – 118.

Metwally, M.M. (1997) “Economic Consequences of Applying Islamic Principles in Muslim Societies”, International Journal of Social Sciences, 24(7, 8, 9): 941-57.

Mortazavi, Saeed (2004). ‘Islamic Economics: A Solution for Environmental Protection’. Trade, Growth and the Environment. Oxford University.

Na’iya, I. Ibrahim (2007). ‘Environmental Issues & Islamic Economics: Nature & Solutions’. Proceedings of the 2nd Islamic Conference. Islamic Science University, Malaysia.

Samad, Abdus (2008), “Market Analysis from an Islamic Perspective and the Contribution of Muslim Scholars", Journal of Islamic Economics, Banking and Finance, 4 (4), pp. 55-68.


Adoption of AAOIFI Shariah Standards: Case of Pakistan.

Shariah Standard No. 3: Default in Payment by a Debtor

AAOIFI Shariah Standard No. 3; Default in Payment by a Debtor, issued in May 2000 provides explanation for Shraih rulings which are applicable to Islamic financial institutions (IFIs) in situations;

(i) delay by solvent debtor in settling their debts

(ii) delay by guarantors and contractors in fulfilling their obligations

(iii) penalty clauses

The scope of the standard expresses that this standard is not applicable to insolvent debtors or bankrupt who delays payment for any established Shariah reason.

The Shariah ruling of this standard has been categorized into six main clauses; (i) Default in payment by a debtor (ii) Guarantor (iii) Contractor or concessionaire (iv) Non-material punishment for default in payment (v) General rulings and (vi) The Establishment of default in payment

(i) Default in payment by a debtor: With regard to this category the Shariah rulings have been explained in eight sub-clauses. After mentioning the default as Haram by a solvent debtor in first sub clause, sub-clauses two and three express that it is not allowed to specify or to make a judicial demand for compensation in cash or any other form as a penalty clause from a debtor for delay in settling his debt. However, fourth clause discusses that the debtor will pay all expenses that creditor incurs to recover the debt and in fifth clause the creditor has been given the right to apply for the sale of the asset that has been pledged as collateral. It has also been allowed that the creditor can stipulate for debtor to give a mandate to the creditor to sell the pledged asset without any course from him (debtor) to the court. The sixth clause suggests considering an outstanding installment as default only after notifying this it to the debtor and after a reasonable period of time which should not be less than two weeks. The last two clauses are related to defaults in case of Murabaha sale ; (i) it has been advised to creditor to

.Source: Quarterly Islamic Banking Bulletin State Bank of Pakistan.


repossess the asset if it is available in the condition it was sold instead of initiating the bankruptcy procedure in the situation where the buyer has defaulted to settle the price and has become bankrupt (ii) To prescribe an obligation in contract in form of any amount or percentage of the payment due on debtor in case of default which would be donated to charitable cause under the bank‟ s Shariah Supervisory board.

(ii) Guarantor: While focusing on the Guarantor, this clause of the standard allows the creditor to demand from guarantor to settle the debt according to Shariah principles. The clause describes that the institution is entitled to demand the settling of debt from either the debtor or guarantor provided that there is no condition in the contract asking for to seek the settlement first from debtor. Moreover all rulings applicable to debtors in default are also applicable to guarantors in default.

(iii) Contractor or concessionaire: The inclusion of penalty clauses in contracts for construction, supply and Istisna‟ a has been allowed under this clause of the standard. It has also been permitted to deduct the due amount from outstanding amount due to the contractor and in case of refusal to pay the due amount under penalty clause all rulings of default in payment by a debtor would be applicable.

(iv) Non-material punishment for default in payment: The institution is permitted to include the name of defaulter in black listed customers and can also exchange the same information either when inquiry is made from other companies or when exchange of black listed customers is being made between companies directly.

(v) General rulings: Three sub-clauses explain general rulings where the creditor institution has been allowed (i) to follow the affairs and financial dealings of a defaulting debtor (ii) accept the amount in excess to defaulted amount from debtor provided that that there is no contractual conditions ( written or verbal) about the excess amount (iii) to include condition in a contract under which the institution is entitled to recoup the amount due from any of the accounts ( including current and investment accounts) of the customer ( in case of default )with the institution . This may be done even without the consent of the debtor only if the debt and account are of the same currency, in case of varying currency of both parties are required to agree on the exchange rate

(vi) The Establishment of default in payment : This clause describes when to established the default in payment; when the debtor remains unable to prove that he is insolvent to settle his debt on due date on normal demand for payment.

Adoption of AAOIFI Shariah Standard in Pakistan: As has been discussed in earlier issues of bulletin that Shariah Standards are being

adopted in Pakistan in with customization after consultation with stakeholders and approval from Shariah Board at State bank of Pakistan (SBP); standard relating to default in payment by debtor has been made mandatory in the country with one amendment as follows;


Amendment/Clarification*Original Clause 2/1/e: The creditor is entitled to applyfor

the sale of any asset pledged ascollateral for the debt, for the liquidation of the debt. He is equally entitled to stipulate that the debtor must give a mandate to thecreditor to sell the pledged asset without recourse to the courts.

The words “on giving the debtor reasonable notice of sale”

shall be added after the word “debt” in 2nd line of the clause. The clause can be as;” The creditor is entitled to apply for the sale of any asset pledged as collateral for the debt on giving the debtor reasonable notice of sale, for the liquidation of the debt. He is equally entitled to stipulate that the debtor must give a mandate to the creditor to sell the pledged asset without recourse to the courts.

These clarifications are added as foot note with original clauses. Sources: 1. Shariah Standards for Islamic Financial Institutions, AAOIFI (2010) 2. Website of State Bank of Pakistan ( ) www.sbp.org.pk3. Website of AAOIFI (http://www.aaoifi.com)


http://www.sbp.org.pk/

http://www.aaoifi.com/

Adoption of AAOIFI Shariah Standards: Case of Pakistan Shariah Standard No. 9: Ijarah & Ijarah Muntahia Bittamleek Definition

Ijarah: Ijara referring to “give something on rent” can be used in two situations according to Islamic jurisprudence7;

i. To employ the services of a person on wages given to him as a consideration for his hired services. Employer in this case is termed as „Musta‟ jir‟ , employee is „ Ajir‟ while wages paid are „Ujrah‟

ii. To transfer the usufruct of a particular property to another person in exchange for a rent claimed from him. This Ijara closely resembles leasing where lessor in this situation is known as „Mujir‟ , lessee as „Musta‟ jir‟ and the payable rent to lessor is „Ujrah‟ .

According to AAOIFI definition Ijarah refers to leasing of property pursuant to a contract under which a specified permissible benefit in the form of a usufruct is obtained for specified period in return for a specific permissible consideration

Ijarah Muntahia Bittamleek: To make Ijarah a viable banking tool, jurists have allowed Islamic hire purchase in form of Ijarah Muntahia Bittamleek which is also termed as Ijarah wa-Iqtina. Ijarah Muntahia Bittamleek is a lease contract that is concluded with the transfer of legal title at the end of lease period at the price specified in the lease.

In terms of AAOIFI definition Ijarah Muntahia Bittamleek is a form of leasing contract which includes a promise by the lessor to transfer the ownership in the leased property to the lessee, either at the end of the term of the Ijarah period or by stages during the term of the contract, such transfer of the ownership being executed through one of the means specified in the contract

Shariah Standard of Ijarah & Ijarah Muntahia Bittamleek: AAOIFI Shariah Standard No. 9 issued in May 2002 is applicable to Ijarah and

Ijarah Muntahia Bittamleek (operating lease of properties) where the institution is the lessor or the lessee while this is not applicable to labour contract. The standard outlines the basis for Ijarah and Ijarah Muntahia Bittamleek mode of transaction through nine main clauses, brief description of those clauses is as follows;

• Promise To Lease (an asset); After describing the scope of the standard in the first clause, the second clause provides three sub-clauses that covers (i) the acquisition of asset or its usufruct (ii) master agreement between financial institution and its client and (iii) the option of advance payment and its treatment

• Acquisition of the asset to be leased, or its usufruct, by the institution: This clause is divided into seven sub-clauses covering; (i) acquisition of asset (when


asset is in ownership of institution or when it is acquired from customer or from third party (ii) treatment of acquisition and lease contract (ii)option of sub-lease contract (iv) rent in varying duration(tenures) (v) option of Ijarah with accurate specification of asset to be delivered when the lessor does not own the asset (vi) co-ownership of lessor and lessee in asset to be leased (vii) agency agreement between lessor and lessee for lessee to purchase asset on behalf of lessor

• Concluding an Ijarah Contract and the Forms of Ijarah: This clause is divided into two main sub clauses (i) signature of the contract and the consequences thereof (ii) forms of the Ijarah contract. The first sub-clause is further explained through four clauses focusing on (i) binding obligation under the lease contract (ii) duration of the contract, (iii) linkage of rental with delivery of asset at specified time and (iv) Urboon and its treatment. The second sub-clause of Forms of the Ijarah contract is explained in four clauses discussing various options of having one lessee or leasing of asset to more than one lessee and their durations and lessee inviting co-lessees in sharing the usufruct of asset.

• Subject Matter of Ijarah: Rules governing benefit and leased property and rules governing lease rentals form two main parts of this clause. The first part is further discussed through eight sub clauses discussing areas like capability of asset being used, Shariah permissibility of use of asset, contingency of execution of Ijarah contract with non-Muslim on Shariah permissible use of leased asset, responsibility in case of damage to leased asset during lease duration. The second part about governing of lease rentals is explained in five sub-clauses; (i) payment mode and payment frequency of rentals (ii) obligation of rent by Ijarah contract (iii) floating rental (iv) possibility of advance by lessor to lessee for maintenance purposes (v) option of amendment of rentals in future date with renewal of Ijarah contract

• Guarantees and Treatment of Ijarah Receivables: This clause is divided into five sub-clauses covering (i) the acquiring of permissible security to secure the rental payment (ii) frequency of rental payment (iii) treatment of rental in case of delays (iv) donation in charitable cause in case of late payment (iv) adjustment of rentals/legitimate compensations from submitted security

• Changes to the Ijarah Contract: This clause is divided into two main parts; (1) selling of or damage to the leased asset and (2) termination, expiry and renewal of the Ijarah Contract. The first part is further explained through six sub clauses; (i) sale of leased asset to lessee (ii) sale of leased asset to third party by lessor (iii) termination of contract in case of destruction of leased asset (iv) possession of leased asset by lessee (v) treatment of rentals and damages in case of partial destruction of leased asset (vi) return of leased asset to owner without owner‟ s consent. The second part of the clause is discussed in detail with the help of six sub-clauses covering (i) the permissibility of termination of contract with mutual consent (ii) termination in case of lessee‟ s failure to pay rent on time (iii) preservation of contract with the death of either of part (lessor and lessee) (iv)


expiration of contract with the total destruction of the leased asset (v) termination of contract before its start (vi) option of contract being operative for good cause even after expiry.

• Transfer of the Ownership in the leased property in Ijarah Muntahia Bittamleek: This clause is explained by eight sub-clauses. The first sub clause discusses that the evidence document for transferring the title in the leased asset to lessee should be separate from Ijarah contract document while the transfer can take place in one of three possible ways; (a) by means of a promise to sell for a token or other consideration , or by accelerating the payment of the remaining amount of rental, or by paying the market value of the leased property (b) a promise to give it as a gift and (c) a promise to give it as a gift contingent upon the payment of remaining installment. Remaining seven clauses of this final clause of the standard include (ii) transfer of ownership is a binding promise only by lessor (iii) a new contract is necessary for transfer of ownership by way of gift or sale (iv) transfer of ownership of leased asset in case of contingent transfer upon the payment of remaining installments (v) avoidance of in‟ ah in case of purchase of leased asset from lessee (vi) the rules governing Ijarah cannot be breached under Ijarah Muntahia Bittamleek (vii) non-permissibility of sale contract of future date along with Ijarah contract (viii) adjustment of rental in case of destruction of leased asset or discontinuity of contract for cause not attributable to lessee

Adoption of AAOIFI Shariah Standard of Ijarah & Ijarah Muntahia Bittamleek in Pakistan:

Shariah Standards are being adopted in Pakistan with customization after consultation with stakeholders and approval from Shariah Board at State bank of Pakistan (SBP)8; standard relating to Ijarah has been made mandatory in the country with following amendments;

Original Clause Amendment/Clarification* 3/2: An asset may be acquired from a party and then leased to that party. In this case, the Ijarah transaction should not be stipulated as a condition of the purchase contract by which the institution acquires the asset

Prior approval from Shariah Advisor of Islamic banking Institution(IBI) must be sought whenever an IBI is going to use it as a mode of Islamic finance

3/4 : The lessee may lease the asset back to its owner in the first lease period for a rental that is lower, same or higherthan what he is paying, if the two rentalsare paid on spot basis. However, this is not permissible if it should lead tocontract of in‟ ah, by varying the rent orthe duration.

In special cases prior approval from Shariah advisor must be sought


7/2/5 :The two parties may terminatethe Ijarah contract before it begins to run.

An addition of words “with mutual consent” was made after the word contract for explanation

8/1 In Ijarah Muntahia Bittamleek, the method of transferring the title in the leased asset to the lessee must be evidenced in a document separate from the Ijarah contract document using one of following methods;

(a) By means of a promise to sell for a token or other consideration , or by accelerating the payment of the remaining amount of rental, or by paying the market value of the leased property

(b) A promise to give it as a gift ( for no consideration) (c) A promise to give itas a gift, contingent upon the payment of the remaining installments

In all these cases, the separate document evidencing a promise of gift, promise of sale or promise of gift contingent on a particular event, should be independent of the contract of Ijarah Muntahia Bittamleek and can not be taken as an integral part of the contract.

The additional sub-clause as follows is added; It is also permissible to ask the customer to give an "Undertaking to Purchase Ijarah Asset" from the bank in case of early purchase or default

* See IBB June 2012 for details * These clarifications are added as foot note with original clauses Sources: • Shariah Standards for Islamic Financial Institutions, AAOIFI (2010) • Website of State Bank of Pakistan (www.sbp.org.pk) • Website of AAOIFI (http://www.aaoifi.com) • Usmani, T.M. (2000); An Introduction to Islamic Finance; Idaratul Ma‟ arif, Karachi • Rahman, et. all (2003); An Exploratory Study of Ijarah Accounting Practices In Malaysian

Financial Institutions; Vol. 5, No. 3 International Journal of Islamic Financial Services


http://www.sbp.org.pk/

Islamic Finance in a Multipolar World: Traversing the Complexities of a New World

By Abbas Mirakhor and MugheesShaukat*

Abstract The recent financial developments have given rise to a developing consensus that the Unipolar economic growth regime dominated by U.S, Japan and few European centers, is under great stress. The consensus takes into consideration the present financial stresses and strains, and theensuing uncertainty surrounding the sustainability of the unipolar regime, which has given way to a shift towards a multipolar economic setup. Scholarship has already hinted on not only better trade and investment opportunities, but also on a much more resilient global economic growth that such a shift can bring. However, there are some major obstacles that need to be overcome in order to reap fully the desired benefits of multipolarity.Continuation of debt-based financing regime (the hallmarks of which are risk transfer and risk shifting) will not necessarily allow the benefits of emerging multipolarity to accrue to the world economy. The new system can be more effective with a new regime of financing. Indications are that almost all emerging countries in Asia are actively considering risk sharing via Islamic finance as a possible alternative.

Key Words: Multipolar regime, Debt stress, Complexity, Black swans Risk Sharing, Islamic Finance

* Authors Abbas Mirakhor is the first holder of the chair of Islamic finance at INCEIF, Kuala

Lumpur, Malaysia. Noureddinekrichene is former staff of the International Monetary Fund (IMF) and currently, Professor of international finance at INCEIF. Mughees Shaukat is currently a PhD candidate and Assistant Researcher in Islamic banking and finance at INCEIF. E-Mails: [email protected], [email protected] and [email protected] respectively.

Note: The paper is based on an earlier version of the paper by Abbas Mirakhor, titled: ‘Islamic Finance in a Multipolar World’, published in the European Financial review, October, 2011. An earlier version was also presented at the Asian Institute Finance Distinguished Speaker Series. Kuala Lumpur, 13 September 2011.




Introduction:By 2025, Brazil, India, Indonesia, Korea, Russia are expected to join China as new

growth poles in the global economy, according to a recent World Bank Global Development Horizon report, (2011). The size, dynamism and dominance in forward and backward linkages in trade and investment of an economy are the criteria for selection. However, the central rationale for this fast developing consensus is supported by the fact that the present unipolar regime− dominated by U.S., is under ever increasing debt stress; creating serious doubts about its sustainability. This has led to developments where (i) The balance of global growth is shifting from developed to emerging market economies leading to the emergence of a new global economic order; (ii) there will be a shift in the drivers and sources of global trade and investment flows; and, (iii) the international reserve currency structure will move from a unitary to multicurrency regime. The evidence for the premise includes the fact that: (i) the emerging markets are leading the global growth; (ii) these economies have been a major source of origination of cross-border mergers and acquisition with a significant increase from US$27 billion in 1997 to US$254 billion in 2011 and from 576 deals to 2,447 over the same period; (iii) emerging market economy corporates have increased the strength of their presence in the global financial markets as their borrowing increased from US$123 billion in 2000 to US$461 billion by the end of 2010; and (iv) their borrowing costs have reduced. It is for the first time that the emerging markets have gained the status from being plain borrowers to becoming plain creditors (sheng, 2009).

There are indications that the shift in the global economic growth drivers which began in the 1990s has accelerated. During the period of 2000-2008, twenty-nine countries had achieved sustained growth rates of 7 percent or higher for 25 years or more, thus cushioning global growth performance. Eleven of the 29 countries were African. Among these, the Asian economies were the best performers. The United Nations Economic and Social Commission for Asia and Pacific 2011, considers the region as the most dynamic in the global economy, growing at 8.8 percent in 2010 and forecasted to grow at 7.3 percent in 2011. This compares well with the anemic growth performance of the countries at the center of the present unipolar system. One of the most important implications of the shift is the potential for the emergence of multiple international reserve currencies. The Global Development Horizon, 2011 suggests three possible scenarios for the future: (i) continued dominance of the US$ as the international reserve currency; (ii) possibility of the SDR as the international reserve currency; and (iii) emergence of at least three international reserve currencies. In the first scenario, evidence suggests that the US$ is being used less and less as official reserve in invoicing of international transactions, as an anchor for other exchange rates, and in denominating international claims. The SDR, while originally designed with the intention of serving as the international reserve currency, has never been allowed to serve that function and it is not likely now. What is more likely, according to the report, is that Chinese currency will emerge as the third international reserve currency alongside the US$ and the euro. China is now the largest exporter in the world. As Chinese corporates and banks increase their activities across the world, they are likely to settle their trade, track accounts, and book their profits in renminbi. Chinese sovereign wealth funds are now among the largest in


the world, China has large international reserves, and debt and equities are being issued in renminbi. Consequently expectation of its emergence as an international reserve currency is well founded. However, there are few major obstacles which if not confronted, may not only threaten the emergence of a multipolar regime, but could lead to a failure in reaping the full benefits from such a development.

Obstacles to the emergence of multiple growth poles:The emergence of multiple growth poles in the global economy has potential

benefits, the most important of which is greater resilience of emerging market economies and developing countries to idiosyncratic shocks similar to what triggered the 2007/2008 crisis. Additionally, greater trade and investment opportunities between the emerging markets of the South and low-income developing countries can be enormously helpful and effective in accelerating growth, development and poverty reduction in the latter. China has been doing that effectively since the early 1990s particularly in the low-income countries of Africa. There are, however, major obstacles to overcome. These include, inter alia, the architecture and governance of global finance. The former is woefully inadequate in providing requisite infrastructure of supervision and regulation to accommodate balanced growth of global finance. The fact is that some four years after the beginning of the global crisis, there is no global agreement on cross-border financial flows, there is no internationally agreed sovereign – debt work-out mechanism and there is no effective representative global structure for policy coordination. Moreover, the existing structures are non-representative and suffer from high democratic deficit. They make policies; impose standards and codes of conduct and international best practices on the rest of the world without an effective representation of much of the world’s most dynamically growing economies. Last but not least, one of the obstacles to the global economic recovery and emergence of multiple growth poles is the important structure of global finance, which is overwhelmingly dominated by debt-creating flows. As the ongoing financial crisis suggest, this structure is imposing anew a great deal of burden and stress on the recovery and growth of the global economy. Perhaps, the stresses and shocking financial events of recent months in Europe and the US are signs of regime uncertainty. The regime of interest rate-based finance is the source of much of the economic and financial uncertainty tightly gripping the global system. Moreover, the continuing adverse economic and social consequences, as well as the failure of significant policy actions to elicit the desired response, seem to provide evidence that the global financial system displays the characteristics of a ‘complex system’. Added to the shock of occurrence of “fat tail” events, increased poverty and worsening distribution of income and wealth in individual and collective economies have intensified regime uncertainty.

Complexity of the Interest Rate Based Debt Finance: Discussions on the complexity of the present system and its connections with

the forces which render the system uncertain and unstableseem to have surged. Complex systems are dynamical and are characterized by non-linearity (Lorenz, 1993). These systems are governed by feedback loop mechanisms where small, marginal


changes in the system have significantly large impact on the overall behaviour. Such arrangements are all characterized by “bifurcation points” at which system can either move to more stability and order or to chaos (Prigogine, 1997). There has to be zero defect policy for the system to work in an ordered way. Unavoidably, complex systems are uncontrollable and innately carry with them large elements of uncertainty and ambiguity (Wheatley, 1992).

In early 1940s, a British mathematician, Alan Turing, was perhaps the first modern scientist to formulate complexity. The hallmark of his contribution was a paper he wrote about the growth of biological system in which he put forward the idea of “morphogenesis” (Turing, 1952). He showed that a biological system described by two simple equations with feedback loops among the variables was capable of behaving in totally unpredictable, complex patterned behaviour. Decade later, meteorologist, Edward Lorenz, via similar methodology made famous “The Butterfly Effect1”, by observing small changes creating large impact in the overall system.

The financial sector is now being increasingly thought of as a system governed by feedback processes or knock-on effects. It means that the system is influenced by past events, nullifying any ‘random walk’ phenomenon (Johnson, 2007). The system corresponds to ‘critical state’ phenomena in which the long-range dependence between the elements can effect massive systemic changes due to small changes in certain parameter: another important feature that assures the complexity of the system (Bookstaber, 2011). It needs a ‘zero error’ policy for it to function well because when a system is complex it can reach bifurcation points at any time, making the system so sensitive that it can further amplify small changes into large feedbacks. The recent U.S. subprime crisis, as well as the financial crises in Greece and now in elsewhere, can be clearly referred as to as those small marginal changes that have affected the dynamics of the whole system. The system reached a critical state or a perpetually unstable organization of the critical state, where the system became so unstable and unsustainable that it had to implode or explode − like in the 1990s Asian crisis.

A growing numbers of observers believe that the present financial system is complex and non-linear. Benoit Mandelbrot while using a relatively simple equation with feedback interaction claimed that the market is not governed by assumptions of normal distribution and Brownian motion. Instead it is irregular and non-linear. Their behaviour could be better described by ‘Fractal Geometry mathematics’ (Mandelbrot and Hudson, 2004).Peters (1996) also showed that in fact markets are non-linear dynamic systems: with feedback effects, criticality levels as well as fractal in nature. Chorafas (1994) echo both Mandelbrot and Peters and suggests that neither linearity nor the 1 The ‘butterfly effect’ also known as"sensitive dependence on initial conditions", is

referred to an occurrence where a small marginal change has a large impact on overall behavior of the system.The phrase was discovered in Edward Lorenz's talk for the 139th meeting of the American Association for the Advancement of Science in 1972.Titled, “Does the flap of a butterfly wing in Brazil set off a tornado in Texas


hypotheses of normal distribution can provide the right support in understanding markets. Financial analysts have to turn their attention to non-traditional means of research and analysis in figuring out financial market behaviour. These new tools he argues come under the heading of ‘Complexity Theory’ and include tools such as ‘non-linearities’, ‘bifurcations’, chaos theory, fractals and other ‘fuzzy engineering techniques’.

Ilya Prigogine (1980, 1989 and 1997) suggested that for a complex system, there is a “point of bifurcation”, a moment of truth, for the system to choose which path it follows. Chaos Theory suggests that a complex system approaching a bifurcation point becomes so sensitive that it can amplify small changes into large feedbacks. Decisions made at such a point lead the system either toward greater chaos or toward higher order (Mirakhor and Hamid, 2009, p. 231). It appears that the “point of bifurcation” has been operating to increase regime uncertainty. At every ‘bifurcation point’ reached, policy makers seem to have made decisions that have rendered the system more unstable. Finally, Taleb (2007/2010) introduced ‘Black Swans’; events with very low probability of occurrence but with significantly large impact; quite reminiscent of the ‘Butterfly effect’. Recently, the global system has experienced events that would have been thought of as low probability events not long ago. These include, inter alia, the down grading of U.S from its ‘AAA’ rating, the looming collapse of the much hailed Eurozone, the effort by Switzerland to convince the world that Swiss franc is not a safe haven, the Brazilian suggestion of bailout of advanced economy by emerging markets, China’s contemplation of buying Italy’s debt, and the Libor rate fixing. The list can go on. Looming in the back ground of the present uncertainties in the global economy there is a potential event, termed as “the mother of all black swans”, the effects of which may be chaotic global economy: contagion-riddled events of sovereign default.

Hence, there is increasing uncertainty regarding the stability and sustainability of the interest rate based debt financing regime.

Unipolar regime under Debt Stress: The fall of the Soviet Union consolidated the power of the dollar-based unipolar

international trade and financial system until the 2007/2008 global crisis. The stress and strain in the unipolar system and its associated arrangement were becoming apparent in the 1990s as Japan, followed by The Asian Tigers, Russia, Argentina, and Brazil were sending distress signals. Neither the signals nor the lessons of these crises made any significant impact on the way the centers of the dollar-based unipolar system were conducting policies. The regime was quick to impose policy and structural reforms, standards and codes through the International financial institutions (IFIs) in which the US-Western Europe-Japan held major sway. However, the center of the system itself was slow to adopt the prescriptions it was writing for the emerging market economies and developing countries. The case in point was the diagnostic device: Financial Sector Assessment as well as other best international practices and codes which the IMF required from all its members. The US were one of the last to adopt them but much too late to prevent the idiosyncratic trigger of the global crisis.


A central and overwhelmingly cause of the Asian crisis was debt in all its dimensions. The global financial crisis has been analysed voluminously, and a variety of reasons have been given for the crisis. By far the most comprehensive has been the study by Reinhart and Rogoff (2009) which conveys a central message that all financial crises, whether currency or banking crisis, are at root debt crises.IMF had already focused on this issue in its post-Asian crisis diagnostics and had recommended that emerging markets and developing countries must avoid debt-creating flows and rely on foreign direct investment. The safe level of government debt-to-GDP was less than 25 percent according to these recommendations. Reinhart and Rogoff 2010 study; “Growth in a Time of Debt”, confirmed that a government debt-to-GDP ratio beyond 30 percent begins to stress growth. They studied 44 countries for which data was available over a period of 200 years, dividing debt categories into: under 30 percent; 30-60 percent; 60-90 percent; and over 90 percent. They showed that growth comes under stress in all these categories but becomes quite seriously impaired at higher levels so that when the ratio reaches 100 percent, interest payments equal the nominal GDP.

Whilst the emerging economies learned the lessons of 1997/98 crises, put their macroeconomic policy house in order, reduced their exposure to sudden stops, and accumulated reserves, most advanced economies went in the opposite direction. They reduced their savings, increased consumption, ran fiscal deficits and accumulated large debts. Empirical research suggests that debt-to-GDP ratio of the richest members of the G-20 will reach 120% mark by 2014 while by 2020 the U.S and the other major European centres would amass a ratio of at least 150%, with Japan and U.K going to 300% and 200% respectively. Even more disconcerting is the projected interest rate paths on their debts which would increase from 5% to 10% in all cases, and as high as 27% in U.K (BIS, 2010). These countries suffer from high unemployment, fiscal instability, low capacity utilization and high debt and leverage. Accordingly, growth is unlikely to provide a source of debt relief. Rogoff, (2011) suggests that there are now $200 trillion of financial paper in the global economy, nearly 75 percent or US$150 trillion is in interest-bearing debt. This picture becomes more alarming when it is realized that the growth of the global economy is anemic at best while the interest rate on debt is sure to exceed the rate of growth of global GDP for the foreseeable future. According to the World Bank, global GDP is projected to increase 2.5% in 2012, with growth accelerating to 3% and 3.3% in 2013 and 2014 (World Bank, 2012). Given the events in countries such as Greece subsequent to the 2007/2008 US crisis, It appears that the debt dynamics in global financial system has again made the system reach a point of criticality and bifurcation, where a sovereign default by one country can prove chaotic to global economy. Observers suggest that Ireland, Portugal and Greece are only the tip of the proverbial iceberg and that there is a heightened risk of the emergence of an even more serious global debt crisis. According to John Mauldin and Jonathan Tepper (2011):

“When things are unstable, it isn’t the last grain of sand that causes the pile to collapse or the slight breeze that causes the ruler on your finger tip to fall. Those are proximate causes. They are the closet reasons at hand for the collapse. The real reason though, is the remote cause, the farthest reason. The farthest reason is the underlying instability of the system itself”.


Risk-sharing finance regime as an alternative: Risk sharing−the essence of Islamic finance, has a number of desirable

characteristics that endorse it as the ideal method of financing in the age of information superhighway. It weakens the rationale for existence of age-old debt financing, i.e. lack of information and all associated informational problems” (Mirakhor, 2011). Research has demonstrated sizeable potential welfare benefits of risk sharing (see for example, van Wincoop, 1999; Kim, S., et.al. 2005; Lee Imbs, 2006 and Shin, 2008). Analyses of the pre-crises data shows a fast growing, debt-creating process in the global financial system with increasingly tenuous links with the growth of the real economy. Although equity portfolio and foreign direct investment flows were growing at a more rapid pace than debt-creating flows before the global crisis, their magnitudes were not significant enough to make a dent in the low level of risk-sharing coefficients in the empirical studies. For example, study by Kim, s., et.al. (2005) showed that even in the fast growing East Asia-10 countries the size of the coefficient of risk sharing was very small and some were negative (Indonesia and Malaysia). Increased debt-creating flows, a characteristic of financial globalization in the run up of 2007/2008 crises, does not improve risk-sharing, as they either transfer or shift risk. More importantly, risk-shifting or risk-transfer financial transactions led global finance toward decoupling from real sector activities with the growth of the former outpacing that of the latter by double-digit multiples, intensifying the risk of “sudden stops” Mirakhor., et.al.(2012).Even the emergence of a multipolar global economy may not improve risk sharing across the globe. Perhaps the most important reason for this state of affairs is the reliance of global finance on debt-creating flows.

Islam is a rules-based system in which a network of prescribed rules governs the socio-economic-political life of the society. Compliance with these rules renders the society a union of mutual support by requiring humans to share the risks of life (Mirakhor, 2011b).The epistemological roots of risk sharing as an organizing principle of Islamic financial system is discernible from the verse 275 of chapter 2 of the Quran. This verse, in part, decrees that all economic and financial transactions are conducted via contracts of exchange (al-Bay’) and not through interest-based debt contracts (al-Riba). Since in the Verse the contract of exchange appears first and no-riba thereafter, it can be argued that requiring contracts to be based on exchange constitutes a necessary condition and “no-riba” the sufficient condition of existence of an Islamic financial system. Together, these conditions constitute the organizing principle of that system. The necessary condition (al-Bay’) and sufficient condition (no riba) must be met for a contract to be considered Islamic (Mirakhor, 2011).

The method of finance that renders pay offs to financial assets contingent on the outcome of economic activities – rather than on ex-ante fixed rates that must be paid as contractual obligation of the debtor regardless of the outcome of the project for which it was borrowed – is technically known as state-contingent financing. Arrow-Debreu, (1971) proof of existence of a stable equilibrium for a competitive economy required that all assets must be state-contingent, i.e. their pay-offs depended on the outcome of economic activities. Residual payments to equity shares of modern corporations are the best examples of state-contingent claims. One justification for rapid globalization was


that it would increase interaction in the human community and create a “global village”. Risk-sharing will do just that since it would require a familiarity among partners to a risk sharing contract to make it work. As demonstrated by the recent crisis, dealing at “arms-length”, a much-heralded characteristic of debt financing has made shifting risks from financiers to taxpayers, without their knowledge or consent, a much easier task. Because of its contingent character, a risk-sharing contract requires close coordination between maturities, values, and pay offs of assets and liabilities sides of the balance sheet. These would move simultaneously in the same direction in response to changes in asset prices. In an economy dominated by state-contingent, risk-sharing finance, there would have to be a close correspondence between the real sector activities and the financial sector, as the rates of return to the former would determine the rate of return to the latter. This alone would impose limitation on credit expansion and leverage since these would increase only to accommodate growth in the real sector. These and other characteristics assure the stability of the financial sector Askari, H. et.al. (2010).

It is often claimed that risk-sharing, or Islamic finance, increases risks in the economy. There appears to be a conceptual confusion in cognition of the justification for finance. If finance is conceived as intermediating and facilitating the link between demand for finance emanating from the real sector and the supply of finance, then there must be a close link between the real and finance sectors of the economy. In this case risks are taken in the real sector. When it comes to financing, the modality can be risk sharing, risk transfer or risk shifting. But the overall risk of the activity seeking financing does not increase. The exception is when finance is decoupled from real sector activities as it happened during the run up to the recent crisis. For a number of years during the 1990s, observers, including Hans Tietmier, the then President of Bundesbank, warned in international fora that “financial decoupling” was increasing the risks in global finance Menkoff, L. and Tolksorf (2001). These warnings were not attended to and consequences followed Epstein, G. (2006).

Continuation of a debt-based financing regime will not necessarily allow the benefits of emerging multipolarity to accrue to the world economy. The new system can be more effective with a new regime of financing. Indications are that almost all emerging countries in Asia are actively considering risk sharing via Islamic finance as a possible alternative. Quite a few are leveraging the “first-mover” status of Malaysia in education, manpower training and instrument innovation in Islamic finance to introduce their own brand of risk-sharing method of financing. If these efforts succeed, the benefits of emerging multiple growth centers will be buttressed further with greater stability and resilience in the supporting financial transactions through enhanced risk sharing. Even now, risk sharing could be an effective alternative to the debt-based ways and means of helping European countries facing sovereign debt crises. For example, Eurozone could issue long-term securities with pay offs based on the GDP performance in these countries. Similarly, China could buy Italian GDP-based securities rather than the consideration reportedly being given to purchase of Italian debt. This type of risk-sharing instruments has been proposed by analysts such as Shiller, (2003) for some time now. Recently, Farmer suggested central banks’ purchase of equity shares to stabilize the equity markets Farmer, R. (2010). Perhaps the present regime uncertainty has created a valuable opportunity to seek alternatives to the debt-based finance regime.


References: World Bank, Global Development Horizon, 2011. Washington, D.C.; see also Justin Yitu

Lin and MansoorDailami: “Are We Prepared”for a Multipolar World Economy?” Project Syndicate, Syndicate.webarchive.

Andrew Sheng (2009). “From Asian to Global Financial Crisis”,Cambridge University Press.

Arrow, K.J. (1971). “Essays on the Theory or Risk-bearing”Chicago: Markam.

Askari, H. et.al.(2010). “Stability of Islamic Finance” Singapore: John Wiley.

BIS(2010).“ The Future of Public Debt: Prospects and Implications”. By Stephen et. al, (2010). Monetary and Economics Department, Working Papers No. 300.

ChorafasDimitris N. (1994). “Chaos Theory in the Financial Markets: Applying Fractals, Fuzzy Logic, Genetic Algorithms, Swarm Simulation &The Monte Carlo Method To Manage Market Choas and Volatility”. IRWIN Professional Publishing. U.S.A

Epstein, G. (2006). “Financialization and the World Economy”. New York: Edward Elgar.

Farmer, R. (2010). “How the Economy Works: Confidence, Crashes, and Self-Fulfilling Prophecies”. New York: Oxford University Press.

Imbset. al, (2005), “The Overhang Hangover”.World Bank policy Research Working Paper No. 3673.

John Mauldin and Jonathan Tepper (2011). “End Game:The End of Debt Super Cycle and How It Changes Every Thing”. Published by John Wiley & Sons. New Jersey, U.S.A

Johnson, Neil (2007). “Simply Complexity: A Clear Guide to Complexity Theory”. One World Oxford Publications.

Kim, s., et.al.(2005). Regional versus Global Risk Sharing in East Asia.

Lorenz, Edward N. (1963). "Deterministic non-periodic flow".Journal of the Atmospheric Sciences, vol. 20, pages 130–141.

———. (1993), “The Essence of Chaos”. Seattle, Washington: University of Washington Press, 1993.

Mandelbrot, Benoit B.; Richard Hudson (2004). “The (Mis) behaviour of Markets: A fractal view of Risk, Ruin & Reward”. Perseus books group. New York.

Menkoff, L. and Tolksorf (2001).“Financial Market Drift: Decoupling of the Financial Market from the Real Economy?” Heidelberg-Berlin: Springer-Verlag.

Mirakhor,A. and I. S. Hamid (2009). Islam and Development. New York: Global Scholarly Publications.


———.(2011). “Risk Sharing and Public Policy”. Paper presented in the 5th International Islamic capital Market Forum. Security Commission of Malaysia. Kuala Lumpur, 10th November 2011.

Mirakhor., et. al.(2012). “Regime Uncertainty: Interest rate based debt financing system”.Journal of Islamic Business and Management.Vol.2, Issue 2. December, 2012.

Peters Edgar.E, (1996).“Chaos and Order in the Capital Markets: A new view of cycles, prices, and market volatility”. Second Edition.John Wiley & Sons.

Progogine, Ilya (1980). “From Being to Becoming”. San Fransisco: W. H. Freeman And Company.

Progogine, Ilya (1989). “Exploring Complexity”. New York: W. H. Freeman and Company.

Progogine, Ilya (1997). “The End of Certainty”. New York: The Free Press.

Reinhart, C. and K. Rogoff (2009).“This Time Is Different: Eight Centuries of Financial Folly”. Princeton University Press.

Reinhart, C. and K. Rogoff (2010).“Growth in a Time of Debt.”NBER working paper no. 15639.

Rogoff, K. (2011). “Global Imbalances without Tears.” Project syndicate, 2011-03-01.

Shiller, T. (2003).“The New Financial Order. Princeton”: Princeton University Press.

Taleb, Nassim Nicholas (2007/2010). “The Black Swan: The Impact of the Highly Improbable”. New York: Random House and Penguin.

Turing.A.M (1952).“The Chemical Basis of Morphogenesis”.Philosophical Transactions of the Royal Society of London.Series B, Biological Sciences, Vol. 237, No. 641.(Aug. 14, 1952), pp. 37-72.

Van Wincoop., E., (1994). “Welfare Gains from International Risk Sharing,” Journal of Monetary Economics, vol. 34, October, pp. 175-200

vanWincoop, E., (1999). “How big are Potential Welfare Gains from International Risk Sharing?” Journal of International Economics, vol. 47, February, pp. 109-235.

World Bank Report on “Global Economic Prospects”, 2012.


Dynamic Model of Islamic Bank Profitability By

Titi Dewi Warninda*

Abstract Analysis of profitability determinants will contribute in increasing Islamic bank profitability. This research aims to analyse Islamic bank profitability determinants in the short and long run. It uses data of Indonesian Islamic banking. It applies dynamic model of Error Correction Model (ECM) to find several internal and external factors that influence Islamic bank profitability in the short and long run. This research shows that Total Financing becomes dominant variable in the short run and has positive effect. In the long run, Loan Loss Provision becomes dominant variable but has negative effect. Mark Up Financing has significant influence in the short and long run, but Equity Financing only has significant influence in the long run. Surprisingly, this research indicates that Equity Financing has stronger influence than Mark Up Financing in the long run.

Keywords: Islamic bank, profitability, Error Correction Model

1. Introduction: Islamic banking in Indonesia has experienced quite rapid growth in the last seven

years. In 2005, total net assets reached 21 trillion rupiah, increased to 146 trillion rupiah in December 2011. Islamic banking has disbursed 15 trillion rupiah total financing in 2005 and became 103 trillion rupiah in December 2011. Profitability of Indonesian Islamic banking demonstrated by Return on Assets (ROA) reached 1.35% in 2005, and became 1.79% in December 2011.

Profitability of Indonesian Islamic banking should be improved to continue its development. Analysis of profitability determinants will contribute in increasing Islamic banks profitability. Factors affecting Islamic banks profitability can be different from the conventional one and Islamic banks in other countries. The analysis can indicate which variables that have significant influences and whether the effects are positive or negative.

Some researchers have done studies about profitability determinants of Islamic banks. Wasiuzzaman and Tarmizi (2010), and Idris, Asari, Taufik, Salim, Mustaffa, * Author: Titi Dewi Warninda is a lecturer at Economic and Business Faculty, Syarif

Hidayatullah State Islamic University Jakarta – Indonesia. E-Mail: [email protected]


and Jusoff (2011) have done researches in Malaysian Islamic banks. Ramadan (2011) has studied about Islamic banks in Jordan. Akhtar, Ali, and Sadaqat (2011) have done research for Islamic banks in Pakistan. The research of Srairi (2009) was for conventional and Islamic banks in GCC countries. Smaoui and Salah (2011) have studied about Islamic banks profitability determinants in GCC countries.

Differences of this research over previous researches are as follows. First, this research uses data of Islamic Commercial Banks and Islamic Business Units in Indonesia. Second, this research uses some specific variables of Islamic banks such as Equity Financing (Mudharabah and Musharakah Financing), Mark Up Financing (Murabahah Financing), and Mudharabah Time Deposit. Third, this research uses dynamic model of Domowitz-El Badawi Error Correction Model (ECM) for analysing Islamic banking profitability determinants in the short and long run. ECM is dynamic model for correcting short run time series data disequilibrium into long run equilibrium. Because of its advantages in combining short and long run effects, ECM becomes a model that can explain the explanatory variables well.

2. Research Method: This research uses data from monthly Islamic Banking Statistic published by

Central Bank of Indonesia for the period of January 2007 – March 2012. The data consists of Islamic banks profitability and its determinants. This research uses variables as follows.

Table 1. Description of Variables

Variable Symbol Variable Definition Dependent Profitability ROA Net Income/Total Assets

Independent Total Financing TOF Total Financing/Total Assets

Mark Up Financing MUF Murabahah Financing/Total Assets Equity Financing EQF Mudharabah and Musharakah

Financing/Total Assets Loan Loss Provision LLP Loan Loss Provision/Total Assets Mudharabah Time Deposit MTD Mudharabah Time Deposit/Total Assets

Bank Size SZE Growth of Total Assets Money Supply M2 Growth of Money Supply

This research uses dynamic model of Domowitz-El Badawi ECM. Steps to analyse Islamic banks profitability determinants for short and long run using ECM are as follows.

2.1. Stationary Test: This research uses Augmented Dickey Fuller (ADF) unit root test to determine

stationary data. Comparing ADF statistic value with Mackinnon statistical distribution critical value will determine stationary data. Greater ADF statistic value than critical


value indicates stationary data. Besides using ADF statistic value, determination of stationary data can be done by comparing probability value with 5% significance level. Probability value that is less than 5% significance level will indicate stationary data. The stationary test is done from level stage and can be continued to difference stage until all variables are stationary.

2.2. Cointegration Test: This research uses Johansen cointegration test to obtain long run relationships

between dependent and independent variables. Comparing trace statistic value with critical value at 5% or 1% confidence level can indicate Johansen cointegration test conclusions. Greater trace statistic value than critical value will indicate that the two variables are cointegrated.

2.3. Error Correction Model: Error Correction Model (ECM) is technique or model for correcting short run

disequilibrium into long run equilibrium. Because of its advantages in combining short and long run effects, ECM becomes a model that can explain the explanatory variables well. ECM equation of this research is as follows:

DYt = b0 + b1DX1t + b2DX2t + b3DX3t + b4DX4t + b5DX5t + b6DX6t + b7DX7t + b8ECTt-1 + et

Where : Y = Return On Asset (ROA) X1 = Total Financing (TOF) X2 = Mark Up Financing (MUF) X3 = Equity Financing (EQF) X4 = Loan Loss Provision (LLP) X5 = Mudharabah Time Deposit (MTD) X6 = Bank Size (SZE) X7 = Money Supply (M2) ECT = Error Correction Term e = error term ECTt-1 is t-1 cointegration error, or written as: ECTt-1 = Yt-1 - b0 - b1X1t-1 - b2X2t-1 - b3X3t-1 - b4X4t-1 - b5X5t-1 - b6X6t-1 - b7X7t-1

ECM will have valid model specification if it has a statistically significant Error Correction Term (ECT) coefficient. Probability value of ECT coefficient that is less than 5% significance level will indicate its significance.

2.4. Classical Assumption Test: Classical assumption test of this research uses Jarque-Bera normality test, Breusch-

Godfrey Serial Correlation LM autocorrelation test, and Breusch-Pagan-Godfrey heteroscedasticity test. Other classical assumption test that is multicollinearity test uses correlation coefficients between independent variables.


3. Result and Discussion: 3.1. Classical Assumption Test Result:

Classical assumption test results indicate that this research model is free from autocorrelation, multicollinearity, and heteroscedasticity problems. It also meets the assumption of normality.

3.2. Stationary Test Result: Augmented Dickey Fuller (ADF) stationary test results indicate that Total

Financing (TOF), Mark Up Financing (MUF), Equity Financing (EQF), Loan Loss Provision (LLP), and Mudharabah Time Deposit (MTD) variables are not stationary at level stage. However, all variables then are stationary at first difference stage.

3.3. Cointegration Test Result: Johansen cointegration test results indicate that all independent variables are

cointegrated with dependent variable in the long run. This results mean that the research can be continued to ECM.

3.4. Error Correction Model Result: Error Correction Model (ECM) test result is as follows:

Table 2: Error Correction Model Result

Variable Coefficient Std. Error t-Statistic Prob. C -0.065355 0.025426 -2.570402 0.0135

D(TOF) 0.115581 0.025963 4.451815 0.0001 D(M2) 0.051311 0.019337 2.653437 0.0109

D(MUF) 0.109224 0.057953 1.884706 0.0658 D(EQF) 0.034486 0.063119 0.546360 0.5875 D(LLP) -0.217030 0.208091 -1.042959 0.3024 D(SZE) 0.040855 0.015045 2.715591 0.0093 D(MTD) 0.010661 0.021109 0.505024 0.6160 TOF(-1) -0.483527 0.121963 -3.964530 0.0003 M2(-1) -0.459915 0.121129 -3.796901 0.0004

MUF(-1) -0.500998 0.131647 -3.805616 0.0004 EQF(-1) -0.472979 0.135827 -3.482210 0.0011 LLP(-1) -0.644402 0.169548 -3.800697 0.0004 SZE(-1) -0.513463 0.127757 -4.019061 0.0002 MTD(-1) -0.473190 0.130245 -3.633070 0.0007

ECT 0.518407 0.131078 3.954959 0.0003

ECM has a valid model specification because it has statistically significant Error Correction Term (ECT) coefficient. Analysis of independent variables influence on Islamic banks profitability in the short and long run uses the ECM t statistic test results in Table 2. Short and long run ECM equations are as follows.


Based on short run analysis of t statistic test, short run ECM equation is as follows:

ROA = -0,066 + 0,116TOF + 0,051M2 + 0,109MUF + 0,041SZE

Based on long run analysis of t statistic test, long run ECM equation is as follows:

ROA = -0,126 + 0,067TOF + 0,113M2 + 0,034MUF + 0,088EQF – 0,243LLP + 0,010SZE + 0,087MTD

Analyses of ECM short and long run equations give some indications. Total Financing (TOF) has significant positive influence on Islamic banks profitability at 1% significance level in the short and long run. This result means that Total Financing has a positive and strong influence. Increasing the percentage of Total Financing to Total Assets will increase profitability. Significant positive impact of Total Financing is in accordance with previous research by Khrawish (2011) which indicates that Total Loan to Total Assets variable has positive effect on commercial banks profitability in Jordan.

Mark Up Financing (MUF) has significant positive effect on Islamic banks profitability at 10% significance level in the short run and 1% significance level in the long run. This result shows stronger positive effect of Mark Up Financing in the long run than short run. Increasing the percentage of Murabahah Financing to Total Assets will increase profitability. Significant positive effect of Mark Up Financing is consistent with significant positive effect of Total Financing variable above. This result suggests that significant positive effect of Total Financing on Islamic banks profitability in the short and long run above can be derived from the significant positive effect of Mark Up Financing, although the effect of Mark Up Financing in the short run is relatively small.

Equity Financing (EQF) has no significant effect on Islamic banks profitability in the short run but has significant positive effect at 1% significance level in the long run. This result suggests that the significant positive effect of Total Financing in the short run above gets more influence from other type of financing rather than Equity Financing. But in the long run, Equity Financing contributes to the positive effect of Total Financing. In the long run, increasing the percentage of Mudharabah and Musharakah Financing to Total Assets will increase Islamic banks profitability.

Loan Loss Provision (LLP) has no significant effect on Islamic banks profitability in the short run but has significant negative effect at 1% significance level in the long run. This result means that in the long run, the increase of Loan Loss Provision to Total Assets percentage will decrease profitability. The significant negative influence of Loan Loss Provision is in accordance with previous research by Ramadan, Kilani, and Kaddumi (2011) that Loan Loss Provision to Total Loans variable has a negative effect on bank profitability in Jordan.

Bank Size (SZE) has significant positive impact on Islamic banks profitability at 1% significance level in the short and long run. This result means that Bank Size has a great positive influence on Islamic banks profitability. The greater the growth of total assets will further enhance profitability. Significant positive influence of Bank Size is consistent with previous research by Idris, Asari, Taufik, Salim, Mustaffa, and Jusoff (2011) that Bank Size variable has significant positive impact on listed Islamic banks profitability in Malaysia.


Mudharabah Time Deposit (MTD) has no significant effect on Islamic banks profitability in the short run but has significant positive effect at 1% significance level in the long run. This result suggests that third-party funds in the form of mudharabah time deposit has a great positive influence on Islamic banks profitability in the long run. Increasing the percentage of mudharabah time deposit to total assets will further enhance Islamic banks profitability. It means that Islamic banks have been able to distribute the mudharabah time deposit third-party funds into financing that can generate profits in the long run. Significant positive impact of Mudharabah Time Deposit on Islamic banks profitability is in accordance with previous research by Kundid, Skrabic, and Ercegovac (2011) that total deposits divided by total assets variable has a significant positive impact on commercial banks profitability in Croatia.

Money Supply (M2) has significant positive influence on Islamic banks profitability at 5% significance level in the short run and 1% significance level in the long run. This result shows greater positive effect of Money Supply growth in the long run than short run. The increase of Money Supply growth will increase Islamic banks profitability. This significant positive influence of Money Supply is consistent with research by Srairi (2009) that Money Supply variable has a positive effect on Islamic banks profitability in GCC countries.

4. Conclusion and Recommendation: 4.1. Conclusion:

Based on ECM result analysis above, Total Financing, Money Supply, Mark Up Financing, and Bank Size become variables that positively influence Islamic banks profitability in the short run. But no variable has negative influence in the short run.

Total Financing, Equity Financing, Mark Up Financing, Money Supply, Bank Size, and Mudharabah Time Deposit become variables that positively influence Islamic banks profitability in the long run. While Loan Loss Provision becomes variable that has negative effect in the long run.

Total Financing, Money Supply, Mark Up Financing, and Bank Size become variables that positively influence Islamic banks profitability both in the short and long run. Increasing Total Assets and Total Financing in the short and long run will improve profitability.

Total Financing becomes dominant variable in affecting Islamic banks profitability in the short run and has positive effect. But in the long run, Total Financing no longer becomes the dominant variable. Loan Loss Provision becomes the dominant variable in the long run and has negative effect. It means that non performing financing becomes bigger problem in the long run for Islamic banks.

Mark Up Financing has significant effect on Islamic banks profitability in the short and long run, while Equity Financing only in the long run. The explanation can be because of greater disbursement of Mark Up Financing than


Equity Financing. Surprisingly, Equity Financing has stronger positive influence than Mark Up Financing in the long run.

4.2. Recommendation: Based on the results of this research, it is useful to draw several

recommendations in order to increase Islamic bank profitability. First, Islamic banks should increase Mudharabah and Musharakah Financing (Equity Financing) rather than Murabahah Financing (Mark Up Financing) because Equity Financing has stronger positive influence than Mark Up Financing on Islamic banks profitability in the long run. Second, Islamic banks should pay more attention to reducing the amount of nonperforming financing because Loan Loss Provision becomes the dominant variable in affecting Islamic banks profitability in the long run and has negative effect.

References: Akhtar, Muhammad F., Ali, Khizer, and Sadaqat, Shama. (2011) ‘Factors Influencing the

Profitability of Islamic Banks of Pakistan.’ International Research Journal of Finance and Economics, Issue 66.

Idris, Asma’ R., Asari, Fadli Fizari A. H., Taufik, Noor Asilah A., Salim, Nor J., Mustaffa, Rajmi, and Jusoff, Kamaruzama. (2011) ‘Determinant of Islamic Banking Institutions’ Profitability in Malaysia.’ World Applied Sciences Journal, Vol. 12 (Special Issue on Bulstering Economic Sustainability).

Khrawish, Husni Ali. (2011) ‘Determinants of Commercial Banks Performance: Evidence from Jordan.’ International Research Journal of Finance and Economics, Issue 81.

Kundid, A., Skrabic, B., and Ercegovac, R. (2011) ‘Determinants of Bank Profitability in Croatia.’ Croatian Operational Research Review, Vol. 2.

Ramadan, Imad Z. (2011) ‘Bank Specific Determinants of Islamic Banks Profitability: An Empirical Study of the Jordanian Market.’ International Journal of Academic Researc,. Vol. 3 No. 6.

Ramadan, Imad Z., Kilani, Qais A., and Kaddumi, Thair A. (2011) ‘Determinants of Bank Profitability: Evidance from Jordan.’ International Journal of Academic Research, Vol. 3 No. 4.

Smaoui, Hacem, and Salah, Ines Ben. (2011) ‘Profitability of Islamic Banks in the GCC Region.’ Annual Paris Conference on Money, Economy, and Management, Paris, France.

Srairi, Samir Abderrazak. (2009) ‘Factors Influencing the Profitability of Conventional and Islamic Commercial Banks in GCC Countries.’ Review of Islamic Economics, Vol. 13 No. 1.

Wasiuzzaman, Shaista, and Tarmizi, Hanimas-Ayu Bt. (2010) ‘Profitability of Islamic Banks in Malaysia: An Empirical Analysis.’ Journal of Islamic Economics, Banking and Finance, Vol. 6 No. 4.


Efficiency and Performance of Islamic Banks in Bangladesh

By Muhamad Abduh*

Sidratul Mahabub Hasan Alfatih Gesan Pananjung

Abstract The aim of this study is to investigate the efficiency and performance of five Islamic banks in Bangladesh namely, Islami Bank Bangladesh Limited, Al-Arafah Islami Bank Limited, Social Islami Bank Limited, Shahjalal Islami Bank Limited and First Security Islami Bank Limited. Data are collected through their published annual reports from the year of 2006 to 2010. In addition, methods used to measure the performance and efficiency of Islamic banks are ratio analysis and data envelopment analysis respectively. With regard to banks’ performance, this study concludes that Shajalal Islami Bank limited is better than other Islamic banks in terms of its ROA, ROE, ETA, CAR, IER and AU ratios. On the other hand, with regard to banks’ efficiency, all Islamic banks have shown an improvement on their efficiency level. However, the result shows that First Security Islami Bank is better in terms of efficiency. This study complements other studies which discus about performance and efficiency in Islamic banks, particularly in the case of Bangladesh.

Keywords: Islamic bank, performance, efficiency, Bangladesh.

1. Introduction: The emergence of Islamic banking started in the mid-twentieth century and has

continued until this very day. It is becoming a novel phenomenon and is gaining attention of the whole financial world. Islamic banking has been construed as financial * Authors: Muhammad Abduh, Assistant Professor, IIUM Institute of Islamic Banking and

Finance International Islamic University Malaysia. Sidratul Mahabub Hasan, a Postgraduate Student, Department of Finance, Kulliyah of Economics and Management Sciences, International Islamic University Malaysia. Alfatih Gesan Pananjung, Senior Lecturer Bahrain Institute of Banking and Finance, Manama, Bahrain

Corresponding author. Fax: 00-60-03-2094-7728. Email: [email protected]


intermediaries that mobilize resources within the direction of Shari’ah approved projects by using Islamic financing instruments (Siddiqi, 1983). Despite certain linkages in terms of similarities with its conventional counterpart in a wide array of aspects, Islamic banking in most parts is to be regarded as having characteristics and features that are significantly distinctive and unique. Molla et.al., (1988), observed that, the aim of Islamic banking is not only the elimination of interest based transactions and the introduction of the Zakah system (religious alms that contributes to the poverty alleviation). This is further supported by Warde (2000), who concludes that one of the salient features of Islamic banking and finance, which makes it different from its conventional counterpart is that Islamic banking strives for a just, fair and balanced society as pictured in the area of knowledge of Islamic economics. These differences in objectives, along with other fundamental differences, whether philosophical, technical, or practical, in addition to the opportunity that Islamic banking presents for the financial sector, have contributed to the tremendous growth and expansion of Islamic banking encompassing a multitude of countries globally over the last 30 years. Today, Islamic banking is not merely of interest for Muslim customers but also for non-Muslims customers who see the benefit from such a system (Dar and Presley, 2000).

The fact that Islamic banks have inherently its own unique features that act as the foundation on why it should thrive differently as compared to conventional banks, it does not mean Islamic banks operate exclusively in a different financial system, completely separate from the other financial institutions. In one aspect for example, Islamic banks do face the same variety of risks as does what the conventional banks have experienced and have had to deal with, and actually even more. The scopes of competition are also equivalent, thus Islamic banks have to compete with conventional banks head on. The main reason for this is because both Islamic banks and conventional banks belong in the same universal financial system. Because of this it is imperative that Islamic banks also need to take into consideration each and every factor that ensures its continuous healthy existence, and factors hinder it from achieving so. Islamic banks, as with other types of financial institutions in the global system, are constantly looking for new ways to add value to their services due to increasingly tighter competition, globalization pressure, volatility of market dynamics.

In order to do this, Islamic banks must improve their performance, but the question of what factors drive performance must then be answered together with an analysis of the current performance of Islamic banks. This question must be addressed from the strategic level right until its operational details. Parallel to the aforementioned effort, a benchmark in measuring the efficiency of Islamic banks must then be established. In measuring efficiency, a-priori knowledge of both input and output of an Islamic bank is implied. The most widely frequently studied efficiency issue is of operational efficiency, and hence this is what this paper mainly discusses, especially based on certain financial ratios that are used. It is understood, however, that even operational efficiency may assume a wide range of input (technology, human resources, organizational structure, etc.) and output (loans; transactions processed, etc.) assumptions.

The specific context of efficiency in this paper is related to the ability to produce a result with minimum effort or resources. Efficiency can be used as an indicator to measure a bank’s success. It measures how close a production unit gets to its production


possibility frontier, which is composed of sets of points that optimally combine inputs in order to produce one unit of output. Basically, the term “Economic Efficiency” refers to the use of resources to maximize the production of goods and services. It can be measured in three ways; maximization of output, minimization of cost, and maximization of profits (Kumbhakar and Lovell, 2003). The aforementioned efforts should then be translated to Islamic banks wanting to maintain a continuously increasing level of efficiency in all areas of the bank, which in turn will affect the performance of the Islamic bank, portrayed by its periodic financial reports.

However, there are not yet many researches that have been done to measure the efficiency of Islamic banks in Bangladesh. Islamic banking in Bangladesh seems to lack participation from Muslims who shape the majority of the population in the country due to the lack of awareness in regard to what Islamic banking is and why it should be the obvious alternative of its conventional counterpart. In another aspect, the performance gap between conventional and Islamic banks is too high, as it can be clearly seen that in most cases conventional banks tend to better in a multitude of aspects as compared to Islamic banks. In order to compete and resolve the situation in favour of the Islamic financial institutions, the existing Bangladeshi Islamic banks probably need to develop effective business strategies that can be directly implemented. Efficiency measurement efforts can be a useful tool for in that can position the relevant parties responsible in formulating these kinds of strategies. Hence, the aim of this study is to empirically investigate the performance and the efficiency level of five of the Islamic banks in Bangladesh namely: Islami Bank Bangladesh Limited, Al-Arafah Islami Bank Limited, Social Islami Bank Limited, Shahjalal Islami Bank Limited and First Security Islami Bank Limited.

2. lslamic banks in Bangladesh: The banking landscape in Bangladesh consists of a mix of public, private and

foreign commercial banks. Bangladesh Bank is the central bank of the country, established soon after the independence in 1971. As with any other central banks of any country, Bangladesh bank has the responsibility to control the monetary policies of the country, which also includes the control of all commercial banks that are established within the country. Islamic banking’s resurgence spread to Bangladesh in 1983 with the opening of Islamic Bank of Bangladesh Limited (IBBL).

Following the establishment of the first Islamic commercial bank in the country, an ever-increasing number of investors were interested to open up other Islamic banks. Recent statistical data shows that the growth of Islamic banking in Bangladesh is steadily progressing day by day, which is contrary to how conventional banks in general are doing at present. As of 2011, there are 46 banks working in the financial market of the country that includes six Islamic banks and nine foreign banks. Interestingly, Ahmed et.al., (2006) and Ahmad and Hassan (2007) found that Islamic banks in Bangladesh have shown relatively better performance in terms of loan recovery and various other financial measures as compared to its conventional counterpart.

In Bangladesh, Islamic banking is steadily becoming an established major player in the mainstream banking industry around the world. Based on the existing supporting factors that are in support of Islamic banking growth, it does appear that the inclination is likely to continue. However it is important that continuous efforts of improvement in areas that are lacking need to be focused on and resolved.


3. Literature Review: In the banking sector, the efficiency of banks is considered to be an important

issue. Fundamentally, banking efficiency can be measured in two ways, (i) Technical Efficiency; and (ii) Cost Efficiency (CE). A producer is considered technically efficient if, and only if, it is impossible to produce more of any output without producing less of some other output or using more of some inputs (Koopmans, 1951).

Improving the efficiency of the banking sector has been considered an important issue in Bangladesh. In 1986, the Government formed the national commission on money, banking, and credit in order to find solutions for efficient operation and management of the banking system. In addition, in 1991 a taskforce was formed to formulate strategies to promote the development of the banking and financial sector. In the same period, the World Bank has assisted in the conducting of several studies on banking sector reform in Bangladesh (Shameem, 1995).

To measure efficiency of Islamic banks in Bangladesh, Sarker (1999) looked at the performance and operational efficiency of Bangladeshi Islamic banks and suggested that Islamic banks can survive even within a conventional banking framework. Islamic banks offer products and services which are very similar to conventional banks. However, the approaches of Islamic banks are clearly different from the ones of conventional banks (Ahmad, 2000; Chapra, 2000; Ahmad and Hassan, 2007). On another matter, there is a lack of interbank money market which also affects the performance of the Islamic banking in Bangladesh. Legal reserve requirements have also been observed. According to Ahmad and Hassan (2007), the independent banking act should be constituted to control, guide and supervise the operations and practices of Islamic banks. From the empirical studies that have been conducted, there is strong evidence to believe that efficiency gains can be secured through competition. In other words, regulation, if properly implemented, will enhance competition and make the bank more effective in the market place framework.

4. Methods: 4.1 Ratio Analysis:

This study uses ratio analysis measurements in analyzing the banks’ performance. This method has been adopted by many researchers, such as Chen and Shimerda (1981), Sabi (1996), and Ahmad and Hassan (2007). This methodology shows various positive aspects, however the main advantage is that this method removes existing disparities. It is common that banks that are used as the subject matter of the research are not equal in terms of size. This method removes disparities and brings all banking firms at par. In this study, five Islamic banks in Bangladesh are included. The financial statements that are used for the research are obtained from the annual report of each banks and are taken from the period of 2006 to 2010.

4.2 Profitability Ratio: 4.2.1 Return on Asset Ratio (ROA):

ROA is the indicator of measuring managerial efficiency. Return on Asset ratio shows how a bank can convert its asset into net earnings. The formula for calculating return on asset ratio is, Return on Assets (ROA) = Net Profit % Total Assets. A higher ratio indicates a higher ability and therefore is an indicator of better performance.


4.2.2 Return on Equity Ratio (ROE) : ROE is an indicator of measuring managerial efficiency. ROE shows how well a

company uses investment funds to generate earnings. It measures a firm’s efficiency at generating profits from every unit of shareholders’ equity. A higher ratio is an indicator of higher managerial performance. The formula for calculating ROE is, Return on Equity (ROE) = Net Profit % Equity.

4.3 Credit Risk Performance: 4.3.1 Equity to Total Assets ETA:

The ETA ratio is used to measure the credit risk performance of banks. The formula to calculate the ETA ratio is Common Equity % Assets. This ratio measure’s the equity capital in the form of a percentage with regard to total assets. It shows the potential of protection of the banks against investment and assets. It also demonstrates capacity of shock absorbance for losses of potential loaned assets. A high ratio is favorable for the bank in order for it to maintain the assets losses.

4.3.2 Capital Adequacy Ratio (CAR): The CAR is a measure of the amount of a bank’s capital expressed as a percentage

of its risk weighted credit exposures. A high CAR doesn’t always indicate good performance. Having a high CAR will mean that large amount of money of the bank is stuck in provisions or risk management, which translates to limited money for investment. A standard CAR is around 12%. CAR is calculated as CAR= Tier One Capital Tier Two capital % risk weighted Assets.

4.4 Managerial efficiency: 4.4.1 Income Expense Ratio (IER):

The IER is the ratio that measures the amount of income earned per dollar of operating expense. This is the most commonly and widely used ratio in the banking sector to assess the managerial efficiency in generating total income in respect of controlling its operating expenses. A high IER is preferred over a lower one as this indicates the ability and efficiency of the bank in generating more total income in comparison to its total operating expenses. IER is calculated as IER = Total Income % Total operating expenses.

4.5 Management Ability: 4.5.1 Asset Utilization (AU):

How effectively the bank is utilizing all of its assets is measured by the assets utilization (AU) ratio. The bank is presumably said to be using its assets effectively in generating total revenues if the AU ratio is high. If the AU ration is low, the bank is not using its assets to its optimum capacity and should either increase total revenues or dispose of some of the assets (Ross et.al., 2005). AU is calculated as AU = total revenue % total asset.

4.6 Data Envelopment Analysis (DEA) : The DEA was initially developed by Charnes et.al., (1978) to evaluate the

efficiency of public sector non-profit organizations. However, Sherman and Gold (1985)


were the first to apply DEA to banking. DEA is a mathematical linier programming approach based on the technical efficiency concept, which can be used to measure and analyze the technical efficiency, which reflects the ability of a firm to obtain maximum output from a given set of inputs, of different entities: productive and non productive, public and private, profit and nonprofit seeking firms. There is an increasing concern in measuring and comparing efficiency of firms under different environments and activities.

Usually, the DEA does not require specifying the functional form or distributional forms for errors and it is more flexible than the parametric approach. It can be applied to multi-input and multi-output variables, thus, it has been extensively used in measuring the efficiency of banks in many countries. However, the DEA has some limitations. When the integrity of data has been violated, DEA results cannot be interpreted with confidence. Furthermore, the DEA approach does not allow for any error in the data.

4.7 Sample Size: The motivation of this paper is to investigate the banking performance and

efficiency using the ratio analysis and the DEA respectively. To achieve the objective of this study, five Islamic banks are included in the analysis, which are Islami Bank Bangladesh Limited, Al-Arafah Islami Bank Limited, Social Islamic Bank Limited, Shahjalal Islami Bank Limited and First Security Islami Bank Limited.

Total deposits are estimated as an input variable, whereas total assets and total financing are considered as output variables. The data are acquired from the annual reports of each respective banks.

5. Empirical Result and Discussion: 5.1 Ratio Analysis: 5.1.1 Profitability Ratios: ROA and ROE:

Table 1 shows that the ROA of AIBL was greater than other Islamic banks in the year 2006. Then it decreased significantly from 2.20 % to 0.519% (323.89% decreases) at the end of year 2010. In year 2007, SJIBL had the higher ROA (2.28%) but year 2008 and 2009 it decreased. After comparing the overall ROA among these banks, we found that all banks except SJIBL and AIBL have the consistency in increasing the ROA during the period (2006-2010). Finally, the ROA on average is higher in SJIBL (2.0309%) than other Islamic banks. This indicates that SJIBL has better managerial performance to that of other Islamic banks. At the same time, the risk level of this profitability, which is measured by the standard deviation, are quite small for all the banks.

Table 1. Ratio Analysis for ROA Year Bank 2006 2007 2008 2009 2010 Mean Std.Dev.

IBBL 0.754% 0.579% 0.929% 0.999% 1.006% 0.854% 0.002 AIBL 2.200% 1.151% 1.797% 1.771% 0.519% 1.488% 0.007 SIBL 0.293% 0.611% 0.678% 0.739% 0.895% 0.643% 0.002 SJIBL 2.170% 2.282% 1.854% 1.817% 2.630% 2.031% 0.003 FSIB 0.573% 0.114% 0.334% 0.681% 1.010% 0.543% 0.003

Table 2 shows that the ROE of FSIB is slightly lower than the average of other banks. One of the reasons of this lower ROE is that FSIB is paying a much higher share in profit for its depositors than the available deposit rate compared to the other Islamic


banks. If we compare all the banks based on the average, AIBL has the highest ratio (19.525%), showing that it has good managerial performance.

Table 2. Ratio Analysis for ROE Year

Bank 2006 2007 2008 2009 2010

Mean Std.Dev.


5.1.2 Credit Risk Performance: ETA and CAR: The ETA ratio shows the potential of protection of the banks against investment

and assets. It also demonstrates capacity of shock absorbing for losses of potential loan assets and how the Islamic banks use their equity funds to support the bank’s assets side. The higher ratio is favorable for the bank as it equates to stronger ability to maintain the assets losses.

Table 3. Ratio Analysis for ETA Year

Bank 2006 2007 2008 2009 2010

Mean Std.Dev.


Table 3 shows that the average ETA of SJIBL is 10.809%. Other banks, however, have attained a result of less than 10%, which implies that they rely on a large proportion of liabilities instead of equity to support their assets. The high ETA for SJIBL explains that the equity’s fund for SJIBL can better support the total asset than the other banks.

5.1.3 Capital Adequacy Ratio (CAR): Capital adequacy ratios measure the amount of a bank’s capital in relations to the

amount of its risk weighted credit exposures. The higher the capital adequacy ratios a bank has, the greater the level of unexpected losses it can absorb before becoming insolvent. Table 4 shows that, on average, AIBL has a higher ratio (11.98%) than other Islamic banks. However, having to high of a CAR may be translated to the bank having a large amount of money stuck in its provisions or risk management, further implying that that there will be less money left for investment or for the continuation of the business activity. The usual standard benchmark for a CAR is somewhere around 12%.


Table 4. Ratio Analysis for CAR Year Bank 2006 2007 2008 2009 2010 Mean Std.Dev.


5.1.4 Managerial efficiency: IER:

The Income to expense (IER) is the most commonly and widely used ratio in the banking sector to assess the managerial efficiency in generating total income in respect of controlling its operating expenses. Table 5 shows that the IER of AIBL was greater than other Islamic banks in year 2006. When comparing the overall ROE among these banks, we found that only SIBL has the consistency in increasing the IER during this the period of 2006-2010. Finally, on average, the IER of SJIBL (186.52%) is higher than others Islamic banks. This higher IER ratio indicates that SJIBL has the ability and efficiency in generating more total income in comparison to its total operating expenses.

Table 5. Ratio Analysis for IER Year Bank 2006 2007 2008 2009 2010 Mean Std.Dev.


5.1.5 Management Ability: AU The asset utilization ratio (AU) measures the management’s ability to make the

best use of its assets to generate revenue. A high ratio for a particular bank indicates that it has a more efficient management. Table 6 shows that, in the year 2006, AIBL had the higher AU ratio (4.00%) compared to other Islamic banks. But the following year its AU decreased very sharply. We found that only SIBL has a consistently increasing AU ratio during the tested period. On average, the AU of SJIBL (4.47%) is higher than other banks. This shows that SJIBL is using its assets effectively up to its optimum capacity in order for it to generate total revenues.

Table 6. Ratio Analysis for AU Year Bank 2006 2007 2008 2009 2010 Mean Std.Dev.



5.2 Empirical result on the Data Envelopment Analysis (DEA): This part discusses the findings of the efficiency index summary and Malmquist

index summary of Islamic banking in Bangladesh using the DEA approach. Table 7 shows a summary of the overall efficiency, including the technical efficiency (TE) from constant return to scale and TE from variable return to scale. A Constant Return to Scale (CRS) refers to when the output increases are at the same proportional change. Unlike CRS, variable returns to scale (VRS) means that the proportional change varies in term of input and output. In this study, the overall summary is 1.000, which means that the TE from constant return to scale and TE from variable return to scale are efficient. The scale efficiency is also founded to be 1.000 because the scale efficiency is equal to the ratio of technical efficiency from constant return to scale and technical efficiency from variable return to scale.

Table 7. Efficiency Summary

Bank Name TE from CRS TE from VRS Scale of Efficiency AIBL 1.000 1.000 1.000 IBBL 1.000 1.000 1.000 FSIB 1.000 1.000 1.000 SJIBL 1.000 1.000 1.000 SIBL 1.000 1.000 1.000 Mean 1.000 1.000 1.000

Table 8 summarizes the distances, which means the changes efficiency in terms of

years. Here, the “t” is considered as the current year, “t-1” and “t+1” refer to the previous and following years respectively. In this table, “t-1” in year 2006 and “t+1” in the final year is not defined because the change of measurement is not possible due to unavailable data. If the efficiency result is 1, it means that the result is accurately efficient, and the more it is closer to 1, the more efficient it is. A result of more than 1 refers to improved efficiency in terms of efficiency measurement. The overall results show that changes in efficiency in terms of years have improved from year 2006 to 2010, indicated by an efficiency of more than 1.000.

Table 8. Summary of Distances TE from CRS related to ΔTE Year: t-1 t t+1

Variable Returns to Scale (VRS)

Year 2006 AIBL 0.000 1.000 1.074 1.000 IBBL 0.000 1.000 0.945 1.000 FSIB 0.000 1.000 1.088 1.000 SJIBL 0.000 1.000 1.062 1.000 SIBL 0.000 1.000 1.118 1.000 Mean 0.000 1.000 1.057 1.000






Note: t-1 in the first year and t+1 in the final year are not defined.

Table 9 represents the Malmquist index summary. The Malmquist Productivity Index (MPI) measures productivity changes along with time variations. It can be decomposed into changes in efficiency and technology. This table includes the change of efficiency, change of technical efficiency, change of pure efficiency, change of scale efficiency, and the change of total factor efficiency. The MPI is a popular technique for efficiency measurement of banks.


Table 9. Summary of Malmquist Index

ΔEfficiency ΔTE ΔPure

Efficiency ΔScale

Efficiency ΔTotal Factor

Efficiency Year 2007

AIBL 1.000 0.951 1.000 1.000 0.951 IBBL 1.000 1.089 1.000 1.000 1.089 FSIB 1.000 0.965 1.000 1.000 0.965 SJIBL 1.000 0.970 1.000 1.000 0.970 SIBL 1.000 1.058 1.000 1.000 1.058 Mean 1.000 1.007 1.000 1.000 1.007

Year 2008 AIBL 1.000 1.015 1.000 1.000 1.015 IBBL 1.000 0.952 1.000 1.000 0.952 FSIB 1.000 1.876 1.000 1.000 1.876 SJIBL 1.000 1.000 1.000 1.000 1.000 SIBL 1.000 1.162 1.000 1.000 1.162 Mean 1.000 1.201 1.000 1.000 1.201



The overall result of the Malmquist Index Summary shows that changes of technical efficiency and changes of total factor efficiency is the same for all of the banks involved. This is because the changes of total factor efficiency depend on the changes of technical efficiency. On average, we found that the result is more than 1.000, which means an improved level of efficiency. However, in terms of change of efficiency,


change of pure efficiency and change of scale efficiency, the results are 1.000, which means that they are efficient.

Table 10. Malmquist Index Summary of Bank Means

ΔEfficiency ΔTE ΔPure

Efficiency ΔScale

Efficiency

ΔTotal Factor

Efficiency AIBL 1.000 0.974 1.000 1.000 0.974 IBBL 1.000 1.010 1.000 1.000 1.010 FSIB 1.000 1.219 1.000 1.000 1.219 SJIBL 1.000 1.191 1.000 1.000 1.191 SIBL 1.000 0.960 1.000 1.000 0.960 Mean 1.000 1.071 1.000 1.000 1.071

The above stated Table 10 is the Malmquist Index Summary of the Banks which provides the efficiency statistics separately in for AIBL, IBBL, FSIB, SIBL and SJIBL. If we compare the overall means among these banks, First Security Islami Bank (FSIB) seems more proficient in terms of efficiency.

6. Conclusion: This study is aimed at investigating the performance and efficiency of Islamic

banks in Bangladesh, within the period of 2006 to 2010. It uses ratio analysis to measure the performance of the Islamic banks and DEA with Malmquist Index to measure the efficiency of the Islamic banks. The result concludes that Shajalal Islami Bank limited has performed better than other Islamic banks in terms of ratios analyzed, namely ROA, ROE, ETA, CAR, IER and AU. Moreover, the result of DEA reveals that the trend of all Islamic banks was on the rising stage during year 2006 to year 2010, suggesting that the Islamic banks have improved their efficiency over the study period. In every aspect, AIBL, IBBL, FSIB, SJIBL and SIBL seem competent in terms of efficiency. More specifically, between these five banks, First Security Islami Bank (FSIB) seems to be the most competent in terms of efficiency.

6.1 Limitations and Suggestions: This empirical research has some limitations and further research should be

considered to gather more information. In this paper we have focused only on six ratios due to data constraints. For further study, we should consider non-performing ratios. On another note, in the DEA application we also have some limitations as well. Firstly, the DEA approach does not allow for any error in the data which is quite unrealistic. In this case, the stochastic frontier approach has to be focused on. Secondly, we only use five years of yearly data. The data was taken from the Annual Reports and the duration was from 2006 to 2010. Lastly, in this research we only used one input and two outputs. For further research, the researchers need to increase the number of time period use as well as to increase the number of inputs and outputs. The last suggestion would be to also include a comparison with conventional banks.


7. References: Ahmad, A.U.F. and Hassan, M.K. (2007), “Regulation and Performance of Islamic

Banking Bangladesh”, Thunderbird International Business Review, Vol. 49 No. 2, pp. 251-277.

Ahmad, K. (2000), “Islamic finance and banking: the challenge and Prospects”, Review of Islamic Economics, Vol. 9, pp. 57-82.

Ahmed, E., Rahman, Z., and Ahmed, R.I. (2006), “Comparative analysis of loan recovery among nationalized, private, and Islamic commercial banks of Bangladesh”, BRAC University Journal, Vol. 3 No. 1, pp. 35-52.

Chapra, M.U. (2000), “Why has Islam prohibited interest: rationale behind the prohibition of interest”, Review of Islamic Economics, Vol. 9, pp. 5-20.

Charnes, A., Cooper, W.W., and Rhodes, E. (1978), “Measuring Efficiency of Commercial Banks with the Use of Financial Ratios: Data Envelopment Conventional Banks”, IIUM Journal of Economics and Management, Vol. 7 No. 1, pp. 1-25.

Chen, K.H., and Shimerda, T. (1981), “An Empirical Analysis of Useful Financial Ratios”, Financial Management, Vol. 10 No. 1, pp. 51-60.

Dar, H., and Presley, J. (2000), “Lack of Profit Loss Sharing in Islamic Banking: Management and Control Imbalances”, International Journal of Islamic Financial Services, Vol. 2 No. 2, pp. 3-18.

Koopmans, T.C. (1951), “An analysis of production as an efficient combination of activities”, In Koopmans, T.C. (Ed.), Activity Analysis of Production and Allocation, Monograph No.13, Cowles Commission for Research in Economics, Wiley, New York, NY.

Kumbhakar, S.C. and Lovell, C.A.K. (2003), Stochastic Frontier Analysis, Cambridge, University Press, Cambridge.

Molla, R.I., Moten R.A., Gusau, S.A., and Gwandu, A.A. (1988), Frontiers and Mechanics of Islamic Economics, University of Sokoto, Nigeria.

Ross, S.A., Westerfield, R.W., and Jaffe, J. (2005), Corporate Finance, McGraw-Hill Inc. Sabi, M. (1996), “Comparative Analysis of Foreign and Domestic Bank Operation in

Hungary”, Journal of Comparative Economics, Vol. 22 No. 2, pp. 1979-88 Sarker, M.A.A. (1999), “Islamic banking in Bangladesh: performance, problems, and

prospects”, International Journal of Islamic Financial Services, Vol. 1 No. 3, pp. 15-36. Shameem, A.K.M. (1995), “Impact of Flexible Interest Rate on Savings and

Investment”, Bangladesh Journal of Political Economy, Vol. 13 No. 2, pp. 62-78. Sherman, D. and Gold, F. (1985), “Branch Operating Efficiency: Evaluation with Data

Envelopment Analysis”, Journal of Banking and Finance, Vol. 9, pp. 297-315. Siddiqi, M.N. (1983), Banking without Interest, Leicester, The Islamic Foundations. Warde, I. (2000), Islamic Finance in the Global Economy, Edinburgh University Press.


Country Model: Bangladesh Introduction:

The People's Republic of Bangladesh is the 8th most populous country and third largest Muslim country. The history of Islamic banking in Bangladesh started with the establishment of Islamic bank Bangladesh Limited (IBBL) in 1983. Today the Islamic banking industry in the country comprises of 7 full fledged Islamic banks and 13 conventional banks having Shariah compliant windows and counters constituting more than 15 percent share of overall banking industry1. Six full fledge takaful operators and 13 Shariah compliant windows of conventional insurance are also operational in the country.

The highlight of Islamic Finance of Bangladesh is that it is the first country to adopt Islamic microfinance (MF) in the world. At present Islamic MF in Bangladesh though constitutes only 1 percent of MF industry of the country, however, in terms of clients it is still the largest among global Islamic MF.

Historical Evolution of Islamic banking:

The initiation of Islamic banking in Bangladesh was led by a volunteer organization; the Bangladesh Islamic Bankers Association, having an objective of making Bangladesh a riba free economy. As a result of their efforts and effective lobbying the very first Islamic bank; Islami Bank Bangladesh Ltd (IBBL) was established in early 80‟ s. IBBL was not only the start of Islamic banking in Bangladesh but also in South East Asia. IBBL was a joint venture of multinational institutions including Islamic Development Bank (IDB) Al-Rajhi Company for Currency Exchange and Commerce of Saudi Arabia, Kuwait Finance House, Jordan Islamic Bank, Islamic Investment and Exchange Corporation of Qatar, Bahrain Islamic Bank, Islamic Banking System International Holding S.A, Dubai Islamic Bank, Kuwait Ministry of Awqaf and Islamic Affairs, with Bangladeshi government having a 5 percent share in paid up capital. Realising the lack of Shariah complaint instrument and markets in the country and to encourage new entrants the central bank of Bangladesh provided preferential provisioning like low statutory liquidity reserve (SLR) for Islamic banks compared to conventional banks .

On Regulation and Legislation front progress remained relatively slow; amendments were made to accommodate the special requirements of Islamic banks including amendments in Income Tax Ordinance (1984) that viewed the profits paid 1 Source: Reuters‟ report [accessed on Feb 25, 2012] Source: Quarterly Islamic Banking Bulletin, State Bank of Pakistan


on Mudaraba as expenditure. These changes have provided a conducive environment for the growth of Islamic banking in prevailing parallel banking model; however, this remained unsuccessful in absolution of interest from the economy. The Central bank of Bangladesh, Bangladesh Bank, also established a Research and Islamic Economic Division within the bank during the start of 90‟ s.

Realizing the limited avenues of investment for Islamic banks, Bangladesh Bank on behalf of the government has issued the very first Sharaih Compliant bond; “Government Islamic Investment Bond” in 2004. Subsequently in 2007, IBBL issued Mudaraba Perpetual Bond (MPB) in 2007. These bonds have provided an attractive Investment avenue for Islamic banks and have also impacted the capital market positively.

On the operational and management side, the Bangladesh Bank issued guidelines in 2009 after detailed discussion with Islamic banks as well as Central Shariah Board of the country. These guidelines cover areas like corporate and Shariah governance, product definitions and operational frameworks, alternative investment modes, and conversion of conventional banks into Islamic banks. The central bank has also issued short term money market instruments for Islamic banks enabling them to manage their liquidity efficiently.

Though the regulation and legislation for Islamic banking in the country has not been very progressive due to failure of efforts to include Islamic banking Act in the prevailing Banking Act 1991, the industry has shown considerable growth over the years.

While Islamic banking Industry has progressed in Bangladesh since the inception of the first bank in the country in 1983, in order to sustain this growth serious efforts are required to provide conducive policy environment by introducing dedicated regulatory framework for Islamic banking industry in the country. Moreover Islamic Banks need to invest in human resource and innovative products to cater to growing demands from a Muslim dominant society.

References: • Salim, & Islam, S (2011).; “Analysis of the Operational Efficiency of Commercial

Banks: A Study of the Islamic Banks in Bangladesh”, Journal of Banking & Financial Services, University of Dhaka, Vol. 5, No. 1, July 2011

• Z Mamun, M (2011).; “Prospects and Problems of Islamic Banking from Bank’s Perspective: A Study of Bangladesh” 8th International Conference on Islamic Economics and Finance

• Islam et al. (2011); “The Role of Mudaraba Perpetual Bond (MPB) of IBBL for Development of Bangladesh Bond Market”, Thoughts on Economics, Vol 21, No. 4

• Global Islamic Finance Report 2011, BMB Islamic UK Limited • Global Islamic Finance Report 2012, BMB Islamic UK Limited • Sarker, A.A; “ The Need for Regulatory Framework for Islamic Banks and Islamic

Financial Institutions in Bangladesh” • Sarker,A.A; " Islamic Banking in Bangladesh: Achievements & Challenges" • Reuters‟ report [accessed on Feb 25, 2012]

http://www.reuters.com/article/2012/06/05 /islamic-finance-liquidity-idUSL5E8H45DN20120605


http://www.reuters.com/article/2012/06/05/islamic-finance-liquidity-idUSL5E8H45DN20120605

http://www.reuters.com/article/2012/06/05/islamic-finance-liquidity-idUSL5E8H45DN20120605

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Meezan Bank signs MoU with Journal of Islamic Banking and Finance for research

on Islamic Finance March 18, 2013 - Karachi: Meezan Bank, Pakistan’s first and largest Islamic

Bank, has signed MoU with the Journal of Islamic Banking and Finance (JIBF), one of the oldest Islamic finance research publications of Pakistan (1984), under which Meezan Bank will contribute its research and articles on Islamic Banking & Finance to JIBF for publication. With the objective to bridge the gap between academia and industry, Meezan Bank with its largest research team across all Banks in Pakistan, will share case studies, research papers and articles with JIBF. The agreement was jointly signed by Meezan Bank's Head of Consumer Banking & Marketing, Mr. Muhammad Raza and Unit Head Shariah Audit, Mr. Farhan Ul Haq Usmani with JIBF's Chairman, Mr. Basheer Ahmed Chowdry and Chief Editor, Mr. Aftab Siddiqui. Mr. Ahmed Ali Siddiqui, Head of the Product Development & Shariah Compliance at Meezan Bank said "Meezan Bank’s efforts are focused towards its Vision of establishing Islamic banking as banking of first choice and this initiative is an example of the Bank’s dedication towards this cause."


SBP to launch media campaign for promotion of Islamic banking

KARACHI: The Deputy Governor, State Bank of Pakistan (SBP), Kazi Abdul Muktadir has said that a comprehensive media campaign for promoting inherent strengths of Islamic finance and clearing common apprehensions, confusions and misconceptions about Islamic banking and finance is being launched shortly.

"This campaign is to be led by the Islamic banking industry with the support of SBP", he said in his opening remarks while chairing a meeting for initiating the media awareness campaign to promote Islamic banking in Pakistan at SBP.

He said that preliminary findings of SBP comprehensive country-wide survey on "Knowledge, Attitude & Practices of Islamic Banking in Pakistan" suggest the dire need for initiating mass awareness campaign to increase public trust and confidence in Islamic banking.

The SBP Deputy Governor said that since 2001, the Islamic banking industry has been able to maintain strong momentum with annual growth rate of above 30 percent, a network of 1100 branches in 79 districts across the country, and market share of approximately 10 percent.

He observed that despite this growth, the industry is still facing many issues and challenges which, among others, include limited human resource capacity and low awareness and understanding of public at large about Islamic banking and its distinction over conventional banking. "The low awareness and understanding has been a major reason for mis-perceptions and confusions about the need, utility and Shariah permissibility of Islamic finance", he added.

Abdul Muktadir set up a 7-member Steering Committee for launching the media awareness campaign. Headed by Irfan Siddiqui, President, Meezan Bank, the Committee members include Hasan Bilgrami, President Bank Islami Pakistan, Junaid Ahmad, President Dubai Islamic Bank, Mohsin Ali Nathani, President Standard Chartered Bank, Nauman K. Dar, President Habib Bank, Atif Bajwa, President Bank Alflah, and Saleem Ullah, Director Islamic Banking Department, SBP. "The Committee may constitute one or more sub-committees to undertake and execute various components of the media campaign", he added.

He said the State Bank and Islamic Banking Institutions (IBIs) have taken several initiatives to enhance the public awareness about Islamic Banking and Finance by holding seminars, conferences etc., but no significant effort has so far been made to create mass awareness using electronic and print media.

The SBP Deputy Governor expressed his confidence that this initiative will be instrumental in significant improvement in awareness about Islamic banking and lead to further acceleration in the growth of Islamic banking. Source: Business Recorder


http://www.brecorder.com/top-news/108-pakistan-top-news/105740-sbp-to-launch-media-campaign-for-promotion-of-islamic-banking.html

http://www.brecorder.com/top-news/108-pakistan-top-news/105740-sbp-to-launch-media-campaign-for-promotion-of-islamic-banking.html

Meezan Bank records good growth in first quarter 2013 Dubai, April 30, 2013: The Board of Directors of Meezan Bank approved the

financial statements of the Bank for the quarter ended March 31, 2013 in its meeting held at Dubai on April 30, 2013. H. E. Sheikh Ebrahim Bin Khalifa Al-Khalifa, Chairman of the Board presided the meeting that was also attended by Mr. Abdullateef A. Al-Asfour, (Vice Chairman) and other Directors.

Meezan Bank recorded 9% growth in its Profit-after-tax which increased to Rs. 982 million compared to Rs. 903 million earned in the corresponding period of 2012. The Earnings per Share of the Bank increased to Rs. 0.98 (March 2012: Rs. 0.90) on the enhanced share capital of Rs. 10 billion. Deposits of the Bank grew to Rs. 235 billion as at March 31, 2013 (Dec 2012: Rs 230 billion)

The increase in profit has been achieved despite the monetary easing of 400 basis points by the State Bank of Pakistan during the last eighteen months. The Bank’s share capital increased to Rs. 10 billion with the issuance of 11% bonus shares approved by the shareholders in the Bank's 17th Annual General Meeting held on March 28, 2013. Accordingly, Meezan Bank has met SBP minimum capital of Rs. 10 billion required to be completed by December 2013, a year in advance.

The JCR-VIS Credit Rating Company Limited, an affiliate of Japan Credit Rating

Agency, Japan has maintained the Bank’s long-term entity rating at AA- (Double A Minus) and short term rating at A1+ (A One Plus) with stable outlook. The short-term rating of A1+ is the highest standard in short-term rating. The rating indicates sound performance indicators of the Bank.

Meezan Bank's is Pakistan's 8th largest bank in terms of branch network, with 313 branches in 91 cities of the country. The Bank has been consistently recognized as the best Islamic Bank in Pakistan by various local and international institutions over the past several years.

Meezan Bank Hosts the First Industry Forum on Challenges in Islamic Treasury Operations

Karachi, Meezan Bank Limited took the initiative to introduce the first ever forum on Challenges in Islamic Treasury operations. The forum’s first session was held at Meezan Bank and was attended by many leading Shariah Advisors including Dr Imran Usmani, Mufti Irshad Ijaz, Mufti Khalil Aazmi, Mufti Zahid Siraj, Mufti Najeeb Khan, Mufti Hasaan Kaleem, Mufti Ebrahim Essaa, Mufti Bilal Qazi and many Product development professionals. Many issues related to treasury operations were discussed. Both Islamic Commercial Banks and Islamic Bank windows welcomed the initiative.

Prolific discussion over recent issues in FX Trading and Interbank Products was held and the participants agreed to standardize the FX and Interbank Musharakah Agreements among the Islamic Banks and Islamic Windows, which would help Islamic Banks solve their problems of deploying excess liquidity. All the participants agree that this forum has the potential of becoming a representative forum of Islamic Financial Institutions and will play a crucial role in addressing the issuing pertaining to the Industry by providing an opportunity to Shariah and Product Experts of the industry to share their


experiences and knowledge. The forum was concluded with a vote of thanks by the attendees.

Burj Bank concludes a successful year of serving its customer Karachi: the Bank launched Burj Bank has concluded 2012 as a turnaround year

in terms of service delivery with the announcement of its annual financial results. The Bank started the year 2012 with a focus on delivering world class Shari’ah compliant banking services to its customers. During the year, & established an array of products & the Bank posted an after tax profit of Rs.85 mn for 2012; with a basic/diluted EPS of Re.0.114 per share posted for the year. The Bank’s deposit base grew from Rs.20 billion to Rs.36 billion reflecting a deposit growth of 77% whereas the total assets grew from Rs.27.6 bn to Rs.47 bn reflecting 70% growth during the year.

The balance sheet growth was achieved while following a focused re-pricing strategy for both liabilities and assets. As a result of the customer’s trust, innovatively designed branches was amongst the several customer focused initiatives which the Bank undertook during the year. The customers have responded positively to the Bank’s service quality which has resulted in significant balance sheet growth for the Bank. In 2012, the Bank has also converted to the iMal Islamic Core Banking system within a record time of nine months to enhance the touch point capabilities of the Bank and the overall customer experience. Source: Burjbanktld.com.

IBA Holds a Comprehensive Workshop on Islamic Capital Markets Karachi: IBA Karachi, the one of the top ranked business school of South Asia,

organized a 5 day workshop on Islamic Capital Markets which was attended by many Islamic Bankers along with representatives from the State Bank of Pakistan and the Security and Exchange Commission of Pakistan.

Dr. Kabir Hassan, Professor of Finance from the University of New Orleans conducted the workshop. Dr. Kabir’s area of research has been Islamic Finance and he has been a prominent speaker on a number of high profile forums across the gulf. The workshop specifically revolved around the Islamic Sukuk markets and the different structures being used in Sukuks in different countries. Mufti Irshad, Shariah Advisor, Bank Islami Pakistan also gave a telephonic talk to the participants on how Islamic Capital Market in Pakistan function and what are the areas of improvement. All the attendees benefited by this workshop and showed their support for more similar workshops in the time to come.

A Tailor-made Workshop Conducted for Business & Finance Journalists on Islamic Banking Concepts

April 23, 2013, Karachi: Meezan Bank Limited, the Premier Islamic Bank of Pakistan conducted a workshop on the Concepts of Islamic Banking for various leading Business & Finance Journalists at Meezan House. The workshop was aimed at increasing the understanding of Islamic Finance in today’s world.

The concepts and principles of Islamic Banking were discussed in detail with the participants, and the response from the audience was overwhelming. Mr. Ahmed Ali Siddiqui, Head of Product Development and Shariah Compliance conducted the


workshop. There was representation from various media personnel from Financial Daily, Daily Jehan Pakistan, Abb Takk, Bloomberg, Daily Times and Express.

This was yet another industry specific initiative taken by Meezan Bank. The participants appreciated the efforts of Meezan Bank and gave concluding remarks by a vote of thanks followed by distribution of certificates.

IFC and BankIslami Sign Accord to Support Cross-Border Trade, Economic Development in Pakistan

Karachi: IFC, member of the World Bank Group, and BankIslami Pakistan Limited signed an agreement that will help Pakistani companies access global import and export markets, spurring trade, production, economic growth, and job creation.

The agreement sees BankIslami joining IFC’s Global Trade Finance Program, which promotes trade in emerging markets by supporting the flow of goods and services. Under this agreement, IFC will support BankIslami’s trade finance business by providing partial or full guarantees for individual trade transactions.

“IFC guarantees will help Pakistan’s private sector access global markets and in turn contribute to economic growth and job creation,” said Hasan Bilgrami, Chief Executive Officer of BankIslami. “It is a testament to the strong business franchising and expanding market share of BankIslami in general and in the Islamic banking sector in particular.”

Since the trade finance program’s inception in Pakistan in 2006, IFC has provided more than 3,500 guarantees worth $1.74 billion to financial institutions, helping to drive trade and create jobs.

“Trade finance is the engine of an estimated $14 trillion in annual global commerce,” said K. Aftab Ahmed, IFC Director for Financial Markets and PE Funds for Europe, Central Asia, Middle East and North Africa. “With easy and affordable access to trade finance, local entrepreneurs can reach new markets, grow their businesses, and hire more employees.”

Close to 85 percent of IFC’s trade finance guarantees in Pakistan covered the import of products which are crucial for sustainable economic growth. Those included food and raw materials used in industrial production.

Pakistan is a priority country for IFC. During the last three years, IFC has ramped up its investments and advisory services work in the country, supporting the development of Pakistan’s private sector. IFC has focused on mobilizing investments in power and infrastructure, and providing access to finance for micro, small, and medium enterprises through financial intermediaries.

Meezan Bank Introduces an Innovative Musharakah Based Financing to Asset Management Companies

Karachi: Meezan Bank Limited has successfully executed a short term Musharakah to facilitate the financing needs of Al Meezan Investment Management Limited (AMIM) which is also the largest Islamic Fund manager of the country.


In this transaction, Meezan Bank and AMIM has entered into a Musharakah Shirkat-ul-Aqd and invest their agreed investment shares in the identified special pool of business assets/operations of AMIM. The actual profits of the business pool earned during the tenor of Musharakah will be shared between Meezan Bank and AMIM as per pre-agreed profit sharing ratios agreed at the start. In case of loss to the Musharakah the loss shall be shared between the parties as per their investment ratios in the Musharakah.

The transaction was structured jointly by the Bank’s Product Development and Corporate Finance Team comprising Mufti Bilal Ahmed Qazi – Shariah Scholar, Mr. Suleman Muhammad Ali- Unit Head Product Development & Shariah Compliance and Mr. Fahad Iqbal – Asst. Vice President Corporate Finance Department.

Meezan Bank is renowned for its strength in innovation and product development throughout the industry and in this case, this product solves the problem of asset management companies in availing funding from Islamic financial institutions due to the lack of assets on their Balance Sheets. The Bank has been instrumental in structuring various Shirkat-ul-Aqd based solutions; considered an optimum level of Shariah compliant financing instrument by Shariah Scholars. The bank has also structured various Shirkat-ul-Aqd based sukuk issues in recent times.

BankIslami successfully achieves branch expansion target of 141 branches in 66 Cities

Karachi: BankIslami Pakistan Limited has successfully completed its expansion target of 2012. The Bank opened 39 Branches/Sub-Branches taking its network to 141 Branches/sub-branches covering 66 cities, a statement issued here said.

The statement further said that BankIslami has also received permission from the State Bank of Pakistan to add further 60 branches/sub-branches in 2013. This expansion will see the network expand to 200 branches/sub-branches covering more than 100 cities.

The second phase of expansion is expected to take the network to 300 branches in next three years covering approximately 150 cities further consolidating its position as the second largest Islamic bank in Pakistan. The Bank further added that expects to report better operating results despite of almost 100% expansion in two years and drastic cut in the policy rates.


Meezan Bank Conducts an Exclusive Seminar on Islamic Banking for Businessmen of Islamabad

Islamabad: Meezan Bank Limited conducted a seminar on “Islamic Bank” for Traders of Sabzi Mandi, Fruit Mandi and Grain Market in I-11 Islamabad. There was an overwhelming turn up at the venue of the seminar which was held at the nearby area of these markets. The Seminar was attended by the Senior and Middle management of all Trade Unions and key traders of these markets.

Mr. Ahmed Ali Siddiqui - Head of Product Development and Shariah Compliance, conducted the seminar and talked about how Islamic Banking has rapidly grown in the country due to its dynamic and vibrant nature. Mr. Ahmed Ali Siddiqui informed the audience that Islamic Banks have developed various Islamic products that any conventional bank offers. He also clarified the difference of “Islamic” and “Conventional” Banking. Upon conclusion of the presentation, the Q & A session was held, participants asked numerous questions regarding their concerns about Islamic Banking which were answered by the Mr. Ahmed Ali Siddiqui. The audience appreciated and acknowledged the efforts of Meezan Bank are taking in promoting Islamic Banking in the country.


Note to contributorsJournal of Islamic Banking and Finance is an official publication of International

Association of Islamic Banks Karachi, Pakistan. It is a refereed quarterly journal, as well as a pioneer in the field of Islamic banking and finance being published since 1984. It provides a forum for researchers, particularly in Islamic Banking and Finance, wishing to share their expertise with a vast intelligentsia in the form of articles, research and discussion papers and book reviews. Major areas of interest for the journal include: (i) Theoretical issues in banking and financial industry specially from Islamic perspective; (ii) Empirical studies about the Islamic banking and financial institutions; (iii) Survey studies on issues in Islamic banking and financé; (iv) Analytical studies of applied Islamic banking; (v) Comparative studies on Islamic and conventional banking systems; and (vi) Short communications and interviews investigating the perceptions of leading bankers and banking experts as well as policy makers. Articles Submission:

The contributors are requested to observe the following rules. • Articles should be typed in M.S. Word and restricted to 10 to 15 pages of A-4 size

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Journal Of Islamic Banking and Finance

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