in the name of allah, the benefic ent, the...

Journal of Islamic Banking and Finance January. – March. 2012 1

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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2 Journal of Islamic Banking and Finance January. – March. 2012

Journal Of Islamic Banking and Finance

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Journal of Islamic Banking and Finance

Volume 29 January – March 2012 No. 1

Founding Chairman Muazzam Ali (Late)

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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, PH.D Legal Policy (Shariah Law) Shariah Academy, International Islamic University, Islamabad, Pakistan. Professor Dr. Khawaja Amjad Saeed FCA, FCMA Hailey College of Banking & Finance University of Punjab, Lahore, Pakistan

Dr. Mehboob ul Hassan Foreign Professor, International Islamic University of Islamabad, Pakistan

Mr. Salman Ahmed Sheikh External Reviewer Bankers Academy USA, Karachi, Pakistan Prof/ Dr. Habib ur Rahman Head Business Administration Deptt Sarhad University of Science & Information Technology, Peshawar, Pakistan Dr Muhammad Zubair Usmani Jamia Daraluloom Karachi


Journal of Islamic Banking and Finance

Volume 29 January. – March. 2012 No. 1

C O N T E N T S

1. Editor’s Note........................................................................................ 11 2. Source of Public Finance in an Islamic Economy By Salman Ahmed Shaikh....................................................................... 15 3. Application of IAS – 7 on the CFS of IFIs By Altaf Noor Ali ACA........................................................................... 33 4. The Propagation of Non-Interest Banking in Nigeria: An Appraisal Of the Ideological Risk By Abubakar S. Orisonkoko.................................................................... 45 5. The Foundation of the Islamic Financial System By Hossein Askar, Zamir Iqbal and Noureddin Krichene ........................... 61 6. Money Creation and Control from Islamic Perspective By Prof. Dr. Zubair Hasan..................................................................... 70 7. Customer’s perceptions about Shari’ah compliance of Islamic Banks in Malaysia By Abdelghani Echchabi & Hassanudden Abd. Aziz .................................. 86 8. Experience of Promotion of Islamic Banking in Pakistan Extract: Key Note Address of Governor SBP at Islamic Economic Forum, Muscat, Oman............................................... 105 9. Test Your Islamic Vocabularies ............................................................ 110 10. Note To Contributors of Articles ........................................................... 115 11. Order Form for Subscription/Ad to the Journal ....................................... 116


Editor’s Note The aim of this study on “Sources of Public Finance in an Islamic

Economy” conducted by Salman Ahmed Shaikh is to find out the ways and means available to a Government in Islamic economy to meet its budget deficit and provide finance for development, as it can not issue T. Bills and T. Bonds owing to prohibition of interest. Besides an Islamic Government has only one means for collection of revenue viz Zakat as prophet (p.b.u.h) and the pious caliphs did not impose any other tax.

The paper has discussed in details all aspects of Zakat which is an important source of public finance in Islamic economy. Religious scholars have conflicting opinions and Maudoodi also differed on the point of no taxation except Zakat. It has suggested various modes for meeting budget deficit. One of them is to bring into Zakat net several other means of income like stocks, mutual funds, debentures, bonds, rental income on houses, assets, building, agricultural and industrial income etc. Non-tax revenue can be earned from state owned enterprises like Railways, Post offer etc. It has also specified several other means of increasing income of Government which will suffice for its needs and it will not have to resort to loan on interest. The paper carries many tables containing statistics to support his suggestions.

This article on “Application of IAS-7 on cash flow statements in the financial statements of Islamic financial institutions” authored by Altaf Noor Ali discusses Cash Flow Statements of IFIs. The submission of this statement is mandatory as per IAS-7 as an integral part of its financial statements. The IAS-7 is applicable to all entities. The IAS comprises of 53 paragraphs. Two paragraphs relate to CFS of Islamic Financial Institutions but the remaining paragraphs are also not irrelevant for IFIs. The directions for compiling CFS are scanty and are over arched by general provisions. Appendix B to the Standard gives a specimen CFS statement based on direct method for financial institutions. The appendix does not provide any specimen based on indirect method.

This paper is based on study of CFS from the latest available accounts for the period ended on 31st December 2011. A copy of CFS from IFIs is provided in Enclosure – I. The objective of CFS is “providing users of financial statements with a basis to assess the ability of the entity to generate cash and cash equivalents and its needs to utilize those cash flows”. The Standard encourages its submission using direct methods as this method provides information which is not available in indirect method. But the study found that all IFIs present CFS using indirect method. It is


suggested that the bank regulator should make it mandatory for all IFIs to prepare CFS on direct method.

The second deviation is that investment made by IFIs is classified as investing activity whereas according to the Standard they should be treated as operating cash for financial institutions. The Standard has explained the reason for this decision. The paper further enumerates quite a few instances in which the IFIs have side-stepped the IAS requirements.

The purpose of preparing CFS is to facilitate the users to understand it but it has not achieved its aim as CFS are not prepared according to the guidelines of IAS and not from the point of view of the users but keeping in view the convenience of the IFIs.

The paper therefore suggests that the IAS be revised and its enforcement in substance ensured to address the concerns expressed above.

The artic le on “The Propagation of Non-Interest Banking in Nigeria: An Appraisal of the Ideological Risk” by Abubakar S. Orisankoko has tried to differentiate between Islamic banking and non-interest banking. Islamic banking is based upon commandments of God in Holy Quran and tradition of prophet (p.b.u.h.) Abolition of interest in not the only ingredient of this system. There are many other facets of Islamic banking which have also to be implemented. Some of them are enumerated below

Low Consumer lending

Profit and loss sharing

High Real Investing

Because interest was prohibited even in some other religions, therefore it is desired by some people to change the nomenclature of Islamic banking to divine banking or non-interest banking. This paper opposes these suggestions and has given reasons for this stand. It clarifies that except for prohibition of Riba which is the common ground in both Islam and Christianity, there is no other similarity between the two. Islamic banking is regulated by provisions of Shariah which contain guidance on every aspect of banking. Its aims and working are poles apart from any other system, therefore it is a very narrow interpretation of Islamic banking that it is merely ban on interest which distinguishes it from other systems. In Islamc there is a very strong condemnation of interest and warning of severe punishment Hereafter for those who continue this practice. Thus Islamic banking has quite a distinct identity and it should not be changed.

This paper on “The Foundation of the Islamic Financial System” has been written by three authors Hossein Askari, Zamir Iqbal and Noureddine Krichene.

The functions of all financial systems is to support economic growth through intermediation and channel the savings to firms, entrepreneurs and Government for investment. Islam has prescribed rules and principles of economics in financial dealings. As a result of putting some of these principles into practice, Islamic


banking and Islamic capital markets have come into existence. Basic principles of Islamic financial system have been enumerated. One of the core principles is banning of Riba. The corollary of prohibition of interest is that interest based contracts should be replaced with contracts of exchange. This is followed by a description of the ways by which this is practically done. Excessive risks taking or trade in alcoholic goods, speculation, debt trading are not allowed. All financial elements are based on risk and the sharing of profit and loss. In short no unethical activity is allowed.

This paper on “Money Creation and Control from Islamic Perspective” Prof. Dr. Zubair Hasan traces the evolution of money from the earliest period when barter system was in vogue. However it continued to change and passed through various stages when hides, skins etc performed its function followed by Bronze, Copper and lastly by Gold and Silver. Ultimately paper currency appeared on the scene. Even during the period when gold coins were in use, inflation, depression and fluctuation in prices could not be checked and they continued to plague the economy by their occasional visitation. Therefore gold standard in the present era is no remedy against these evils.

The paper diagnoses that the cause of this malady does not lie in money itself but it is human factor which is responsible. He further opines that it is the religion which can inculcate in human beings moral values which will obviate the misuse of the money which brings about these devastating calamities. All mal-practices in banking which have been banned in Islamic banking continue in conventional banking. If these are stopped we would be spared the sufferings which now occasionally afflict the banking sectors.

Abdelghani Echchabi & Hassanuddeen Abd Aziz have jointly conducted a study on “Customers’ perceptions about Shari’ah compliance of Islamic Banks in Malaysia”. It aims to find out the opinion of bank customers about the criticism that Islamic bank are not fully Shariah compliant. It also estimates the clients level of understanding Shariah compliance.

The paper has given a brief background of the establishment of Islamic banking in Malaysia parallel to conventional banking. It further gives details of Islamic banking network in Malaysia.

The paper then outlines the specific practices of Islamic banks which are the target of criticism as being non-Shariah compliant e.g. bench marking to conventional banks interest rate etc. The paper quotes many authors who have objections to several practices of Islamic banks as being non-Shriah compliant.

The earlier researchers had resorted to quantitative research methods. This study has employed qualitative approach. Ten people, clients of Islamic banking-both foreigners and locals and well educated were selected for interview. Their detailed replies are included the paper. Broadly speaking they all upheld the objections but opined that the system was new and the time should be given to it to reform itself. It was also noticed that the interviewees were not well grounded in the Islamic banking system.


Lastly the paper asserts that the samples were taken from only two Islamic banks and only the point of Shariah compliance was investigated. It is suggested that future studies may cover other aspects.

The Governor State Bank of Pakistan recalled the recent recession which played havoc with economies the world over and to avoid its future visitation it was considered necessary that there should be greater accountability and proactive role of regulators. It was stated that Islamic banks emerged with the least adverse affec t of the financials storm and that Islamic banking is not just limited to abolition of interest but it also promoted other values of banking. Thus it has gained popularity and continues to expand not only in Muslim countries but also in non-Muslim areas.

In the first instance it was introduced in Pakistan in 80s but the attempt was less successful although the relevant changes in laws had been affected. In the second attempt in 2001 evolutionary approach was adopted and both Islamic banking and conventional banking were allowed to work in parallel. The industry took a leap and has since then been on the uptake. The number of banks are multiplying and its shares in the total banking system in the country is also improving.

State Bank of Pakistan has played active role and many improvements have been made in the scheme. Conventional banks have been allowed to open Islamic banking windows and also stand alone Islamic banking branches. Shariah boards have been set up. Microfinance banks have been allowed to be established. In short a host of improvements continue to be made and the system is on the rise. All aspects of Islamic banking are receiving attention of the State Bank of Pakistan and the system promises to have a bright future in Pakistan.

Disclaimer

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

We invite our readers not to hesitate in communicating to us their opinion which will be welcomed. This will help us in improving the standard of the Journal.


Sources of Public Finance in an Islamic Economy

By Salman Ahmed Shaikh1

Abstract

Since interest is prohibited in Islam, the government in an Islamic economy cannot issue interest based T-Bills, T-Bonds and/or obtain interest based sovereign debt. Based on the literature review, it is argued that neither Prophet Muhammad (P.B.U.H) nor the pious Caliphates (rta) levied any taxes other than Zakah. Accordingly, this study explores the sources of revenue for a government in an Islamic economy. In discussing sources of tax revenue, it is maintained that Zakah is the only tax the government in an Islamic economy can levy. Nevertheless, the government can charge service/performance based fees, duties, charges etc in providing public goods. Furthermore, the profitable operations of state owned enterprises form an important part of non-tax revenues. It is also analyzed that how the non-profitable public institutions like police and courts will be funded. This study also discusses that how the government can finance its deficit keeping in view that interest is prohibited in Islam and Zakah rates are very low and Zakah base is very narrow as per common understanding. The study also gives brief insights into how much Zakah can be collected in Pakistan. Finally, it suggests that the nominal GDP growth linked rate of return can be used to benchmark domestic and external loans including those from IMF, WB and IDA etc.

Keyword = Fiscal Deficit, Capitalism, Bench Mark, Nisab, Liquidity, Subsidies

1 Salman Ahmed Shaikh is a researcher in Islamic Economics. He is author of "Proposal

for a New Economic Framework Based on Islamic Principles". He has also written 20 papers and more than 60 articles on Islamic Economics. PhD Economics candidate IBA Karachi. Email Address: [email protected]


1. Introduction

1.1 Background of the Study

The role of government in an economy has always been an important issue among economists and policy makers. Economic order sans Government has not appeared in reality in any part of the world throughout the known economic history. At the least, its role as a regulator is however accepted even in a free market economy. In a Keynesian framework though, it has been placed at the center by acting not only as a regulator, but also as an active economic player.

In the midst of Great Recession, the role and importance of government has once again reappeared as an important issue. Indeed, when one looks at the bail out package of U.S government to its financial sector in December 2008 and also to its producing sector later on while also providing huge subsidies to its agricultural sector right throughout the last decade, the government's role is far from being considered minor. In an interest free economy, the key question is that how the broad based development would be achieved let alone reducing fiscal deficits.

In this backdrop, this study takes on important issues in public finance in an Islamic economy. More specifically, it analyzes the sources of tax and non-tax revenue for the government, sources of financing for the government and means of pricing capital in public finance.

1.2 Problem Statement

This study analyzes public finance literature in Capitalism and in Islamic economics on one hand while on the other hand, this study suggests and estimates the means of revenue, sources of finance available to the government to reduce its budget deficit and spend on development in an Islamic economy and the appropriate way to price capital in public finance.

1.3 Objectives of the Study

The study sets forth following important objectives:

1. It suggests the sources of revenue for the government in an Islamic economy.

2. It explores the ground rules for Zakatable assets and Zakatable income found in the study of sources of Islamic faith i.e. Quran, Way of the Prophet Muhammad (P.B.U.H) as well as four primary schools of Islamic jurisprudence. In line with civilizational changes, it endeavors to suggest some modifications inductively as well. These modifications would make the recommendations more relevant and applicable.

3. It estimates the potential of tax revenues that can be collected in Zakah.

4. It also analyzes economic history in early Muslim civilization to decipher and account for some notable principles that can be applied today as well.


1.4 Importance of the Study

The study has significance in academics as well as in public policy making. This study takes a broader approach to help in public policy making and adds to the literature as it discusses more the contemporary developments in both literature and public finance practice. It has explored the means of revenue and source of public finance through and beyond Zakah in an Islamic economy.

1.5 Research Methodology

This study is exploratory and analytical in nature. This study analyzes Islamic economics literature to clarify various charges of anomalies in the institution of Zakah. It takes into account quantitative data to estimate the potential of tax revenues by using the institution of Zakah and non-tax revenues using various other means available in an Islamic economy. It also gives an analytical appraisal of the proposed system in light of public finance literature.

1.6 Scope of the Study

The study sets forth a determined objective to contribute in public policy making as well as add to the academic literature of Islamic Economics. It also suggests means of financing beyond tax and non-tax revenue collections and the way to price capital in public finance instruments in an Islamic economy.

1.7 Limits of the Study

Due to the unique nature of the institution of Zakah, coming up with the precise measurement of potential of Zakah is a difficult task, more so in the case of Pakistan where there is dearth of documentation. Therefore, the study could only provide preliminary insights into potential of tax revenues through Zakah.

2. Literature Review

In conventional economics, the government has following sources of tax revenue: General Sales Tax, Excise Tax, Custom Duty, Import Duty, Export Duty, Octroi Tax, Property Tax, Wealth Tax, Development Surcharge, Personal Income Tax, Corporate Income Tax, WHT etc. In conventional economics, government can earn through non-tax sources by way of earning through the profitable operations of State Owned Enterprises (SOEs) in public sector. Fines and activity based charges and duties are also an important source of revenue for the government. In conventional economics, if a government needs to finance deficit, it can issue Treasury Bills/Bonds or obtain loans bilaterally or multilaterally. Some governments have gone beyond issuance of Treasury bonds in the local market to issue sovereign bonds in the international market.

In an Islamic economy, the problem comes in the issuance of debt (due to prohibition of interest) and imposition of taxes. In an Islamic economy, as we discuss later, imposition of tax beyond Zakah is not recommendable. Zakah is a combination of a net worth tax and production tax.

Zakah is a religious obligation to pay a part of wealth and production to the government. However, in most countries, Zakah is not collected by the government


and is not considered a compulsory payment (Powell, 2009). Respected Muslim scholar Ab-ul-ala Maududi (1970) reasoned that Zakah is a religious obligation and is not a substitute of tax. Taxes other than Zakah can be imposed in an Islamic economy if these taxes are levied by the legislative council and used for public welfare. He reasoned that the taxes discouraged in Ahadith are those which were imposed by autocratic kings for their own lavish consumption and this kind of usurpation of public property was discouraged.

Discussing the issue of distributing Zakah, Islahi (1985) and Qardawi (2000) explained that it is not necessary to make some living person the owner of the Zakah. Zakah can be given to any person or cause or an organization working for a cause. It is not necessary to make some living person the owner of the Zakah.

Mannan (1986) opined that Zakatable goods can be modified as did Hazrat Umer (rta) who levied Zakah on horses; whereas, horses were exempted from Zakah before Him. He also noted that since Zakah is a religious obligation, it would result in low tax evasion in the opinion of the author. He argued that Zakah could be distributed on the welfare of the people as well as given to people themselves. He further wrote that if a policy of full employment requires high MPC; then, a progressive taxation like Zakah could help in boosting aggregate demand and increasing employment.

Elaborating the legal importance of Zakah, Liam (2002) reasoned that property rights are valid in a post-tax environment i.e. one obtains the right to own property in the eyes of law when one pays the taxes due. Consistent with logic and this economic philosophy, property rights in Islam are also valid in a post-Zakah context.

Next, we give a brief account of literature review on the institution of Zakah in Caliphates’ times. Kuran (2003) identified that the application of Zakah was never uniform even in the period of Prophet Muhammad (P.B.U.H) and pious Caliphates (rta). In Umer (rta) and Abu Bakar (rta) period, Zakah was collected by the government, but, in Usman (rta) period, people were allowed to pay Zakah privately. Horses were exempted from Zakah in Prophet’s time, but, Umer (rta) brought it in the Zakah net in His period. Similarly, Mahmud (2001) argued that institution of Zakah is flexible to a certain degree as Umer (rta) levied Zakah on horses and skins and at the time when Arab was hit with a drought and famine, he exempted poor from Zakah and suspended Zakah from the rich.

The collection of Zakah was centralized initially and then it was decentralized in the period of Usman (rta). Usman (rta) also levied Zakah on the production in forests (Nadvi, 1996). It is to be appreciated here that such modifications point to the flexibility that policy maker can use to maximize the benefits of Zakah system rather than pointing to inefficiency or non-uniformity in the system. This flexibility makes the system more adaptable and applicable than rigid with limited scope for flexibility.

Kuran (2006) in another work stated that since traditional understanding on Zakah excludes industrial production and services sector from the net of Zakah, it can hardly achieve anything substantial from agriculture sector. His arguments are


noteworthy as the share of agriculture in GDP is declining in developed as well as developing countries and it is a sector with huge documentation problems in developing countries. He also mentioned that Zakah rates are very low to have any impact i.e. 2.5% to 20%. He also identified few anomalies in the Zakah system. For instance, the trader has to pay Zakah on tradable inventory, but the manufacturer is exempted from paying Zakah on means of production. Furthermore, minerals like gold and silver are taxed at 2.5%, while other minerals are taxed at 20%.

It is to be noted that the amount on which tax is levied is more important than the tax rate. A small percentage levied on a gross income would still ensure substantial revenue. Government would have the flexibility to allow certain deductions and not allow others. Furthermore, tax coverage, if comprehensive with low exemption amount would still result in substantial aggregate tax revenue even if marginal tax revenue from individual units (corporations as well as natural persons) is low.

Another anomaly identified by Farooq (2008) in the institution of Zakah and its common understanding is that people in livestock/dairy industry are needed to pay Zakah on cows, goats etc which are means of production for them. But, means of production in other industries are exempted from Zakah. He also stated that in Umer (rta) period, poverty diminished, but, in that period, the ground breaking conquests brought huge resources at the disposal of the then government. Such a thing can hardly happen nowadays.

On the economics of a wealth tax, Moore (2006) disclosed that in France, the solidarity tax has caused capital flight to more wealth-friendly nations. Heckly (2004) insisted that in the current environment, capital and individuals are both highly mobile, countries are working to implement active social policies, without sending capital and the wealthiest taxpayers on the run. That is the reason why, several European countries are now discontinuing wealth tax.

This led some economists to raise questions as to how public finance would work in an Islamic economy. Some studies have shown concern over the applicability of Islamic finance principles beyond the commercial banking into the pricing of loans between countries and IFIs (Reddy, 2001) and monetizing public debt (Darrat & Bashir, 2000). In this regard, Usmani (2003) proposed issuance of GDP growth linked instruments to finance public debt.

Up to now, we have quoted those Muslim scholars who maintained that taxes can be imposed for running the affairs of the state other than Zakah and it is not the mandate of Zakah to fulfill that fiscal need.

On the other hand, Kahf (1987) tracing the history of public finance during Prophet’s and Caliphate’s times opined that neither the Prophet Muhammad (P.B.U.H) nor the pious Caliphates (rta) levied any tax other than Zakah even when they were aware of the taxes imposed by neighboring non-Muslim countries on their citizens. Saleem (1992) pointed three narrations of the Prophet explaining that the government cannot levy any tax other than Zakah.


The narrations of the Prophet explaining this rule are mentioned below:

a) There is no [legal] share [for the society] in the wealth [of people] except Zakah.” (Ibni Maajah: Kitab-uz-Zakah).

b) “After you have paid the Zakah of your wealth, you have paid [all] that was [legally] required of you.” (Ibni Maajah: Kitab-uz-Zakah).

c) “No tax-imposer shall enter paradise.” (Abu-Daud: Kitab-ul-Khiraj).

Thus far, we have discussed issues related to Zakah which is one important and unique institution available to economic managers in an Islamic economy; Next, we discuss other alternatives for finance in an Islamic economy.

Haque & Mirakhor (1998) classified government expenditures into i) asset creating and ii) non-asset creating. Non-asset creating activities can be financed through tax revenues. But, in asset creating activities, equity modes of financing can be used whereby financing would be generated by way of an instrument. As per their recommendation, this instrument would be priced using the formula:

I = w1WI + w2PPI + w3LSI + w4ROG

Where,

WI = World Index

LSI = Stock Index, a measure of market performance index based on ROE.

PPI = Index representing average returns on commercial participation papers.

ROG = Return on government investments and project.

w1, w2, w3 and w4 are weights assigned to each variable.

However, if the resultant rate is stipulated; then, it would be including opportunity cost. Two mutually exclusive equity financed projects cannot arbitrarily set to have same returns on the basis of opportunity cost.

It can be seen from the literature review that Muslim scholars are divided on the issue of whether taxes beyond Zakat can be levied or not. Basing our analysis on the viewpoint that Zakat is the only tax that can be levied other than activity/performance based duties/charges/fees and reciprocal duties on trade as were levied by Umer (rta), we now turn to present our analysis on tax and non-tax sources of revenue available in an Islamic economy and to what extent these sources identified can meet the requirements of the state.

3. Institution of Zakah: An Important Source of Public Finance in Islamic Economy

Zakah is a religious obligation to pay a part of wealth and income to the government. Nisaab on wealth was basically specified in silver. Following Hadith testify this viewpoint:


“There is no Zakah below five wasaqs of dates; there is no Zakah below five uqiyahs of silver and there is no Zakah below five camels.” (Mu’atta Imam Malik, No: 578)

For calculation purposes, people used the cross rate between gold and silver and determined their nisaab in gold as well. This cross rate has changed historically; that is why, we will have to resort to the original base i.e. 612 grams of silver when there is no bimetallic monetary standard in operation. One important implication of this principle is that tax exemption amount in silver is much lower than gold using current cross rate and hence taxable assets will increase in magnitude. Zakah would be levied as per the ceiling rates defined for each category of wealth or production.

The classification is as follows:

a) 2-½% on cash, wholesale value of held for trade inventory and capital in excess of need payable once a year at a particular set date.

b) 5% on production using both labor and capital. It is charged at the completion of the production process.

c) 10% on production using either labor or capital. It is charged at the completion of the production process.

d) 20% on production using neither labor nor capital. This is applicable on treasure or any other natural gift obtained without using either labor or capital.

To estimate Zakah on wealth, the following model is established:

ZR = 0.025 [ZA ? (MNA x PMNA] Where

ZR = Potential Aggregate Zakah Revenue ZA = Potential Aggregate Zakatable Assets MNA = Minimum Nisab Amount i.e. market value of 612 grams of silver PMNA = People with Minimum Nisab Amount

Zakatable assets include all assets above the value of nisab except the assets in personal use and means of production. Minimum Nisab Amount is the market value of 612 grams of silver. Population with minimum nisab amount is to be estimated looking at wealth distribution of population.

On the surface, it can be seen that as Zakatable assets increase, Zakah revenue increases. Minimum nisab amount in silver terms would remain constant, but its value in currency would change. But, the effect of inflation would impact almost all endowments of an individual overtime.

4. Issues in Estimation of Zakah

Wealth/Assets subject to Zakah include Cash in hand, Cash in Bank, gold and silver not in daily usage (for women), gold and silver owned by men, held-for trade inventory, property/plot purchased for the purpose of resale.


Production is not limited to agriculture nowadays, but the major part of it is coming from industries as well as services sector. Therefore, industrial production could also be taxed just like agriculture. Services income could also be taxed on the same principle.

Khan (2005) stated that investment in stocks should be interpreted as any other investment with some means of earning income. Stock is a means of earning dividend or capital gains. Just like means of production/income are exempt from Zakah, investment in stocks should be exempted from Wealth Zakah as investment in stocks means that the money is not kept idle rather it is invested and even its value could reduce to zero or increase by a long way theoretically. Therefore, any income arising from investment in stocks i.e. capital gains or dividend must be subject to Income Zakah. Similarly, this argument could be extended to introduce Income Zakah on mutual funds, investment in NSS, debentures, bonds etc. Furthermore, if land/building/house is leased, the land/building/house becomes the means of earning rent. Hence, income Zakah could also be introduced on rental income on houses, assets, buildings etc.

5. Estimation of Zakah

As can be seen from Table 1, Zakah collection and its disbursement is very low and it has not been able to bring about a major socio-economic change. In FY 2009, approx. PKR 150 Billion were paid by people in Pakistan in charity, 90% of which was for the purpose of paying Zakah. (Dawn, September 07, 2009).

Table 1: Total Zakah Disbursement in FY 2007-08

(Rs. Million)

Punjab Sindh NWFP Balochistan ICT Northern Areas

Regular Zakat Programmes 1857 395 411 41 23 38

Total beneficiaries 995 205 94.175 31 12 32

Other Zakat Programmes 738 16 148.881 5 3 5


National level Schemes 196 83 62.527 30 35 0


Total amount disbursed 2791 495 623 77 61 43

Total beneficiaries 1376 304 195 59 31 42

Grand Total Amount Disbursed (Rs. Million): 4090

Grand Total Beneficiaries (Rs. Thousand) 2007 Source: Ministry of Religious Affairs Zakat and Ushr

Going into estimation of potential Zakah from agriculture produce, we first present some data that gives us an idea of how much Zakah could be collected both with present production and with enhanced production due to efficient utilization of


land. It can be seen from the following data that 9.13 million hectares are unutilized cultivable land in Pakistan. If agriculture’s share is 21% of GDP utilizing 22.76 million hectares, an addition in production through utilization of that idle farm land can be computed assuming constant returns to scale on average.

Table 2: Land Utilization (Million Hectares)

Fiscal Year

Total Area

Reported Area

Forest Area

Not Available

for Cultivation

Culturable Waste

Current Fallow

Net Area Sown

Total Area Cultivated

(1+8)

Area Sown More Than Once

Total Cropped

Area (8+10)

1 2 3 4 5 6 7 8 9 10 11

90-91 79.61 57.61 3.46 24.34 8.85 4.85 16.11 20.96 5.71 21.82

91-92 79.61 57.87 3.47 24.48 8.86 4.87 16.19 21.06 5.53 21.72

92-93 79.61 58.06 3.48 24.35 8.83 4.95 16.45 21.40 5.99 22.44

93-94 79.61 58.13 3.45 24.43 8.74 5.29 16.22 21.51 5.65 21.87

94-95 79.61 58.50 3.60 24.44 8.91 5.42 16.13 21.55 6.01 22.14

95-96 79.61 58.51 3.61 24.35 8.87 5.18 16.49 21.68 6.10 22.59

96-97 79.61 59.23 3.58 24.61 9.06 5.48 16.50 21.98 6.23 22.73

97-98 79.61 59.32 3.60 24.61 9.15 5.48 16.48 21.96 6.56 23.04

98-99 79.61 59.28 3.50 24.52 9.23 5.35 16.58 21.93 6.28 22.86

99-00 79.61 59.28 3.66 24.50 9.13 5.67 16.32 21.99 6.44 22.76

00-01 79.61 59.28 3.66 24.50 9.13 5.67 16.32 21.99 6.44 22.76 Source: Ministry of Food, Agriculture & Livestock

Next, we move to estimate potential Zakah from individuals on their wealth including Cash in bank, investments in Shares, NSS, gold deposits etc.

5.1 Calculation of Nisab for Individuals (Exemption Amount)

Price of Silver (per oz.) = USD 15 (1 oz. = 28.34 grams) Nisab in (oz.) = 612/28.34 = 21.60 oz. Nisab value in USD = 21.60 x 15 = USD 324 Nisab value in PKR = 324 x 85 = PKR 27,540

5.2 Zakatable Assets

5.2.1 Bank Deposit

Proxy of Measurement: Total Banking Deposits (Rs.) Data Source: Weekly Profile of Broad Money, SBP, March 2010 Total Banking Deposit (Rs.): R 5,137.219 Billion Gross Zakatable Value: 2.5% x PKR 5,137.219 Billion Gross Zakatable Value: PKR 128.430 Billion

However, total banking deposits include the money multiplier effect. The total currency in circulation is less than total banking deposits. If we take the total currency in circulation as the base for Zakah on Cash/currency, we have the following details.


5.2.2 Currency in Circulation

Proxy of Measurement: Total Currency in Circulation in FY10 (Rs.) Data Source: Weekly Profile of Broad Money, SBP, March 2010 Total Banking Deposit (Rs.): PKR 1,152.173 Billion Gross Zakatable Value: 2.5% x PKR 1,152.173 Billion Gross Zakatable Value: PKR 28.804 Billion

5.2.3 Import Duty

Proxy of Measurement: Total Imports in 2008/09 Data Source: FBS Imports (USD): USD 34.822 Billion Rationale for Levy: Umar (rta) imposed it 10%; so leviable.12 Gross Zakatable Value: 10% x PKR 2.96 Trillion = PKR 296 Billion

5.2.4 Gold

Proxy of Measurement: Gold in Private Hands Data Source: World Gold Council Total Gold Deposit in Pakistan: 65.4 Tons Gold Deposit at SBP (Rs.): PKR 157.544 Billion3 Price of 10g Gold: PKR 30,000 Price of 1Kg Gold: PKR 3 Million Value of Total Gold Deposit: PKR 196.2 Billion Value of Total Gold Deposit held Privately: PKR 38.656 Billion Gross Zakatable Value: 2.5% x PKR 38.656 Billion Gross Zakatable Value: PKR 0.96 Billion

5.2.5 Agricultural Income/Produce

Proxy of Measurement: Agricultural Income’s share in GDP Data Source: Budget Report FY08/09, FBS, CBR GDP (Rs.): PKR 14,972 Billion Agricultural Income: 21% x PKR 14,972 Billion=PKR 3144 B Zakat Rate Used: 80% land is irrigated & 20% land is rain-fed Gross Zakatable Value: 0.8 x 0.05 x 3144 + 0.2 x 0.1 x 3144 = 189 B

Additional Farm Income with farm-lease: (9.13/22.76) x 3144 = 1,261 Billion Additional Zakatable Value: 0.05 x 1,261 = 63.05 Billion Total Zakatable Value from Farm Income: 252 Billion

5.2.6 Services Income

Proxy of Measurement: Services sector’s share in GDP Data Source: Budget Report FY08/09, FBS, CBR 2 Umar (rta) levied import duty on foreign goods imported into the Islamic state. 3 As on June 2009 (Source: Analytical Accounts, State Bank of Pakistan).


GDP (Rs.): PKR 14,972 Billion Services Sector Income: 53% x PKR 14,972 Billion=PKR 7935 B Gross Zakatable Value: 0.1 x 7935 = 793.5 B

5.2.7 Industrial Income 4

Proxy of Measurement: Industrial sector’s share in GDP Data Source: Budget Report FY08/09, FBS, CBR GDP (Rs.): PKR 14,972 Billion Industrial Sector Income: 26% x PKR 14,972 Billion=PKR 3893 B Gross Zakatable Value: 0.1 x 3893 = 389.3 B

Next, we have to make an estimate of how many people have the wealth from various sources mentioned above exceeding Nisab Amount. For instance, if we assume that 10 million people in Pakistan have the wealth exceeding Nisab amount; then:

PMNA =10,000,000

PMNA =10,000,000

MNA = PKR 27,540 (as calculated above)

ZA = Total Currency in Circulation + Total Gold in Private Hands

ZA = 1,152.173 Billion + 65.2 Billion = 1217.373 Billion

From ZA, we deduct the product [PMNA x MNA],

PMNA x MNA = 275.4 Billion

NZA = 1217.373 - 275.4

NZA = 941.973 Billion

We formulated the equation to estimate Zakat as follows:

ZR = 0.025 [ZA - (MNA x PMNA] ZR = 0.025 x [941.973] Billion ZR = 23.55 Billion

Total Potential of Zakat from Wealth = 23.55 Billion Total Potential of Tax from Import Duty = 296 Billion Total Potential of Zakat from Agriculture Produce = 252 Billion Total Potential of Zakat from Services Sector Produce = 793.5 Billion Total Potential of Zakat from Industrial Produce = 389.3 Billion Total Potential of Zakat & Import Duty = 1754.35 Billion Total Taxes in FY09 = 1,157 Billion Zakat/GDP Ratio = 11.71% 4 The tax would be levied as a VAT (Value Added Tax).


It is to be noted that the estimate has not included Zakah on real estate held for trade and on held-for trade inventory. It could also not include potential Zakah coming from Capital Gains Tax on Real Estate, Stocks and Mutual Fund Units and on lease income. It has also been assumed that total receivables and total liabilities for individuals are same on average. It implies that there is no effect of receivables and payables.

Kahf (1987) mentioned that once the uncle of Prophet Muhammad (P.B.U.H), Abbas (rta) paid Zakah in advance for two years and that was in the knowledge of Prophet Muhammad (P.B.U.H). This provision can greatly facilitate the liquidity and financing needs of the state in an Islamic economy even in modern times.

Other than Zakah, stamp duty can be levied which is a tax on documents before they become legally effective. Toll Tax can also be levied to fund the development of roads and infrastructure. In developing industrial zones, export processing zones and developing necessary infrastructure, the government can charge a licensing fee from the industrialists to fund expenditure on development. Such a tax/fee or charge is not against the Islamic injunctions as it is directly linked with provision of services and performance. It is also effective in funding expenditure on producing public goods as voluntary payments on public goods are economically ineffective. Excise tax on activities and operations creating negative externality can also be levied. This will be a cost paid to the society for meddling with natural environment.

Tax Increment Financing could also be used which is a tool to use future gains in taxes to finance current improvements which will create the conditions for those future gains. Johnson and Mann (2001) explained that when a public project such as a road, school, or hazardous waste cleanup is carried out, there is often an increase in the value of surrounding real estate and new investment. This increased site value and investment sometimes generates increased tax revenues. The increased tax revenues are the "tax increment." Tax Increment Financing dedicates tax increments within a certain defined district to finance debt issued to pay for the project. This tool is widely used in U.S and in Europe.

Adam Smith in his monumental work “An inquiry into the nature and causes of wealth of nations” gave cannons of taxation. The proposed Zakah based taxation system goes very well with Adam Smith’s cannons of taxation. It has a proportional tax which can be manoeuvred to be progressive as well. It does not tax production heavily (i.e. lenient tax rates) which is in line with Smith’s assertion that production must not be taxed heavily. It is simple and certain. It is convenient to collect, more so because it is a religious obligation than just involuntary wealth fetching tool. It only taxes those who have ability to pay i.e. it does not tax those who do not reach a minimum threshold of wealth in their hands.

6. Economics of the Proposed Zakah Based Taxation System

6.1 Effects of Proposed Zakah System on Property Market

If the tax (Zakah) program is implemented as proposed, there will be a 10% income tax on the proceeds of sale of a property. The tax will be more if the property is kept than when it is sold. This will increase the supply of land that was not


presented for sale before. The increase in supply will bring the prices of properties down. Hence, affordable housing and commercial facilities i.e. office premises, factories etc will come in the reach of consumers and commercial enterprises respectively. A simplified model is presented below:

Property value at t0 : USD 1,000,000

Property Prices increase at t1 by 10%: USD 1,100,000

If property kept at t1, 2.5% tax on property: USD 27,500 If property sold at t1, 10% tax on Gain : USD 10,000

Net Tax Gain: USD 17,500

If the property owner does not want to sell the asset and use it in future, but still wants to benefit from the fiscal incentive, he can give it on rent. It will be considered an investment and hence instead of wealth tax, 10% income tax will be charged.

Property value at t0 : USD 1,000,000

If property given on rent @10%/year of property value

If property kept at t1, 2.5% tax on property: USD 25,000 If property rented until t1, 10% tax on Rent: USD 10,000

Net Tax Gain: USD 15,000

6.2 Effects of Proposed Zakah System on Investment

Private sectors including both local and foreign investors have an essential role to play in achieving the desired growth and development targets. The goal is not only to redistribute the pie, but to increase the pie is well.

The lenient tax rates will decrease the tax expense and free more resources for reinvestment and profit distribution among shareholders i.e. dividend. Lenient tax rates will help increase in the inflow of FDI. This will increase the competition and convert the major oligopolistic industries into more competitive industries.

It can be seen from fiscal models presented above that if any form of wealth i.e. property, fixed asset, cash etc is put into investment, its nature for fiscal treatment changes and tax saving of at least 2.5% results on the gross investment i.e. if there is no income on investment, 2.5% tax saving results and no income tax is paid since there is no income.

6.3 Effects of Proposed Zakah System on Equity Markets

With interest-based deposits discontinued, savers will have to make a choice between keeping their money idle and pay wealth tax or invest it in some asset and pay the tax only on income if it is earned. A simplified model is presented below:


Value of Stock of Company A at t0 : USD 100 Stock Prices increase at t1 by 10%: USD 110

If no investment in stock or other assets : USD 2.5 If stock sold at t1, 10% tax on Gain on Sale : USD 1

Net Tax Gain: USD 1.5

If the shareholder does not want to sell the stock, but still wants to benefit from the fiscal incentive, he can keep the stock and pay tax on dividend. Purchase of stocks for capital gain/dividend will be considered an investment and hence instead of wealth tax, 10% income tax will be charged. A simplified model is presented below:

Value of Stock of Company A at t0 : USD 100 Company A is profitable & pays 10% dividend

If no investment in stock or other assets : USD 2.5 If stock kept at t1, 10% tax on Dividend : USD 1

Net Tax Gain: USD 1.5

7. Non-Tax Revenues

Non-Tax Revenue can come from profitable operations of State Owned Enterprises (SOEs). State Owned Enterprises (SOEs) in postal services, railways, airline industry, steel industry, communication industry, public utilities, transportation industry, aviation industry etc can be run effectively and generate profits as they operate in industries which have significant potential for economies of scale, economies of scope and face relatively inelastic demand. With deficit financing not an option available, there will be an automatic check on government to run these State Owned Enterprises (SOEs) effectively and efficiently.

Fines and penalties is another source through which government will generate funds. Ideally, this is not a source of revenue as the objective of fines and penalties is to enforce law, improve competition and put right market imperfections. But, this will materialize only when the good practices are rewarded and bad practices penalized.

8. Funding Non-Revenue Generating Activities

The real problem arises in funding operations of non-revenue generating activities like the operations of courts and police etc. It is to be noted here that in Muslim societies under the rule of Caliphates, there was no concept of jail which is a later invention. The Islamic punishments like capital punishment on murder, forced rape etc, monetary fines and physical punishment in extreme cases of stealing, fraud,


robbery etc do not require people to be imprisoned. As a matter of fact, these prisons become the nurseries for bringing societies even more seasoned criminals rather than acting as a place for rehabilitation. Besides the convicted person, the family of the convicted also gets heavily affected by such imprisonment.

Therefore, reforming the penal law based on Islamic principles will significantly reduce expenditure on making, developing and maintaining such prison cells. If we study the judicial system in Caliphates time, the judicial system did not have high cost of advocacy. Infact, there was no concept of third party advocacy as the law of the land was simple and its implementation enforced strictly. The society put huge emphasis on honest testimony. The judicial system was highly centralized and that too in Umar (rta) and Usman (rta) period when the Islamic state was spread all over Arabia and touching North Africa as well as Eastern Europe.

9. Alternative for Public Finance Other Than Zakah

Next, we discuss how the budget deficit could be financed in an Islamic economy. First of all, it is to be noted that sources of revenue (tax and non-tax) will be substantial enough to meet necessary development and non-development expenditure. Furthermore, if true Islamic values are adopted, non-development expenditure in providing perks to the government officials will also reduce.

Looking beyond imposing more taxes, Usmani (2003) proposed issuance of GDP growth linked instruments to finance public debt. In public finance, a Nominal GDP linked bond could be issued.

In public projects valuation, this benchmark rate would be used to find present values of cash flows. This would be appropriate due to following:

i. It will not lead us into falling in time value of money as we are using an enterprise or output related benchmark rather than interest based benchmark.

ii. The cash flows are obtained using equity contractual modes like Mudarabah and Musharakah.

iii. In this case, we are calculating valuation models for the investor and not for the borrower. Borrower or financee will not be obliged to provide the returns based on these valuations. But, the investor can use this “indicative valuation” to rank investment alternatives.

In actual distribution of income between financier and financee, profit sharing ratio would be used and agreed upon at time (t) and applied to the actual gross profit earned by the financee in time period (t+1). In Figure 1, data for the period 1970-2008 for a group of big economies i.e. America, Britain, Canada, China, the euro area, India and Japan is shown on the variables Nominal Interest Rates (t) and Nominal GDP Growth Rate (t-1) since Nominal GDP responds to interest rate changes as it decreases aggregate demand for the subsequent period, a lag variable for GDP i.e. GDP (t-1) is taken.


Figure 1: Nominal GDP (t-1) and Nominal Interest Rates (t)

for a group of big economies

It can be seen that both variables virtually moved together throughout the period and especially since 1990. Therefore, it is plausible to use Nominal GDP growth rate as the benchmark for pricing instruments in public finance. Since this figure confirms the movement of both variables in the same directions, it can be used for indexing multilateral loans, loans between central banks and between central banks and international financial and development organizations such as IMF, WB, IDA, IDB, ADB etc.

Most developing countries are going through a perpetual debt trap which takes away resources that could have been used on development, but instead are used to service compounded debt. In Figure 2, it is shown that interest payments take up most of the resources of government.

Figure 2: Interest expense as a % of total government’s expense


The proposed NGDP linked instrument will not only compensate the financier for parting with liquidity and capital, but also provide a stable mechanism for recipient countries to get out of debt trap with debt servicing linked with output performance benchmark and it will provide relief in the balance of payment and foreign debt management to central banks in developing countries. Second, the government could divest its ownership in State Owned Enterprises (SOEs) or privatize some of them altogether. It could also issue new stocks of State Owned Enterprises (SOEs) and obtain funds for these corporations through primary equity markets.

Conclusion:

This study explored the sources of revenue for a government in an Islamic economy. Though Zakah rates are low, but Zakah base is very broad and can include all productive activities. The study also provided brief insights into how much Zakah could be collected in Pakistan and showed that there is ample potential to reach a double digit Zakah to GDP ratio and together with non-tax revenue, the government in an Islamic economy can manage its operations without resorting to interest based deficit financing. This study also discussed that the government if needed can finance its deficit by using nominal GDP growth linked rate of return as a benchmark for domestic and external loans including those from IMF, WB and IDA etc.

References:

1. Darrat, Ali, F. & Bashir, M. Abdul-Hameed (2000). “Modeling Monetary Control in an Interest Free Economy”. J.KAU: Islamic Economics, Vol. 12, pp. 3-19.

2. Dawn, Karachi (September 07, 2009). “20pc Less Charity This Ramadan”. Economics & Business Review. Afshan Subohi. p1.

3. Farooq, Mohammad Omar, The Challenge of Poverty and the Poverty of Islamic Economics (2008). Journal of Islamic Economics, Banking and Finance, Vol. 4, No. 2, pp. 35-58.

4. Federal Bureau of Statistics [2008] Yearly External Data 2009, Islamabad.

5. Government of Pakistan [2009] Budget Report 2008-09, Islamabad.

6. Haque, Nadeem-ul & Mirakhor, Abbas (1998). “The Design of Instruments for Government Finance in an Islamic Economy”. International Monetary Fund. IMF Working Paper, WP/98/54.

7. Heckly, Christopher (2004). “Wealth Tax in Europe: Why the Downturn?” in Michel Taly and Gérard Mestrallet, dir., “Estate Taxation: Ideas for Reform”, Institute Reports, Paris, Institut de l’entreprise, pp. 39-50.

8. Islahi, Amin A. (1985). “Tauzeehat”. Lahore: Islamic Publications.

9. Kahf, Monzer (1987). "The Early Islamic Public Revenue System" (Lessons and Implications). Jeddah: IRTI.


10. Khan, M. Akram (2005). Comments on A. Azim Islahi & M. Obaidullah: Zakah on Stocks: Some Unsettled Issues. J.KAU: Islamic Econ., Vol. 18, No. 1, pp. 41-42.

11. Kuran, Timur. (2006). “Islam and Mammon: The Economic Predicaments of Islamism”. Princeton University Press.

12. Kuran, Timur (2003). “Islamic Redistribution through Zakat: Historical Record and Modern Realities,“ in Bonner, M, Ener, M, and Singer A. (eds.). Poverty and Charity in Middle Eastern Contexts, SUNY Press, pp. 275-293; pp. 275-276.

13. Liam, Murphy & Thomas Nagel. (2002). “The Myth of Ownership: Taxes and Justice”. London: Oxford

14. Mahmud, Irfan. (2001). “Economic System under Umar the Great”. Lahore: Shaikh Muhammad Ashraf Publishers.

15. Mannan, M. Abdul. (1986). “Islamic Economics: Theory & Practice”. London: Hodder and Stoughton.

16. Maududi, Sayyid Abul A'la (1970) Ma’ashiyat-e Islam [Economic System of Islam], Lahore: Islamic Publications.

17. Moore, Molly (2006). “Old Money, New Money Flee France and Its Wealth Tax”. Washington Post Foreign Service. Sunday, July 16, 2006; Page A12

18. Nadvi, S. Moeen-ud-din (1996). “Taareekh-e-Islam [History of Islam]”. Lahore: Maktaba-e-Rehmania.

19. Powell, Russell, Zakat (2009): Drawing Insights for Legal Theory and Economic Policy from Islamic Jurisprudence (February 28, 2009). Available at SSRN: http://ssrn.com/abstract=1351024

20. Qardawi, Yousuf Al (2000). “Fiqh Al Zakah. A Comparative Study of Zakah, Regulations & Philosophy in the Light of Quran & Sunnah”. Jeddah: Scientific Publishing Centre.

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Application of IAS-7 on Cash Flow Statements in the Financial Statements of

Islamic Financial Institutions. By

Altaf Noor Ali, ACA*

Abstract

Islamic Financial Institutions (IFIs) in Pakistan are required to present a cash flow statement as an integral part of its financial statements.

This write up brings on record insufficient direction in International Accounting Standard-7 (IAS-7) in the context of a financial institution generally. It goes on to record instances of deviations from stated standards observed and instances which appear to be misapplication and or misinterpretation of the Standard noted in the IFIs.

Keywords:

Cash flow statement, direct and indirect method of deriving cash flows from operating activities, cash flows from investing activities, segmental cash flows, accrual-based and cash-based earnings of an IFI.

Issues with the IAS-7 on Cash Flow Statements:

The IAS1-7 on “Cash Flow Statements” mandates all entities to present a CFS as an integral part of its financial statements for each period for which such

* The author Altaf Noor Ali is a Chartered Accountant, Fellow Institute of Islamic

Banking & Insurance (UK) and Member of Editorial Board Journal of Islamic Banking & Finance (JIBF)

1 The International Accounting Standards were originally issued by the Board of the International Accounting Standards Committee, and adopted by the International Accounting Standards Board at its inception in 2001. The term “International Financial Reporting Standards” include IAS. “Standards approved (or adopted) by the IASB include paragraphs in bold type and plain type, which have equal authority” (Para 14, Preface to the IFRS).


statements are presented2. A Cash Flow Statement (CFS) is a mandatory part of a set of financial statements3 of Islamic Financial Institutions (IFIs) as well.

The IAS-7 is applicable to all entities. It primarily focuses on non-financial entities, and understandably so, as financial institutions are far few in terms of absolute numbers than other business entities.

In terms of contents, the said Standard is made up of 53 paras, out of which only two relate to the CFS of a financial institution4; rest are general in nature, applicable to entities according to their specific circumtances. However, that is not to mean that all of the fifty-one paras are irrelevant for a financial institution.

The fact is there is limited direction for compiling CFS of a financial institution and that too is embedded in general provisions. Ofcourse the requirements applicable to a financial institution are irrelevant for a non-financial entity, and appear to be insufficient to the extent of being incomplete, for a financial institution.

Appendix “B” to the Standard5 sets out a specimen CFS statement, for financial institutions. The stand-alone CFS here is based on direct method of deriving cash flows from operating activities (cfs-o), preferred by Standard6. The appendix contains no specimen of what CFS based on indirect method of deriving cfs-o would look like for a financial institution.

Furthermore, appendix B is without its pretext or context when compared to appendix A, which is meant for CFS of non-financial entities. In fact there is not a single note to further explain any of the figures in CFS, not even comparatives.

This paper calls upon the international accounting standard setters to take up the revision of this standard at the earliest, addressing the concerns mentioned here. The future standard may as well be restructured to be in three parts; the first applicable to all entities, the second for non-financial entities and the third dealing exclusively with the CFS of financial institutions. The explanatory material to the appendices to the standard should be of similar nature, even if it is not a part of the Standard as presently.

Selective application of IAS-7 on the CFS of the IFIs

Scope. This paper is based on a study of CFS from the latest available accounts (or financial statements) relating to the calendar year ended 31 December

2 Para 1, IAS-7 Cash flow Statements. The Standard is operative for financial statements

covering periods beginning on or after 1 January 1994 (Para 53). 3 A complete set of financial statements comprises: a balance sheet; an income statement;

a statement of changes in equity; a cash flow statement; and notes, comprising a summary of significant accounting policies and other explanatory notes. See para 8, International Accounting Standard 1 Presentation of Financial Statement.

4 Paras 15 (loans made by financial institution are usually classified as operating activity) and 24 (cashflows may be reported on net basis for a financial institution), ibid

5 As stated: “this appendix accompanies, but is not a part of the IAS-7”. 6 Para 18(a), ibid


2010 of the Islamic Financial Institutions (IFIs)7. A representative of CFS from an IFI is provided here as enclosure 1 for reference8.

A CFS provides information about the historical changes in cash and cash equivalents of an entity.9

The stated objective of preparing a CFS is “providing users of financial statements with a basis to assess the ability of the entity to generate cash and cash equivalents and its needs to utilise those cash flows”10.

Where IAS-7 direction is not being followed.

Cash flows from operating activities disclosure using the indirect method

“An entity presents its cash flows from operating, investing and financing activities in a manner which is most appropriate to its business”11.

The CFS of an IFI are also reported in three broad categories: operating (cfs-o), investing (cfs-i) and financing (cfs-f) activities 12.

The Standard considers cfs-o to be a “key indicator”13 and encourages its reporting using the direct method, further stating that the direct method provides information “which is not available under the indirect method”14.

Our study found that the IFIs present cfs-o on indirect method, without exception. We also consider this practice to be a root cause of poor user’s understanding of information contents of CFS.

Under the indirect method, the net cash flow from operating activities is determined by adjusting profit and loss for the effects of non-cash items and all other items for which the cash effects that are reported separately as investing or financing cash flows15.

7 Most banks follow calendar year. Financial statements of the most IFIs are released in

March every year. 8 We have also referred to the accounts of conventional financial institutions (CFIs)

for the same period and our findings regarding cfs are representative of the CFIs, or for the banking sector as a whole.

9 “Objective”, ibid 10 “Objective”, ibid. “An individual standard should be read in the context of the objective

stated in that standard” (Para 14, Preface to the IFRS). 11 Para 11, ibid 12 Para 10, ibid 13 Para 13, ibid 14 Para 19, ibid 15 Para 20, ibid


No financial institution in Pakistan prepares cfs-o on direct basis. Indeed there has never been one that did so since 1994 when this IAS-7 came to be applicable. This situation is not satisfactory.

The specimen in appendix B to the standard is on direct method. Infact there is no specimen for financial institutions on indirect method available – the prevailing practice on which IFIs are presenting its CFS.

In this age of computing it is hard to justify why cfs-o are not presented using direct mehtod.

This situation calls upon the bank regulators to make it mandatory for all financial institutions to perpare its cfs-o on direct method. This would be in line with the objective stated of preparing a CFS and will certainly improve the next-to-bottom user’s understanding of this statement.

Misclassification of cash flows as investing activities

The second notable deviation from this Standard relates to the manner in which “investments” and its return by an IFI is classified as an investing activity, whereas the Standard categorically states:

“Interest paid and interest and dividends received are usually classified as operating cash flows for a financial institution”16.

The Standard explains rationale for this as: cash flows from operating activities are primarily derived from the principal revenue-producing activities of the entity”17. In case of an IFI, investment is a principal revenue producing activity, unlike non-financial entities where it is not. What the IFIs disclose as a cash flow from investing activity is not actually so; it is a part of the cfs-o18, even if it appears as “other income” in the profit and losss account of an IFI.

We found the IFIs to be partly in compliance with this requirement. Return paid (to depositors / accountholders) becomes a part of profit before tax – the starting point of deriving cfs-o, but dividends received is reported as an investing activity. Investment available for sale are presented as a cfs-i. This approach is certainly not valid.

Non-disclosure of Segmental Cash Flows

The Standard requires “the disclosure of segmental cash flows, (which) enables users to obtain a better understanding of the relationship between the cash flows of the business as a whole and those of its component parts and the availability of segmental cash flows”19.

16 Para 33, ibid 17 Para 14, ibid 18 This topic was discussed in “Refining financial reporting practices of Islamic Financial

Institutions in Pakistan” by Altaf Noor Ali published in Volume 28 (July-Sep 11) of this Journal (see page 36).

19 Para 52, ibid


The financial statements of an IFI discloses “segmental details with respect to business activities”. The segmental details of income, expenses, net income, assets, liabilities, etc are usually shown for retail banking, commercial banking, trading and sales, etc.

Segment cash flows are not disclosed anywhere. The same is true for the term segment used with reference to “investments by segments”.

Where the application of IAS-7 results in insufficient disclosure of cash flows.

Reporting cash flows on a net basis

“Cashflows are inflows and outflows of cash and cash equivalents”20.

The IFI permits a financial institution to report its cashflows arising from acceptance and repayments of deposits with a fixed maturity date, placement and withdrawal of deposits from other financial institutions, and cash advances and loans and its repayment made to customers, on a “net” basis21. We will take each one in turn.

Acceptance and Repayment of Deposits with a fixed maturity date.

A careful review of the financial statements show that not all the deposits in an IFI are those with a fixed maturity date. Infact, most of the deposits do not have a maturity date.

Taking the “net” disclosure as applicable to all the deposits, which is not the case, the IFIs show the result as a net change in the “deposit and other accounts” as a single line item in the CFS as a “net change in operating assets”, which is a component of the cfs-o.

The user is left clueless on the adjustments made to arrive at the figure reported in the cfs which can easily be done by way of an additional note to it.

Placements of deposits and its withdrawal with other financial institutions.

An IFI interacts with a number of financial institutions for a diversified nature of financial transactions. These tranactions feature in assets as receivables and in liabilities as payables.

The CFS, on the other hand, provides no clue of a dealing of an IFI with other financial institutions. Making the most of the “net” basis, all these transactions are disclosed as a “single” figure, and its comparative for last period.

This treatment of dealings with the financial institution expressed in a single line as a “net change in operating liabilities”, as cfs-o, in the CFS, obviously means nothing to the user. It simply leaves a user with super-computing skills and lot of time on hand to figure on its own how this figure has been arrived at.

20 Para 6, ibid 21 Para 24, ibid


Cash Advances and loans, and its repayment, made to customers

“Financing” of customers is a principal revenue-generating activity for an IFI. An IFI carries out its financing by a number of modes permissible in Shari’a.

The Standard asserts that “cash advances and loans made by financial institutions are usually classified as operating activities since they relate to the main revenue producing activity of that entity”22.

The treatment financing gets in the CFS of an IFI is consistent and indiscriminate with the two items mentioned above.

There is of course no concept of cash in flows or out flows generated by this activity. Change in financing from one period to the other is simply expressed as a single absolute number as ‘change in operating assets” – a component of cfs-o.

The user is as clueless as ever about the changes in the indvidual components of financing.

“Net” basis reporting for IFIs: Standard’s anamoly or its misapplication and/or misinterpretation?

The financial statements of financial institutions are differ from other entities. (see enclosure 2).

The disclosures in cfs are primarily reported on “net change” basis, without any further explanation by way of notes to the financial statements to link the figures with those reported in the balance sheet and income statement, specially where the figures reported in the CFS do not reconcile.

What is ignored is the Standard’s requirement which states: “an entity shall disclose….a reconciliation of the amounts in its cash flow statement with the equivalent items reported in the balance sheet”23.

It would be logical to know why should the user should expect additional information when what is being provided is specifically stated in the standard? Those responsible for presenting financial statements may even take the ground, mistakenly, that the Standard would not allow disclosure of information more than what is stated therein.

As if addressing such mindsets, the Standards states: “additional information may be relevant to users in understanding the financial position and liquidity of an entity. Disclosure of such information, together with a commentary by management, is encouraged”.24

22 Para 15, ibid 23 Para 45, ibid 24 Para 50, ibid


If you have read so far, there are no points for assuming what our study found: the financial statements of IFIs do not contain any management commentry or additional information about CFS, without exception.

From cash flows to cash earnings of an IFI

While researching CFS, I came across this topic and found it to be interesting, if not fascinating. It is called “cash earnings’.

The concept is fairly simple. It seeks to find out, primarily from the information contained in the CFS, the extent to which the amount of “accrual-based” earnings (as in the profit and loss account) was converted into “cash-based earnings”.

Is the concept simple enough for a user to understand? What purpose will it serve? Is this concept useful to the users understanding of financial statements? If so, is it possible to compute cash earnings from available CFS data for an IFI for a given year? What difference it makes if cash earnings are more or less than the accrual-based earnings? These and many similar questions came to my mind. I share my views humby as enclosure 3, in case you would like to know more about it.

Conclusion:

The Standard, from its first text line and throughout, employs the term “users of financial statements” as the only recognised entity for which CFS is prepared. These users include “present and potential investors, employees, lenders, suppliers and other trade creditors, customers, governments and their agencies and the public”25.

This paper was initiated to figure out the major factors for poor users understanding of CFS. It ended up describing the prevailing practices in the IFIs.

In essence, we found that the reason for this poor understanding of users in general relates to what should have been followed, is being followed, not from the point of view of the users but what appears to be convenient as a practice and as an interpretation.

The Standard is being followed largely in terms of its form for the sake of compliance; the same can not be said of its substance. The information contents of CFS do not add to the understanding of the users. So much so that its omission in the present state from a set of financial statements would hardly be noticed by a majority of its users. This assertion is equally true for the Conventional Financial Institutions as well.

The CFS may be a part of the financial statements of an IFI but it is yet to be its integral part.

25 Para 9 “Framework for the Preparation and Presentation of Financial Institutions”.

“The Framework is not an International Financial Reporting Standards” (See its “Purpose and Status”) . It sets out the concepts that underlie the preparation and presentation of financial statements for external users.


Enclosure 1: Cash flows from operating activities using indirect method

for the year ended 31 December ====>> 2010 2009 cash flows from operating activities profit / (loss) before taxation 41,833 (572,307) less: dividend income (1) 0 41,832 (572,307) adjustments: depreciation 331,722 303,420 amortisation 27,798 25,453 depreciation on operating Ijarah assets 89,403 29,266 (reversal) / provision against non-performing financings (7,424) 89,780 provision for diminution in the value of investments 12,671 15,000 provision against other assets 11,528 0 provision against sukuk murahaba 0 6,418 gain on sale of property and equipment - net (20,260) (192) deferred cost amortised 16,083 16,083 461,521 485,228 increase in operating assets due from financial institutions (494,319) (3,984,881) financings (6,294,801) (4,233,615)

other assets (excluding advance taxation and deferred cost) (126,997) (2,855,453) (6,916,117) (11,073,949) increase / (decrease) in operating liabilities bills payable 77,412 131,962 due to financial institutions 196,840 (89,779) deposits and other accounts 10,198,139 15,499,053 other liabilities 238,000 100,284 10,710,391 15,641,520 4,297,627 4,480,492 income tax paid (36,476) (7,576) net cash generated from operating activities 4,261,151 4,472,916


Enclosure 2: Financial Statements & Cash Flows statement: Distinctive features.

The financial statements of a financial institution differ from a business engaged in non-financial activities, like manufacturing or service. Entities, other than financial institutions, do not accept deposits and make advances, the core activities of a financial institution. Furthermore, unlike other entities, the assets and liabilities of a financial institution are not classified as current or long-term.

In the financial statements of an entity other than a financial institution, which prepares its cashflows from operating activities on indirect basis, changes in its current assets and current liabilities are a part of its operating activities.

This treatment of changes in current assets and current liabilities is appropriate in the CFS of entities engaged in manufacturing.

For example, adjusting changes in current assets such as receivables (from sales) adjust cashflows from sales. Similarly, changes in the current liabilities, such as payable, adjusts the related cashflows of purchases.

Our analysis shows that the same is applied in compiling CFS of IFIs. Its source is para 15 of the Standard, which states:

“An entity may hold securities and loans for dealing or trading purposes, in which case they are similar to inventory acquired specifically for resale. Therefore, cash flows arising from the purchase and sale of dealing or trading securities are classified as operating activities. Similarly, cash advances and loans made by financial institutions are usually classified as operating activities since they related to the main revenue-producing activity of that entity”.

Enclosure 3: Deriving Cash-based Earnings for an IFI.

From cash based accounting to accrual based accounting.

Background: Evolution of modern accounting concepts from basic cash accounting. Many businesses, even today, record accounting transactions on cash receipts and payments only. If you go about fifty years back, in nineteen sixties, accounts of most businesses, including banks, use to be compiled on cash basis.

All cashflows during the period were aggregated and laid out in the form of a receipt and payment account. Out of these, cash flows relating to the revenue and expenditure were taken to the profit and loss account to compute earnings (financial performance) and the rest affecting the financial position (assets, liabilities and equity) to the balance sheet.

In this time, the receipt and payment account took the central position from which the cash flows relating to the sales, purchases, and expenditure were segregated to compute cash-based earnings.

The challenge with cash based accounting was it accounted accurately for the cash receipts and payments during the period but not for the receivables and payables figures, among others. Income earned during the period but not received in cash


during the period was not accounted for as income. Similarly, expenses incurred but not paid were not accounted for as expenses for the period. Furthermore, payment of an expense made as pre-payment or in advance, as in case of insurance was accounted for as an expense for the period. Advance received from customers for the future delivery of goods or service was accounted for as an income for the period.

This state of affairs was obviously not considered desirable and as a result, over a period of time, the accrual principle came to be known as a basic fundamental principle of accounting. With accrual principle in place, quite rightly, the accounts reflected the figures about the receivables and payables. It accounted for advance paid for goods to be delivered as an asset, and pre-payment as a deduction from total payment of an expense. It accounted for advance received from customer as a liability, rather than as income for the period in which received.

Surely this made the life of the accountants a lot difficult. Earlier, the focus was on proper recording of receipts and payments only. Now, it was to account for cash flows in its designated reporting period and also to account for the financial transactions not yet translated into cash and settled fully.

Earlier, any receipt on account of income used to be treated as income for the period even if the transaction happened in the earlier period. Now the accountant had to make a distinction. Receipt for the current period was to be recorded as income whereas receipt of a receivable was to be knocked off against it.

The practice of accrual-based accounting however shifted the focus from the cash-based transactions. In a way, the accrual-based accounting took the driving seat and the cash flows were relegated to back seat. That is not to say that the importance of cash flows diminished in any way for the survival of an entity. Cash flows retained the primary concern of day to day fund management. However, for financial reporting purposes, compiling statement of financial position (balance sheet) and performance (income statement) captured the focus.

It may be taken for granted that the burden on accountants, post-accrual era accounting, is to produce the balance sheet and income statement that accounts for financial transactions during the period, a worthy outcome of the whole process being to determine accrual-based earnings for the period. To account for the cash flows, the indirect way of deriving the cash flows for operating activities was found convenient and is followed in most cases.

One of the vital piece of information that got lost in the transition from cash-based to accrual-based accounting was earnings. The present arrangement gave us the accrual based earnings, known as “profit after tax” as bottom-line of income statement. However, the cash-based “earnings” totally vanished.

From cash flow statement to cash-based earnings. One way to convert the information available in the cfs to derive cash earnings

is to simply consider each cash flow individually. Each cash flow is to be classified as either relating to the financial performance (income or expenditure) or financial position (asset, liabilities, equity).

To make it even more simple, if we were to identify cash flows relating to the financial performance, we can reasonably assume that the rest relate to the financial position.


Adjustments required in cash flows from operating activities (cfs-o) for deriving cash earnings

The most convenient way of deriving cash earnings is to “adjust” the cfs-o of an IFI. We will take it that the cfs-o are based on indirect method. We are going to do so in two stages.

In the first stage, we will take out from cfs-o those items that we consider to be relating to the financial position. Now what we are going to assume here is contrary to what IAS-7 says but that should not bother us. We are going to assume that the changes in assets and liabilities are NOT a part of cfs-o. So we will restate cfs-o without these items.

In the last stage, we will add back those items relating to the financial performance that have been taken as cash flows in investing or financing activities. For example, the dividends received are shown as a part of the investing activity (these are not added because they already form a part of the profit before tax). To find out the cash earning, we will take this as a cfs-o.

By restructuring we have transformed cfs-o as cash earnings. An example, after adjustments of the cfs-o in enclosure 1 is as follows (enclosure-4)

for the year ended 31 December ====>> 2010 2009 reconciling accrual-based and cash-based earnings depreciation 331,722 303,420 amortisation 27,798 25,453 depreciation on operating Ijarah assets 89,403 29,266

(reversal) / provision against non-performing financings ? 7,424 89,780

provision for diminution in the value of investments 12,671 15,000

provision against other assets 11,528 0 provision against sukuk murahaba 0 6,418 gain on sale of property and equipment - net ? 20,260 ? 192 deferred cost amortised 16,083 16,083 a adjustments not involving cash flows 461,521 485,228 proceeds from sale of fixed assets 56,239 3,330 income tax paid ? 36,476 ? 7,576 b cash flows affecting income statement 19,764 ? 4,246

c=a+b net impact of adjustments and cash flows 481,285 480,982


d profit/ (loss) before tax (accrual-based earnings) 41,833 ? 572,307

e=c+d cash based earnings 523,118 ? 91,325

As you can see from above, the cash based earnings in 2010 was Rs. 523,118 and a cash loss of Rs. 91,325 in 2009. Compare this to accrual based profit before tax of Rs. 41,833 in 2010 and loss before tax of (Rs. 572,307).

Applying this simple process, provides further insight into the reported earnings.

The “net impact of adjustments and cash flows” is more or less similar in the year 2010 (Rs. 481,285) and 2009 (Rs. 480,982). However, the accrual based loss of Rs. 91,325 has been neutralised and there is a cash earning of Rs, 523,118 in 2010. This is not apparent from the plain reading of the cfs.

For 2010 we can say that the cash based earnings were 12.50 times higher than the accrual-based earnings (Rs. 523,118 divided by Rs. 41,833). For 2009, the cash loss was Rs. 91,325 was 16% of the accrual based loss of Rs. 337,000, (Rs. 91,325 divided by Rs. 572,307, expressed as a percentage.


The Propagation Of Non-Interest Banking In Nigeria: An Appraisal Of The

Ideological Risk By

Abubakar S. ORISANKOKO, *

Abstract

Apropos the propagation of Islamic banking in Nigeria, it is stated that in the Holy Quran appear commandments of Allah and there are Traditions of Prophet which condemn levying of interest in any financial deal and warns sinners of severe punishment Hereafter. On the basis of the above religious requirement, a whole edifice of rules, principles have been framed by Shariah for strict observance by Muslims. The Islamic banking therefore does not merely mean prohibition of interest but a whole code has to be implemented in practicing Islamic banking. However in Nigeria there are demands to drop the Islamic nomenclature and to call the system non-interest banking or divine banking because Bible also rules against interest.

The Muslims have reservations against these suggestions on the grounds:

(i) Islamic banking is not merely meant to ban interest.

(ii) It has to implement all the Shariah rules in its working.

(iii) Under the two proposed changed names the entire practice of banking prescribed by Shariah will be continued but Islamic system will get no recognition for it and the Muslims most probably will start distancing themselves from such banks.

Key words

Ideological Conflict, Nomenclature, Propagation, Exploitation, Antecedent.

* The Author , Abubakar S. Orisankoko Department of Common & Islamic Law, Faculty

of Law, University of Ilorin, Ilorin, Nigeria. Also, Coordinator/Senior Instructor, Caliphate Islamic Academy of Research and Publicity, Secretary international Islamic thoughts (IIT) Ilorine, Kware State, Nigeria. Email: [email protected]


Introduction

The passion in the propagation of Islamic banking in the modern age as a way of sensitizing the public and convincing the would-be investors and practitioners informs the basis for the multi-facets approach undertaken. The aggressive nature of the promoters in Nigeria have equally contributed to this, whether the driving force is merely to engage in this venture as an act of ibadah or as a part of the normal protocol on how the campaign should be carried out. The other factor is to convince the would-be customers and clients of the proposed Islamic Bank on its religiosity and viability. The population of Nigerians, particularly those who contribute to the driving force of the banking sub-sector in Nigeria, is a mixture of the Christians and Muslims in trade, business, financial and non-financial institutions. This factor therefore leads the academia, jurists and practitioners to place much reliance on the words of the two Holy Scriptures in order to achieve the goal of canvassing such people into patronizing the prospective Islamic Bank. But this act however raises a concern as to whether or not the use of Holy Scriptures can validly stand the tests of convincing the prospective customers. It should be mentioned that it appears this act will amount to sacrificing the legacy of Islam for the glory of another faith by graduality. This issue is the focus of this paper. The contents of this discourse include the introduction, definition of terms, historical basis of Islamic Bank, antecedent of Islamic Bank in Nigeria, contradistinction of non-interest banking as faith-based banking, recommendation and conclusion.

Definitions of Terms

i. Ideological conflict: Disagreement of technical concepts based on the fundamental belief, principles or tenet guiding the conduct and affairs of such.

ii. Non-interest: Interest free; that does not attract any form of interest through investment, enterprise or venture.

iii. Developing: That which has not developed but on the struggle to become developed.

iv. Islamic bank: Banking system that is being operated in strict compliance with the dos and don’ts of Shari’ah.

The Historical Basis of Islamic Banking

The emergence of (modern) Islamic banking came into the limelight more than four decades ago at the world level even though Orisankoko1 has argued it that the basis is traceable to the (savings) banking practised by the Holy Prophet Muhammad

1 Orisankoko A.S. (2009): ’’An Appraisal of Unethical Practices in the Contemporary Nigerian Banking System vis -à-vis Recourse to Islamic Panacea.” A conference paper presented at the 1st International Conference on Islamic Banking and Economic Reform, jointly organized by Department of Islamic Law, University of Ilorin, Ilorin, Nigeria, and IRTI of the International Development Bank, Jeddah, October 6-8, 2009, Pp 2-3


(SAW) and the pre-Islamic Arabian banking practice as well as the historic goldsmith that founded the modern conventional banking. Prophet Muhammad (SAW) also combined this savings banking with the practice of Mudarabah, as Ahmad explains:

The mudarabah, for example, is an ancient financial instrument that was utilized by the Holy Prophet himself, who acted as a Mudarib (agent) for his wife.2

Aburime and Alo 3 have identified four primary features of Islamic banking, which include:

i. Prohibition of interest

ii. Low consumer lending

iii. Profit and loss sharing (same as Profit and Risk Sharing )

iv. High real sector investing

Furthermore, Ahmed4 submits that the modern day Islamic banking began like an initiative, though not without other prior attempts, in Mit Ghamr (Egyptian city) in 1963 and it has grown enormously worldwide:

Prior to the Mit Ghamar experience of 1963, small scale or limited scope interest free banks had been tried before, one in Malaysia in the mid-40s and another in Pakistan in the late 1950s. Neither of them survived. In 1962, the Malaysian government set up the ‘pilgrims management fund’ to help prospective pilgrims save and at the same time make a profit from the investment of the savings. This fund is what came to be known today as the ‘Tabung Hajji.’

In the same vein, record has it that the 2nd Conference of the Foreign Ministers of Muslim countries held in Karachi, Pakistan, led to the emergence of modern Islamic mega banking, first with the mooting that failed for the institutionalization of Islamic Development Bank, Jeddah in 1975, though its chief goal was to provide project financing fund on free-interest basis. Same 1975 witnessed the establishment of the first full-fledged commercial banking operation in Dubai, i.e. Dubai Islamic Bank; the Faisal Islamic Bank of Egypt, Sudan and Kuwait in 1978; Jordan Islamic Bank for Finance and Development in 1979 and later, the Bahrain Islamic Bank. Quoting Siddiqi, Aburime and Alo argued that: 2 S.A. Ahmed (2003): “Current Development in Islamic Banking and Finance: A Global

Perspective in Islamic Banking and Finance; S. Sulyman and B.S. Galadanci (eds), p. 125

3 U. T. Aburimo & F. Alo (2009): “Islamic Banking: Theories, Practices and Insights for Nigeria”, in International Review of Business Research Papers, Vol. 5 No 1, January 2009, p. 322

4 S.A. Ahmed, Pp.126-127


The pioneering effort, led by Ahmaad El-Najjar, took the forum of a savings bank based on profit-sharing in the Egyptian town of Mit-Ghamr in 1963. The bank was very popular and prospered. The experiment lasted until 1967, by which time there were nine such banks in the country. These banks neither charged nor paid interest, invested mostly by engaging in trade and industry, directly or in partnership with others, and shared the profit with their depositors.5

Furthermore, non-Muslim dominated countries have equally valued the viability, practical essence and healthy commercial values emanating from this type of banking and have consequently commenced operation on it, with Citigroup (having a subsidiary as in Citi Islamic Investment Bank) and HSBC (having HSBC Amanah) leading in the global scene.

Today, the growth of Islamic/non-interest banking is rapid. Most countries have adopted it and it is certain that the capital base of this bank worldwide is on the geometric increase. It has similarly increased in sizes (branches and networking) across the globe. Several development and acceptable innovations have been embraced to the level by which Islamic banking progresses and it has also impacted positively on the revolutionary dimensions taking place in the conventional banking sub-sector. Adebayo6 comments that:

The success of Islamic banks made some conventional banks to start offering Islamic financial products, some of which consequently established Islamic branches dealing exclusively in Islamic products. According to Abdul Ghafar (2010:10), by the 1990s, over fifty Islamic Bank branches were established by the Citi Islamic in Bahrain, Grindlays in Karachi, and the National Commercial Bank in Saudi Arabia.

Islamic banking has no doubt transformed from being a mere assumption to reality, as it has become globally accepted to both Muslim and non-Muslim. The actual number of the Islamic bank cannot be given with precision. Sairally (2007: 280) cites Iqbal and Molyneux who put the number of Islamic banks as at 2004 at 70 excluding those in Iran and Sudan, 40 conventional banks offering Islamic banking windows, 200 Islamic investment funds and 70 Islamic insurance companies with a total market operation exceeding US $150 billion. Ahmed (2003: 144-145) also has a catalogue of fifty four countries and the number of financial institutions in each of them with Sudan having the

5 U. T. Aburime & F. Alo, Pp. 322-323 6 R. I. ADEBAYO (2010): “The Motivating Factors for the Viability of Islamic Banking in

Nigeria”, being a paper presented at an International Conference on Islamic Banking and Finance, held at Crescent University, Abeokuta, Between 19th And 22nd March 2010, P.4


highest of thirty, followed by Bangladesh with twenty-five. The above might be with the exception of Saudi Arabia and the United Kingdom where Al-Rajhi Islamic Bank, which was established in 1987 in Saudi Arabia, is said to have had 362 branches, 451 ATM machines and 59 ladies branches in the United Kingdom (Salama, 2003: 159).

It is pertinent to examine the fact that “Islamic” and “Non-interest” are being used synonymously and interchangeably when referring to banking in Islamic way. How correct is this? This is vehemently objected to because an institutional product or service may be operated in such a way that it does not attract interest (riba) but yet it is an operation devoid of Islamic recognition. So, therefore what is Islamic is any product and or service run mainly in strict compliance with the dictates of the Shari’ah provisions. Against this background, it is not sufficient to refer to non-interest banking window as Islamic bank or Islamic banking window, as most commonly do erroneously, so long the system operating it is alien to Islam. It should rather be delimited to a non-interest banking, such that any economic system can operate7 and as a result should not be branded Islamic.

World Interest Rates Table Country Current Rate Previous Rate Change Last Change

1. Argentina 9.55% 9.6% -0.05% May 15 2010 2. Australia 4.5% 4.25% 0.25% May 04 2010 3. Brazil 9.5% 8.75% 0.75% Apr 28 2010 4. Canada 0.25% 0.5% -0.25% Apr 21 2009 5. Chile 0.5% 0.75% -0.25% Jul 10 2009 6. China 5.31% 5.58% -0.27% Dec 22 2008 7. Columbia 3% 3.5% -0.5% Apr 30 2010 8. Czech Republic 1% 1.25% -0.25% Dec 16 2009 9. Denmark 0.75% 1% -0.25% Jan 15 2010 10. Egypt 8.25% 8.5% -0.25% Sep 22 2009 11. European Monetary Union 1% 1.25% -0.25% May 07 2009 12. Hong Kong SAR 0.5% 1.5% -1% Dec 17 2008 13. Hungary 5.5% 5.75% -0.25% Mar 29 2010 14. Iceland 8.5% 9% -0.5% May 05 2010 15. India 5% 4.75% 0.25% Mar 19 2010 16. Indonesia 6.5% 6.75% -0.25% Aug 05 2009 17. Israel 1.5% 1.25% 0.25% Mar 28 2010 18. Japan 0.1% 0.3% -0.2% Dec 19 2008 19. Korea, Republic of 2% 3% -1% Feb 16 2009 20. Malaysia 2.5% 2.25% 0.25% May 12 2010 21. Mexico 4.5% 4.75% -0.25% Jul 17 2010 22. New Zealand 2.5% 3% -0.5% Apr 29 2009 23. Norway 1.75% 1.5% 0.25% Dec 16 2009 24. Pakistan 12.5% 13% -0.5% Sep 10 2009 25. Peru 1.5% 1.25% 0.25% May 9 2010 7 http://www.worldinterestrates.info/


26. Philippines 4% 4.25% -0.25% Jul 09 2009 27. Poland 3.5% 3.75% -0.25% Jun 24 2009 28. Russia 8% 8.25% -0.25% May 9 2010 29. Saudi Arabia 2% 2.27% -0.27% Jan 10 2009 30. Singapore 0.06% 0.05% 0.01% May 22 2010 31. Slovakia 1.75% 2.25% -0.5% May 13 2009 32. South Africa 6.5% 7% -0.5% Mar 25 2010 33. Sweden 0.25% 0.5% -0.25% Jul 02 2009 34. Switzerland 0.25% 0.5% -0.25% Mar 12 2009 35. Taiwan 1.25% 1.5% -0.25% Feb 19 2009 36. Thailand 1.25% 1.5% -0.25% Apr 08 2009 37. Turkey 6.5% 6.75% -0.25% Nov 20 2009 38. UAE 1.79% 1.78% 0.01% May 15 2010 39. United Kingdom 0.5% 1% -0.5% Mar 05 2009 40. United States 0.25% 1% -0.75% Dec 16 2008 41. Venezuela 17.94% 18.99% -1.05% May 22 2010

The Antecedent Of Islamic Bank Operation In Nigeria

The issue of Islamic banking operation in Nigeria is an issue that has caused confusion to many scholars. The popular perception and knowledge is that there has been nothing like Islamic bank operating in the Nigeria economic and financial history. Scholars of repute and other researchers have equally drenched in this misbelieve. Even when the situation became critical with the conscious Muslims according to Adebayo, the highest they subject themselves to is the age long subscription to operating current account, which does not totally replace or remedy the infiltration on ground. Adebayo further shares this ordeal thus:

However, while many Muslims are not satisfied with the operation of the conventional interest-based banking system for fear of incurring Allah’s wrath, they are incapacitated by the fear of exposing their money to risk of theft should they decide to keep their money at home, or the fact that their wages will be paid to them through the banks, or rather, some other unavoidable transactions with these conventional banks which do not operate in line with the dictate of Allah. Those who opted for current accounts with these banks still stand the risk of moving in the periphery of usurious transaction, as this product has percolated element of interest to customers as well. It therefore becomes pertinent to put all hands on the deck to explore the available resources for the successful take-off of an Islamic bank in Nigeria to save the Ummah from perpetual drowning into these abominable transactions.8

8 R. I. ADEBAYO, P.5


The situation however became lighter and newer to the joy of the Ummah with the granting of the defunct Habib Bank a license to operate Islamic banking window. In the same vein, when Messrs Sanusi Lamido Aminu Sanusi assumed office in 2009 a parade of products non-interest (Islamic) banking window was developed, different from the current sectorial experience9. Thus, since ‘non-interest’ principle as well as the principle of ‘profit and risk-sharing’ constitute partial features of the Islamic banking, it suffices to conclude that approval for the operation of Islamic banking system in Nigeria dates back to 1991 though, but license was not granted to any bank until the year after. This in the words of Usman is explained thus:10

It, clearly, in section 9(2) sub-section (1) gives the necessary legal framework for the establishment of profit and loss banks in Nigeria. In fact, two of such banks were actually licensed in 1992 but, unfortunately, none has been able to start operation.

It should be noted that the operation of Islamic Bank in Nigeria and Nigeria economic and financial industry dates back to around the period of the Nigeria independence. There was an Islamic Bank, called Muslim Bank West Africa Limited. The operation of this bank was short lived. According to Ajayi, the operation of the bank was abruptly brought to an end when then Minister of Finance, Chief Obafemi Awolowo declared that the bank should cease operation in 1962. This bank is said to have operated in Lagos, where it used to have its head office. Accordingly, a house with a bold inscription ISLAMIC BANK HOUSE somewhere in Lagos is purportedly said to be where this bank had operated. Inspite of its acclaimed extinction, evidences of its operation11 can be traced to some two court cases it had with some other organization, which include:

(1) On Opening a Bank Account: United Nigerian Insurance Co. v. Muslim Bank West Africa Ltd. (1972): The Court held the bank negligent and thereby lost the protection of S. 77 (2) Bills of Exchange Act 1960 because it failed to obtain necessary references and follow proper banking procedure while opening a new current account.

(2) On the negligence of Bank: Nigerian Breweries Ltd. v. Muslim Bank West Africa Ltd. (1963) The court held that where it was proved that the defendant was negligent, he could not claim the protection afforded by the Bill of Exchange Act 1960.

9 Draft Framework For The Regulation And Supervision Of Non-Interest Banks In

Nigeria, BSD/DIR/GEN/NIB/01/008, emanating from D. A. N. Eke, Ag, Director of Banking Supervision, March 4, 2009.

10 S. Usman (2003): “The Legal and Regulatory Issues of Islamic Banking in Nigeria,” in Islamic Banking and Finance, S. Sulaiman and B.S. Galadanci (eds), IIIT, Nigeria office, Kano, p. 41

11 See: Ajayi O. A. (1999): “Law and Practice of Banking”, Andy-P Corporate Bureau, Ibadan, Pg. 57


With the above clarification, it thus suffices to say that the operation of Islamic Bank in Nigeria in this modern day is rather a re-introduction and cannot therefore be the debut (first time experience). This pertains to Jaiz International Bank which is popularly put out to be the first of its kind in Nigeria. Though it is yet to commence operation as Adebayo substantiates:

In actual fact, Jaiz International Plc was about to start operation, when it was obstructed by the banking reform exercise of the Central Bank of Nigeria. The Jaiz International Plc was incorporated on 1st April 2003 as a public limited liability company and with the opportunity of establishing an Islamic banking institution in Nigeria. The approval to establish Jaiz Bank International Plc was given by the Central Bank of Nigeria and it subsequently raised over 2.5 billion Naira in 2003. However, the CBN new minimum capital requirement of N25 billion seems to have drawn the foot of Jaiz back, as it is still struggling to raise the amount since then.12

In the same vein, he adds to the credence of the Muslims’ effort at establishing an Islamic Bank, even at the level of the State. This he puts thus:

It needs to be mentioned that the Zamfara State Government had initially taken a bold step to establish an Islamic Bank as part of its policy of application of full-fledged Islamic law. It however suspended this action in order to pool resources together for the successful take-off of the Jaiz International Bank.13

Contradistinction Of Non-Interest Banking As A Divine Banking

Jurisprudentially, there is need to critically review the contradictory position of some scholars, who see the product of Islamic non-interest banking as similar to the Christian ideological concept of usury or interest prohibition. Many writers14 have often juxtaposed this tenet of both Islam and Christianity. I want to believe that this assumption is being used rather as strong weapon to either establish the authenticity of this mode of banking or convince the world that interest-classified dealing is against the commandment of God generally. But it appears there is a confusion or misplacement of order in this situation. Although, both Qur’an and Bible contain divine provisions that de-emphasize interest (riba) but applicability of the biblical provision is not as comprehensively encompassing and relevant as the Holy Qur’an, when applied to banking operation. According to Bello:15

12 R. I. Adebayo, P.5 13 R. I. Adebayo, P.11 14 Jaiz International Plc, private placement memorandum, p. 13; A.F. Bello (2003):

“Divine Banking in Nigeria: The Qur’anic and Biblical Injunctions, an overview and the regulatory framework, Pp 47-54.

15 A. F. Bello, p. 49


The glorious Qur’an and the Holy Bible,…have clearly and unequivocally prohibited usury or Riba, a type of contract in the pre-Islamic Arab world and the west today under which money lent would continue to increase in value. Both Islam and Christianity view Riba as exploitation of man by man, and for this reason, prohibited their followers from practising it.

Bello’s position, there is no gainsaying, is of the opinion that both Qur’an and Bible disallow commercial activity that leads to making money continuously increase in value through riba. Generally speaking, the focal point of this view is the prohibition of riba, usury or interest because it leads to exploitation of man by man. One thing that is clear in this respect is that the writer has expressed his opinion in favour of canvassing people to embrace Islamic banking by simply entrenching its religious permission but the fact remains that the provisions of these divine scriptures differ distinctively. Analytically, one of these scriptures has a fundamental basis supporting this mode of banking while the other lacks it. Perhaps, many do not have a sound understanding of the term, “Islamic banking.” The differences in the provisions of these two divine scriptures do not allow the fact that the Holy Bible contains riba prohibitory provisions to be sufficient in referring to it as an equivalent basis for justifying Islamic banking as divine banking. “Non-interest” product is not the only dominant business of Islamic banking. There are various other products and services that are not known to Christendom, in the face of religious interference. While any form Christian banking system, if any, cannot boast of such banking products operating under Islamic banking system. The following are the provisions of these divine scriptures, beginning with the Holy Qur’an: Surah Al-Baqarah, verse 275-276, 278-279:

Verse 275: Those who eat Riba (usury) will not stand (on the day of resurrection) except like standing of a person beaten by shaitan (satan) leading him to insanity. That is because they say, “trading is only like Riba (usury),” whereas Allah has permitted trading and forbidden riba (usury). So, whosoever receives an admonition from his Lord and stops eating riba (usury) shall not be punished for the past; his case is for Allah (to judge); but whoever returns (to Riba usury), such are the dwellers of the fire, they will abide therein.

Verse 276: Allah will destroy Riba (usury) and will give increase for sadaqat (deeds of charity, alms) and Allah likes not the disbelievers, sinners.

Verse 278: O you who believe! Be afraid of Allah and give up what remains (due to you) from Riba (usury) (from now onward), if you are (really) believers.

Verse 279: And if you do not do it, then take a notice of war from Allah and His messengers but if you repent, you shall.


The Biblical provisions are as follows:

Deuteronomy 23, verse 19:

You shall not charge your interest to your brother, interest on money or food or anything that is lent out at interest.

Verse 20: To a foreigner, you may charge interest, but to your brother, you shall not charge interest, that the Lord your God may bless you in all to which you set your hand in the land which you are entering to possess.

Ezekiel 18, verse 8:

If he has not exacted usury nor taken any increase, but has withdrawn his hand from iniquity and executed true judgment between man and man.

Verse 13: If he has exacted usury or taken increase, shall he then live? He shall not live! If he has done any of the abominations, he shall surely die; His blood shall be upon him.

Verse 17: Who has withdrawn his hand from the poor and not receive usury or increase, but has executed my judgments and walk in my statutes, he shall not die for the iniquity of his father; he shall surely live!

Exodus 22, verse 25: If you lend money to any of my people who are poor among you, you shall not be like a moneylender to him; you shall not charge him interest.

Luke 6, verse 34: And if you lend to those from whom you hope to receive back, what credit is that to you? For even sinners lend to sinners to receive as much back.

Verse 35: But love your enemies, do good, and lend, hoping for nothing in return; and your reward will be great, and you will be sons of the Most High. For He is kind to the unthankful and evil.

Leviticus 25, verse 36:

Take no usury on interest from him; but fear your God, that your brother may live with you.

Verse 37: You shall not lend him your money for usury, nor lend him your food at a profit.

Proverb 28, verse 8:

One who increases his possessions by usury and extortion gathers it for him who will pity the poor.


Psalm 15, verse 5:

He who dares not put out his money at usury, nor does he take a bribe against the innocent. He who does these things shall never be moved.

From the above chapters and verses of both the Qur’an and Bible, it is discernible that the common ground shared by the two is just the prohibition of usury, riba, interest. There are a lot of differences too. It is on this basis that it is not sufficient to agree with the view of those who generalize ‘Non-Interest banking’ as a divine banking. Islamic banking can be said to mean a banking transaction that is founded, managed, organized and regulated based on the core values of Islam and the Shari’ah principles of muamalat. It deals fairly with everybody and makes the legal relation justiciable16. This is the nature of non-interest or Islamic banking in context. However, part of the differences barring the biblical injunctions from being referred to as the provision of Islamic banking (divine banking) is as follows:

In the first place, the business of banking is not intrinsically known to Christendom. There is no historical evidence alluding to the genesis of this in Christian theology17. The usury prohibition only related to commerce and that does not take any form of banking. Moreso, banking and commerce are not practically the same even if element of commerce were to be found in banking transaction. Banking merely helps to facilitate the business of commerce. Relying on Isaiah 24:2, it is inferred that:

…it was a business in that age, the lender and borrower being social types.18

The same is not the story with Islam; banking has a historical sedimentation in the practice of the Holy Prophet Muhammad (SAW)19 and so commerce. Aside the fact that Prophet Muhammad (SAW) was a farmer, he also traded (mudarabah) for Khadijat before their marriage. Likewise, he discouraged riba the pre-Islamic Arabians indulged in. A Hadith substantiates this:

Naratted Abu Sa’id Al-Khudri (R.A): once Bilal brought Barni (a kind of) dates to the Prophet (SAW) and the Prophet (SAW) asked him, “from where have you bought these?” Bilal replied, “I had some inferior kind of dates and exchanged two Sa’ of it for one Sa of Barni dates, in order to give to the Prophet (SAW) to eat.” Thereupon the Prophet (SAW) said, “Beware! Beware! This is definitely riba (usury)! This is definitely riba (usury)! Don’t do so, but if

16 See the case of Alhaji Tijjani v. Kaodafo , Unrepoerted case, Suit No MCA/CV/115,

holden in Kaduna on the 28/1/1961 17 Matthew 25:27 and Luke 19:23 18 Bible history.com, International Standard Bible Encyclopedia, www.bible-history.com.

Accessed 2nd, December, 2009 19 Orisankoko A.S., “An Appraisal of the Unethical Practices…”, p. 3


you want to buy (a superior kind of dates) sell the inferior kind of dates for money and then buy the superior kind of dates with that kind of money20.

To cap it all, it is categorically mentioned that “in Israel, there was no system of credit or commercial loans in Moses’ time and after.”21 Then, where is the place of banking of any form in the Christian chronology?

The legal injunction of the Holy Qur’an is clear on riba. Allah and His Prophet have prohibited riba (interest)22 for all and sundry. The Muslims must not discriminate in this regard; neither must they give it, prefer it on anybody nor can they demand or collect it from whomsoever.23 This is not so with the Bible because a sort of contradiction is clearly and unequivocally unraveled. Notwithstanding the perception that “a poor man borrowed money because he is poor,”24 when the provisions of Ezekiel, Exodus, Luke, Leviticus, Proverb and Psalm quoted above categorically condemn the acts of giving and taking interest, Deuteronomy 23, verse 19 and 20 classify those to be charged the payment of interest and those to be spared:

You shall not charge your interest to your brother-interest on money or food or anything that is lent out at interest.

To a foreigner, you may charge interest, but to your brother, you shall not charge interest, that the Lord your God may bless you in all to which you set your hand in the land which you are entering to possess.

If this is the case, the inference is that there is no outright prohibition of riba. And if there is none, then Bible and Christianity have not achieved anything in the war against riba. This can further be proved by the fact that:

In the New Testament, references to interest occur in the parable of the pounds (Luke 19:23) and of the Talents (Mt. 25:27). Here, the men were expected to put their master’s money out at interest, and condemnation followed the failure to do so. Thus, the principle of receiving interest, only it was not to be taken from a brother Israelite. In the New Testament, it is definitely encouraged25.

20 Sahih Al-Bukhari, vol. 3, Hadith No. 506 21 Biblehistory.com, op. cit. 22 Riba: usury, which is of two major kinds (a) Riba an-Nasi a i.e. interest on lent money;

(b) Riba Al-fadi, i.e. taking a superior thing of the same kind of good by giving more of the same kind of goods of inferior qualities, e.g. dates of superior quality for dates of inferior quality in great amounts.

23 Qur’an and Hadith maintain the equality status of all mankind generally. 24 Biblehistory.com 25 Biblehistory.com


Another point of difference is the status of enforceability of the Biblical injunction of usury prohibition. According to these provisions, they appear visibly to be more of moral persuasion and less of legal provision.26 Moreso, the only provision appearing to have provided a punitive measure does not really spell out a definite penalty other than that the violator: “shall die.”27 Since the reality is that all souls shall taste death28, can this still be upheld as a penalty? Whereas, the Holy Qur’an has established the form of punishment(s) awaiting the dissidents:

…but whoever returns (to riba [usury]), such are the dwellers of the fire, they will abide therein.29

To be well convinced about the verisimilitude of this Qur’anic provision as a penal measure, the rationale has been provided by Asein:30

The central thesis of this school of thought is that law has a divine or supernatural origin and that for human laws to be legally valid, they must conform to certain objective moral principles based on the nature of man and the dictate of reason. Rooted in the remote past, this line of thinking started by recognizing the interplay of spiritual forces in the physical organization of human societies.

It is therefore sufficient to say at this juncture that these basic and obvious points of weakness, non-justiciability, contradiction and abrogation of usury prohibition in the Bible have posited the correct position of the Christian tenet on the issue. Therefore, Islamic banking as a divine banking is exclusive of the Christianity’s interest and biblical interplay.

Surmised to say that Christendom now favours usury when the underlying principles of Islamic banking completely and vehemently stand against it. More particularly, in view of the provisions of Luke 19:23, Matthew 25:27 and Deuteronomy 23:19-20, it does not justifiably worth it that Muslim proponents31 of Islamic banking should employ this basis to justify the viability, truthfulness, genuineness and prospect of this type of banking to canvass for patronage. Shari’ah as a working tool is sufficient to make the system work; makes the genuine investors (God-fearing and result-oriented) patronize it and the services embraced. Against this backdrop, to avoid further or similar attempt, the Holy Prophet Muhammad (SAW) cautions: 26 See Deuteronomy 23:19-20; Ezekiel 18:8; Exodus 22:25; Luke 6:34-35; Leviticus

25:36-37; Proverb 28:8 and Psalm 15:5 27 See Ezekiel 18:13 and 17 28 See also Qur’an 29 Surah Al-Baqarah, verse 275 30 J.O. Asein 92005): “Introduction to Nigerian Legal System,” 2nd edition. Ababa Press

Ltd, Surulere, Lagos. p.10. See also A. Sanni (ed) (2006): “Introduction to Nigerian Legal Method, Obafemi Awolwo University Press Limited, Ile-Ife, Nigeria, Pp. 14-17

31 Jaiz International Plc: A.F. Bello, “the title, under which this paper was presented during the first seminar held in Kano, was “Emerging Opportunities for Divine Banking in Nigeria. Here, the title is modified to reflect the issues addressed by the paper. Alhaji Falalu Bello is the Managing Director, Intercity Bank Plc, Nigeria” (as he then was).


On the authority of Abu Abdullah an-Nu’man, the son of Bashir (RA) who said; I heard the Messenger of Allah (SAW) saying: verily that which is lawful is plain and that which is unlawful is plain and between the two of them are doubtful matters about which many people do not know. Thus, he who avoids doubtful matters clears himself in regard to his religion and his honour, but he who falls into that which is unlawful, like the shepherd who pastures around a sanctuary, may be he graze therein. Truly, everything has a sanctuary, and truly Allah’s sanctuary in His prohibitions. Verily in the body, there is a morsel of flesh, which, if it be right, all the body is right and which, if it be diseased, all of it is deceased…32

Conclusion

Finally, not all religions prohibit riba, which is the basis for the particular banking service operated because of the conflict of inconsistency discovered, especially with regard to the argument and justification raised to favour Christianity. Hence, Bible is not sufficiently a basis to affiliate Divine Banking with Christianity on the basis of Non-Interest. This appears to be posing a serious danger to the firmness, virility, veracity and reliability of the only Scripture upon which Islamic Banking is founded. Al-Qur’an (and Sunnah). The two definitely suffice for the propagation of this banking. Attempt to harness any Scripture other than the provisions of Shari’ah is a plain testimony to the unreliability, incomprehensiveness and irrelevance of the Shari’ah. It gives the colouration therefore to the object of our propagation not to be Islamic as it is purely branded. This would otherwise make the Ummah and Islam lose the glory of being the owner of the Islamic Banking as it will be snatched and re-packaged, like most of the other professions and fields33, by the non-Muslims. We should not be surprised that some of them with bright sight for the prosperity of Islamic Banking have already commenced calling for a change of nomenclature34.

32 Reported by Bukhari and Muslim. 33 Such fields as Chemistry, Algebra, Medicine, etc were all started by the early Islamic

researchers, practitioners and scholars, in the early days of Islam. 34 Prof. R. O. C. Somoye of Business and Finance Department, Crescent University

suggested a change of its name from Islamic Bank to Divine Banking, during the recently International Conference on Banking, at Crescent University, Abeokuta, Ogun State, Between 19th And 22nd March 2010. See also: R. O. C. Somoye “The Role of Islamic Banking and Finance in the Sustainability of Enterprenuership and Innovation in Nigeria: A Faith Finance Hypothesis”, being a Paper presented at the International Conference on Banking, at Crescent University, Abeokuta, Ogun State, Between 19th and 22nd March 2010, P. 16. “It was Islam that revived the human pursuit of science and it was through the Arabs, not the Romans that the modern world achieved light and power through science.” Adeyemi K. A. (2000). History of Arabic and Islamic Education in Nigeria The Journey So far, in Seriki I. A. & Folorunsho M. A. (Eds.) Book of Readings in Arabic & Islamic Education, Alamseki Press Ltd., Ijebu-Ode.


Bibliography

R. I. ADEBAYO (2010): “The Motivating Factors for the Viability of Islamic Banking in Nigeria”, being a paper presented at an International Conference on Islamic Banking and Finance, held at Crescent University, Abeokuta, Between 19th And 22nd March 2010

Adeyemi K. A. (2000): “History of Arabic And Islamic Education in Nigeria The Journey So far”, in Seriki I. A. & Folorunsho M. A. (Eds.) Book of Readings in Arabic & Islamic Education, Alamseki Press Ltd., Ijebu-Ode.

Ahmed, S.A. (2003): “Current Development in Islamic Banking and Finance: A Global Perspective in Islamic Banking and Finance; S. Sulyman and B.S. Galadanci (eds), IIIT Publication, Nigerian Office, Kano

Aburime U.T and Alo F. (2009): “Islamic Banking: Theories, Practices and Insights for Nigeria,” in International Review of Business Research Papers, Vol. 5 No1, January 2009

Asein, J.O.(2005): “Introduction to Nigerian Legal System,” 2nd edition. Ababa Press Ltd, Surulere, Lagos

Bello, A. F. (2003): “Divine Banking in Nigeria: The Qur’anic and Biblical Injunctions, an Overview and the Regulatory Framework, in Islamic Banking and Finance; S. Sulyman and B.S. Galadanci (eds), IIIT Publication, Nigerian Office, Kano

Draft Framework For The Regulation And Supervision Of Non-Interest Banks In Nigeria, BSD/DIR/GEN/NIB/01/008, emanating from D. A. N. Eke, Ag, Director of Banking Supervision, March 4, 2009.

Jaiz International Plc, “Private Placement Memorandum.” February 15, 2006

Orisankoko A.S. (2009): ’’An Appraisal of Unethical Practices in the Contemporary Nigerian Banking System vis-à-vis Recourse to Islamic Panacea.” A conference paper presented at the 1st International Conference on Islamic Banking and Economic Reform, jointly organized by Department of Islamic Law, University of Ilorin, Ilorin, Nigeria, and IRTI of the International Development Bank, Jeddah, October 6-8, 2009

Sanni A. (ed) (2006): “Introduction to Nigerian Legal Method, Obafemi Awolwo University Press Limited, Ile-Ife, Nigeria

Somoye R. O. C (2010): “The Role of Islamic Banking and Finance in the Sustainability of Enterprenuership and Innovation in Nigeria: A Faith Finance Hypothesis”, being a Paper presented at the International Conference on Banking, at Crescent University, Abeokuta, Ogun State, Between 19th and 22nd March 2010

Usman S. (2003): “The Legal and Regulatory Issues of Islamic Banking in Nigeria,” in Islamic Banking and Finance, S. Sulaiman and B.S. Galadanci (eds), IIIT, Nigeria office, Kano


Internet

Biblehistory.com, International Standard Bible Encyclopedia, www.bible-history.com. Accessed on the 2nd, December, 2009

World Interest Rate, http://www.worldinterestrates.info/, Accessed on 22nd August , 2010

Scriptures

Bible, King James Version.

The Noble Qur’an, (Translated by), Al-Hilali, M. T., Dar-us-Salam Publications, Riyadh Saudi Arabia.


The Foundation of the Islamic Financial System

By Hossein Askari, Zamir Iqbal and Noureddine Krichene1

Abstract

The entire foundation of Islamic financial system is based on the teachings of Islam which incorporate rules and principles as enunciated in the commandments of God in the Holy Quran and the tradition of Holy Prophet. A synopsis of basic principles of Islamic banking and the modes of financing in compliance with these principles had been given One of the cardinal principles is prohibition of Riba in all its forms. The difference in working between Islamic system and conventional system in intermediation and other fields has been emphasized. In Islamic system trade is allowed in Halal Merchandise and disallowed in Haram goods. The article brands the present Islamic banking as not completely Islamic for which some examples have been quoted.

Key words

Speculating behavior, Sanctity of contracts, Preservation of Property Rights, Securitization

In any financial system, conventional or Islamic, the raison d’être of finance is to support real economic growth. The essential financial function is intermediation that is at the heart of any financial system. The reason is that those who invest are not necessarily the same as those that save. There is a need for financial intermediation to encourage and channel savings to the most productive investments. It traditional function has been to transfer savings (real resources) to firms, entrepreneurs and governments for investment, and increasingly in recent years to transfer risk to those who are better able to assume it and thus enhance risk sharing. 1 Hossein Askari is the Iran Professor of International Business and International

Affairs at the George Washington University, Zamir Iqbal is Lead Investment Officer at the World Bank, and Noureddine Krichene is an economist with a PhD from the University of California at Los Angeles. Views expressed in this article are those of the authors and do not necessarily reflect the views of their affiliated institutions.


The teachings of Islam define rules and principles, which encompass all aspects of human life including the economic and financial dealings. Islam offers a well-defined framework to structure an economic and financial system. Although, core principles of conducting business adhering to Islam have been practiced for centuries, more recently, researchers have made attempts to formulate a sketch of a system that reflects the principles of Islam as dictated through the Divine message of Quran and practices of the Prophet. In the last three to four decades, some principles of Islamic economic and financial system have been put into practice, which has led to development of Islamic banking and Islamic capital market products. However, a full-fledged financial system that is totally compliant with Islamic teaching is still at the conceptual stage. In the box below we provide some basic principles of the Islamic financial system.2

Box 1-Basic Principles of an Islamic financial system Prohibition of interest or riba. Literally meaning "an excess" and interpreted as "any unjustifiable increase of capital whether in loans or sales" is the central tenet of the system. Any positive, fixed, predetermined rate tied to the maturity and the amount of principal (i.e., guaranteed regardless of the performance of the investment) is considered riba and is prohibited. The general consensus among Islamic scholars is that riba covers not only usury but also the charging of "interest" as widely practiced. Direct implication of prohibition of interest is prohibition of pure debt security with pre-determined interest rate. This prohibition is based on arguments of social justice, equality, and property rights. Islam encourages the earning of profits but forbids the charging of interest because profits, determined ex post, symbolize successful entrepreneurship and creation of additional wealth whereas interest, determined ex ante, is a cost that is accrued irrespective of the outcome of business operations and may not create wealth if there are business losses. Social justice demands that borrowers and lenders share rewards as well as losses in an equitable fashion and that the process of wealth accumulation and distribution in the economy be fair and representative of true productivity. Risk sharing. Because interest is prohibited, pure debt security is eliminated and therefore suppliers of funds become investors instead of creditors. The provider of financial capital and the entrepreneur share business risks in return for shares of the profits and losses. Asset-Based: Prohibition of debt and encouragement of risk sharing suggests a financial system where there is direct link between the real and the financial sector. As a result, the system promotes “materiality” aspect requiring linking of financing directly with the underlying asset so that the financing activity is clearly and closely identified with the real sector activity. There are strong linkages between the performance of the asset and the return on capital used to finance it. Money as "potential" capital. Money is treated as "potential" capital--that is, it becomes actual capital only when it joins hands with other resources to undertake a productive activity. Islam recognizes the time value of money, but only when it acts as capital, not when it is "potential" capital.

2 For an introductory description of Islamic financial system, please refer to Iqbal and

Mirakhor (2011)


Prohibition of speculative behavior. An Islamic financial system discourages hoarding and prohibits transactions featuring extreme uncertainties, gambling, and risks. Prohibition of harmful activities. Islam prohibits harmful activities such as the production of alcoholic drinks and gambling. Sanctity of contracts and Preservation of Property Rights. Islam upholds contractual obligations and the disclosure of information as a sacred duty. This feature is intended to reduce the risk of asymmetric information and moral hazard. Islam places great importance on preservation of property rights, defines a balance between rights of individuals, society and the state, and strongly prohibits encroachment of anyone’s property rights.

One of the core principles of Islamic finance is the prohibition of Riba. Although, the term Riba has much wider meaning, there is consensus among scholars that this term clearly includes the notion of ‘interest’ on a debt as practiced in today’s financial system and this prohibition applies to interest in all forms, irrespective of the type of interest or its level.3

Islam is a rules-based religion. There is no rule-violation in the Quran that has been treated as seriously as the charging of interest, which is considered a great injustice. An economic understanding of the essence of the verses prohibiting Riba is that interest-based debt contracts have to be replaced by contracts of exchange—requires an analysis of particularities of the two contracts. Interest rate-based debt contracts have two major characteristics: (i) they are instruments of risk shifting, risk shedding and risk transfer; and (ii) the characteristic of interest-based debt contracts is that upon entering into such a contract, the creditor attains a property rights claim on the debtor, equivalent to the principal plus interest and whatever collateral may be involved, without losing the property rights claim to the money lent. This is a violation of Islamic property rights. Namely, a person can transfer a property rights claim to another via exchange, inheritance or the redemption of the rights of the less able. Interest rate-based debt contracts create an instantaneous property rights claim for the creditor against the debtor regardless of the outcome of the objective for which the two sides entered the contract. The creditor obtains this property rights claim without commensurate work. 3 The basic tenets of Islamic finance are stated in the Quran in a number of verses.

Quran, Chapter 2, verse 275: 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 (interest), but Allah hath permitted trade and forbidden usury (interest). Those who after receiving direction from their Lord desist, shall be pardoned for the past; their case is for Allah (to judge); but those who repeat the offense are companions of the Fire: they will abide therein (for ever). Quran, Chapter 2, verse 276: Allah will deprive usury (interest) of all blessing, but will give increase for deeds of charity; for He loveth not creatures ungrateful and wicked. In verses 278-279: Oh you who believe fear Allah and give up what remains of riba (interest); if you do it not, take notice of war from Allah and His Apostle. These are by no means the only verses that define Islamic finance. Other verses also prohibit interest, including: 3-130, 4-161, 5-42, 5-63, 9-34-35, 30-39. A large number of verses and ahadeeths (plural of Hadeeth, sayings of the Prophet, Muhammad (pbuh) directly address and elaborate on what are the principles of Islamic finance.


Endorsing exchange contracts as a replacement for interest rate-based debt contracts has important implications: before parties can enter into a contract of exchange they must have property rights over what is to be exchanged; exchange facilitates specialization and allows the parties to share production, transportation, marketing, sales and price risks. Thus the alternative to debt-based contracts is a mutual exchange in which one bundle of property rights is exchanged for another, thus allowing both parties to share all business risks. It further allows parties to an exchange to reduce the risk of income volatility and to allow consumption smoothing, which is a major outcome of risk sharing and increases welfare of the parties to the exchange. Therefore, exchange is above all a means of risk sharing. In a typical risk sharing arrangement such as equity finance, the parties share the risk as well as the reward of a contract. This is to be contrasted to an interest rate-based debt contract where the risk is transferred from the financier to the borrower, with the financier retaining not only the property rights claim to the principle and interest but also that of any collateral that has enhanced the financing arrangement. In equity investment, owners of money and physical assets, and entrepreneurs, share the risk; their income is a priori an unknown and depends on the performance of the investment.

Box 2 – Basic Building Blocks of Islamic Financial System

Trade with markup or cost-plus sale (Murabahah). One of the most widely used instruments for short-term financing is based on the traditional notion of purchase finance. The investor undertakes to supply specific goods or commodities, incorporating a mutually agreed contract for resale to the client and a mutually negotiated margin.

Sales contracts. Deferred-payment sale (bay’ mu’ajjal) and deferred-delivery sale (bay’salam) contracts, in addition to spot sales, are used for conducting credit sales to promote trading of real goods.

Leasing (Ijarah). Islamic mode of leasing is very similar to conventional lease. Different forms of leasing are permissible, including leases where a portion of the installment payment goes toward the final purchase (with the transfer of ownership to the lessee).

Partnership (Principal/Agent) (Mudarabah). This is identical to an investment fund in which managers handle a pool of funds. The agent-manager has relatively limited liability while having sufficient incentives to perform. The capital is invested in broadly defined activities, and the terms of profit and risk sharing are customized for each investment.

Equity or Profit/Loss-Sharing (Musharakah). This is analogous to a classical equity investment. Both entrepreneur and investor contribute to the capital (assets, technical and managerial expertise, working capital, etc.) of the operation in varying degrees and agree to share the returns (as well as the risks) in proportions agreed to in advance.


In other words, an Islamic financial system is driven by real forces of trade and production and not by monetary factors such as interest, since interest is forbidden. In an Islamic system money cannot be made from money. A return can be made from all real activities that are not prohibited, such as excessive risk taking, gambling and producing alcoholic drinks for human consumption. All real activities involve risk. An Islamic financial system as one in which there are no risk-free assets and where all financial arrangements are based on risk and the sharing of profits and losses. Hence all financial assets are contingent claims and there are no debt instruments with fixed or floating interest rates.

Financial intermediation in Islam is considered different from that in a conventional system. In the Islamic system, financial intermediaries, especially banks, do not contract interest bearing loans and therefore, do not create and destroy money. As a result, they do not finance speculation, nor do they engage in debt trading. Although lending is not prohibited in Islam, it has to be interest-free and just; this is because economic and social justice are at the heart of Islamic teachings. In Islam, just and ethical practices are a part and parcel of all economic and financial dealings and it is for this reason that lending with interest cannot be part of Islamic finance. Moreover, lending and borrowing largely act to redistribute wealth when there is wide fluctuation in prices. Lending can increase the wealth of borrowers in an undeserving way at the expense of workers and low-income classes. Besides causing inflation when it exceeds savings, excessive lending (leveraging) and borrowing and money creation can fuel speculation.

In order to fit into the framework laid down in Islam, financial intermediation and banking in Islamic financial system is structured as a two-tier banking system: (i) a banking system that accepts deposits for safe keeping without accruing any return and requiring 100 percent reserves, thus protecting the payment system of the economy while concurrently limiting credit-creating ability of the banking system thus obviating the need for deposit guarantee needed in the conventional fractional reserve system; and (ii) an investment component that functions as a classical financial intermediary, channeling savings to investment projects, where deposits in investment banks are considered as equity investments with no guaranty for their face value at maturity and subject to the sharing of profits and losses. Depositors are investors in the pool of assets maintained by the bank on the asset side of its balance sheet.

These banks invest directly in real projects in every segment of the economy (except activities that are prohibited, such as gambling and alcohol) and share in their attendant risks. An Islamic bank is assumed to match deposit maturities with investment maturities (with no need for asset-liability management). Short-term deposits may finance short-term trade operations, with the bank purchasing merchandise or raw materials and selling to other companies; liquidity is replenished as proceeds from sales operations are generated. For longer-term investment, longer-term deposits are used. In all these investments, an Islamic bank is a direct owner of the investment process, which is awarded through the normal due-diligence process. In such a system, a financial institution therefore participates directly in the evaluation, management and monitoring of the investment process. Returns to


invested funds arise ex post from the profits or losses of the operation, and are distributed to depositors as if they were shareholders of equity capital. Since loan default is absent, depositors do not face this risk of loss of their assets. Due to the nature of financial intermediation, which is on “pass-through” basis, there is greater need and emphasis on the intermediary to enforce close monitoring of borrowers and relationship building with them. Close monitoring requirement puts additional responsibility on the fiduciary duties of the managers who are entrusted with the trust to fulfill sacred duties of the borrowers and lenders who wish to avoid dealing with Riba.

For the successful operation of the Islamic financial system, and specifically to fulfill its all- important mission of financial intermediation, it is essential that capital markets be developed and vibrant. Vibrant capital markets—including well-developed stock markets and other secondary capital markets for equity finance to motivate savers to provide financing and to supply entrepreneurs with sufficient resources for their projects—are essential for these institutions to fulfill their central role as intermediaries as envisaged in Islamic finance. There is no reason why governments should not also become active in stock markets for risk sharing. They could choose to finance part of their budget, at least development spending, through risk sharing and direct ownership of development projects with their citizens. In this way, they would also reduce their budgetary debt burden; the attendant reduction in government borrowing would in turn reduce the burden on monetary policy. Governments undertake public goods projects because the characteristics of these goods – especially indivisibility and non-exclusivity characteristic – prohibit their production by the private sector.

Elimination of debt by Islamic financial system is substituted by securitized “asset-linked” securitized market. The main difference between the conventional securitization and Islamic securitization is the way the end investor would have ownership rights to the securitized assets. Whereas in the conventional system, there may be multiple layers of ownership, which may leave the final investor without any recourse, in case of Islamic system, scholars have maintained strict requirements of clear ownership rights for the investor. This feature, in contrast with the conventional system, would afford an Islamic system more stability as the same underlying asset is not traded many times over that could have a cascading effect in case of liquidation. This is another feature of an Islamic system that promotes stability. More importantly, in the conventional securitization, the underlying assets are debt based and, therefore, have an implicit guarantee of principal whereas securitization in Islamic system would be based on the basis of risk sharing and, therefore, the principal return would depend on the market value of the underlying asset as opposed to securitization in conventional system where the notion of market value is supposed to be reflected in the market price of the security and not the market price of underlying asset. Again, this is an important factor re-enforcing financial stability.

An Islamic asset-linked security will complement the risk/return profile of a typical stock market security in one crucial way. Whereas an equity share represents ownership in equity capital of a firm and is, therefore, exposed to general business of the firm, an asset-linked security will represent a security where the investor’s return


would be linked to the profit and loss of a pool of heterogeneous assets. Since the pool will be a portfolio of assets of the same type, i.e. leases where the returns are driven by the performance of underlying assets, it would be relatively easy for the investor to forecast its future payoffs. As a result, it is expected that the volatility of such asset-linked securities will be lower in comparison to simple stake in equity capital (i.e. common stocks) assuming no change in the credit worthiness of the asset-owner. Due to low volatility, it can cater to the needs of investors who would like more deterministic and low risk returns in the risk spectrum of the financial system.

There is another compelling reason to encourage securitization and development of asset-linked securities. The Islamic financial intermediary’s primary function is to intermediate between the savers and the users of funds. It can operate optimally when it performs the intermediation with the least degree of frictions. However, if the financial intermediary takes on additional responsibilities of maintaining physical assets, i.e. warehousing and trading of real assets, its attention will divert from intermediation and it may not do either task optimally. For example, it may not be efficient for the financial intermediary to operate leases or mortgages. One way of avoiding this problem would be for the financial intermediary to originate the assets but ultimately pool such assets, securitize the pool, and issue marketable securities some of which the financial intermediary can hold on its balance sheet. This will free the financial intermediary from operational issues of the assets and will enable it to focus on intermediation

Recent financial crises have raised questions on the appropriate functions and roles for financial intermediaries and the markets. Financial intermediaries whose primary role was to lend and finance the real sector were engaged in speculative activities and the users of funds were left at the mercy of the markets. The model of Islamic financial intermediaries is that of a specialized funds manager who acts as buffer between the depositor who happens to be an investor and the market. Islamic financial institutions specialize in processing information about markets and economic agents and performing the functions of assets- and maturity-transformation on behalf of the depositor who is contractually an investor in the Islamic institution.

To foster the development of Islamic finance, there is a need to emphasize its risk sharing foundation; remove biases against equity finance; reduce transaction costs of stock market participation; create a market-based incentive structure to minimize speculative behavior; and develop long-term financing instruments as well as low cost efficient secondary markets for trading equity shares. These secondary markets would enable better distribution of risk and achieve reduced risk with expected payoffs in line with the overall stock market portfolio. Absent true risk sharing, Islamic finance may provide a false impression of being all about developing debt-like, short-term, low risk and highly liquid financing without manifesting the most important dimension of Islamic finance: its ability to facilitate high growth of employment and income with relatively low risk to individual investors and market participants.

But for the Islamic financial system to be successfully established and functioning as the financial system in a country (as contrasted with the current


practice of developing Shariah-compliant products and calling it Islamic finance), there are important pre-requisites and complementary requirements. A financial system, ceteris paribus, is more likely to thrive the healthier is the underlying economy. This obvious point deserves little discussion because if the real economy is moribund, savings are non-existent and investment opportunities not to be found, the contribution of a financial system will be limited. Unfortunately, the economies of Muslim countries have not exhibited superior performance and the broad economic performance (sustained economic growth) of the great majority of Muslim countries has been quite disappointing. The common missing element in most Muslim countries has been quality institutions. The only exception may be Malaysia. Thoughtful and consistent macroeconomic policies are another missing element in a number of Muslim countries. Good institutions are also essential for a thriving financial sector.

There is no doubt that well-developed political, economic and legal institutions are essential to facilitate financial contracting and are a necessary element of a robust financial system. Better institutions promoting checks and balances and the quality of governance can affect financial markets in several ways. Starting with the legal system, unless there is clarity with respect to creditors’ and borrowers’ rights, the protection of property rights, and recourse to collateral in case of default, it would be difficult to build an efficient financial system. Prevailing legal systems are predominantly based on the conventional legal system, which may or may not have the provisions for handling specific treatment of Shariah rules. Furthermore and importantly, legal systems in place in Islamic countries are invariably plagued by enforcement shortcomings, a significant deterrent for any investor. Therefore, development of supportive legal and tax codes, and harmonized regulatory framework based on Islamic law for Islamic financial services industry is absolutely critical for the efficient operation of the Islamic financial system.

Two facts should be emphasized in the case of most Muslim countries. First, economic and social justice is not what it should be in most Muslim countries, but this may be best promoted by a social safety net, rapid growth and an increase in incomes of the poor, which depend on good institutions and sound policies. The increase in incomes and a reduction in poverty would in turn increase access to finance as financial institutions would be motivated to provide services to individuals and entities who could meet their requirements. Second, in the specific case of Muslim countries, a significant percent of Muslims have a clear preference for Islamic financial products and services; and for some Muslims it is more than simple preference, it is a binding constraint—that is financial access for them cannot be increased without the increased availability of Islamic financial products and services.

Development of efficient institutions and of a sound governance framework is important, not only for sustained economic growth, but also for the emergence of a sound financial system. Institutions lay the foundation of the system and the governance framework ensures that the rules are enforced so that the desired results are achieved. The Islamic financial system is based and centered on risk sharing, affording equity finance a pre-eminent position in the financial system. Given the


moral hazard and agency problems associated with equity-based financial contracts, institutions and governance become even more important in developing a risk-sharing financial system. Institutions governing economic transactions, such as property rights, trustworthiness, truthfulness, faithfulness to the terms and conditions of contracts, transparency, and non-interference with the workings of the markets and the price mechanism so long as market participants are rule-compliant, provide a reasonably strong economy where information flows unhindered and participants engage in transactions confidently with minimal concern for uncertainty regarding the actions and reactions of other participants. The result is that in such economy with reduced uncertainty, economic agents will be encouraged to engage in risk-sharing contracts. As can be readily inferred, strict rule-compliance is absolutely essential for an Islamic financial system to live up to its expectation and billing. Human frailty being what it is, efficient institutions, especially the rule of law and all that it entails, are a pre-requisite to success; and this must be accompanied by governance and effective enforcement.

Although there are numerous gaps or impediments to the development of a truly Islamic financial system in Muslim countries—including developed economic and financial infrastructure, efficient and reliable institutions, sound economic and financia l policies, institutions and policies required for the widespread practice of Islamic finance, and the required human capital to develop the regulatory, supervisory and functioning of a broad and complete Islamic financial system—the most difficult element to develop and put in place may be the high ethical and moral practices demanded by Islam. A society or country must be based on a foundation of social and economic justice, with the government responsive to the needs of society as called for in the Quran and enunciated by the Prophet (PBUH) and individuals members of society committed to ethical standards in all their dealings.

References

Askari, Hossein, Zamir Iqbal, Nourredine Krichene, and Abbas Mirakhor (2009), New Issues in Islamic Finance and Economics, Singapore: John Wiley and Sons (Asia).

Askari, Hossein, Zamir Iqbal, Nourredine Krichene, and Abbas Mirakhor (2010), Globalization and Islamic Finance, Singapore: John Wiley and Sons (Asia).

Askari, Hossein, Zamir Iqbal, Nourredine Krichene, and Abbas Mirakhor (2010), The Stability of Islamic Finance, Singapore: John Wiley and Sons (Asia).

Askari, Hossein, Zamir Iqbal, Nourredine Krichene, and Abbas Mirakhor (2011), Risk Sharing in Islamic Finance, Singapore: John Wiley and Sons (Asia).

Iqbal, Zamir and Abbas Mirakhor (2011), An Introduction to Islamic Finance: Theory and Practice, 2nd Ed., (Singapore: John Wiley and Sons).


Money Creation And Control From Islamic Perspective

By Prof. Dr. Zubair Hasan*

Abstract

This paper deals with familiar facts in monetary economics from an unfamiliar angle. It argues that it is not factual to regard the legal tender money and bank credit as of different genus: they work in tandem to the same ends in an economy, conventional or Islamic. Also, it does not matter what serves as money – solid gold or flimsy paper – for keeping its value stable; only the blind would argue that staff is indispensable for walking. Money is just an instrument: it was never nor can ever be classified into Islamic and non-Islamic. What it does – good or bad – depends on how we use it. Money does not generate crises; its mismanagement does. It follows that the refuge the world is searching today from recurring financial crises does not lie in money substance: history testifies that national economies could not remain turmoil-free during the centuries of the yellow metal sway over the monetary scene. The paper concludes that it is the human factor that has been the source of good or evil for mankind including money matters. And the quality of human factor true religion can alone improve: morality without faith is rudderless.

Key words:

Monetary policies; Gold standard, managed currency; Islamic banking; Central banks

1. Introduction

At the dawn of societal living economies were run by a system known as barter: A person exchanged whatever good or service he had with the goods or services others possessed. Barter required double coincidence of wants – B should not only have what A wanted but must also be in need of what A could offer in * Author, Prof. Dr Zuhair Hasan, is a Professor Department of Economics &

Governance INCEIF. The Global University of Islamic Finance Kuala Lamupur Malaysia


exchange. This was restrictive of transactions that could be made, consumed more time and curtailed specialization. The frustrations barter imposed on human ambitions led people to create money. We can define money by what it does i.e. by its functions or by identifying the substance which performed those functions. The temporal uniformity of the notion lies in the functional approach because what substance performed those functions over time and space is a welter of things approaching infinity. But herein lays the romance of money. From hides and skins via cowrie shells, salt, spices and precious metals to promise to pay working as money has been a fascinating journey of human ingenuity.

The functional approach to the definition of money sees its significance in serving as a medium of exchange, as a measure and a store of value and as a unit of account. In essence, these functions help tear apart the two sides of the barter coin – sale and purchase. You can sell what you have for money, keep that money with you and buy at will what you want and when. The eventual exchange involves real goods and services at both ends; money works merely as a go-between. If paper or plastic can perform the functions efficiently why use much more valuable things to serve as money? If roads could be built in the air will that not release land for growing more food? Money derives its significance from its general acceptability and that acceptability stems from its value remaining stable, not from the value of what it is made. We do not print cinema tickets on chocolate so that people could eat them in case they miss the movie.

Why are then suggestions today for a return to gold as the fulcrum for restructuring the international monetary system?1

To me, psychology, haplessness, loss of direction and presumably some national interests are among the major factors. The search for an answer drags us back to the history of the money’s evolution. This we do in the following Section 2. In section 3 we shall argue that it is not the systemic failure but the demise of human integrity that has pushed the world to the brinks of disaster. In Section 4 we summarize the argument and present a few policy prescriptions for consideration.

2. Evolution of Money

2.1 A social convention

Money was not invented: it evolved as a social convention and took various forms over time and space. This lent precedence to money substance over its functions in discussions on the subject. The importance of what works as money was reinforced as in the process of measuring the value (prices) of other goods and services money assumed a value for itself that fluctuated inversely with variations in the general price levels over time and space. In that money was a different sort of measure compared to others that we use in our daily lives. Money made of or linked to something valuable in use, like gold or silver, made its value fluctuate inversely 1 The suggestion that surprised many came from a person of no less stature than the

World Bank governor Bob Zeollick (December 2010). Interestingly, it gave a boost to the clamor for a return to Gold Dinars and several articles on the subject made their appearance on the heels of Bob’s statement including Karim (2010), KFH Research (2010) and Zein (2011)


with those of other goods and services. The stability in the internal value of money thus requires the controlling of fluctuations in the domestic price level. Also, what worked as money in various countries is not mostly identical. This gave rise to the issues relating to the determination of the values of different moneys in terms of each other or foreign exchange rates for promoting inter-nation trade. The rising tide of international trade with the passage of time demanded something tangible that could help local monies enable their mutual convertibility. The need added to the significance of substance for the role money played in an economy.

Bronze and copper were the first to get converted into coins but gold and silver did not take much to replace them. Gold silver coins were made in Lydian – modern Turkey - as early as around 560 BC and could well be regarded the earliest forms of metallic coins. However, these coins were too soft to withstand the wear and tear in circulation or resist corrupt clippings resulting in their weight falling below the initial measure. Gold and silver had to be mixed with alloy to make coins adequately hard. This demanded standardization of the alloy proportion in the coins to ensure their authenticity and uniformity in terms of their precious metal content. The work was done by informal private agencies for most part of the 2500 years of sway the yellow metal had over the monetary matters across the world. Touchstones were used to verify the purity of coins in terms of their fineness. the convention continued even beyond the publication of Smith‘s Wealth of Nations,1776. Indeed, the author was much impressed by the spontaneous evolution of such benevolent social institutions as money, division of labor and capital accumulation that played such a vital role in promoting growth in the wealth of nations.2 Note that gold standard in England was established by an Ac t of Parliament only in 1860 and in the USA much later in 1900

2.2 State entry

In the private manufacture of coins, the standardization process required that gold was pre-alloyed and coins were weighted before they went into circulation. As long as people knew the manufacturer and had trust in him no touchstones were needed. At the time when Islam made its appearance on the scene, the gold coins in circulation were made in Rome and carried the stamping of pagan idols. The fact that the Prophet (Peace be upon him) allowed their remaining in circulation, testifies by implication that the faith did not divide money into Islamic and non-Islamic. However, to continue with the thread, the governments soon started stamping the coins with an emblem to strengthen the process of standardization. The emblem was a guarantee for the weight of the coin, its degree of purity and its value. The facility gave people the satisfaction of carrying value within their money, but it could not prevent the loss of precious metal in the circulation process and more than that through clipping of coins for recycling. Carrying money in pockets and over space involved both cost and risk. Governments of all shades soon discovered that coins derived their value essentially from the emblem; they often debased the coins to lower their precious metal content. To that extent coins became no better than notes 2 See Gide & Rist (1953) for an excellent analysis of this influence under a sub-title: The

naturalism and optimism of Smith pp. 85-109. One would not presumably come across such detailed and graphic description of the subject in other books on the History of Economic Thought.


printed on metal. This led Gresham to postulate during the Victorian era that bad (debased) money drives good (full-bodied) money out of circulation.3 Finally, the side by side circulation of coins made of gold, silver and copper in many places, especially in Europe, led merchants to place premium on gold and distort the relative price of metals.

2.2.1. From metals to paper

To overcome the above mentioned difficulties of commodity money – the coins – banks began to issue paper receipts to depositors stating that the receipt was redeemable for the precious metals stored with them. Soon the receipts started circulating as money because everyone started taking them as good as gold. They were representative of the yellow metal. The suggestion for enforcing a 100% reserve requirement today, especially in Islamic economics, derives its inspiration from the policy of that era. But much water has since turned in the ocean around the world.

It soon became apparent to spend money and toil to dig the glittering metal out from the bowels of earth only to lock it back into the dark vaults of banks was an avoidable folly. To the relief of our pretty ladies, representative money proved just a small step to usher in the practice of banking based on fractional reserve. Banks were soon printing receipts above and beyond the amount of yellow metal deposited with them. It benefited traders and enriched the bankers. Paper notes had appeared in China as early as the year 806 AD and dominated the scene until the middle of fifteenth century. China stopped using paper notes in 1455 because their overproduction led to high inflation. But the fractional reserve system being an easy and effortless way for self-enrichment, the banks could not curb the temptation to over issue notes. Intermittent bouts of inflation became rampant across the world. If the linkage of money to gold at its zenith could not stop the emergence of the malady; on what basis the advocates for its revival can convince one that the resuscitation of gold can ensure it today? Inflation could not, as it cannot, sustain itself for long because it carries within its fold the weapons for its own demise. Sooner or later, it must turn its tail upward to nose dive. The slump that the burst of the bubble generates is found to be sticky and more damaging. We shall return to the issue in some detail later. Presently, we turn to the two interesting developments in monetary history that the non-sustainability of inflation triggered. The first was the emergence of the state as a monopolist for the conversion of gold into coins and of coins into gold at the official mint. Initially, this service to people was rendered free of cost but later on a small fraction of gold (or silver) brought to the mint for coinage was used to be taken out to cover manufacturing costs. The deduction was known as

3 Could that be the reason for the Qur’an to condemn the hoarding of gold and silver (9:

34-35)? Some claim gold and silver are Islamic money and their hoarding will reduce the quantity of money in circulation to the disadvantage of the economy; so the condemnation of hoarding these metals. I have a different interpretation. The reference in the two verses is explicitly to the stock of metals for which Zakat has not been paid. Even after zakah has been paid it may not be desirable to retain money just for the sake of pleasure of seeing and touching it at will but it may not be punishable the way the verses state.


the seignorage – the right of the king/lord over the possessions of the commoners. Thus, free coinage did not mean free of cost. It meant that people were free to bring for conversion into coins at the mint only the indicated precious metals – gold or silver.4 The main reason for acquiring monopoly power in coin-making was its profit churning potential. The need to put a tab on money supply for curbing inflation and keep it commensurate with the overall needs of the economy was of smaller significance. Thus, money creation could not be left entirely to private discretion. And this brings us to the second major development.

The expanding international trade and the resultant complexity of foreign exchange issues added further to the growing governmental interest in the monetary affairs. Even as the authorities were attracted to money creation for a variety of reasons, especially the profit, it was sure to bring in, they did not consider it expedient to put their finger in the business directly; they chose to raise a facade – the Central Bank.

2.2.2 The rise of central banking

The process of government overtaking the creation of money proceeded on a slow pace. The first to come in were the regulations limiting the credit creation power of banks. They had to cope with some organizational restrictions including the continuation of the partners’ liability as unlimited in banking far longer than in other businesses. But at the same time, the risks bankers took were sought to be reduced through severe penal provisions including in places even capital punishment for the defaulters.

The rise of democracy and the concern for human rights brought in some relief for the borrowers in the form of increased transparency in dealings and lowering of interest rates. Meanwhile, industrial revolution spread fast to other countries in Europe and their control of colonies had stabilized. International trade was rapidly expanding. The growth of wealth and prosperity of European nations became increasingly dependent on the colonies for obtaining industrial inputs and to sell finished products in their vast markets. Private banks still had the sway and there is an argument that their coalitions that had already started emerging in the face of liquidity shortages could presumably have efficiently functioned well also as ‘the lenders of the last resort”. The argument candidly implied that the ushering in the central banks was not needed. (Gorton and Hung 2001).

But the governmental objectives for intervention as stated above were different. Bank failures during the second half of the 19th century created the opportunity for intervention and a large number of banks collapsing like a house of 4 Coins were divided into two types: Standard and token. Standard coin was full-bodied

money. Its face value and intrinsic value (the pure gold content at market price) were the same. It was the unit of account , unlimited legal tender and a standard for deferred payments. Minting was free only for standard coins. Token coins were multiples of standard coin and their face value was more than their Intrinsic value. Token coins were legal tenders only up to a limit after which one could refuse to accept them in receiving payments or discharge of debts. Token coins were made of base metals like copper and did not enjoy the facility of free coinage.


card during the interwar period only helped hasten the process. Thus, central banks came into existence as a response to the inability of banks themselves to cope with panics (Goodhart1985). The process took the semblance of a natural evolution as some private banks were asked to operate as government’s bank (Gorton & Hung 2001).5 The authors provide some interesting information on the rising numbers of the central banks over time. This we reproduce in the following Table. Many of them were allowed to take up the ‘Lender of the last resort’ function much later.

Table 1: Growth of central banks over time

Year 1900 1950 1990 Number of central banks 20 59 161

3. Central banks and economic stability

The declared objective of establishing a central bank in a country was to have an institution devoted to keeping stable the value of its currency both internal and external. For performing the function central banks were given some privileges: inter alia they were to serve as bankers to the government, granted the sole right for issuing currency notes, adopt measures to control the creation of credit by commercial banks and operate as the lender of the last resort. Central banks could not compete with ordinary commercial banks for business in the market. They had to guide and help the latter with a view to achieving stability in the value of money. Since coins of gold were already in circulation in many countries, central banks were to streamline the system for the issuance of currency with reference to the yellow metal. The rules for such streamlining were embodied in what came to be known as gold standard described below

3.1 The Gold standard

As explained earlier paper money grew gradually out of gold coinage. The era of 100% reserve for note issue was very short. As a first step, a certain portion of (legal) money was allowed to consist of currency notes convertible into gold which could circulate along with coins. A one-on-one reserve of gold for paper currency was not needed to ensure convertibility as all people were rarely expected to seek conversion of their notes at the same time. Schemes of keeping gold reserves to cushion currency note issue varied among countries6. But the common element of them all was to have and maintain an overall relationship between the gold held in reserves and the volume of currency in the country. In other words, gold controlled the volume of money in circulation through keeping a minimum gold reserve, however defined. To invoke public confidence, monetary authorities had to keep the price of gold stable in the country. This was the essence of what was named in the literature as the domestic gold standard. 5 Prior to the establishment of the Reserve Bank of India the Imperial bank was entrusted

to work for the government. Later it was converted into the State Bank of India and then nationalized. Even today in some matters it works as an agent of the RBI where the latter has no branches of its own. The state Bank of Pakistan is an off shoot of the same development.

6 For a brief discussion of these schemes, see Crowther (1948, pp. 281-300 )


But gold standard as described above could not ensure pric e stability at home. For, gold standard does not stabilize price levels; it merely stabilizes the relation between the volume of gold and the volume of currency. Even if the price of gold remains unchanged, fluctuations in the volume of gold must make the volume of currency vary, forcing variations in the general level of prices. Thus, Instead of stabilizing, the domestic gold standard forced prices to fluctuate7; it failed to curb inflation or to prevent depression.

Domestic gold standard was part of the evolution of money - not the result of ‘invention’ - and its extension to external transactions was part of the same process. When gold coins constituted most of the money supply in two countries, there was little room for variations in their exchange rate. So long as the two currencies A and B were freely convertible into gold at a fixed price, their rate of exchange could not vary from their mint parity by more than the small margin from what were called as the gold points. Any demand for foreign currencies that could not be met in the foreign exchange market at a rate within say 0.5 percent on either side of the mint par was shunted out to the gold market. Thus, the demand for any currency in the foreign exchange market always equaled its supply. The gap was covered by the gold movement across the two countries.

Figure 1 explains the automatic nature of the balancing mechanism.

Figure 1: The Gold. Standard Mechanism

It is assumed that currency A contains 3.2727273 grains of gold 11/12 fine while currency B has 10 grains of gold 9/10 fine. The mint par (the domestic price of foreign currency (ER) of the two currencies will then be:

For country B : 10 ?

910

3.2727273 1112

= 3 units of A per unit (3.1)

For country A : Reciprocal of 3 i.e = 0.333333 of B per unit (3.2)

7 A reduction in the volume of currency may cause a reduction in the quantity of money

or it may not the two can, on occasions, run divergent courses. See Crowther (1948, p. 297 where he also mentions a few historical examples of such diversions with reasons).


Assume further that the cost of transporting gold worth 1 units of currency A between the two countries is 0.0005 units of that currency. Then, in the foreign exchange market of country A the exchange rate .3333 + 0.0005 = .3338 will be the upper gold point (UGP), and the lower gold point (LGP) will be (.3333 – 0.0005) = .3328.We now have the apparatus to explain how gold standard would operate between the two countries.

If the demand for currency B starts rising relative to its supply in country A – the balance of payments moves against A – the exchange rate in the market will start rising8 but it cannot cross the UGP9

as it will become cheaper for importers to buy gold in the market and export it to country B. D1 will cease shifting up: any more; excess of demand will move out from the currency market to that of gold, allowing only a tiny (tx) departure from ER. In contrast, if the balance of payments becomes increasingly favorable to country A, raising the supply of B currency relative to its demand in the exchange market, the ER will start falling: currency A will become dearer in country B. But the process cannot go on unabated. As soon as the rate crosses the upper gold point which would be the same as LGP in A -- again a small divergence (tm) from ER – the importers in country B will find it cheaper to ship gold to country A rather than buy currency in the exchange market. Under gold standard no country can stop either export of gold or its import. Gold standard works on the assumption that at gold points the supply of the metal is kept perfectly elastic. The assumption could become a reality only if countries or some international authority is willing to buy and sell at a fixed price.

Stability of exchange rates is desirable, rather necessary, in the present era of globalization for promoting free trade and liberalization, but on a return to gold only the naïve or the vested interests will insist. Let me explain very briefly the reasons as to why the return is neither desirable nor practicable. The issue of internal stability, I have already touched upon. Under the strict rules of the game, it is realistic to assume that the central bank of country A keeps gold in reserve just what is obligatory, say 40% of notes in circulation, to ensure their convertibility. Suppose now that there is an inflow of gold, ignoring reasons, worth $ 1 million. This moves into the reserves of the central bank. If it does not, as it cannot, build a buffer stock of gold, it must put additional notes worth $ 2.5 million in circulation. And if the banking system is to maintain a 10% reserve for credit creation the economy would become awash with a monetary expansion of $ 25 million. This multiple expansion of money supply may impose inflationary pressures on an otherwise stable economy. You may work out the deflationary potential of gold out flow of a similar magnitude. In fact, gold standard inherently carries a deflationary bias: a country losing gold must contract credit but the one receiving it is under no compulsion to expand credit.

Gold standard can work smoothly if prices - wages in particular - were reasonably flexible, there were no structural rigidities in the economy, and public authorities were willing to surrender their discretion and independence to the 8 For a real world illustration see Halm (1956, pp.176-177-). He explains how the

exchange rate between USD and Pound Sterling was settled when both countries were on gold standard during the inter-war period

9 It may be noted, as shown in Figure 2, that the gold export point of one country becomes the gold import point of the other country and vice versa


automation requirements of gold standard mechanism. The suspension of gold standard under adverse circumstances in the past was the proof of the unwillingness of policy makers to accept such surrender.10 This unwillingness has only become more obstinate with the passage of time. This obstinacy was one of the reasons why the original designers of the IMF scheme rejected a return to gold standard so as to impart a measure of flexibility in the arrangement; the amendments of 1978 buried the gold-link for good.

Until the beginning of the last century the measure of money requirements was the amount of the work money had to do, largely as a medium of exchange. Given the velocity V of money circulation, the measure was in close harmony with the level of real output. Even as per this criterion, the quantity of money needed could initially be managed; but gold supplies soon fell short to meet the monetary needs of economic expansion and currency notes with partial metal backing soon appeared on the scene to supplement coins. Compare this situation with the current scenario.

During the second half of the last century the real output the world produced was more than what it could during its entire existence before 1950. Where is the gold to support money expansion to match the increase? The growing volume of financial transactions knows no bounds. More than a trillion US$ go round the world stock markets every twenty four hours in speculative trading. It is estimated that the volume of money involved in foreign exchange spot transaction alone is 70 times of the money value of world’s real output. Supply of money tied to gold would fail to meet the money requirements of the modern age. One may be fond of day dreaming but return to gold is not even worth that dream. Today, financial transactions are an ocean wherein real transactions are just a tiny island. Return to gold (Dinar) is not possible (Hasan, 2008).

Since the last semblance of national currencies being linked together via gold disappeared forty years back all countries have been running their economies entirely with fiat money; the money which is not backed by the reserve of any real commodity. Legal tender laws are the legs on which it stands. To me it is true money. It is not the moon drawing its shine from the sun – the reserves. It is the sun itself.11

10 For a detailed explanation of the monetary expansion and contraction processes under

the gold standard and their repercussions, see Halm (1956, Chapter 12, section 4 pp. 189-192).

11 It will be wrong to believe that we have fiat money for the first time now. In fact, even during the era of commodity money there were legal tender laws put in operation to strengthen the monetary systems. These laws legally relieved the debtors of their obligations if they offered to pay the debt using what government declared as money. In some cases refusal to accept this form of payment was illegal and could at times attract even death penalty. Ancient Rome and post-revolution France are cited as examples. (Cobb 2010. Why Cobb (p.12) calls it a major breakthrough in the history of money is not clear. In the past the existence of fiat money was an exception, today its non-existence is an exception.


3.2 Creation of money

Undergraduate text books on money and banking invariably make a distinction between legal tender money as issued by the central bank of a country and credit or bank money that is generated by commercial banks through the granting of loans to borrowers. They also teach us that fiscal policy of a country falls in the government terrain while the monetary policy is autonomously designed and operated by its central bank. All such lessons must be taken with a grain of salt.

The early central banks were established when the mercantilist era was still on. They were brought into existence by powerful businessmen controlling politics for serving their own nefarious ends (DeLorenzo, 2008). Ownership structures and the role of central banks have since witnessed many changes over time and space but their basic functions have virtually remained unaltered (Goodhart 2010)12. Three of their functions – (i) working as bankers to the government, (ii) being the sole issuer of currency notes and (iii) controlling of credit the commercial banks create. These functions unfold the linkage between the fiscal and monetary policies of a country and the extent of a central bank’s autonomy.

3.2.1 Fiscal policy-money supply interface

The function of the central bank to work as the banker to the government opens the window for the latter to interfere with the supply of currency or base money in the country. Even as the central banks have the sole right to issue currency notes, the right has not always been absolute. For example, in India, the one rupee note which is unlimited legal tender was issued by the government of India not by the RBI. The government could always exchange these notes for bigger denomination with the latter. The second source is that the government can always borrow currency from the RBI through the creation of treasury bills which the latter could sell in the money market. The conversion of government securities into legal tender money at the RBI was used by the British to unleash unprecedented inflationary pressures on the Indian economy to their own advantage.13

Another example, an eye-opener, comes from the German economy during the1920s. After their victory in the WW1 the allied powers imposed such heavy reparation on the vanquished that the payments devastated the economy of the country as never before in modern history. The annual national income plus the liquidation of the accumulated wealth of the Germans was not sufficient to maintain

12 However, there is a strong case for scrutinizing the power structure in the central banks,

especially the ones operating in the area of Islamic banking. This can bring to light forces influencing their workings.

13 In short the story was as follows. When England returned to Gold Standard after the WW1 in the twenties the Indian rupee was tied to it at a fixed rate to have the prestige of being on gold (exchange) standard via the Sterling. In 1931 England went off the Gold Standard but the Indian rupee remained hanging by the Sterling coat minus the prestige. The linkage enabled the British to finance their huge balance of payments deficits with the country during the WW2 period through making RBI issue Indian currency against the piling up sterling debt, paper just replacing paper. Real goods and services moving to War Theater and money supply expanding within led to high inflation in India. It is interesting to note that inflation rate in England at war averaged not more than 7% a year during 1940-1945. Domestic inflation was largely transferred to India (and other colonies).


the payments schedule. On the one side of the road the central bank was printing notes day and night so that the government could purchase goods from the market for export to meet the dates. On the other side the Germans ran with basketfuls of currency to beat the spiraling inflation – in one year prices rose 10^13 times. Inflation ran parallel to the depreciation of the German Mark that in fact had caused it. Table 2 presents the depreciation drama..

Table 2: Exchange rates: 1US$ value in German marks.

Jan 1918 5.21 Mar. 1923 21, 190.00

Jan. 1919 8.20 Apr. 1923 24,475.00

Jan 1920 64.80 May 1923 47,670.00

Jan. 1921 64.91 June 1923 109,966.00

Jan. 1922 191.81 July 1923 353,412.00

April 1922 291.00 Aug. 1923 4,620,455.00

July 1922 493.22 Sept. 1923 98,860,000.00

Oct. 1922 3,180.96 Oct. 1923 25,260,000,000.00

Jan. 1923 17,972.00 Nov. 193 2,193,600,000,000.00

Feb. 1923 27,918.00 Dec. 1923 4,200,000,000,000.00

Source: Schools History – The seeds of evil: The rise of Hitler (ASK.Com/Downloaded on 10.11.2011)

Figure 2


Figure 2 is constructed using Table 2 data on semi-logarithmic scale to keep its size manageable. We did not put the actual dates on X-axis to avoid congestion.

In Pakistan also the central bank of the country is at a loss to find ways of liquidating the huge debt the government owes to it as the consequence of deficit oriented fiscal policies of successive governments. The bank had to print notes unmatched with the corresponding expansion in real output. The result was continual depreciation of the currency in the foreign exchange markets and inflation at home.

It follows from the above discussion that the central bank cannot determine the monetary base exogenously. It erodes the capability of the central bank to discipline the banking system and tempts the banks to defy cautions in credit creation that brings their owners large effortless leverage gains. This requires us to understand the credit creation power of banks and its limits.

3.2.2 Money creation by banks

We have already made a distinction between (i) currency or legal tender money and (ii) bank the credit or bank money. The two together constitute the M1 version of money supply. The relationship between them lies at the heart of credit creation process that commercial banks follow. The volume of (i) i.e. currency in an economy serves as the base for generating (ii); the credit money. Part of the base money (currency) always remains inside the central bank while the remaining part is held outside by the public 14. People deposit a part of the outside money with them in commercial banks as demand or time deposits which together constitute the cash deposits of the bank. A portion of deposits, say 10%, the banks have to keep with them as statutory reserve to meet the daily withdrawal needs of the depositors; the remaining they can lend on interest or invest in the Islamic profit earning schemes. In conventional banks the sum loaned is credited to the account of the borrower. Thus, loans generate what we call credit deposits. These loans and deposits appear one for each other as contra entry in the bank balance sheets. The banks make no distinction between the two sorts of deposits – cash or credit – in their lending operations.

To illustrate, let us assume that the amount of currency or base money circulating in a country at a time point is IOOT half of which people keep with them under the Keynesian liquidity preference motives; the remaining 50T they deposit with the commercial banks. Suppose the banks on an average retain F fraction of their cash deposits as reserve to meet the daily withdrawals while the central bank wants them to maintain with it a minimum fraction R of their deposit – cash plus credit. How much credit can a bank create with these constraints? The credit multiplier M provides the answer. It is calculated as under.

M = 1/F [1 – R]

Suppose a bank has 50M in cash deposits and has to keep F = 0.1 fraction of the sum every moment in its safe to meet the daily withdrawal demands.

14 The classification of currency into outside and inside money is of recent origin and

some economists have found it a useful explanatory tool in their discussion of the credit creation process of commercial banks.


Furthermore, suppose that the central bank requires each commercial bank to maintain with it 5% of its deposits – cash plus credit - in the form of cash implying R = 0.05. The credit multiplier M will then be 9.5. The 50M cash deposit with the bank will enable it to have total deposits worth 50 x 9.5 = 475M. From that amount if we take out cash deposits, the remaining 425M will be the credit (loan) deposits the bank has generated. Note that an individual bank cannot create credit disproportionate to others because on balance it will soon find its net cash inflows reducing via inter-bank clearances. The cash string forces it to remain with the group. However, the created creation power of the banking system is on the whole tremendous. The interest received on this amount minus the part of it payable for cash deposit holders and other operating expenses will all belong to the bank. Banking is thus an exceedingly lucrative business. Collectively, banks may generate a huge inverted credit pyramid as Figure 3 shows for our illustrative bank.

Figure 3: Inverted credit pyramid with

F = 1 / 10 and R = 1 / 20 (Multiplier M = 9.5)

Businesses too are tempted to support the process as the rates of interest are usually much lower than returns the borrowings provide. Producers are tempted to finance even long run projects from short-term borrowings because in good times repeated and easy renewals can convert them into long-term funding. Leverage gains tend to make businesses over adventurous. But continued pumping in of funds ultimately causes the credit balloon burst, economies roll down the hill and unemployment tends to become rampant. Should Islamic banks indulge in credit creation as do the commercial banks as a part of the process? I refrain from discussing this issue here because I have already discussed it threadbare in my earlier writings (Hasan 2008 and 2010) However, put briefly my position is as follows.

3.2.3 Islamic banks: credit creation and the crisis

Commercial banks and their functions evolved over time in response to the changing and expanding needs of trade industry and commerce. Eventually, they emerged for meeting the short-term needs of business. These needs have been of seasonal character and creation of base money was geared to the more enduring demand for money to serve as a medium of exchange and a store of value. Credit creation is meant to keep the growth of base money smooth over time. This development left untouched the financing modes in Muslim lands. Islamic finance


emerged on the scene very late for a variety of reasons. Innocuously, it chose to follow in the footsteps of the same system that it rose to replace. To me, Islamic banks have little option in the matter of credit creation: their methods and precautions could of course be different. The real problem in fact is on the control side: what would or could replace the bank rate as control weapon in the hands of the central bank. Even in the case of conventional banks, the policy has failed to deliver. Long run profit expectations tend to run much higher above the schedules of interest rates after the WW2. The rising leverage ratios and commissions have to be curbed. Perhaps, there exists a case for taxation of leverage gains with steep progression.

It seems a bit misguiding to claim that Islamic banks withstood the current crisis better than their mainstream counterparts. They are yet too small to catch the cold and have not nursed the linkages for infection. And yet many Islamic banks did come to grief. Kuwait has recently refused to bailout the defaulting banks in the country.

4 4. Concluding remarks

This paper had set out to discuss some familiar ideas in the area of money creation and control in modern societies from an Islamic angle but arrived at some unfamiliar conclusion. The main ones are as under.

1. Money evolved as a social convention. Its essence lies in what it does, not in what it is made of. Its significance follows from the fact that it tears apart the two sides of the barter coin into sale and purchase. Money has no religious content. It was never nor can ever be divided into Islamic and non-Islamic

2. Gold standard was evolved by the erstwhile imperial powers to exploit colonies for obtaining raw material and other inputs for their growing industries and open their vast markets for selling their products. It sacrificed the internal stability at the alter of external stability That often hurt the developing nations, Gold standard never ensured that none will lurch; it only ensured that all will lurch together. The world should never return to gold. Presently, the IMF rules bar the linking of any currency to gold. The dinarists are traveling on a blocked end road.

3. The autonomy of central banks is illusory. Governments have always been the prime movers in the matter of money supply. Fiscal policies have frequently been the undoing of monetary policies initiated by central banks. Governors of central banks are after all appointed by the government; they have to watch the movement of the authoritative eyes. They tend to be late to miss the train and under kill to avoid the charge of over killing.

I believe that any system can possibly deliver if human element is virtuous. Human beings are the greatest source of instability in the world – political, economic and social. Presidents retire and only then the nation knows that they bankrupted the nation for self-enrichments. Corruption, conspiracy and injustice rule the world. Powerful armies have marched for non-existent reasons into flourishing countries and destroyed them completely And for that they got away by merely saying sorry. The entire nations as Greece have gone bankrupt because of the misdeeds of their


rulers – democratic or despotic. Today, if banks are too big to fail, nations are much bigger. To me all reforms will fail to deliver unless human beings are reformed. Rational morality has failed; faith is the hope.

Acknowledgements

I express my gratitude to Datuk Agil Nutt the CEO of INCEIF who spares time to go through the initial drafts on my papers and readily comes back with his insightful and constructive comments. I am also thankful to my students Mughees Shoukat and Nurhafiza Abdul Kader Malim at INCEIF who helped me as usual with data collection and proof readings of the earlier drafts of the paper. The usual disclaimer applies.

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Customers’ perceptions about shari’ah compliance of Islamic banks in Malaysia

By By Abdelghani Echchabi Hassanuddeen Abd Aziz*

Abstract The main purpose of the paper is to examine the perception of the customers regarding the shari’ah compliance of Islamic banks in Malaysia. The study also attempts to assess the awareness of the Islamic banks’ customers of the shari’ah compliance concept, as well as their exposure and perception of the current criticisms concerning shari’ah compliance of Islamic banks. The study employs qualitative approach to understand in detail the customers’ perception and experiences about shari’ah compliance of Islamic banks. Semi structured interview is used with 10 Islamic banks’ customers in Malaysia. The study also used phenomenological techniques to analyse the data. The findings revealed that the customers perceive that Islamic banks as they practice today are still not shari’ah compliant. However, they are optimistic about the achievement of full shari’ah compliance in the future. This research is the first to study the shari’ah compliance of Islamic banks in Malaysia from the customers’ perspective, by using qualitative research approach. The findings of this study are of original importance, because they unveil the customers’ experience in an area that has been severely looked at from the professional and experts’ point of view only. Keywords: Islamic banks, Malaysia, Shari’ah compliance, Awareness.

Introduction

In countries where Islamic banks co-exist together with conventional banks, an important criterion that differentiates the former from the latter is its compliance with the Islamic rules or its shari’ah compliance. In the current practice of Islamic banking, many issues have been raised regarding the compliance of the existing Islamic banks with shari’ah or Islamic law, and this threatens the success of the Islamic banking system not only in countries where it simultaneously exists with the conventional banking system, but also in a full Islamic banking system. * The author Abdelghani Echchabi and co-author Professor. Dr. Hassanuddeen Abd. Aziz

are affiliated with International Islamic University Malaysia, e-mail: [email protected], ahassan(a)iium.edu.my


Furthermore, in a dual banking system, the patronisation of a certain bank would be more challenging, in the sense that Islamic banks are relatively new. Thus, the services offered by the long existing conventional banks as well as the magnitude of the operations would be more elaborate. Thus, it is very crucial to examine the perception of the Islamic banks’ customers in Malaysia about their banks, and whether they consider the religious factor when choosing a given bank.

The aim of this research is to study the perception of Islamic banks’ customers regarding the compliance of their respective banks to shari’ah, and find out to what extent the Islamic banks’ customers in Malaysia consider shari’ah compliance factor in choosing and keeping loyal to the bank. As part of the specific objectives, the study attempts also to examine the exposure of the Islamic banks’ customers to the current criticisms of the shari’ah compliance of Islamic banks, and their perception about these criticisms.

Correspondingly, the current study is an attempt to answer the following research questions:

1. How important is shari’ah compliance to the customers?

2. Are the Malaysian Islamic banks’ customers aware of the concept of shari’ah compliance?

3. Are the Malaysian Islamic banks’ customers aware of the current criticisms to the shari’ah compliance of Islamic banks?

4. What are the perceptions of the Islamic banks’ customers about the criticisms of shari’ah compliance of Islamic banks?

5. What are the perceptions of the Islamic banks’ customers about the shari’ah compliance of Islamic banks in Malaysia?

Following this introduction is a brief overview on the development of the Islamic banking industry in Malaysia. Thereafter, a review of the previous studies will be presented, focusing on the criticisms of the shari’ah compliance of Islamic banks, as well as the consideration given to the shari’ah compliance factor while choosing the Islamic bank to patronise. Then the methodology, the findings, the discussions and conclusions will be presented sequentially.

Brief overview on Islamic banking development in Malaysia

According to Mokhtar, Abdullah and Alhabshi (2010), the history of Islamic banking in Malaysia can be traced back to the establishment of Tabung Haji in 1963. The idea was mooted out of the necessity to develop a mechanism to encourage the Muslims to save for their pilgrimage, as the Malaysian Muslims in the past had resorted to various traditional means of saving and keeping their money for the sacred journey (Laldin, 2008:3).

In this regard, Sufian (2007) argues that the establishment of Islamic banking in Malaysia was mainly affected by its prior implementation in the Middle East. Notably, in 1980, the Bumiputera Economic Congress requested the Malaysian


government to allow the establishment of an Islamic bank in the country. Subsequently, the National Steering Committee was set up in 1981 in order to study this proposal in its different aspects. The conclusions of the study suggested that it will be viable to establish an Islamic bank in Malaysia. In fact, this marked the establishment of the first Islamic bank in the country, namely, Bank Islam Malaysia Berhad in 1983.

Laldin (2008) considers that the bank’s progress was very encouraging, with its activity rapidly expanding throughout the country. This prompted the government to further develop the Islamic banking industry in Malaysia.

As a result of the government’s efforts, Malaysia has emerged as the first country to implement a dual banking system where Islamic banking system operates side-by-side with the conventional banking system. The Malaysian model has been recognised by many Islamic countries as the model of the future and many countries have shown interest in adopting the Malaysian system in their respective countries. In fact, delegates from various countries, mainly Muslim countries, have come to Malaysia, particularly to the Central Bank and Bank Islam Malaysia Berhad (BI MB), to study how the dual banking systems work (Mokhtar et al., 2008).

The Malaysian Islamic banking system is currently made up of 15 banking institutions comprising nine domestic commercial banks, four foreign commercial banks and two Islamic banks offering Islamic banking products and services under the Islamic Banking Scheme. These Islamic banking institutions offer a comprehensive and broad range of Islamic financial products and services ranging from savings, current and investment deposit products to finance products such as property financing, working capital financing, project financing, plant and machinery financing, etc. (Sufian, 2007).

Literature review

Shari’ah compliance of Islamic banks and the current criticisms. The Islamic aspect of the Islamic banking practice is considered one of the most important factors differentiating it from its conventional counterpart. Thus, for the Islamic banks to compete in the current dual markets, it is important for them to keep aligned with the shari’ah requirements that represent the very essence of the religious rules of Islam. In fact, banks looking to move into the Islamic banking market first need to appoint a shari’ah board or a shari’ah counsellor to ensure conformity and minimize Shari’ah risk (Sungard Ambit, 2008).

Generally speaking, shari’ah compliance means the conformity of the Islamic banking transactions to the Islamic law or shari’ah. In elaborating further about shari’ah compliance, Dusuki and Abozaid (2007) distinguished between hukm qada’i and hukm diani. The former consists of the compliance with all the shari’ah conditions and requirements pertaining to a contract in its form and structure, while the latter is related to the purpose of the contract which must be in line with the shari’ah. It is important to note that the intention as well as the form and structure of the Islamic products should be in total compliance with shari’ah, for the Islamic banks to be qualified as full shari’ah compliant.


Shari’ah compliance of Islamic banks has been severely criticised especially in the current era, where the industry is in a “between the hammer and the anvil” situation i.e. faced with the innovation obligation to satisfy commercial objectives that are restricted by the shari’ah requirements, whic h makes the Islamic jurists exposed to the possibility of issuing fatwas that may run in conflict with their lucrative position (Rosly, 2010). This actually gives a comparative advantage to the conventional banks that can be more innovative and competitive as they have no other restriction except the banking acts.

Ownership is one of the issues that have evoked so many criticisms as to the shari’ah compliance of Islamic banks (Sairally, 2002). The rule of ownership here means that the Islamic banks should hold ownership of the asset, which is equivalent to taking risk and liability as well, following alkharaj bi daman or alghurmo bil ghunmi principle in Islam, that is there is no return without risk and liability. As such, Rosly (2010) argues that the rule of ownership must prevail in all the sales bearing the contract of Al bay’.

However, in practice, Jarrar (2009) discovers that the Islamic banks transfer the ownership to the customers, so that the latter will bear the risks as well as the liabilities involved. And this view was further supported by Dusuki and Abozaid (2007) who argue that the Islamic banks do not hold any liability. In fact, the banks transfer all the risks to the customer leaving the bank without any undertaken risk (Kamali, 2007). This is done through what is commonly called beneficial ownership, while the customer will have his name on the official documents as legal owner (El-Din and Abdullah, 2007).

Though the Islamic banks attempted to resolve the ownership issue by resorting to the beneficial ownership, the latter is still not acceptable from shari’ah point of view. This is because it is simply a modified version of the conventional practice (El-Din and Abdullah, 2007).

In the same context, the Islamic banks practice the sale of assets before acquiring them (Sairally, 2002; Rosly, 2010), and this is strictly prohibited in Islam as the prophet pbuh warned from selling something that one does not own. As such, Kamali (2007) came to the conclusion that the transfer of assets without transfer of ownership is not valid, and this view was consolidated by Rosly (2010) concerning sukuk, whereby he considered it to be non shari’ah compliant if the Special Purpose Vehicle (SPV) fails to transfer the asset ownership to the holders or investors.

The criticisms addressed to Islamic banks include also that of penalty payment (Jarrar, 2009; Rosly, 2010). In practice, Islamic banks usually charge a penalty fee of 1% on the late repayment of the customers. El-Din and Abdullah (2007) highlight the majority view of the scholars stating that this penalty charge from the debtor for the late payment is similar to riba prohibited by the holy Qur’an. Therefore, the owner cannot charge an additional amount if the hirer delays the payment. This view was supported by Al-Omar and Iqbal (2000) confirming that Islamic banks cannot charge anything extra if the buyer defaults or settles his payment lately, because that would be a serious riba. As such, Usmani (1999) argues that the penalty stipulated for instance in case of financial lease agreement is not valid in an Islamic lease. On the


other hand, Meenai (2001, cited in Sairally) argues that in murabahah financing, once the contract is finalised, a fixed liability is created implying that the price once agreed upon cannot be increased or decreased in relation to time. Hence, clients who pay early cannot be rewarded, and those who default in making payments on time cannot be penalized.

Nevertheless, some of the scholars consider that the penalty payment is permissible in some instances. For example, Baharum (2004, cited in El-Din and Abdullah) argues that when two parties or more enter into a valid contract, they will be bound by terms and conditions in the contract. As such, breaching any of these terms will cause the innocent party to suffer a loss, which needs to be compensated.

Similar to the penalty payment, Dusuki and Abozaid (2007) considered the custodial fee in the case of rahn or Islamic pawn broking to be equivalent to the interest rate used in conventional banking. More importantly, Sairally (2002) highlights the value of time compensation, the use of interest rate to discount future cash flows as well as the fact to include default risk margin with the mark-up margin, as against the shari’ah rules. In this context, Kamali (2007) asserts that some aspects of Ijarah for example, are not fully shari’ah compliant. This includes the maintenance and insurance fees that are solely borne by the customers (El-Din and Abdullah, 2007), hence, contradicting with the concept of justice in Islam.

Moreover, the current debate on the shari’ah compliance of Islamic banks is crucial regarding the benchmarking of the Islamic profit rate to the conventional interest rate (Rosly, 2010). This is quite different from the implementation of conventional- like instruments, in the sense that some of the instruments are theoretically and practically compliant with the shari’ah requirements; however, in the profit rate determination, the Islamic banks use the conventional interest rate as a proxy or benchmark. At that level, this is considered as making conventional and Islamic banking operations similar (Yusof and Fahmy, 2008).

In addition, Islamic banks are perceived to have used various conventional- like instruments such as term charges in the case of hire purchase agreement. These instruments are mostly based on market interest rate; making instruments like AITAB for instance look like conventional hire purchase agreement (El-Din and Abdullah, 2007). This argument is similar to that of Sairally (2002) concerning liquidated damages as well as the mark down approach used by Islamic banks to give rebates to customers. In the same context, Rosly (2010) considered profit rate swap with upfront profit and profit made by Islamic banks for late payment as conventional like instruments.

Islamic banks are equally reproached for the large reliance on Bay’ al ‘inah (Sairally, 2002) and tawarruq, which is a direct instrument of debt creation (Siddiqi, 2007) and that do not conceptually and practically differ much from the conventional. In addition, it is an indirect way of obtaining funds without involving in sale transactions and their implications (Sairally, 2002).

Bay’ al ‘inah is generally known as sale based on the transaction of Nasi’ah. The debtor sells to the creditor some object for cash which is payable immediately;


the debtor immediately buys simultaneously the same object for a greater amount for a future date. Thus the transaction amounts to a loan. The difference between the two prices represents the interest. Such contract was evolved in the early period of Islam and it exists for the fundamental reason that a loan for interest is forbidden because it is equivalent to usury. In this contract, there is an economic interest for both the borrower and the lender, which at the same time circumvents the prohibition of usury (Rosly, 2010: 8). This view is supported by that of Dusuki and Abozaid (2007) stating that Bay’ ‘inah based transactions and riba based transactions are actually same. Rosly and Bakar (2003) also described ‘inah as a way of legitimising interest or interest-like financing.

Another issue related to the shari’ah compliance of Islamic banks is the non-existence of a written shari’ah law (Abdullah and Dusuki, 2004) as well as accounting standards specific to the Islamic banking industry (Rosly, 2010). As such, some instruments like Al Ijaraha Thumma Al Bay’, Musharakah, Murabahah, etc. are entertained on the basis of conventional regulations and are recorded and treated as financing rather than leasing (Abdullah and Dusuki, 2004; Rosly, 2010; El-Din and Abdullah, 2007). As such, El-Din and Abdullah (2007) argue that the above matters can only be resolved by having shari’ah regulations and of course accounting standards specific to the Islamic banking principles. And since these are not currently available, then Islamic banks are still not compliant with shari’ah.

Furthermore, there is an argument that touches the essence of the Islamic banking practice today. That is the use of money in its current form i.e. fiat money or debt money (Siddiqi, 2007; Meera, 2002, Meera and Larbani, 2009). This argument states that the use of money in its current form contributes to the unattainableness of maqasid shari’ah which represents the core of shari’ah itself. The use of the current fiat money has also created a huge gap between the real market and the financial market, because of the exponential increase of debt.

Based on the above arguments, a number of researchers have reached a serious assessment of the Islamic banking practice in terms of shari’ah compliance. Sairally (2002) came to the conclusion that Murabahah is a good way of charging interest, by referring to the artificial transformation of the initial financing transaction. Dusuki and Abozaid (2007) supported this argument by stressing that the only difference that exists between the Islamic and conventional banking systems is in the technicalities and legal forms while in essence the substance is same. The authors backed their argument by putting forward the statement of Ahmad Al-Naggar that “Islamic banking operations differ only cosmetically from conventional banking operations”.

From the customers’ point of view, Abdullah and Dusuki (2004) found that Islamic banks’ customers perceive that there is no difference between AITAB and conventional hire purchase agreement. In the same context, Yusuf and Fahmy (2008) argued that Islamic banks are seen by customers as just a change in names. The tendency of Islamic banks to be modelled after the conventional banking system (Dusuki and Abozaid, 2007) is considered to be due to the eagerness of the Islamic banks to participate and compete in the banking industry (Yusuf and Fahmy, 2008). Rosly (2010) supports this view and concludes that Islamic banks close the front door to riba while opening the back door of riba.


Shari’ah compliance as part of the patronization behaviour

Several studies have been done in order to point out the variables that determine the patronization behaviour of customers in various industries. For the Islamic banking industry, Osman, Ali, Zainuddin, Rashid and Jusoff (2009) have studied the customers satisfaction in Malaysian Islamic banking and they have found that the compliance to the Islamic principles is considered the most important and significant criterion. Their findings are similar to those of Haque, Osman and Ismail (2009), Gait and Worthington (2008), Ahmad, Rehman, Saif and Safwan (2010), Al-Ajmi, Abo Hussain and Al-Saleh (2009), Amin and Isa (2008), Metawa and Almossawi (1998), Naser Jamal and Al-Khatib (1999) as well as Karim and Afif (2006).

Nevertheless, Abd Jalil, Yusoff and Mahmud (2010) found that the religious motivation was not part of the factors that motivate the selection of Islamic banks by the customers; rather, the customers were more interested in the advantage and goodness of products, the income and advice from third party, as well as the lifestyle. These findings are also similar to those of Aldlaigan and Buttle (2005) as well as Boyd, Leonard and White (1994).

Thus, the Shari’ah compliance factor illustrated by the Islamic motivation of the customers was found in many previous researches to be one of the main selection criteria of Islamic banks. This shows its importance as a patronization determinant to be considered by the decision as well as policy makers.

Finally, it is worth mentioning that all of the above studies have used quantitative research methods. Hence, to have a better and deeper understanding and description of the degree of importance of shari’ah compliance factor in the bank customers’ selection criteria, a qualitative approach will be undertaken in the current study.

Methodology Approach

In line with the objectives abovementioned, a qualitative research approach was applied. According to Merriam (2009), qualitative research allows the researcher to understand how people interpret their experiences, how they construct their worlds, and what meaning they attribute to their experiences (p.5).

The choice of qualitative research methodology can be further explained by its ability to generate comprehensive information to determine the perception of the customers about the shari’ah compliance of their Islamic banks. Given that, brief answers to structured questions will not be able to provide the required in depth information to assess the issue at hand adequately (Weischedel, Matear and Deans, 2005).

Sample and Data collection

A total of ten interviewees were selected depending on some specific criteria. The sample is comprised of well-educated and articulate individuals, with the ability


to understand and respond to detailed questions concerning shari’ah compliance of Islamic banks as they are practicing today. Polit, Beck and Hungler (2001) recommend that not more than ten interviewees should be included in the study, to allow an in-depth exploration in phenomenological studies. Furthermore, the sample of 10 respondents is considered suitable since it has been used in similar studies (Tijani, Fifield and Power, 2009; Koenigstorfer and Klein, 2010).

To access participants’ experiences, in dept interviews were conducted, in forms of semi structured interviews, using tape recorder. These interviews were ranging from 10 to 20 minutes. At the beginning of every interview, the interviewees were given a guarantee of the confidentiality and were also assured that their identities will not be revealed in any publication.

The interviewees have been customers of their respective Islamic bank for 2 to 8 years. The informants were basic ally 8 males and two females that were customers of Islamic banks for at least 2 years. Notably, this will allow them to have a better understanding and familiarity with the Islamic banking practice.

The interviewees were local Malaysian as well as international customers temporarily or permanently living in the country. Specifically, there were three interviewees from Nigeria, two from Somalia, one from Indonesia, one Malaysian, one from Thailand, one from Bangladesh and one from Tajikistan.

Data analysis

All the ten interviews were reviewed several times before been transcribed. Subsequently, a phenomenological approach to analyse data was adopted, which involves interpreting and reflecting on the data transcript so as to achieve a holistic understanding of the meaning of the participants’ experiences (Alexis and Vydelingum, 2007).

Furthermore, the area of shari’ah compliance of Islamic banks has been severely discussed from the experts and professional’ perspective. Hence, this data analysis approach was chosen to allow the customers also to express their opinion based on their own experiences.

Results

Importance of shari’ah compliance of the bank

This question is meant to clearly examine the importance of the shari’ah compliance factor for the Islamic banking customers. All the interviewees consider shari’ah compliance as a very important factor for them. Some of them consider that it brings barakah to their transactions, some others belief that it helps them in avoiding riba transactions, etc. The statement by interviewee J is typical and represents majority of the answers:

Shari’ah compliance is very important, because without following the actual guidelines of shari’ah, you cannot practice the Islamic banking guidelines. This shari’ah compliance is the one that differentiates between the Islamic banks and conventional banks. The shari’ah compliance will tell us whether they are involved


in any activities which involve gharar, uncertainty, riba, interest and so on. So all this should be put in one’s actions so that people can clearly understand that the activities of the Islamic bank are different than those of the conventional. That is why shari’ah compliance is very important.

The economic and social wellbeing that the shari’ah promotes within the nations were also highlighted by interviewees as some of the factors that make shari’ah compliance an important factor in deciding which bank to patronise. Meanwhile, the principle of maqasid shari’ah was also highlighted as one of the points to be observed in order not to deviate from the shari’ah compliance framework. Interviewee B noted:

The statement shari’ah compliant is very important for me because anything and everything that is in accordance with shari’ah, is good for us. As such, when the bank operates in accordance with shari’ah, this means that the objectives of shari’ah will mostly benefit the people, there will be no corruption, good employment.

Thus, shari’ah compliance was proven to be of high importance for all the interviewees, and this is compatible with the above results. In fact, this is similar to the findings of Haque, Osman and Ismail (2009), Gait and Worthington (2008), Ahmed, Rehman, Saif and Safwan (2010), Al-Ajmi, Abo Hussain and Al-Saleh (2009), Amin and Isa (2008), Metawa and Almossawi (1998), Naser Jamal and Al-Khatib (1999) as well as Karim and Afif (2006).

Understanding of the shari’ah compliance concept

The understanding of shari’ah compliance concept has not been studied in the previous literature. However, there are various definitions that are available from the previous studies (see Dusuki and Abozaid, 2007). As such, the current study will attempt first to examine the knowledge and understanding of this term by Islamic Banks’ customers.

The interviewees provided different definitions of what shari’ah compliance means. The most frequent is that shari’ah compliance means that all the operations of the bank should follow the guidelines of the shari’ah law. For instance, interviewee E noted:

To be shari’ah compliant means that all the operations of the bank should follow the shari’ah guidelines.

Interviewees A and I respectively added more specifications by noting some of the aspects that should be considered when establishing shari’ah compliance transactions,

Shari’ah compliance should prevail in all the aspects of the daily transactions of the bank. First of all the financial aspect meaning how the bank deals with the money and do they involve with non halal businesses, haram or halal, as well as other aspects, including management, whether they encourage Islamic environment or not. Also the management of operations and marketing should be considered. It should be an example of ethical organisation.


Our priority should be shari’ah compliance in every aspect, especially in the economic aspect.

In the same context, many of the interviewees limited the shari’ah compliance to the financial and monetary aspects. For instance, interviewee D mentioned that,

When something is shari’ah compliant, to me it means, it fulfils all the rules of shari’ah as far as money transactions in Islam are concerned.

Interviewee J is of the same view, however, he limits shari’ah compliance to the Islamic financial instruments that are theoretically derived from the Islamic legal sources. As such, he considers an Islamic bank to be shari’ah compliant or otherwise, depending on the conformity of the practical aspect of these transactions with the theoretical counterpart.

We know the banking transactions and we have several modes of transactions of Islamic banking, including Mudarabah, murabahah, Ijarah, ‘Istisna’, etc. You have to fully follow those mechanisms and modus operandi. If you want to follow only some parts and ignore the other parts, it will then be incomplete. So shari’ah compliance will only be in practice if you put all those into your practice.

It is noteworthy that all the above definitions have a general aspect. In fact, none of the above definitions conforms to the definition by Dusuki and Abozaid (2007), stating that the shari’ah compliance should prevail in both the form as well as the intention of the contracts. All the definitions are discussing only a part of the form, which is the financial part without looking to the other aspects as well as the intention which is the other half of the shari’ah compliance concept.

Awareness of the shari’ah compliance criticisms

The criticisms of the shari’ah compliance of the Islamic banks are one of the main concerns of this study because they lead indirectly to the assessment of the Islamic banks’ shari’ah compliance perception of the Islamic banks’ customers.

The interviews provide evidence that all the interviewees are aware of the current criticisms as to the shari’ah compliance of Islamic banks. However, the degree of exposure depends on several considerations. In this regards, interviewee G noted:

I am exposed to many of these criticisms based on my field of study.

Interviewee D associates his awareness about the current shari’ah criticisms to the BBA and hire purchase or Al Ijarah Thumma Al Bay’, which is similar to the argument of El-Din and Abdullah (2007) Rosly (2010) and Siddiqi (2007):

One of them is that their job is trying to paint the conventional products with Islamic names, so like Hire purchase; you have BBA and all these. And at times, some of these products are even worse or more dangerous than those of the conventional banking, because of the shari’ah attached to it. And because when shari’ah is attached to something, you want to fulfil the rules of shari’ah to the latter. But we discovered that they are doing so in a way that pays them not in a way that pays the customer.


In the same context of BBA, interviewee A noted that:

I heard a lot of criticisms of Islamic banks in Malaysia, some people mentioned about the hila of using bay’ dayn. Currently, I heard about BBA, it is said that if we borrow for 20 years, the loan pass 10 years, in BBA it does not pass the principle yet. Only the profit was taken. But the riba takes a little bit of principle already. And we cannot only criticise, some researches also suggest Musharakah, but Musharakah also the bank does not want to touch because it is low profit for them it means that they are doing business instead of money. Not in search of maslahah which is giving more benefit to the society. I can say overall. These are some of the criticisms I have heard.

The above statement is in line with the findings by Meera and Dzuljastri (2009). The authors found that BBA is even more expensive than the conventional housing loans, while musharkah mutanaqisah was found to be the cheaper mode of financing. In addition to the BBA issue, interviewee E expressed that:

I heard many criticisms but I did not really emphasise the issues. I heard lots of criticisms about bay’ al ‘nah transactions.

Additionally, interviewee H was more concerned about the issue of benchmarking, which supports the argument of Rosly (2010):

Actually, the one that I am really particular about is benchmarking of the profit rate to the interest rate. Islamic banks do not need to look after the conventional; they have to find another basis, to move away from the conventional banking practice. I think the main thing is interest rate, once the interest rate is eliminated, all the other issues will be solved.

Lastly, interviewee J mentioned that:

Nowadays, everything comes from the western banks and the shari’ah boards of Islamic banks just recommend them. For instance, credit card, we do not have to be so much crazy with the western innovation, we have to come out with something from our own perspective of innovation and not to depend on their own innovation. I think there is lot of lacking; this is why we can see lot of criticisms, lot of awareness that has already been created among the practitioners and the clients of Islamic banks. I think this will at least help the Islamic banks to think about it.

Overall, the interviewees showed a good degree of awareness of the current criticisms of the shari’ah compliance of the Islamic banks. In the next section we will shed light on the perception of the customers on these criticisms.

Perception on the criticisms of the Islamic banks’ shari’ah compliance

After examining the awareness of the interviewees about the criticisms to the shari’ah compliance of the Islamic banks, at this stage we will explore their perception about majority of these criticisms. Overall, interviewee J agrees with the criticisms to the shari’ah compliance of Islamic banks, and he expressed that:


These criticisms mainly come from academicians. And they themselves have noticed that there is huge difference between the theory and the practice of Islamic banking. I think there is a reasonable ground for all these criticisms.

Interviewee E supports interviewee J’s view and he also looks positively to these criticisms. This:

To some extent, I agree with most of these criticisms......These criticisms actually show that the customers are aware and understand the operations of Islamic banks, to some extent of course. Because otherwise, they would just let the Islamic banks operate just like they want. So for me it is positive.

Interviewee A showed a straightforward position by noting that:

If you go to the bank, you will see the rate already, which contradicts with the Shari’ah rules, because the bank cannot state the profit upfront. In this way the choice of financial instruments will depend on the rates offered, for example choose mudarabah if the rate is higher compared to musharakah and so on. So it should not be like that. Because it not only profit sharing but also loss sharing.

The statement by interviewee A supports the findings of Sairally (2002), Dusuki and Abozaid (2007) as well as Yusuf and Fahmy (2008) claiming that the current practice of Islamic banking today used many of the interest-like financial instruments.

Furthermore, one of the issues emphasised by the interviewees is the darurah usage as criticised by Dusuki and Abozaid (2007). In this regards, interviewee J noted that:

Darurah kind of things can be a good excuse for the Islamic banks while the environment is not Islamic. If you are living in an Islamic environment, Islamic country where 70% of the population are Muslims, then darurah issues should not come to the picture. It should be in fact avoided. It is one of the things that we should stop practicing.

Interviewee I has been more specific by clarifying that the banks should distinguish between the kinds of darurah the banks are referring to. Because if the banks look for the easy way to run the business then there will be no limit for that darurah usage:

Actually, darurah is one of the parts of usulul fiqh. But we should also consider what kind of darurah is it. Is it a real need to Islamic banks or no? In the stage where Islamic banks are now, Islamic transactions are growing, the Islamic economies are also growing, so there should be some alternative. But the darurah should not be for long time, it should change after a period of time. So we cannot basically just keep depending on that darurah, we should find an alternative.

In response to the statement of interviewee I, interviewee G provided an example of instruments that are still in use though the alternative has already been found:


If it is in the issue of bay’ inah, then we have a better one now......the bankers protect their interest, rather than achieving the shari’ah compliance and I think it is not acceptable for them to do that, because it begins with the intention. The intention of the bank must be to fulfil all the shari’ah requirements and not to get the profit, though the bank anyway should aim to get profit. But there should be progress towards achieving shari’ah.

The above statement provides evidence of darurah abuse in the current Islamic banking practice, similar to the argument of Dusuki and Abozaid (2007).

Another issue highlighted by the interviewees is that of benchmarking the profit rate to the interest rate, which has been seen in the literature as against shari’ah (Rosly, 2010). Interviewee C noted that:

Islamic banks do not need to look after the conventional; they have to find another basis, to move away from the conventional banking practice.

However, interviewees H and J disagree with the above statement and consider that Islamic banks should be using this basis at least for the time being; otherwise they will lose the market share. Interviewee H’s comment was typical:

This is a real issue. Because if they do not consider, they will lose the market, so in this financial system, it is difficult to have a different benchmark, because the market is still one single market. So if you do not consider that one that means you will lose. Either you will lose the customer or you will lose the market. So for me, yes, they should consider, at least temporarily.

This contradicts with the argument of Rosly (2010) as well as Yusuf and Fahmy (2008). Their arguments claim that when the profit rate is benchmarked to conventional interest rate then the Islamic banks become more or less similar to the conventional banks.

The interviews also revealed the fact that Islamic banks in Malaysia operate in a dual banking system i.e. under the conventional regulations and accounting standards, and this was claimed to be affecting the shari’ah compliance of Islamic banks as highlighted by Abdullah and Dusuki (2004), Rosly (2010) as well as El-Din and Abdullah (2007). Interviewee G as well as half of the interviewees all agree with the above argument and clearly note that:

The fact that Islamic banks operate under the conventional regulations and accounting standards strongly affects the shari’ah compliance aspect of Islamic banks. In fact, the substance is more important than the form of transactions, and in this case, the form and superficial look Islamic but the substance is nothing but a conventional banking operation. In other words, this is a disguised form of banking.

However, another half disagrees that the accounting standards and regulations affect the shari’ah compliance of the Islamic banks. Interviewee J’s comment was typical:

To me, with my little knowledge, the accounting aspect has no problem with the practice of Islamic banking. For example if you have debit/credit accounting, it


does not mean that the figures have an Islamicity problem. The problem is what the figure is representing, what the amount you are getting represents, profit or interest, which project it is coming from, this is the thing. But your mechanics, your tools should not be a problem, so there is nothing wrong with the technique or calculation. The problem is where the figure is coming from, is it from a halal transaction or non halal. For the accounting standards, we can take good lessons from the western practice, because this has been in place for than 400 years, and Islamic banking is newly born child compared to the conventional.

Overall, majority of the interviewees agree with most of the criticisms of the shari’ah compliance of Islamic banks. However, the customers perceive that the use of conventional like instruments can be solved by first stopping abusing the darurah principle and work forward by establishing Islamic regulations and accounting standards, by further learning from the existing Western regulations. In the meantime, the customers perceive that the current criticisms will also motivate the Islamic banks to move forward to the full shari’ah compliance.

Shari’ah compliance of Islamic banks

The final topic covered in the interviews’ sessions was about the essence of the current practice of Islamic banking, whether the customers perceive it to be shari’ah compliant or not. This in fact will indirectly depend on the interviewees’ perception and assessment of the criticisms discussed above. Surprisingly, majority of the interviewees believe that the Islamic banks as they are practicing today are not shari’ah compliant. Interviewee A firmly noted that:

They seem to be shari’ah compliant, but if we study deeper, actually no. From my opinion, as long as the higher goal is not shari’ah compliant, then the below objective will not be shari’ah compliant. So I do not think they are shari’ah compliant.

Interviewee B, which was of the same opinion, expressed that:

I am in difference saying Islamic banks today are shari’ah compliance or not, because most of their activities are not quite different from the conventional banks. For instance, their products like musharakah, mudarabah, if you go to any Islamic banks, you will see that they have already stipulated the interest rate for every product in advance, this is a kind of guarantee on what they will pay you. For me such kind of operations do not differ much from the conventional and the main condition for such operations is the dual banking system which is the ground on which conventional and Islamic banks equally operate.

Interviewee D highlighted a very important point, which is the possibility of “fatwas a la carte” stated by Grais and Pellegrini (2006), whereby the shari’ah scholars issue fatwas depending on the managers and shareholders’ desires.

We need to know the shari’ah compliance and know what they are doing. What they call shari’ah compliance is it really shari’ah compliance or something that is legalised by paid shari’ah scholars so we need to know this so that we will be able to say that they are compliant or not. But as far as I know, it is just a thin line that


differentiates Islamic banking from the conventional.....For the majority of the Islamic banks as they are operating now, it will be difficult for me to give them more than two out of ten.

On the other hand, though interviewee I notes that Islamic banks are not compliant with shari’ah, he emphasised the fact that Islamic banks are still relatively new compared to the long existed conventional banking system.

Based on my humble understanding regarding Islamic banks, Islamic banks still need to do more efforts to improve their shari’ah compliance. So still there are many aspects that Islamic banks need to work on. In fact, these are only Islamic terminologies, but the applications are only copy and paste of the conventional. I think Islamic banks need to develop and improve the transactions to be more shari’ah compliant. So, the early age of Islamic banking should also be considered.

Interviewees G and J are also of the same view i.e. Islamic banks need time to achieve full shari’ah compliance. They respectively noted that:

I believe that Islamic banks today are not fully shari’ah compliant, but I believe they are going to that level; they just need time to achieve full shari’ah compliance. For the time being, it is not very important for me whether they are shari’ah compliant or not, what I am more concerned about is that one day they will reach that point and achieve this goal.

I think they are moving towards the actual position where it should be. But I think it will take time, because overnight changing is quite different. For example few of the Islamic banks in Malaysia or abroad have started with Islamic operations, they usually start with windows and then shift to full fledged Islamic bank. So it will take time to create the internal atmosphere, organisation, personnel involved in the different positions, beside this, the clients need time to accustom with fully Islamic system into the operations.

In summary, the above results are in accordance with the criticisms addressed in the literature above mentioned, claiming that Islamic banks as they are practicing today are non shari’ah compliant (Dusuki and Aboazaid, 2007; Rosly and Bakar, 2003; Yusuf and Fahmy, 2008; Rosly, 2010; Abdullah and Dusuki, 2004, etc). However, the customers are tolerant for the time being, given that shari’ah compliance cannot be achieved overnight.

Discussions and conclusions

This study provides insights into the experiences of the Islamic banks’ customers in Malaysia regarding the shari’ah compliance parameter of their respective Islamic banks. Prior to the discussion about shari’ah compliance of the Islamic banks from the customers’ experience, a number of other themes were evoked during the interview sessions.

The findings revealed that majority of the customers have chosen Islamic banks because of their religious motivation, and their duty vis-à-vis the achievement of full shari’ah compliance of Islamic banks in the future. This was subsequently proven by the customers’ perceived importance of shari’ah compliance of Islamic banks, unanimously expressed by the interviewees.


Furthermore, the results showed that all the interviewees do not have a thorough understanding of the shari’ah compliance concept. In the sense that what was emphasised by the customers is only the form of shari’ah compliance, not the intention part, which is the other most important part that was scrutinised several times in the hadiths of the prophet pbuh.

However, the interviewees were found to have considerable exposure and awareness of the current criticisms of the shari’ah compliance of Islamic banks. In this regards, most of the interviewees agree and support majority of these criticisms, but they are also optimistic about the future. They believe that these criticisms will motivate Islamic banks to work towards the achievement of full shari’ah compliance, by establishing their own Islamic regulations and accounting standards, and also by regulating the use of darurah for the current period.

The interviewees’ perception about the shari’ah compliance of Islamic banks is compatible with their assessment of the shari’ah compliance of Islamic banks. In fact, all the interviewees agree that Islamic banks as they are practicing today are still not shari’ah compliance. Meanwhile, they have expressed a high degree of tolerance for the current practice, since the most important for them is the continuous improvement of Islamic banks towards achieving shari’ah compliance in the future.

The findings of the current study have significant contributions to the body of knowledge, practitioners and stakeholders as well as to the policy makers and regulators. In fact, this is the first study that examines the shari’ah compliance of Islamic banks from customers’ perspectives, which enriches the literature in this area of research. Similarly, the findings provide hindsight on the customers’ perception on the matter of shari’ah compliance, which will motivate the Banks to deploy more efforts to comply with the shari’ah and subsequently with the expectation of the customers. This also means that the policy makers and regulators should implement the necessary regulations to ensure the compliance of Islamic banks with shari’ah.

Though the findings provide great indication on the customers’ perception about shari’ah compliance of Islamic banks, the study has some limitations that should be considered for the future studies to be conducted in this area. Firstly, the sample is taken from mainly two Islamic banks in Malaysia, and it is also relatively limited, so the results cannot be generalised to the whole country. Secondly, the study focuses only on one aspect of the Islamic banking principles, hence the future studies are recommended to cover other aspects of it. The future studies are also recommended to use mixed methodology with triangulation in order to validate the results.

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Experience: Promotion Of Islamic Finance In Pakistan

By Keynote Address

by Yasin Anwar

Govenor State Bank of Pakistan at

Islamic Economic Forum Muscat (Oman)*

I am honoured to be here at this historic event at a time when Oman is opening its doors to Islamic finance. The prudent approach of Oman towards the financial sector has helped it in steering safely through the financial crisis, and I am sure that despite a relatively late entry in Islamic finance, given His Majesty Sultan Quboos support, Oman will soon be amongst the leading Islamic finance markets in the region.

Your Excellency, Ladies & Gentlemen!

The last financial crisis is viewed as the worst of its kind and tremors from it are still being felt as we keep hearing about fears of economies continuing to remain in recession. Debates on reasons for the financial crisis have led to a wider belief of having greater accountability and a proactive role of regulators to ensure stability of the financial system. Post crisis the world has been trying to rearrange the infrastructure of the financial industry and I view Islamic finance fitting well in the new structure.

Islamic Banking can be traced back to four decades and has its values embedded in the ethics of Islamic society of 1400 years ago. The Islamic economic system is not just about prohibition of interest, it also promotes values such as accountability, transparency and social responsibility. After weathering the financial crisis rather well compared to their conventional counter parts, Islamic financial institutions are increasingly becoming popular. Perhaps the world has been able to see beyond the element of religion and view Islamic finance as an ethics central system that has linkages with real economic activities and an internal shock absorbing ability. From its humble origins Islamic finance today exists around the globe catering not only to the financial needs of Muslims but also to non-Muslim clientele. * Source: State Bank of Pakistan, Govenor’s address December 2011


Volumes can be discussed with reference to Islamic finance and I am sure looking at the two day schedule, you will be hearing prominent speakers give you insights into issues of Islamic finance. Therefore I would restrict myself to sharing with you our experience of establishing and promoting Islamic finance as the preferred mode in Pakistan.

With more than 95 percent Muslim population, and a constitutional obligation of ensuring a riba free economic system, Pakistan has had a relatively favourable environment to launch Islamic finance in the country. However the approach adopted during the 80s for transforming the entire financial system to an interest free system did not meet much success. Despite having introduced landmark changes in the legal framework that included amendments in the Banking Companies Ordinance, enactment of Modarba companies and Mudarabas framework etc., the dream of transforming the entire financial system on Shariah principles could not translate into a reality. The major reasons that can be attributed to this unsuccessful attempt were a) abrupt conversion of the system without creating the necessary infrastructure and human resource, b) lack of ownership amongst the banks’ management and staff as well as the business community to shift to the new system in one step, c) a weak judicial system and dispute resolution mechanism, and d) lack of general awareness among the masses about the utility of Islamic banking.

Learning from past experience, we adopted an evolutionary approach for establishing Islamic finance in the country in 2001 whereby both conventional and Islamic banks were allowed to operate in parallel. This enabled the masses to choose between the two systems that best serves their banking and financial services needs and is also in conformity with their faith. The approach has worked well since then and the industry starting from almost scratch in 2001, has gradually improved its share to more than 7.5 percent of the country’s banking system. We have now 5 full-fledged Islamic Banks and 13 conventional banks having standalone Islamic banking branches. Given the strong growth momentum, which is over 30 percent annually for the last 6 years, we are hopeful of more full-fledged Islamic banks in the country in the near future.

State Bank of Pakistan, the country’s central bank, has been at the forefront of all the major initiatives for development of the industry. We are one of the few regulators who have introduced a comprehensive legal, regulatory, and Shariah compliance framework for the Islamic Banking Industry. The framework allows three types of institutional models for offering Islamic banking services; (i) Full-fledged Islamic banks (2) Islamic banking subsidiaries of conventional banks and (3) Stand alone Islamic banking branches of conventional banks. Moreover, to encourage and facilitate conversion of conventional branches into Islamic banking branches, a detailed criterion has also been issued. The banks are required to have funds of their Islamic banking operations segregated from their conventional side and maintain a separate book of accounts. The permission to conventional banks to offer Islamic banking services through stand alone branches enabled us to leverage their vast network across the country to expand the outreach of Islamic finance. It has also been instrumental in gradually sensitizing the conventional banks about the utility of Islamic banking in business and economic development as well as its growth potential in countries like Pakistan. Presently the conventional banks’ Islamic banking portfolio constitutes about 40 percent of the industry.

Further, in order to enhance the breadth and depth of the industry, the framework also allowed establishment of full-fledged Islamic Microfinance banks,


Islamic microfinance services by full-fledged Islamic banks and Islamic microfinance Divisions in conventional microfinance banks. Considering the growing awareness and acceptability of Islamic microfinance coupled with its inherent controls to ensure end use of the funds provided by MFIs, the outlook for growth and development of Islamic microfinance in Pakistan is highly positive and we may see establishment and operations of new Islamic microfinance banks in very near future. Similarly Pakistan being an agro-based economy, there is huge potential for development of Shariah Based Agriculture financing. The central bank is working with the industry to develop Shariah compliant agriculture finance products to be offered by IBIs after necessary customization. We have recently circulated a model Shariah compliant agriculture finance product based on ‘Salam’ to facilitate IBIs’ entry in the country’s agrifinance markets, which so far have remained grossly un-served or under served. This untapped market includes Dairy products as Pakistan is the fourth largest producer of milk in the world. Cows in Pakistan produce 1000 liters/annum, Australian cows 4000 liters and US cows 9000 liters. This represents an excellent sector for Islamic Finance and once developed, can generate more than $ 500 million in foreign exchange exports. Nestle and Engro have already invested heavily to tap this market segment.

A comprehensive and mutli-tiered Shariah compliance framework is another very important feature of our Islamic banking framework. It comprises

(a) Centralised Shariah Board at the Central bank, which is the apex Shariah Body in the country for Islamic banking institutions. The distinctive composition of this board of having Shariah scholars, an accounting professional, a legal expert and a professional banker benefits the industry by providing comprehensive solutions; that are not only Shariah complaint but also economically viable.

(b) The Shariah Advisor at bank’s level to be appointed in accordance with the State Bank of Pakistan’s Fit and Proper criteria with the responsibility to ensure that the bank’s operations are in conformity with Shariah Principles.

(c) Mandatory internal Shariah audit and

(d) Periodic Shariah inspections by the Central Bank along with routine annual inspection of IBIs. The SBP is one of the very few central banks that have initiated Shariah Inspections. Before the formal launch of the Shariah inspection a comprehensive Shariah inspection manual was developed by engaging a reputed Shariah consulting and auditing firm and comprehensive training was imparted to the Shariah inspectors. The Central bank has also notified the essentials of major Islamic finance products and instruments along with their model agreements; the IBIs while ensuring adherence to the essentials, may develop their own products with the approval of their Shariah Advisor. This arrangement not only allows necessary flexibility to IBIs to develop their own products but also helps in achieving much needed standardization and Shariah harmonization. To further strengthen the Shariah harmonization drive, we are in the process of adopting the AAOFI Shariah standards.

In order to develop sound risk management system and ensure good governance, an incremental approach was adopted whereby the conventional framework was reviewed extensively to identify the gaps and limitations of the


conventional system in covering risks and issues specific to IBIs. The new guidelines were thus formulated by tailoring IFSB and AAOIFI standards; they not only cover all major risk categories but also provide best practices for establishing and implementing risk management and corporate governance in IBIs.

While risk always finds an important place in discussions related to Islamic finance, I believe there is interplay between risk and innovative ideas. IBIs have an opportunity to deploy part of their liquidity into participatory modes such as Mudarabas and musharaka. This will not only help them move away from current paradigm that is criticized for mirroring conventional instruments but will also help them capture the untapped markets like Small and Medium Enterprises. While IBIs have an advantage of attracting faith sensitive population they can further expand their outreach by reaching out to segments that have been earlier ignored by conventional banks. IBIs have a business model that enables them to cater to such clients however further sophistication is required in their product range to capitalize on this opportunity. Access to finance is a key challenge facing regulators and IBIs can play an important role in minimizing the incidence of financial exclusion. Realizing this recently, the State Bank of Pakistan revised its definition of rural areas encouraging IBIs to expand their branch network in these jurisdictions.

Besides Islamic banking, the Islamic capital markets are also very important component of Islamic economic system, which can help both public and private sector to mobilize large amounts of capital for financing economic growth and development. The popularity of Sukuk particularly during last decade has not only been instrumental in fast pace expansion of Islamic finance but has also provided a good and stable source of funds to governments. It also defines the limits on public debt and restricts it to the extent of assets available with the government or the new assets to be created through deficit financing. The government of Pakistan is issuing Sukuk with considerably increased frequency since last couple of years and has raised more than USD 3 billion from domestic market that helped Islamic banks to expand their asset base. Further, Islamic funds have found their way to supporting infrastructure projects around the world especially in the Gulf. Being a Muslim country and given its strategic location Oman can benefit from this increasingly popular trend. Issuance of Shariah compliant papers by central bank, commercial banks, government treasury and private entities are likely to contribute significantly to growth and development of real economy.

The limited liquidity management instruments and lack of lender of last resort facility have been amongst the key issues faced by Islamic banks in most jurisdictions, including Pakistan. So far we have had limited success in developing an effective and ongoing liquidity management mechanism for IBIs due to the infrequent issuance of sovereign Sukuk. As a result of extensive efforts made both at the industry and the central bank level, we are currently at an advanced level of development of a comprehensive liquidity management solution that would include i) development of Islamic interbank money market, ii) development of Islamic Interbank Offered Rate (IIBOR) for use as a benchmark for pricing of Islamic finance products, iii) transformation of a sizeable portion of conventional sovereign debt in the books of central bank into Shariah compliant debt, iv) allowing IBIs to place surplus liquidity with the central bank to be remunerated based on the central bank’s earnings on Shariah complaint assets and investment portfolio, and v) lender of last resort facility for IBIs. The most challenging and time consuming aspect of


this mechanism is the transformation of sovereign debt into Shariah complaint debt as it involves identification of the assets to be used for transformation, their valuation and documentation etc. However, I am confident that with the help and grace of Almighty Allah, we should be able to finalize this mechanism in the near future. This would be a major milestone achieved and would give a big boost to the already buoyant Islamic finance industry in Pakistan.

Islamic finance is an evolving industry and so is its understanding by the masses, the business community and the policy makers. Despite significant improvement during last 10 years, still a very large segment of our population does not have adequate understanding of Islamic finance and its distinction over conventional finance. The Central Bank has thus assumed a dual role for Islamic banking i.e., the regulator, the promoter, and facilitator. Under the facilitation hat we have been partnering with the industry to improve the Islamic banking awareness and understanding of the masses and to build the industry’s HR capacity. To create awareness we have launched an awareness campaign, whereby targeted workshops, public seminars and conferences are being organized. Further, a media campaign is being launched for mass awareness using electronic and print media. To help the industry to build its HR capacity, our training subsidiary NIBAF (National Institute of Banking & Finance) is offering regular and customised Islamic Banking courses to national and international participants. Alhumdullilah! Over the years we have developed a good team of Islamic banking trainers cum practitioners, which coupled with the excellent training facilities at NIBAF, is enabling us to offer quality training programs for local as well as regional and global Islamic banking industry.

Innovation remains the corner stone of Islamic banking. IBIs need to increase their product mix in order to meet the needs of their ever increasing client base. Research and development which has been long ignored in our part of the world should be the hall mark of IBIs. We need to change our perceptions and invest in research as a core ingredient of our strategic objectives. While Islamic banking has made significant strides globally and domestically, I believe it is still in an evolutionary phase and relentless efforts are required to confront challenges in keeping the growth momentum of the industry. A pure Islamic financial system based on ethos of equity justice and social responsibility is ideal, but this cannot be achieved over night. Serious efforts on continuous basis will have to be made to achieve a financial system that is in line with maqasid Shariah, and forums such as this help us in our journey towards achieving such a system.

The Central Bank of Oman deserves to be congratulated again for initiating Islamic banking and I wish them every success in their efforts to develop a vibrant Islamic banking industry. Though a late starter they have the advantage of learning from the good and bad experiences of other countries, including Pakistan, and adopt an approach that is based on international best practices with necessary customization. Let me assure our full support to our colleagues at the Central Bank of Oman and other related institutions and departments in setting up a strong and vibrant Islamic finance sector in this very important Muslim country.

I hope that the deliberations here at this auspicious gathering of leading scholars and practitioners will not only help us in laying out the road map for Islamic finance in Oman but also help us in addressing key issues faced by the industry.


Test your Islamic Vocabulary S.No. Questions Correct Answers

1. What are the activities permissible according to Shari’ah?

Halal

2. Activities, prohibited according to Shari’ah?

Haram

3. Define the contract in which advance payment is made for goods to be delivered later on.

Salam

4. What is charitable giving? Sadaqah

5. How you define the laws contained in or derived from Holy Quran & the Sunnah?

Shari’ah

6. What is the obligation on Muslims to pay a prescribed percentage of their wealth to specified categories in the society?

Zakat

7.

What is the Islamic version of option, that is a deposit for the delivery of specified Quantity of commodity on a predetermined date?

Arboum

8. How you define duty on every Muslim who is financially & physically able to carry it out once in his life?

Hajj

9. Define an interest free loan given either for welfare purpose or for fulfilling short term funding requirement.

Qard Hasana

10. Define the donation covenant in which the participants agree to mutually help each other by contributing financially.

Tabarru

11. What do you mean by Mini Pilgrimage to Mecca? Umra

12. What do you mean by references to the Sayings & actions attributed to prophet Muhammad (PBUH)?

Sunnah


13.

What do you mean by a ruling made by a competent Shariah Scholar on a Particular issue, where fiqah (Islamic Jurisprudence) is unclear?

Fatwa

14. Is fatwa a legal Binding? No, it is an Opinion

15. What is an important source of Islamic Economics? Fiqh

16.

How you define the leasing contract under which a Bank purchases and leases out a building or equipment or any other facility required by its client for a rental fee?

Ijara

17. Define a Sukkuk having Ijara as on underlying structure? Ijara Sukkuk

18. How you define Ijara wa lqtina?

Same as Ijara except the business owner is committed to buying the building or equipment or facility at the end of lease period. Previously paid amount constitutes part of the purchase price. It is commonly used for home & commercial equipment financing.

19. Define Islamic Calender, during which Muslims fast? Ramazan

20. What is the meaning of Maysir?

Gambling a prohibited activity, as it is a Zero sum game, just transferring the wealth not creating new wealth.

21. What is the meaning of Mudarabh?

A form of Business contract in which one party brings capital & the other personal effort.

22. Define Mudarabah Sukuk. A Sukuk having Mudarabah as an underlying structure.

23. How is the profit & loss shared in case of Mudarabah contract?

The proportionate share in profit is determined by mutual agreement at the start but the loss, if any, is borne only by the owner of


the capital, in which case the entrepreneur gets nothing for his labor.

24. What is the meaning of Mudarib? In a Mudarbah/partnership contract, the person who acts as entrepreneur.

25. What do you understand by term Murabaha?

A contract of sale between the bank and its client for the sale of goods at a price plus an agreed margin for the bank. The contract involves the purchase of goods by the bank which they sell to client at an agreed mark up, Repayment is usually in instalments.

26. What do you call the person who invests the capital in Mudarabah contract?

Rab al maal

27.

Who is the competent authority, who supervises and ensures the shari’ah compliance of new product development as well as the existing operation of a financial institution.

Shariah Board

28. What is the meaning of term ta’awuni? A principle of mutual assistance.

29. What is the meaning of word Takaful?

Alternative of conventional insurance, based on the Quranic principle of Mutual assistance Ta’awuni. It provides mutual protection of assets and property and offers joint risk sharing in the event of a loss by one of its members.

30. How would you define Waqf

An appropriation or tying up of a property in perpetuity so that no proprietary rights can be exercised over its use.

31. What are the conditions on Waqf property?

The property can neither be sold nor inherited nor donated to anyone.


32. What is the literati meaning of gimar?

Lit: Gambling Technically, an agreement in which possession of a property is contingent upon the occurrence of an uncertain event.

33. What is the literati meaning of Amanah?

Lit: Reliability, Trustworthiness Loyalty, honesty. Technically it describes a business deal where one party keeps another’s funds or property in trust.

34. Who is Mufti, what is the definition of Mufti?

An Islamic Scholar, who interprets or expounds Islamic Laws & gives fatawa.

35. What do you understand by term Wakil?

A Representative (agent) who acts on behalf of the principal/investor in a Wakala contract.


Shariah Quotation “The very objective of the Shariah is to promote the welfare of the people,

which lies in safeguarding their faith, their life, their intellect, their posterity and their wealth. Whatever ensures the safeguarding of these five serves public interest and is desirable”. Al-Ghazali

“The basis of the Shariah is wisdom and welfare of the people in this world as well as the Hereafter. This welfare lies in complete justice, mercy, well-being and wisdom. Anything that departs from justice to oppression, from mercy to harshness, from welfare to misery and from wisdom to folly, has nothing to do with the Shariah.” Ibn-al-Qayyim

The above stated quotes well summarize the goals and objectives of Islamic Shariah. However, these goals cannot be achieved merely through and words; concerted efforts are required from all stakeholders. Accordingly there is a need to put in place a social and political system that helps attain goals and objectives of Shariah. Besides, a firm economic system is needed which effic iently optimizes the use of financial resources in an equitable and ethical manner ensuring rewards to all factors of production fairly besides providing for those who do not participate in the production process.

Islamic banking emerged as a response to both religious and economic needs. Islam calls for avoiding any transaction based on Riba while economic needs ask for diversity in the role of banking for promoting investment / productive activities, facilitating economic justice and adding stability to the economy. Islamic banking can thus be perceived as an improved and better equipped system in different dimension.

The banking system in an economy works like the blood circulation system of a body. As only an efficient blood circulation system can ensure a healthy body, similarly an efficient and equitable banking system can dispense economic efficiency and justice. These basic concepts and objectives are common to any banking system whether it be conventional or Islamic. The difference lies in the methodology adopted to achieve these objectives. Conventional banking aims to meet these objectives through use of interest-based contracts while Islamic banking achieves these objectives of interest and permissibility of trade is enunciated in following Quranic verses.

‘And Allah has permitted trading, and prohibited riba’

This similarity of objectives and difference in methodology of conventional and Islamic finance defines the regulatory framework required for Islamic banking

system. Similarity of objectives implies that a major portion of the regulatory framework would be the same for both the system. However, the difference in

methodology to achieve the objectives requires amendments to existing regulatory system according to the Shariah principles. This is a more pragmatic approach that helps avoid the tendency of unnecessarily reinventing the wheel, Moreover, it gives Islamic banking a great advantages to get maximum leverage out of already existing

and well-tested regulatory framework of the conventional banking. The SBP has adopted this approach in line with the standard practice around the world.


Note to contributors

Journal of Islamic Banking and Finance is an official publication of International Association of Islamic Banks Karachi, Pakistan. It is refereed quarterly journal, as well as 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, 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 paper. We accept original contributions only and if the material is taken from some book or any other source, the source may be mentioned. The editorial team does not assume any liability for the views of the writers expressed in their articles nor may necessarily agree with their views.

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Abstract: The articles should contain well summarized abstracts between 100 to 200

words, covering the subject matter of the articles its conclusion and the result arrived at, with key words. Tables and Figures:

Figures, tables and boxes should be numbered consecutively in Arabic numeral (i.e figure 1, figure 2 and Table 1 & Table 2) Book Review:

New books (on Islamic economics, finance and banking, as well as on issues and problems of economic development) will be reviewed in the Journal on request. Authors/publishers may send two copies of each book to the editor for purpose of review.

All communications should be addressed to the editor.


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