Islamic Banking in Europe - the Reintegration of Faith and Economy

(Mudarabah Structure, Rights and duties of Participants)
Rashid Mengers is Assistant Director of the Institute of Islamic Banking and Insurance in London

Islam has a unitary approach to life. It does not put the various aspects of human behaviour into water- tight compartments. It considers man as an integral whole. In other words, the numerous functions that he or she performs, e.g., economic, political, social and religious, are not independent of each other. In the economic field, activities are conditioned by social milieu, moral values, cultural heritage, and above all by religious beliefs. It is therefore said that the word religion being just one aspect of life among many others is an insufficient translation for the Arabic term deen, which is often used to characterise Islam.

monotheism

Thus, in the Islamic framework, material pursuits are not independent of spiritual pursuits. Moreover, Islam does not consider economic activity to be a mundane and base pursuit. On the contrary, Islam encourages productive economic activity. Indeed, it considers productive economic activity as an act of worship if pursued in accordance with the Shari'ah. However, Islam does not regard economics as the be-all and end-all of human existence. It prescribes a golden mean between the two extremes of monastic rejection of the world and unbridled materialism.

Communism-capitalism

Islam has a unique perception of what is called the 'economic problem'. According to secular economists, the economic problem arises because of the 'niggardliness of nature', because man has unlimited wants to be fulfilled but the resources available for their fulfilment are limited. This gives rise to the economic problem. The emphasis in secular economic models is on easing the 'supply constraint in order to satisfy these unlimited human wants. Islam, on the other hand, maintains that God has provided sufficient means for the fulfilment of all human needs On the demand side, it does not endorse .all 'wants', since every want does not deserve to be fullfilled.

God does not exist if he exists he is imperfect

In the economic field, man is provided with a set of basic values. These basic values are contained in a framework called hudud Allah (boundaries of God), which define the area of permissible economic action. These boundaries should not be violated or transgressed, but within their limits man is free, indeed encouraged, to use his mental and physical faculties for the betterment of his own life and that of his society.

In Islam, wealth is to be regarded as a means and not as a goal. It is a means of satisfying needs, of providing sustenance, in moderation. In treating wealth otherwise, man becomes materialistic, selfish, ruthless and greedy.

Many authors socialist background

According to the Islamic concept, the real owner of wealth is God. Man is merely a 'trustee' for a term. Realisation of this dual ownership mitigates the selfish and dishonest tendencies that often result from the deceitful notion of absolute ownership.

In addition to the values and guidelines mentioned above, Islam also has a number of specific ordinances; some are positive injunctions and some are definite prohibitions. These include:

1. Zakah

An important part of the Islamic economic system is the institution of zakah - a levy on certain categories of wealth. The importance of zakah may be ascertained from the fact that it is one of the five pillars of Islam. (other pillars belief, prayer, fasting and hadj) According to Islamic belief, paying zakah purifies a person and his wealth. Zakat 2,5% of income.

In an Islamic state, zakah is collected and distributed by the government and is an important source of income for the Muslim treasury (bait-al-maal). Also zakah in an Islamic state is obligatory to Muslims only; non-Muslims are completely exempt. Detailed instructions and rules about the rates of zakah for various categories of wealth, and the beneficiaries of zakah, can be found in books on the subject. Here we make some general observations.

Zakah is applicable to income and savings, agricultural harvests, commercial goods, gold and silver over certain amounts, some categories of livestock, treasures and wealth, etc.

In compliance with this Qur'anic verse, the proceeds from zakah are to be paid to the following categories of disadvantaged persons:

a) The poor (faqir) who have no income. He is to be given as much as he needs.
b) The needy (miskeen) whose income must be supplemented to meet his needs.
c) Slaves who are seeking freedom or for freeing slaves by saving them from their masters.
d) The wayfarer (ibn as sabil) who is on a lawful journey and is in financial difficulty. A person may also be helped from the proceeds of zakah to undertake the journey for performing Hajj or for seeking education.

2. Prohibition of Riba

The word Riba in the Qur'an means "increment" and covers both usury and interest. Islam forbids interest in all its forms in very clear and strong language and considers Riba a serious sin.

The last verse revealed to Prophet is about the issue of riba.
Vast majority of experts say all interest is riba

3. Treating Wealth as a Means and not an End

Islam regards economic well being as a means to peace, freedom from hunger and freedom from fear of, or domination by, any being other than God. Beyond the satisfaction of basic needs, the ultimate objectives of earning and spending money are moral and spiritual. This rules out the seeking of economic gains at the cost of moral and spiritual values, both at the individual and the soc level. It is against Islam to hoard money.

It follows that savings, that is, what is left after consumption and charitable giving, must be put to good use. One who cannot undertake productive enterprise himself can do so in partnership with others, or can supply funds on a profit-sharing basis. People can also borrow and lend, but the lender must not claim interest on the principal, for that is forbidden by Islam. Islam prohibits gambling, cheating, exploitation etc. but gives any theoretical and practical freedom to individuals to undertake any permissible activity. In the west individuals have theoretical freedom. But practical freedom is often restricted by administrative or material hurdles. Freedom to make monetary and financial arrangements is constrained only by a few prohibitions and by the Islamic tendency to treat money as a means to the good life.

Money means of exchange not value by itself

4. Trusteeship

Islam has made a point of stressing that all the resources of the earth belong to God, the Creator, who has made man a trustee for them. Man is therefore accountable to God for the uses he makes of these resources. The idea of trusteeship distinguishes the Islamic approach to economics from materialistic approaches like capitalism and socialism. It effectively rules out the two extremes - laissez faire and collectivisation - while introducing a moral and spiritual element into business life. The idea has been made practical by creating rules to govern individual behaviour and public policy.

Introducing? - reintroducing

5. Application of Shari'ah Law to Business and Financial Transactions

The conditions laid down in the Shariah for the validity of business and financial transactions must be fulfilled. The aim of these laws is to make the transfer of goods safe and easy and to facilitate the conclusion of economic transactions between the contracting parties.

They also aim to eliminate vagueness or misunderstanding in all types of contracts. The goal, in the final analysis is to remove the causes of social tension or litigation and to promote a climate of peace and goodwill.

Islamic banking is often described as banking without interest. Although such a description may be an over simplification, the fact remains that one of the foremost questions regarding any Islamic economic transaction, whether banking based or not, is whether it complies with the Quranic and prophetic prohibitions against interest.

Islamic banking must reflect islamic values

Riba (interest) in the Quran

The Quranic viewpoint on riba is contained in four revelational strings comprising several verses revealed at various stages during the 23 year span of its revelation in Mecca and in Medina. The first verse containing the term riba appears to have been revealed in the fourth or fifth or sixth year of the prophet's mission in Mecca and is contained in the Surah Rum (The Romans) at verse 39 as follows:

Whatever you obtain as riba increasing your wealth out of the wealth of the people will have no increase with God: But that which you lay out for charity, seeking the countenance of God, (Will increase): It is these who will get a huge reward.

The final verses on Riba were revealed late in the prophet's mission. These verses 275-80 of Surah Baqara read as follows:

Those who devour riba will not stand except as stands one whom the Devil has

driven to madness. That is because they say "Trade is like riba," but Allah has

made trade halal (lawful) and made riba haram (unlawful). 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 offence) are Companions

of the Fire, they will abide therein (forever).

Allah will deprive Riba of all blessing, but will give increase for deeds of

charity: for He loveth not creatures ungrateful and wicked.

... O ye who believe! Fear God, and give up what remains of your demand for

riba, if ye are indeed believers.

If ye do it not take notice of war from Allah 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.

If the debtor is in difficulty grant him time till it is easy for him to repay. But if

ye remit it by way of charity, that is best for you if ye only knew.

Defining Riba

two types:- riba al-nasia and riba al fadl. Riba al nasia (literally the increase of or from postponement) essentially means the receipt by a creditor of any extra amount in excess of the principal amount of a loan of money or any other commodity; whether or not the excess is small or large and whether or not it is a fixed or variable percent of the principal and whether or not the excess is in the form of a commodity or a service such as a precondition that the debtor will perform some work for the creditor.

Riba al fadl refers to the exchange of two homogenous commodities by assigning a higher (and perhaps artificial) value to one, so as to derive an interest-like extra payment in kind of cash. For example to sell one kilogram of wheat in anticipation of two kilograms of the same is to indulge in riba al fadl and is forbidden.

Modern Justifications of Riba - The Interest Theories

As we have seen the devourers of riba during the lifetime of the Prophet justified their practices by asserting that trade is like riba. Modern economists have also developed a plethora of arguments to justify the phenomena of usury. One such argument sometimes called the Classical or Real Theory of Interest posits that interest is the price or reward for saving. Interest it is said is a compensation that the creditor pays the debtor for the latters temporary deprivation of the use of the capital forming the loan fund.

Another set of theories, closely related to the Classical Theory, posits that interest is the payment for the loss in value of money due to inflation or for the difference in value between present and future goods. It is based on the propositions that the passage of time affects the value of money, so that the value of a unit of currency today is less than what its value will be tomorrow. The lender of such a unit of currency is therefore justified in charging a rent for the use of the currency, the longer the rental period the more the rental income or interest ought to be. Conversely some of the theorists argue that the value of goods in the present is worth more than future goods of the same quality and quantity. Because of this superiority of present over future goods, people tend to prefer present goods. Interest represents the price paid for the lenders presumed loss of ability to enjoy superior goods in the present.

Why inflation and interest rate are never the same

General guidelines

a) Any predetermined payment over and above the actual amount of principal is prohibited.

Islam allows only one kind of loan and that is qard-el-hassan (literally good loan) whereby the lender does not charge any interest or additional amount over the money lent.

b) The lender must share in the profits or losses arising out of the enterprise for which the money was lent.

Islam encourages Muslims to invest their money and to become partners in order to share profits and risks in the business instead of becoming creditors. As defined in the Shari'ah, or Islamic law, Islamic finance is based on the belief that the provider of capital and the user of capital should equally share the risk of business ventures, whether those are industries, farms, service companies or simple trade deals.

Translated into banking terms, the depositor, the bank and the borrower should all share the risks and the rewards of financing business ventures. This is unlike the interest-based commercial banking system, where all the pressure is on the borrower: he must pay back his loan, with the agreed interest, regardless of the success or failure of his venture.

The principle which thereby emerges is that Islam encourages investments in order that the community may benefit. However, it is not willing to allow a loophole to exist for those who do not wish to invest and take risks but rather content with hoarding money or depositing money in a bank in return for receiving an increase on these funds for no risk (other than the bank becoming insolvent). Islam encourages the notion of higher risks and higher returns and promotes it.

c) Making money from money is not Islamically acceptable.

Money is only a medium of exchange, a way of defining the value of a thing; it has no value in itself, and therefore should not be allowed to give rise to more money, via fixed interest payments, simply by being put in a bank or lent to someone else. The human effort, initiative, and risk involved in a productive venture are more important than the money used to finance it. Muslim jurists consider money as potential capital rather than capital, meaning that money becomes capital only when it is invested in business.

Accordingly, money advanced to a business as a loan is regarded as a debt of the business and not capital and, as such, it is not entitled to any return (i.e. interest). Muslims are encouraged to purchase and are discouraged from keeping money idle so that, for instance, hoarding money is regarded as being unacceptable. In Islam, money represents purchasing power which is considered to be the only proper use of money. This purchasing power (money) cannot be used to make more purchasing power (money) without undergoing the intermediate step of it being used for the purchase of goods and services.

d) Gharar (Uncertainty, Risk or Speculation) is also prohibited.

Under this prohibition any transaction entered into should be free from uncertainty, risk and speculation. Contracting parties should have perfect knowledge of the counter values intended to be exchanged as a result of their transactions. Also, parties cannot predetermine a guaranteed profit.

An Early Experiment

It was in 1963 in Mit Ghamr, in Egypt, that the first interest-free bank came into being, albeit in an experimental capacity. The experiment combined the idea of savings banks with the principles of rural banking within the general framework of Islamic values. Mit Ghamr was essentially a rural area and the people in general, as elsewhere in the Islamic world, were quite religious. They did not place their savings in any bank, knowing that interest was forbidden in Islam. In any case, hardly any financial institution was available to them. In these circumstances, the task was not only to respect Islamic values concerning interest but also to educate the people about the use of banking.

A western observer describes the significance of the Mit Ghamr experiment in the following way:

"The majority of the population had never dealt with financial institutions. Because of this, capital formation had been impaired. Basically rural and religious, they tended to distrust the bankers operating in the western style and, what is more, there were few local branches they could patronise. Since a substantial part of their income was not spent immediately, but put aside for social events, emergencies and the like, this idle capital could not be used for productive investment. A precondition, however, of any change of behaviour from hoarding and "real-asset saving" to "financial saving" was the creation of a financial institution that would not violate the religious principles of large segments of the population. Only then could the majority of the population be integrated into the process of capital formation.î (T. Wohlers-Scharf, Arab and Islamic Banks: New Business Partners for Developing Countries, Paris, OECD, 1983, pp. 79-80)

In the Mit Ghamr project, the following types of accounts were accepted

• Savings accounts
• Investment accounts
• Zakat accounts

No interest was paid to depositors with savings accounts, but they were allowed to make withdrawals on demand. They were also eligible for small, short-term, interest-free loans for productive purposes. The funds deposited in the investment accounts were subjected to restricted withdrawals and were invested on the basis of profit sharing. The zakat account attracted the stipulated amount of zakat for redistribution amongst the poor.

The Mit Ghamr project of Islamic banking had an unexpected success, as savings deposits increased from 1963 to 1966. During the same period, investment deposits increased from 35,000 to 75,000 Egyptian pounds. It is also reported that "the bank functioned on a cautious basis, rejecting, on the average, 60% of loan applications in the first three years. The default ratio was zero in economically good times." (T. Wohlers-Scharf, op. cit., pp.79- 80)

Although the Mit Ghamr project had made a good start, it was abandoned for political reasons.

The Origin of Religious Boards in Islamic Banks

--oil crisis beginning 1970s plus new century (muslim)

With the creation of the IAIB (intl association of islamic banks) came the establishment of a Higher Supervisory Religious Board composed of religious scholars and Grand Ulama of Islamic jurisprudence. The Board's responsibility was to ensure that Islamic banks adhered strictly to the requirements of the Shariah in their policies and day-to-day operations. To do this, it was given the authority to make decisions and issue decrees (fatawa singular fatwa) which would be binding on IAIB member banks. They also hold seminars and conferences concerning Islamic jurisprudence in relation to the new and evolving financial and economic issues being faced by Islamic banks today. The Higher Supervisory Religious Board thus in principle became the supervisory, central authority for all Islamic banks wishing to voluntarily submit to its authority.

The first step the Board took was to ask all Islamic Banks and financial institutions to appoint for themselves a Religious Board of not less than thirteen Islamic scholars to make decisions within their own organisations as to the conformity of their operations to the Shariah. Any bank that did not adhere to these decisions would not be able to claim to be operating within the Shariah.

It is their agreement to operate according to the principles of the Shariah, as set forth in the Qur'an. That distinguishes Islamic banks from traditional, Western interest-based banks.

Prohibition of Interest

The Islamic Fiqh Academy, established by the Organisation of the Islamic Conference (OIC), in its second session held in Jeddah, Saudi Arabia, from 22-28 December 1985, made the important declaration that "any increase or profit on a loan which has matured, in return for an extension of the maturity date, in case the borrower is unable to pay, any increase or profits on the loan at the inception of the loan agreement, are both forms of usury (riba), which is prohibited under the Shariah"

After the Nasser Social Bank, the next to be established was the Dubai Islamic Bank in 1975. The Dubai Islamic Bank is a public limited company having its head office at Dubai, with a capital of 50 million dirhams. The governments of Dubai and Kuwait have respectively contributed 20% and 10% of the bank's capital. Since 1975, a number of other Islamic banks have been established in Muslim countries and in other parts of the world and are functioning successfully.

Dubai stock exchange 13 branches

200 banks worldwide

The Theoretical Basis of Islamic Banking

In order to be justified Islamically, the banking system has to avoid interest. Consequently, much of the literature on the theory of Islamic banking has grown out of a concern as to how the monetary and banking system would function if interest were abolished by law. Here, we will give a brief review of the theoretical basis of Islamic banking.

Islamic banking not interest free banking alone

Modern commercial banking activity is based on the creditor-debtor relationship between the borrower on the one hand and the bank on the other. Interest is viewed as the price of credit, reflecting the opportunity cost of money. The Islamic view about loans is that they should be given or taken, free of charge, to meet any contingency and that the creditor should not take any advantage of the borrower. The Islamic principle in these kinds of transactions is "deal not unjustly, and you shall not be dealt with unjustly" (Quran 2:279). Hence, commercial banking in an Islamic framework may not be based on the creditor-debtor relationship.

The other Islamic principle in matters of financial transactions is that there should be no reward without risk bearing. This principle is applicable to both labour and capital. As no payment is allowed to labour unless it is applied to work, no reward for capital should be allowed unless it is exposed to business risks.

Financial intermediation in an Islamic framework is based on these two principles. Consequently, Islamic financial relationships are participatory in nature. It has been suggested by several theorists that commercial banking in an interest-free system be organised on the principle of profit sharing, which is referred to in Islamic jurisprudence as mudarabah.

The mudarabah, in a present-day context, can be illustrated as follows:

Suppose there are two persons, one of whom has capital but no special skills in trade, while the other has been endowed with some special insight and dexterity in matters of trade but possesses no capital. These two persons can co-operate in either of the following two ways:

The trader can borrow the capital from the capital-owner and invest it in his trade. The capital-owner is to get back his principal and an additional amount worked out on the basis of fixed rate, called the interest rate, as his compensation for parting with liquidity. This is debt financing. Usually, the loan will be granted for a fixed period. The claim of the creditor for repayment of the principal and the payment of the interest becomes viable only after the expiry of this period. This is irrespective of whether the trader has made a profit using the borrowed money. In the event of a loss, the borrower has to repay the principal amount of the loan as well as the accrued interest from his own resources. Islam views this as an unjust transaction.

The other possibility is that the two persons co-operate with each other not on a creditor-debtor basis but on the basis of partnership and cooperation, in which case the capital-owner provides the capital and the other party puts his skill and management into the trade. The capital-owner is not involved in the actual day-to-day operation of the business but is free to stipulate certain conditions that he may deem necessary to ensure the best use of his funds. After the expiry of the period, which may be the termination of the contract or such time that returns are obtained from the trade, the capital-owner gets back his principal amount together with a share of the profit.

The ratio in which the total profits of the enterprise are distributed between the capital-owner and the manager of the enterprise is determined and mutually agreed at the time of entering the contract, before the beginning of the project. In the event of loss, the capital-owner bears all the loss and the principal will be reduced by the amount of the loss. In a way, it is the possibility of the loss that makes the capital-owner entitled to a share in the profits of the enterprise. This is, in essence, the principal of mudarabah.

The creditor-debtor relationship shown in the earlier example is viewed as an problematic one because it gives more leverage to the creditor compared to the debtor. In contrast, the mudarabah agreement grants an position that exactly fits the position both parties have in the agreement.

There are at least three reasons for considering the mudarabah relationship to be more just than the creditor-debtor relationship:

Both parties have an equal position in the determination of the ratio in which profits will be shared between them.

The treatment of both parties is uniform in the event of loss, since if the provider of the capital suffers a reduction of his principal amount, the worker or manager in the mudarabah contract is deprived of a reward for his labour, time and effort.

Both parties are treated equally if there is any violation of the agreement. If the worker/manager violates anyone of the stipulated conditions, or if he does not work, or is instrumental in causing loss to the business by negligence or bad management, he will have to bear the responsibility for the safe return of the whole amount in question. If, on the other hand, the provider of the capital violates any of the stipulated conditions, for example, by withdrawing his funds before the stipulated time, or by not providing part or full funds at the promised time, etc., he will have to pay the worker-manager a reward equivalent to what he would have earned in similar work.

It has been suggested that mudarabah be the basis of reorganising banking activity in an interest-free framework. This can be done by entering into a two-tier mudarabah agreement, which may be explained as follows:

1st tier: An agreement between the bank and the depositors, who agree to put their money into the bank's investment account and to share profits with it. In this case, the depositors are the providers of the capital and the bank functions as the manager of funds.

2nd tier: An agreement between the bank and the entrepreneurs who seek finance from the bank on the condition that profits accruing from their business will be shared between them and the bank in a previously mutually agreed proportion, but that loss shall be borne by the financier only. In this case, the bank functions as the provider of capital and the entrepreneur works as the manager. In case there is more than one financier of the same project, that is, one project is financed by several banks, profits are to be shared in a mutually agreed proportion previously determined, but loss is to be shared in the proportion in which the different financiers have invested their capital.


The principle of mudarabah as a basis of financial intermediation in the Islamic economy is offered as a viable basis for an interest-free banking system. The creditor does not earn interest on a fixed rate in this system, but participates in the business risks and earns a share in the profit. Thus, under an Islamic banking system, the cost of capital is not zero, that is, analogous to a zero interest rate, as some people wrongly assume it to be. The only difference between Islamic banking and interest-based banking in this respect is that the cost of capital in interest-based banking is expressed in terms of a predetermined fixed rate, while in Islamic banking, it is expressed as a ratio of profit.

Islam takes the position that there is no justifiable reason why a person should enjoy an increase in wealth from the use of his money by another, unless he is prepared to expose his wealth to the risk of loss also. Islam views true profit as a return for entrepreneurial effort and objects to money- being only one of the factors that contribute to production- being placed on a pedestal above labour the other factor of production. As long as the owner of money is willing to become a true shareholder in the economic enterprise and is willing to expose his money to the risk of loss, he is entitled to receive the profits of the enterprise. As a matter of fact he is entitled to receive a justly proportionate share of the profits and not merely a merely nominal share based on the prevailing interest rate.


Thus the Islamic banking system can be considered an equity-based, rather than an interest-based system. The depositor purchases equity in the bank and the bank, in turn, has an equity position in whatever activity the borrower uses the funds for.

The main difference between Islamic and conventional banking is therefore not that one allows interest payments and the other does not. The difference is that an Islamic system treats deposits as shares and does not guarantee their nominal value, while in the conventional way, such deposits are guaranteed, either by the bank or by the government.

The equity-based system, now being implemented in many Muslim countries appears to have considerable merit from a purely economic standpoint. From a policy perspective, one could argue that banks should operate two windows for deposit transactions. One window would cover only transaction balances.


The other window would be the profit-and-loss, or equity, account, in which the depositor would be treated like a shareholder. No guarantee would be put on the nominal value or rate of return of these deposits and no official reserve requirement would be necessary for them, since they would be treated as investments.

One can say that Mudarabah is a form of contract that reflects Islams predilection with ordering the economic relations between those sectors of the society that possess surplus capital and others that have entrepreneurial ability but no money on a just and equitable basis. It reflects an underlying doctrinal bias against waged employment and in favour of the dignity of independent business activity.

The mudarabah contract uplifts the status of the waged labourer to that of a ìpartnerî1 in a joint enterprise. What is more, such a ìpartnerî in the joint enterprise effectively sets his own ìwagesî as his income is derived from the profits of the enterprise. Rather, he does not suffer the problems of a wage earner. He does not have to humiliate himself in front of a ìbossî to ask for a raise in light of significant advances in the profitability of the business. All profits, whether attributable to good fortune of the enterprise or the diligent effort of the mudarib, are repatriated and reflected in the proportionate shares of all ìpartnersî to the enterprise.

At the same time the benefit of the mudarabah to the sources of capital is not to be understated. It is a system that aims to distribute justice to favour both sides of the production equation, not just the labour side. The Islamic economic doctrine also views the employment of labour on fixed wages as an inequitable distribution of the results of productive economic activity because this ensures a fixed return for labour without ensuring any profits for capitals faithful devotion to the business enterprise.

Mudarabah is the justly balanced instrument of financing the factors of production. The owner of capital, known as the rab ul maal in the Mudarabah contract contributes all the capital required by labour known as the agent or mudarib who contributes only his managerial efforts or labour. The rab ul maal and the mudarib agree upon the proportions in which the profit is to be shared in advance. In case a loss occurs, the mudarib will lose only his labour and managerial effort, but the rab ul maal will lose part or all of its capital. This is the natural, efficient, and just consummation of the marriage of labour and capital for the production of wealth, existent as a pre-Islamic institution and endorsed and legalised by the Prophet of Islam.

1. Mudarabah, is a commercial agreement in which one party, the rab ul maal exclusively contributes the capital investment while the other, the mudarib, contributes business skills, services as a labourer, and resourcefulness to make profitable use of the capital investment

2. The capital of the rab ul maal may be jointly or separately owned.

3. A mudarabah is ordinarily applicable for the purpose of financing activities concerning trade and commerce.

4. While mudarabah capital represents savings for the owner, it is a source of livelihood for the working partner. For this reason, the owner cannot be allowed to make frequent changes in business plans in a way that might jeopardise the interests of the working partner nor is he allowed to intervene in the routine conduct of the business

5. The rab ul maal has the right to specify the nature, mode and place of the business, to inspect the accounts and to share in the profit. The mudarib enjoys the right to conduct the business as he sees fit, and in a competent and unimpeachable manner befitting a trustee, and is expected to do himself everything that is ancillary to it.

6. The profit share of each party must be determined as a proportion of the amount of the profit. A fixed amount for either party would make the return for the other party uncertain or even nil if the profit were less than the stipulated amount. In fact, it would be equivalent to paying interest to the owner. Mention of any fixed amount, whether in the form of part of the profit, a salary or subsistence allowance, etc. would make the contract void.

While there is no shortage of arguments in favour of the superiority of mudarabah over other modes of financing productive capability and in particular its superiority over debt based modes of financing, the reality is that Islamic banks have so far NOT been able to establish this superiority in practice. Certainly in almost every Islamic economy, to the degree that we can describe any Muslim country as having an Islamic economy, smaller enterprises are starved of development capital and where they do get capital, perhaps the lowest contributors by sector in the financial system are the Islamic banks. The reality is that until Islamic banks are able to develop mechanisms for themselves and their depositors to easily liquidate their mudarabah (and musharakah) investments, they will not be able to afford to spare the amount of resources needed to adequately service these areas of the market. This fact is not unrecognised in the Islamic banking sectors and several proposals have been made and new vehicles for mobilising easily liquifiable funds developed to begin to address the problem. These vehicles, it should be stressed, are applicable for mobilising deposits for use in both mudarabah and musaharkah modes of financing.

Islamic market Bahrain, Malaysia.
Instruments for Mobilising Funds

a) Current accounts
b) Savings accounts
c) Investments accounts

a) Current accounts: these are similar to those of conventional banks as regards the procedures for withdrawing and depositing funds. The bank has the obligation to return the balance to the account holder on request. Needless to say that Islamic banks do not pay interest nor do they charge a fee.

b) Savings accounts: these are similar to those offered by conventional banks. The deposits are repayable to the account-holder on demand. The depositor may assign to the bank the right to invest the deposited sum, in which case he receives a proportion of the profits from the investment. If he does not give the bank this right, his savings account is treated similarly to the current account. Since these savings can be withdrawn on demand, the profits paid are usually less than those paid on an investment account.

c) Investment accounts: these are also called participating accounts. They may be seen as an alternative to the fixed-term deposits accounts offered by conventional banks, except that the returns depend entirely on the result of the bank's dealings with various business projects. There are two types: In the authorised type, the depositor authorises the bank to invest his money in any of its projects, paying them a portion of the total profits at the end of an agreed period. In the unauthorised type, the depositor himself chooses which project his money is to be invested in and his percentage of its profit is agreed with the bank. He may or may not specify the period of deposit. In either case, if the depositor wishes to withdraw his money before the end of an agreed period, he may either have to forfeit his share of the profit or receive a reduced amount according to how long his money has been left in the bank.

Qard ul hasanah

Of the several modes of Islamic financing one, qard ul hasanah, is unique in that no tangible profits accrue. Qard ul hasanah, literally 'beautiful loan, is a terminology derived from the Qur'an where it occurs in si different verses. In Islamic banking it refers to interest free loans. There is a general misconception among many writers to associate qard ul hasanah variously with the institution of zakat (wealth purification). The removal of this misconception can pave the way for the rationalisation of qard ul hasanah as a powerful financial instrument. Although qard ul hasanah shares some characteristics with these other mentioned instruments, it is on further examination quite distinctive apparatus both in its role and function. It would be appropriate to shortly examine the nature of zakat, charity and waqf.

Chronologically speaking, in the development of the Islamic system qard ul hasana preceded the institutionalisation of zakat. The 2.5% zakat ta was formalised in the 2nd year after the hijrah or flight of Muhammad (PBUH) to Medina from Mecca. The primary qard ul hasanah verse of the Qur'an, Chapter 2, Verse 245, was revealed almost as soon as the Prophet entered Medina and established the relationship of brotherhood between the Ansaar (helpers) of Medina and the emigrants (Muhajireen) of Mecca.

Qard ul hasana is primarily business transaction that establishes a relationship of lender and borrower. It was, together with mudarabah (trust financing), an integral aspect of the non-riba based system of economic transactions approved and encouraged by the Prophet himself and was an essential component of the fiscal policy of early Medina-styled Islamic economies. These approved transactions were the primary vehicles used by the prophet for creating employment, alleviating poverty and increasing productivity in the newly created Islamic state.

Qard ul hasana was among the forms of financing encouraged by the prophet for channelling savings into investment and productive activities. It was the primary source of financing introduced by the prophet after entering Medina. It is the only form of financing transaction openly praised in the Qur'an. does not appear to have been looked upon by the prophet and his companions as a form of charity, and the borrowers were not looked upon as people who were seeking alms from the rich.

Rather, the participants in qard ul hasanah must have viewed themselves as key participants in the realisation of the early fiscal policies of the Islamic State. Whether as lenders or borrowers they were involved in the establishment of the primary economic structures necessary for the survival of the Islamic State. It should be noted that these beautiful loans in early Muslim society were primarily used for productive economic purposes, such as setting up qualified but temporarily, economically impoverished people into trade and agriculture, and temporarily relieving people of economic difficulties so that they could turn their attention to more productive work.

Islamic banks have taken quite successful steps to update and rationalise the identified instruments of' non-riba financing other than qard ul hasana.

The following are examples of the types of standard qard ul hasanah instruments that an Islamic Bank may implement:

Qard ul hasanah may be utilised as an overdraft facility for clients with whom the bank has entered into musharakah and mudarabah arrangements. In other words of the total financing package offered the client, a certain proportion of the banks funds ma0 As conventional banking institutions are increasingly doing, qard ul hasanah may be extended to university undergraduates and graduates for financing their studies. The qard ul hasanah could be structured in the form of an account with the Bank where the student has the option to go into overdraft up to a certain amount. As these students graduate and go into full employment the natural tendency would be for them to maintain their accounts with the institution that helped them to realise their educational goals in life. The Bank would then be in a better position than it otherwise would have been to sell a number of its other products and services to the now solvent customer. The return on qard ul hasanah in this case can be a customer for life.

Qard ul hasanah could also be granted to marrying or recently married couples who are often in need of money for their weddings and for purchasing household goods. Again in this arena there can be all sorts of other propositions tied to the incentive of the qard ul hasanah loan. Qard ul hasanah could be one component of a total newly married couples financial package, where the qard ul hasanah component is tied to expenses for the marriage and honeymoon and a murabahah component tied to the purchase of household articles. Another possibility is where the qard ul hasanah is tied to the purchase of household furniture and its repayment suspended for a few years while the profit making component of the financing package is tied to an Islamic mortgage.


Another recipient of qard ul hasanah can be micro-enterprises. Sometimes people may want to establish small shops, craft workshops or other micro-enterprises. Islamic Banks may well find that the administrative costs of overseeing a mudarabah or musharakah investment in these types of enterprises are prohibitive. The Islamic Bank can lend the money for the stock in trade or for the payment of rent and take a debenture over the stock in trade. The micro-enterprise will be required to open a current account with the Bank, which may in the course of normal review of its accounts maintain some measure of control over the micro-enterprise. It is estimated that some 70 to 90 percent of new small businesses will fail in three years. One main reason for small businesses failing is the inability of these businesses to access capital in the riba-based economic system.

Islamic banks can improve the small business sector through qard ul hasanah and introduce other schemes tied to the qard ul hasanah to provide further impediments to the failure of small businesses. Banks may require the management of "micro-enterprises involved in the qard ul hasanah scheme to attend mandatory financial and business training workshops and seminars. The Islamic banks can also provide employment to qualified volunteer and non-volunteer experienced business personnel by establishing these schemes which may be self funding by having the small businesses pay the business advisors for the services rendered or by soliciting government assistance. Of course this is the basis for true partnership or profit and loss banking between the Islamic bank and the public. From these training schemes and business advisory sessions, those businesses with real potential could be identified and mudarabah, musharakah, murabahah and ijara agreements could be entered into with such customers.

Qard ul hasanah is not just giving money away. It is mutual co-operation agreement between the Bank and the customer , where the Bank helps the customer and becomes a catalyst for the longer-term economic development of the customer. The Islamic bank can in many instances establish itself as the first financial adviser of the qard ul hasanah recipient business or individual. Allah promises that qard ul harest-based transactions and makes for justice in the economic system, since, by this system, rewards are proportionate to the capital and labour put into the projects. But this method cannot be brought fully into operation without changes in the economic framework of society, which are outside the control of the Islamic Banks themselves.