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2007/02/28

Islamic finance and the FSA-UK (Financial Services Authority)
Howard Davies Chairman, Financial Services Authority
Thank you for the invitation here today, and for giving me the opportunity of setting out the FSA’s approach to financial regulation, in general, and to Islamic finance and Islamic banking, in particular.

It is a good moment to devote some thought and discussion to the way in which Islamic finance fits into the global financial system, and to the way in which it should be regulated, in all its manifestations. One particularly good reason for doing so is that, in recent years, there has been a significant revival of the historic tradition of Islamic banking. Some countries, notably Iran, Pakistan and Sudan, have moved to structure their systems on a purely Islamic footing. In rather more countries, Islamic banks have been established alongside conventional banks on the Western model.

There are no solidly reliable statistics on the size of Islamic finance, but it is clearly of growing importance globally and is attracting increasing attention and visibility. Some commentators estimate that the Islamic banking and finance market has grown at between 10% and 15% annually over the past decade and that it is currently worth between $200 and $500 billion. As President Reagan once memorably remarked, "a billion here, a billion there and pretty soon you are talking real money".

Bahrain and Malaysia are regarded as perhaps the market leaders in the development of international Islamic finance. And indeed both the Bahrain Monetary Agency and Bank Negara Malaysia, the Malaysian central bank, have been among the authorities who have come together to establish the Islamic Financial Services Board. They have been helped by the Islamic Development Bank and the IMF to set up the Board, which aims to promote, disseminate and harmonise best practice in the regulation and supervision of the industry. It will be launched in new premises in Kuala Lumpur on 3 November of this year, in the presence of Prime Minister Mahathir. The FSA has been invited to attend.

We hope it will play an important role in guiding authorities, including our own, which so far have limited experience of regulating Islamic financial institutions. One of the expressed aims of the Board will be to set standards and principles for supervision and regulation, consistent with the Sharia law and principles, and to liaise and co-operate with other standard setters around the world.

In the UK, of course, we do not yet have a large well-developed Islamic financial structure. But there is already a reasonably significant amount of business of various kinds. There are no purely Islamic banks in the UK today, but London is an important centre for Islamic banking products. Some UK banks have Islamic windows. HSBC is one notable example. They, of course, have considerable expertise elsewhere in the world of operating within financial systems in which Islamic banks are their competitors and collaborators. And some banks here use the London Metal Exchange for Murabaha. The customer buys and sells forward a metal on the London Metal Exchange and earns a profit.

But it is fair to say that most Islamic banking in the UK at present is transacted by relatively wealthy individuals or large institutions. Since there is no focused Islamic bank, and some retail sector Islamic products are rather difficult to construct here at present, I would acknowledge that there is a market gap.

There are approximately 1.8 million Muslims permanently resident in the UK. They make up around 340,000 households. A rough estimate suggests that they have, collectively, savings of approximately £1 billion. And in addition to the permanently resident population there are many Muslims who visit the UK. Last year over half a million Muslims came here from the Middle East and Pakistan, spending nearly £600 million during their visits. So the potential market, whether for savings products, borrowing, or simply transaction-related finance is very large.

Against that background, it is perhaps surprising that, in spite of many initial expressions of interest, and much energy expended by knowledgeable enthusiasts, there have so far been no dedicated Islamic banks established in this country. That certainly does not reflect any lack of dialogue between the FSA and the Islamic community. Those links go well back into the time when banking supervision was the province of the Bank of England, and the current Governor has throughout his time of office taken a particular interest in Islamic financial issues. In September 1999, early in my term of office at the FSA, I hosted a meeting with the Citizens Organising Foundation and Representatives from the Islamic community, at which I tried to set out the FSA’s likely new approach to banking regulation and supervision, when we became fully responsible for it, which we did in December last year.

But time has moved on since then. The FSA is now well established as a single regulator for the whole of the UK’s financial system, so it is a good moment to take stock of the way we now operate, of the objectives given to us by Parliament, and the way in which those objectives, and the regulations which flow from them, can be transposed to handle the particular needs and demands of Islamic financial institutions.

You will be pleased to know that I do not plan to take you through all 500 clauses of the Financial Services and Markets Act, passed in the year 2000, and which provides the legal basis for our work. Indeed, I will restrict myself to a few words only about clause 1, which sets out the objectives of financial regulation. We are given four main tasks.

First, we are required to work to maintain confidence in the UK’s financial markets. That has been something of a challenge in recent months, as we have been blown by forces from across the Atlantic.

Our second principal objective is to promote public understanding of the financial system. That is a new role for a regulator. It has taken us into areas of consumer education which previous regulators have not touched. We have developed materials for use in schools to educate children in the principles of finance. That applies from primary schools right up to the 16 –18 age group. We hope that, over time, all that work will have the effect of enhancing financial literacy which is distressingly low in the UK.

Our third objective is to protect consumers of financial services, but bearing in mind their own responsibilities. In other words we are not meant to protect people from any mistaken saving or investment decision they may make. The principle ‘buyer beware" certainly still applies. Under that heading we try to ensure that financial institutions in our care are reasonably sound in financial terms, that they offer fair contracts which can be reasonably well understood by consumers, and that there is an ombudsman scheme, and a compensation scheme, to underpin the market when things go seriously wrong, as they sometimes do in even the best ordered markets.

Our fourth objective is to work to reduce financial crime. That objective has gained particular prominence in the last twelve months as international concerns about money laundering, in particular, have come to the top of the political agenda. It is our responsibility to try to ensure that financial institutions have systems in place which protect them against abuse by those who wish to launder the proceeds of organised crime, or who wish to finance terrorism.

I mention these four objectives, because they underpin everything we do, and we must ensure that however we regulate financial businesses we are contributing to those aims set for us by Parliament.

When we translate that to the arrangements for supervising banks, we require new applicants to meet five - what we call - threshold conditions for authorisation as an institution entitled to take deposits in the UK. Some of those conditions, such as the legal status of a bank, its location etc, are entirely straightforward. And the two key conditions are that a bank must have adequate resources and must have reasonable systems and controls to manage the type of business it wishes to undertake in a reasonably sound and prudent way.

How do these principles apply, or how would they in principle apply to an Islamic bank? I should emphasise that we have not yet received a formal Islamic bank application, though we are aware of some interest in doing so, and as I have said we have held preliminary discussions already about how our conditions might be met.

Perhaps the first important thing to say is that we welcome diversity and innovative developments in the world of finance, such as the growing Islamic finance market. London has prospered over the centuries by providing a congenial home for international financial institutions, and innovation has been its life blood. So we have a clear economic interest, as a nation, in trying to ensure that the conditions for a flourishing Islamic financial market are in place in London. The business opportunity is large and potentially very attractive. We recognise that there are no banks catering specifically to the large and growing UK Muslim population, and I can tell you that in principle we have absolutely no objection to the idea of an Islamic bank on our patch.

But, that said, we will treat applications from Islamic institutions no differently from any other. Of course there has to be a level playing field and it would not be appropriate, or even legally possible for us, to lower our standards for one particular type of institution. Indeed I would strongly argue that since, if it was to be successful, an Islamic bank would need a reputation for capital soundness and proven management, it would in any but the very shortest term be entirely counterproductive to authorise a bank on a different basis from that which we apply to conventional institutions.

But we recognise that, to fit the bill, our requirements would need to be shaped to suit the particular demands of an Islamic bank. Islamic banks differ from conventional banks in four main ways. They offer a rather different range of types of Islamic finance, from Murabaha through Ijarah and Salam to Istisna. I know that there are other – to me – exotic products like sukuks. I am not going to stand here today and tell you that I am expert in these different types of transaction. But, ‘I know a man who is’. And we have a small team in the FSA who have made a study of Islamic banking, and its regulation.

We recognise that the risk sharing characteristics of these Islamic contracts are rather different from those in place in a conventional bank. We recognise that there is a mix of contracts on the liability side. In particular, unrestricted Islamic investment account holders share in the risks of the bank, since their deposits have some of the characteristics of equity stakes. It is entirely reasonable to take some of these defined features into account when looking at the capital structure of the bank. If customers genuinely share risks, and understand that they are doing so, that may reduce the amount of capital required.

We also think it is important for Islamic banks themselves to be clear about the type of products they wish to offer. If we were to authorise an Islamic bank we would look carefully at its business plan, just as we do with any other institution. We want to know that it has understood the nature of its market, the profit opportunities open to it in that market, the nature and intensity of the competition, and the types of products it wishes to offer. For example, will the bank offer capital-certain deposit products or not? In some, but not all, Islamic deposits the client’s capital is generally at risk if the bank loses money, even if it doesn’t fail. If that is so, then it is important potential customers understand that they do not benefit from the deposit protection arrangements in quite the same way as depositors in Western style institutions.

Relevant to this point is the question of whether Islamic banks are truly banks, or are essentially more like fund managers, even though they may offer traditional banking services such as money transmission. I know that this question is one which is often discussed in the Islamic financial community. But I have to say that, now that we are a single regulator, we think it is of rather secondary importance. At least, that is, from a regulatory perspective. Since we have one regulator we have one basic set of conditions for authorisation, which needs to be met by any firm transacting financial business, albeit the details will differ in the case of a fund manager, on the one hand, or a bank on the other.

These differences are, I believe, less important than the similarities. What we are really looking for when we authorise a bank is an organisation which abides by sound principles of corporate governance, which has adequate capital for the risks it plans to take on, and which has a capacity for managing those risks which we believe to be robust. In the case of an Islamic institution, we would include in that advice and assessment of legal and documentation risks, though I think it would not be appropriate, or even possible, for us to check compliance with Sharia law, which is perhaps an additional risk factor which needs to be taken in to consideration. That in our view, is a matter for the institution itself.

Before I finish, I wonder if I might say a word about one particular issue which has been of some concern in the Islamic community, the question of Islamic mortgages and how they might be treated. A working party led by the Governor of the Bank of England, and of which one of my staff is a member, has been looking specially in recent months at the barriers to Islamic mortgages. The main problem we see is that they unwittingly attract stamp duty twice: once when a lender buys a property and a second time when its transferred to the mortgagor. That is a matter for the Treasury and the Inland Revenue to resolve. It seems to me to be the crucial issue to get right, and one on which I cannot offer you a certain answer today.

There is another potential difficulty, though one which I believe to be of somewhat less importance than the stamp duty point.

As far as we can see, the current Basel Capital Accord which governs the principle and practice of banking supervision around the globe today, does not appear to give us discretion for anything other than 100% capital treatment for Ijarah mortgages. For those who find this a baffling statement, perhaps it will clarify things if I simply state that this means a bank would have to carry twice as much capital in respect of an Ijarah mortgage as it would for a conventional mortgage, where the weighting is 50%. While that it is not necessarily a complete block on the development of the market, it certainly would make Islamic mortgages a little more expensive than conventional ones. This is something we are looking at very carefully at present, in conjunction with the Bank and the Treasury. It is a particularly difficult issue because the Basel rules are incorporated into European Union law. We are trying to look in a sympathetic way at the possibility of a different treatment under the existing rules, and we have asked Islamic financial institutions for more information which might conceivably allow us to propose a case for different treatment.

Even if that were to prove impossible, there is help on the horizon. On the 1st of next month the Basel committee will publish a new version of its capital accord, for consultation. And that would allow a more flexible treatment of Islamic mortgages if it goes through on current plans, which would probably remove this competitive disadvantage. I have to say, however, that we do not expect it to be finally approved for use until around 2006, which undoubtedly is a problem for institutions wishing to get into this market at present.

So let me end where I began. We see no objection of principle to the establishment of an Islamic bank in the UK. Indeed, we would welcome a soundly financed and prudently managed Islamic financial institution in this country, which would be good for Muslim consumers, good for innovation and diversity in our markets, and good for London as an international financial centre. But we have to treat applications from Islamic institutions in the way we do those from other, conventional firms, to ensure that they can compete effectively, and in the long term, on a level playing field with conventional finance providers.

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2007/02/20

SOURCES OF LAW AFFECTING ‘TAKAFUL’ (Islamic Insurance)
Mohd. Ma’sum Billah (Ph.D.)

This paper highlights various sources that could form the basis of law governing Islamic insurance or takaful. The paper covers primary sources of Islamic law, such as, the holy Qur’an and Sunnah and secondary sources, such as, Ijma, and Ijtihad. Other bases of law, such as, maslahah mursalah, urf, precedence etc. are also examined.

An insurance policy remains valid if none of its aspects contravene the Shari‘ah principles. 2 Hence, every element of an Islamic insurance policy should absolutely be based on the Shari‘ah.3 This section attempts to highlight the sources of Islamic insurance contracts which may be divided into two categories:

Sources In General

The general sources of Islamic law begin with the holy Qur’an and the Sunnah or the Traditions of the Holy Prophet (s.a.w.). These two are regarded as the principal sources of Islamic law. Other secondary sources of Islamic law indeed should strictly be based on these two primary sources. This paper attempts to highlight the sources of Islamic insurance contracts, which may be divided into two categories:

“O you who believe! Obey Allah (s.w.t.) and obey the Prophet (s.a.w.) and those charged with authority among you. If you differ in any thing among yourselves, refer it to Allah and His Messenger, If you do believe in Allah and the Last Day: That is best, and most suitable for final determination.” 4

The Holy Qur’an

There are five hundred verses in the Holy Qur’an, which deal with legal sanctions.5 There are indeed a number of Divine injunctions in the Holy Qur’an, which justify the validity of an insurance contract. The contract of insurance contains the elements of mutual co-operation.6 It is a binding promise, which binds both the insurer and the insured, based on the general principle of contract.7 It also contains the elements of alleviation of hardships and provision of material security and assistance for those who face unexpected risk and peril so to ensure for them a comfortable life.8 All these elements of a contract of insurance are justified by the Qur’anic principles. Thus, the Holy Qur’an is the principal guidance to provide an instrumental justification for the application of insurance contract, as the Holy Qur ’an is a plain statement and guidance for mankind in order for them to be successful in both worlds. This is indicated in the following ayat of the holy Qur’an:

“... it is a plain statement to man, a guidance and instruction to those who fear Allah (s.w.t.)... .” 9
The above provisions render an opportunity for mankind to practise inter alia, insurance policy so long as one does not violate the Divine sanctions either directly or indirectly.

The Sunnah

The Sunnah or Traditions of the Holy Prophet (s.a.w.) is a second source of Islamic law immediately after the Holy Qur’an.10 As regards the justification of an insurance contract and practice, there are indeed numerous traditions justifying the validity and permissibility of its concept and practices. For instance an insurance policy embodies the concept of Tawakkul whereby one should strive hard in overcoming one’s unexpected future risk or peril before leaving one’s fate and destiny in the hands of Allah (s.w.t.). Such a concept has been justified in one of the traditions of the Holy Prophet (s.a.w.), which reads:

“.... Narrated by Anas bin Malik ®, the Holy Prophet (s.a.w.) told a Bedwin Arab who left his camel
untied trusting to the will of Allah (s.w.t.): Tie the camel first and then leave it to Allah (s.w.t.)....” 11

Moreover, an insurance policy aims at protecting the insured from future material constraints upon the occurrence of a particular unexpected future risk. Such idea of protection for those who are in need is justified by the following Tradition of the Holy Prophet (s.a.w.):
“Narrated by Abu Huraira ® the Holy Prophet (s.a.w.) said: whosoever removes a worldly hardship from a believer, Allah (s.w.t.) will remove from him one of the hardships of the day of judgment. Whosoever alleviates from one, Allah (s.w.t.) will alleviate his lot in this world and the next... .” 12

There are also other essential aspects of an insurance contract justified by the Sunnah, such as the fact that an insurance policy originated from the ancient Arab custom of al-Aqilah, which was approved by the Holy Prophet (s.a.w.) during his time.13 Moreover a life insurance policy aims at providing, in advance, material security for the offspring of the deceased (assured) and this is also justified by one of the Traditions of the Holy Prophet (saw) as follows:
“Narrated by Amir bin Saad bin Abi Waqqas ®, The Holy Prophet (saw) said verily it is better for you to leave your offspring wealthy than to leave them poor asking others for help...” 14

Practices of the Companions

Insurance originated from the doctrine of al - Aqilah. During the later stage of the period of the second caliph, Sayyidina Umar, ® the Caliph, directed that in the various districts of the State, lists of Muslim brothers-in- arms should be drawn up. The people whose names were contained in those lists owed each other mutual assistance or co-operation and had to contribute to the payment of diyat (bloodwit) for manslaughter committed by one of their members of their own tribe. 15 This was how Sayyidina Umar ® developed the practices of the doctrine of al-Aqilah.

Ijtihad and Consensus of Opinions among the Islamic Scholars

The idea, meaning and legal characteristics of an insurance policy as practised in the world of today had first been discovered by the famous Hanafi lawyer Ibn ‘Abidin (1784 - 1836) probably in early nineteenth century. The ruling of Ibn Abidin is therefore quoted as follows: 16
“And from our noting, the question about which a large number of inquiries are being made, is also answered and it is that when merchants charter ship owned by the subject(s) of belligerent state, then, together with the charges for the ship, another amount is separately paid to the same or another subject of the belligerent state. This payment is known as “Sokra” or insurance premium and its payment means that in case goods on the particular ship catch fire, or if the ship capsizes or if the person who received insurance premium, is responsible to indemnify the merchant(s) who incurred the loss. An agent of the person receives the insurance premium, resides in the coastal cities of our country as a protectorate, after obtaining permission from the government. He receives the premium amount on behalf of his principals and, in the case of destruction of goods, indemnifies the insured for entire loss”.17
From the above rulings of Ibn ‘Abidin, it is understood that a merchant used to charter a ship from the respective ship owner with a mutual understanding that the charterer would pay an additional amount known as sukra (a premium in today’s practice) in which, if the ship faced any form of risk, the owner, in consideration of the sukra, would provide a reasonable indemnity for the loss suffered by the merchant (charterer). The sukra used to be collected by a nominated agent on behalf of the principal (ship owner) and he (agent) would also settle the indemnity (claimed by the merchant) on the owner’s behalf.

Thus, these rulings could be a basis to justify the Islamic insurance (Takaful) practice of today’s world. For example, in Takaful, the participants resemble the merchant in the above ruling and contributions paid by the participants resemble sukra, while the indemnity provided against the risk is similar to the indemnification in Takaful practice. Also, the mutual understanding held between the merchant and the ship owner is like a Takaful policy agreement between the participants and the operator.

Mufti Mohammed ¡Abduh also agreed to the validity of insurance practices generally.18 In 1906, the Mufti of Egypt, Sheikh Muhammad Baqit also accepted the idea of insurance as laid down by Ibn ‘Abidin.19 There are other Islamic scholars who did not oppose the idea of insurance, such as Muhammad Musa, Ahmad Ibrahim, Khan Muhammad Yusuf Musa, Ahmed Taha Sanusi, Abdur Rahman Isa, Ali Khafif,20 Mustafa Ahmad Zarqa, Dr. Nejatullah Siddiqi to name a few contemporary Islamic scholars who agree on the validity of insurance. However, despite agreement among the above-mentioned Muslim scholars, there are some contemporary Muslim scholars who refuse to accept insurance especially life insurance, based on certain objections. They object to the elements of garar, riba, and so on. 21 The diversification of views among the ‘ulama on this issue will be highlighted in Chapter Three of this work.

Analogical Sources

Analogical sources such as qiyas, istihsan, and istishab could also be used as further justification for the idea and practice of insurance, so long they do not contravene the sanctions of the Holy Qur’an nor the Sunnah of the Holy Prophet (s.a.w.). Allah (s.w.t.) advised people to come up with analogical decisions, if necessary, so long as such analogical decisions are not contrary to the Holy Qur ’an and the Sunnah.22

Masaleh al-Mursalah

The insurance contract we see today was not exactly practised during the time of the Holy Prophet (s.a.w.). However, life, necessity, and the status of human beings has changed with the passing of time and the necessity to practice insurance arose to suit the changing environment, in the sense that there is an urgent need to find a way of providing material security for those who are suffering in the society due to unexpected loss, damage or peril. Hence, insurance is necessary in the public interest so that the victim can be rescued from an unexpected risk, and thus, it is justified by the doctrine of Masaleh al-Mursalah. Even though the practice of insurance could also be based on the said doctrine, its validity is still subject to compliance with the divine principles laid-down in the Holy Qur’an and the Sunnah of the Holy Prophet (s.a.w.). The significance of an insurance practice based on the doctrine of Masaleh al-Mursalah is, inter alia, to ensure a comfortable life, which is also a wish of Allah (s.w.t.) as evident in the following ayat:

“ Allah (s.w.t.) intends every facility for you; He does not want to put you to difficulties....”23

Urf

‘Urf means custom, practice or usage of the community. An ‘Urf could also be used as a justification of a particular matter provided that a ‘Urf does not contravene any divine sanction. The initial idea of Islamic insurance practices originated from the Arab’s tribal custom known as al-Aqilah, which was approved by the Holy Prophet (s.a.w.) in a dispute between two women from the tribe of Huzail.24 Hence, it is clear that the ‘Urf (custom) of alAqilah practised by the ancient Arab tribes, and approved by the Holy Prophet (s.a.w.) could stand as a valid justification for the validity of insurance.

Fiqh
There are provisions in the Fiqh which deal with the practices of insurance. For instance, Sayyed Sabeq, in his book Fiqh al-Sunnah, under the section of ‘Shirkatut Tameen’ discusses the validity of insurance contracts. An insurance contract is based on the general principles of Al-`Aqd al-Mudharabah, al-Wakalah, al-Sharikah, and

so on, which have also been discussed in detail in his book.25 There are many other Fiqh sources 26 , which discuss directly or indirectly, partly or wholly, the relevant aspects of insurance.

Relevant Literatures of the Islamic Scholars

There are, in fact, many Islamic scholars who uphold the validity of insurance, as well as the essential procedures and solutions to its practices. For example, in 1982, Abdullah bin Jaid al-Mahmoud wrote a book on insurance entitled Ahkam ‘Uqudut Tamin wa Makaniha Min Shariat al-Deen; in 1989, Saad Abu Zaid wrote al-Tamin binal Khator wal Ibahat, while in 1984, Mustafa Ahmad Zarqa wrote Nizam al-Tamin. In 1969, Dr. Muhammad Muslehuddin wrote Insurance and Islamic Law while Dr. Nejatullah Siddiqi wrote Insurance in an Islamic Economy in 1985.

There are also a number of articles, which have been written by various Islamic scholars. Prof. Shamir Mankabadi who wrote “Insurance and Islamic Law” published in Arab Law Quarterly 1989, is an example. Prof. E. Klingmuller who wrote “The Concept and development of Insurance in Islamic countries” published by Islamic Culture in 1969, is an example of a non-Muslim scholar.

These works written by Islamic scholars portray the validity of insurance practices in the contemporary Muslim world.

Acts of Parliament
based insurance companies established and operating today in the contemporary world, for example, in Malaysia, Sudan, Brunei, Qatar, and Saudi Arabia, to name a few. These Islamic insurance companies have been established and operate based on the Shari’ah based enactment and regulations, approved by the Parliaments of the respective countries. A clear example, among such enactment and regulations is The Takaful Act (Malaysia) 1984 (Act 312) which is one of the Acts of Parliament aimed at controlling insurance practices in Malaysia based on the Shari’ah principles.

Rules of the Shari’ah Supervisory Board

Behind every Shari’ah based insurance company, there is a Council or Board called the Shari’ah Supervisory Board. This Supervisory Board functions as the supervisor of the Islamic Insurance activities run by that particular company to ensure that all these insurance activities operate in accordance with the Divine Principles. For in-stance, the Malaysian Takaful Operation is supervised by a Shariah Supervisory Council by virtue of Section 8
(5) (b) of The Takaful Act 1984. 27 In Sudan, moreover, there is a Shari’ah Supervisory Board which supervises, inter alia, insurance business in the country and it also passed the Rules of the Shari’ah Supervisory Board published by the Faisal Islamic Bank of Sudan (n.d.).

Precedents

Precedents could also play a role as one of the sources of insurance law and practice. Some Islamic scholars have given particular decisions on several issues of insurance policy and practice. These may be useful to regulate Islamic insurance practices. For instance, the opinion given by Ibn ‘Abidin later became a precedent which influenced Muftis in advising the governmental departments and various bodies on insurance matters.28 Mufti Muhammad ‘Abduh said on many occasions that insurance policy and practices are valid. 29 Besides the precedents set by the independent Islamic scholars, there is also another type of precedent set by the contemporary courts relevant to insurance practices.30 Such precedents could also be considered as a valid source of insurance law.

Unanimous Decision of the Islamic Scholars

There have been numerous conferences on Islamic insurance held worldwide in which Muslim scholars have unanimously agreed on the validity of insurance practices. Some of those conferences are listed as follows:

The Islamic Fiqh Week held in Damascus from 1st - 6 th April in 1961;31 The Seminar held in Morocco on 6th May 1972 which upheld the validity of insurance business with the exception of life insurance business;32 The Second Conference on Muslim Scholars held in Cairo in 1965;33 The Symposium on Islamic Jurisprudence held in Libya from 6th - 11th May, 1972;34 The First International Conference on Islamic Economics held in Makkah from 21st - 26th February, 1976;35

The Islamic Conference held in Mecca in October, 1976;36 The First International Summit on Islamic Insurance held in Dubai on 11th Nov, 1996, and The Labuan International Summit on Takaful (Islamic insurance) held in Labuan, Malaysia, on 19 - 20 June, 1997.

Specific Sources
Principles of Contract

An insurance policy binds the parties unilaterally by an offer and an acceptance in reliance on the principles of contract. The fundamentals required in an insurance policy are the parties to the contract, legal capacities of the parties, offer and acceptance, consideration, subject matter, insurable interest and good faith, most of which are found in the general type of contracts. For example, a contract is a promise by an offer and an acceptance, which must be fulfilled as Allah (s.w.t.) has commanded to the effect:

“O ye who believe! Fulfil your obligations.”37

As for the legal capacity as to age of the parties to the contract of insurance, a minor below the age of 15 (the age of rushd or majority or puberty) is not able to buy a policy unless the guardian holds the full supervision over the policy and also the policy should be for the benefit of the minor.38 Thus, the Takaful Siswa operated under the Syarikat Takaful Malaysia Bhd. allows an infant between the age of the majority and the fifteenth day of birth to hold a Takaful policy for education which is under the supervision of the respective guardian.39 This operational method may be justified by the following Qur’anic sanction:

“Make trial of orphans until they reach the age of marriage; if then you find sound judgment in them, release their property to them; but consume it not wastefully”40
The requirement of minimum age of the parties in an insurance policy is the same as required in general contract. Hence the above principles and other relevant principles relating to contract are basically applied to the formation of an insurance contract.

Principles of Liability

An insurance policy covers losses arising from the death, accident, disaster and other losses to human life, property or business. The insurer (insurance company) undertakes in the policy to compensate against the losses to the agreed subject matter. Such undertaking is considered as vicarious liability. For instance, in the case of ‘Aqilah practised in the ancient Arab tribes approved by the Holy Prophet (s.a.w.) if a person was killed by another from a different tribe either mistakenly or negligently, this would bring a liability to the members of his tribe to pay blood wit to the heirs of the slain.41
Moreover, the rights and obligations in an insurance policy mainly arise from the law of contract and tort. For example, in a case of a motor accident, the operator (insurance company) is liable on behalf of the person who causes that accident (i.e. the insured) to compensate the victim. Here, the operator is bound by the terms stipulated in the proposal to pay that compensation under the principles of vicarious liability under the law of Tort.

Principle of Utmost Good Faith

In an insurance contract, for the enforcement of the policy, the parties involved in it should have good faith. Therefore, non-disclosure of material facts, involvement of a fraudulent act, misrepresentations or false statements are all elements which could invalidate a policy of insurance, Allah (s.w.t.) says:
“....Do not misappropriate your property among yourselves in vanities but let there be amongst you
traffic and trade by mutual good will......”42

Principles of ‘Mirath’ And ‘Wasiyah’

In a life policy, the assured (Muslim) appoints a nominee who must not be an absolute beneficiary. This decision was given in the Fatwa on Succession and Will by The National Council for Muslim Religious Affairs, Malaysia, in 1974,43 and also in Amtul Habib v Musarrat Parveen in 1974.44 In both Fatwa and decision, it was ruled that a nominee in a life insurance policy of a Muslim is a mere trustee who receives benefits from the policy and distributes them among the heirs of the deceased, in accordance with the principles of ‘Mirath’ and ‘Wasiyah’.45 The above Fatwa and the case recently gained statutory weight in the Malaysian Insurance Act 1996, which came in force on January 1st, 1997. S167 (1) provides:
“ A nominee, other than a nominee under subsection166 (1), shall receive the policy moneys payable on the death of the policy owner as an executor and not solely as a beneficiary and any payment to the nominee shall form part of the estate of the deceased policy owner and be subject to his debts and the licensed insurer shall be discharged from liability in respect of the policy moneys paid”.
In the light of this provision, it is concluded that the nominee in a policy nominated by a Muslim policyholder should be treated as a mere executor and not as an absolute beneficiary of the policy.

Principles of Al-Wakalah (Agencies)

The appointment of the agent by the insurer and the broker by the insured are of utmost important. In fact, such appointments are widely practiced for the purpose of making the transaction and dealings between the insurer and the insured more effective. The governing principles for the agents and brokers are laid down in the Mejelle as follows:
“Wakalat is for someone to put business of his on another and to make him stand in his own place in respect of that business.”46

Principles of Dhaman (Guarantee)

In an insurance policy, the insurer undertakes to provide material security for the insured against unexpected future loss, damage or risk. The idea of such guarantee is justified by the principles of ‘Dhaman’ or guarantee under Islamic law. 47 In Fiqh, insurance can only be classed under Dhaman (guarantee), which is governed by some essential conditions. Among them the guarantor can only take upon himself a liability which has fallen or may possibly fall upon a person or property. 48 Thus, Dhaman or guarantee may only be payable to the victim or if the victim dies, to his legal heirs, according to their respective shares in inheritance.49

Principles of al-Mudharabah and al Musharakah

The operation of an insurance policy under Shari’ah is in fact based on the principles of al-Mudharabah financ-ing, which is an alternative to the contemporary interest-based transaction.50 In such financing, one person pro-vides the capital while the other party contributes business skills and both parties mutually agree to share the profits accordingly. 51 However, an insurance policy, is a transaction wherein both parties agree that the participant pays regular contributions and the operator invests the accumulated contributions in a lawful business, in which both the insured and the operator share the profits in an agreed portion. At the same time, the insurer also undertakes to provide the insured with compensation (in consideration of the paid-contribution) against an unexpected future loss or damage occurring on the subject matter of the policy. This is how the principles of al-Mudharabah financing in an insurance policy.

An insurance policy also operates on the basis of the principle of ‘al-Musharakah as both the operator and the participants are partners in the policy run by the insurance company.52

Principles of Rights and Obligations

An insurance policy is based on the principles of rights and obligations arising from humanity and nature. For instance, it is logical and natural for every person in the society to feel obliged to provide material security and protection as a right for themselves, their property, family, for the poor and helpless widows, and for children against unexpected perils and dangers. Such a natural obligation and right could well be justified by the following Tradition of the Holy Prophet (s.a.w.):
“Narrated by Saad bin Abi Waqas ® ... the Holy Prophet (s.a.w.) said ..... it is better for you to leave
your offspring wealthy than to leave them poor asking others for help.....”53
The Holy Prophet (s.a.w.) had also emphasized the importance of providing material security for widows and poor dependents in the following Tradition:
“Narrated by Safwan bin Salim ®, the Holy Prophet (s.a.w.) said: The one who looks after and works for a widow and a poor person, is like a warrior fighting for Allah’s cause or like a person who fasts during the day and prays all the night... .”54

Principles of Humanitarian Law

It is one of the purposes of humanitarian law to inculcate mutual understanding in the community, to protect one against unexpected loss, damage or other forms of risks or hardships. Hence, an insurance policy contributes towards alleviating hardships from a person arising from unexpected material risks, which is of course within the scope of the principles of humanitarian law. This has been justified in the following Tradition of the Holy Prophet (s.a.w.), which reads:
“Narrated by Abu Huraira ®, ...the Holy Prophet (s.a.w.) said ... whosoever removes a worldly grief from a believer, Allah (s.w.t.) will remove from him one of the grieves of the day of judgment. Whoso-ever alleviates a needy person, Allah (s.w.t.) will alleviate from him in this world and the next...”55

Principles of Mutual Co-Operation

In a policy, both the operator and the participant mutually agree to lawful co-operation, in which the participant provides capital (through the payments of contributions) to the operator (insurance company), enabling the insurer to invest the accumulated contributions in a lawful business (on the basis of al-Mudharabah) . Meanwhile, the insurer, in return for the payments of the contributions, mutually agrees to compensate the insured in the occurrence of an unexpected loss or damage or risk on the subject matter. Such mutual co-operation among the parties in an insurance policy has been justified by the Divine principles of mutual co-operation, solidarity and brotherhood.56 Allah (s.w.t.) commanded:

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2007/02/17

Islamic Banking in Sudan

Introduction


Unlike the experiences of Iran and Pakistan, Islamic banks in Sudan have been operating in a dual system, i.e., alongside conventional banks. Because of their history and circumstances associated with the inception of some of them, Islamic banks in Sudan do not share the same experience. The Faisal Islamic Bank, Sudan (FIBS), for instance, being the forerunner, started operations in 1978 under a special decree that extended some privileges to it. These were represented by tax holidays, exempted from exchange restriction, exceptions from those articles in the Bank of Sudan law pertaining to interest imposition and exemption from some articles of the Labor Act provided that it adopted a generous pay system (Mudawi 1995, 1995, p.246).

Five Islamic banks are found operating in Sudan as per information published by International Association of Islamic Banks. The banks along with their year of establishment are as follows:
1) Sudanese Islamic Bank, 1983
2) Islamic Bank of Western Sudan, 1983
3) Al-Baraka Bank, Khartoum, 1983
4) Islamic Co-operative Development Bank, 1983
5) Al-Tradamun Bank, 1984.


Although the FIBS was allowed special privileges and it was found to be operating without apparent problems, the rest of the Islamic banks were not provided those facilities. Still they got experience from the operation of FIBS. Their operations were largely prompted by the success of FIBS. FIBS provided these banks with trained manpower and training facilities.


The Islamisation of Banking System


Islamisation of banking system in Sudan was initiated by a presidential order from President Numeiry instructing the Governor of the Bank of Sudan to implement the process immediately. This resulted in an immediate instruction from the Governor to the conventional banks to turn themselves Islamic as from July 1, 1984 allowing them two months’ times. This left virtually no time for advance studies or preparations to be taken by the conventional banks to convert themselves into Islamic. As a result, most of the banks could not do much more than to replace the word “interest” with the word “profit”. The basis of all contractual agreement was made Murabaha. No committee conversed in religious guidance was formed and consulted. Lack of carefulness was also noticed by the incident that no supervisory techniques for Islamic banks were designed by the central bank.

Further, it was the requirement that the central bank would change its philosophy and structure and the way it formulates monetary policy and manages monetary affairs within the framework of Islam. The Bank of Sudan was with the trend but lagged behind since it did not seek right advice in right form at the right time. In spite of that the circulars issued by it had been referring frequently to Islamic financial modalities but the name rather the spirit seemed to be the essence.

The Bank of Sudan maintained the conventional instruments for regulating the money supply. It mainly relied on quantitative control by fixing a random credit ceiling and imposing an across-the board cash ratio on all types of deposits. This has not proven to be an effective way of controlling money supply nor conducive to economic development.

Islamic banks in Sudan have been found to be prudent. They diversified their activities by project, client and economic sector in order to minimize their risky operations in an environment of legal and economic constraints. In spite of the Islamisation of the entire banking system of the country, Islamic banks were singled out and subjected to severe attack. The attack came from official as well as from private circles. This antagonistic environment for Islamic banks in Sudan started under the rule of President Numeiry and prolonged until the military government of Al-Mahdi. During the Numeiry rule the attack did not go beyond accusations by the news media that these banks were behind the famine that struck the country at that time and also behind the shortages in foreign exchange and the high prices of foodstuffs. During the transitional military government and Al-Mahdi government intensity of accusations mounted and tribunals were set up to investigate the accusations.

Problems of Islamic Banks in Sudan


The Islamic banks in Sudan operate in isolation. That means these banks are in the grip of a legally supported system based on a monetary authority (the Bank of Sudan) and subject to many other laws that control activities of the banks.

The first problem come across by these banks was the laws and regulations that were not modified to accommodate their operation. They faced the same types of control and supervision as has usually been used for regulating the activities of the conventional banks. Islamic banks had continuously been pursuing the Bank of Sudan to appreciate that they were different and had to be dealt differently—at least that the reporting forms and their terminology should now be in language used for credit restrictions and cash ratios. As a result of that the Bank of Sudan introduced the terms Musharaka and Mudaraba into its credit policy directives.

Another aspect of the isolation of Islamic banks operating in an interest-based financial setting such as Sudan is the absence of any arrangements for receiving financial support from the Bank of Sudan. This, along with quantitative, restrictive credit policy exercised by the Bank of Sudan, caused those banks to end up with excessive opportunities for utilizing their excess liquidity for very short periods of time or overnight (Ibid, p.247).

Another difficult situation which Islamic banks faced was in the area of staff recruitment. All Islamic banks drew on the staff of the conventional banks to varying degrees when they started their operations. The qualities required by Islamic banks are not only proficiency and integrity, but commitment and sense of belonging. This subjected these banks to the demanding task.

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2007/02/14


Islamic Banking in Iran

Introduction



Following the revolution in 1979, the Iranian authorities took steps to transform the banking system of the country in a way that it fully corresponds to Islamic Shariah. In February 1981, Bank Markazi (the central bank) took some administrative steps to eliminate interest from banking operations. As a result, interest on all asset-side transactions was replaced by a 4 per cent maximum service charge and by 4 per cent to 8 per cent minimum “profit” rate, depending on the type of economic activity. Interest on the deposits was also converted into a “guaranteed minimum profit”. In the mean time, preparations got underway for enacting comprehensive legislation to bring the operations of the entire banking system in compliance with the Shariah. The legislation, prepared by a high-level commission (comprising bankers, academicians, businessmen, and religious scholars), was passed by the Parliament in August 1983 as the Law for Usury-Free Banking, henceforth to be referred to as “the Law”. The Law required the banks to convert their deposits in line with the Shariah within one year, and their total operations within three years, from the date of the passage of the Law, and specified the types of transactions that must constitute the basis for asset and liability acquisition by banks (Iqbal & Mirakhore 1985).

Bank Liabilities under the New Law



According to the new Law, liabilities acquired by the banks were required to be based on two kinds of transaction:

Qard Hasan deposits: According to the Law, Qard Hasan constitutes current and savings deposits as in the conventional banking system except that they earn no returns. Of course, the banks can offer different kinds of incentives like non -fixed prizes and bonuses in cash or in kind; an exemption from, or a discount in, the payment of commission or fees; and priority in use of banking facilities.

If seen from customers’ perspective, the purpose of these accounts would be to serve as a means of transaction, payment, and liquidity. Banks are to consider the money received in the form of current and savings deposits as “their own resources” and accordingly they can use it but no profits are to be given to the depositors. However, the full nominal value of the depositors is required to be guaranteed by the banks.



Term investment deposits: Banks are authorized to receive two types of investment deposits, short-term and long-term. The deposits differ with respect to the required minimum time limits, three months for short-term and one year for long-term deposits, and with respect to the minimum amount required, Rls. 2,000 for short-term and Rls. 50,000 for long-term accounts.

Banks have to give priority on investment deposits, i.e., depositors’ resources over their own resources, that is, their capital plus Qard Hasan. Banks are also allowed to use a combination of their own and depositors’ resources in an investment project, in which case the bank and the depositor share the resulting profits. A third possibility is for the bank to replace the depositor’s bank in an investment project to serve as a trustee. In this case the profits as well as any capital gains are returned to the depositors and the bank charges only a commission to cover the expenses of administering the accounts. The bank can guarantee and insure the principal amount of depositor’s resources.

In the cases where combined resources of the bank and the depositors are invested, the return to depositors is calculated in proportion to the amount of invested deposits after subtracting the required reserve portion from the base amount. The banks are required to announce their profits at the end of each six months of their operation and transfer the shares of the depositors’ profits to each of their accounts. Deposits withdrawn earn no profits before the minimum time required or reduced below the required minimum.

Modes of Financing and Credit Operations



The Law provides a number of modes of operation upon which financing and credit operations are to be based. The following are in brief the discussions on each mode of operation:

Musharaka (Partnership): The Law recognizes two different forms of partnership: civil and legal. The first is a project-specific partnership of short duration in commercial production, and service activities in which each partner provides a share of the necessary capital, and the assets and properties acquired are held as community property until the end of the life of the partnership. In these cases, the bank’s share in the capital cannot exceed the share of the manager-entrepreneur initiating or directing the project.

The second form of partnership is a firm-specific venture of longer duration in which the bank provides a portion of total equity of a newly established firm or buys into an existing corporation. The banks can participate in the equity of such partnership only after the technical, economic, and financial viability of the firm (or the project) has been appraised and minimum expected rate of profit from the investment appears to be high enough to warrant the undertaking of the venture by the bank. The Bank Markazi determines the maximum amount of equity participation by the bank, and the minimum amount of participation by other partners. The banks are allowed to sell and purchase shares whenever they deem it appropriate.

Direct investment: Banks can invest directly to any economic activities they choose so long as the following requirements are met: (i) banks cannot invest directly in projects in collaboration with the private sector, or in projects that lead to the production of luxury and unnecessary commodities; (ii) the ratio of the initial capital of these ventures to total funds needed must not be less than 40 per cent; (iii) the total fixed capital necessary for undertaking these projects must be provided for by long-term financial resources; (iv) undertakings of direct investment by banks must be based on well-documented evaluation and appraisal of the project, and use of bank resources and investment deposits in direct investment projects is allowed if, and only if the expected return from these projects is sufficient to meet the minimum required rate designated by Bank Markazi; (v) banks must report to Bank Markazi the amount of their own, as well as depositors’ resources allocated to direct investment projects; (vi) once the projects in which the banks have directly invested have begun their productive activity, banks can sell shares to the public; and (vii) Bank Markazi is authorized to investigate and audit direct investment projects in which banks have invested.

Mudaraba: This is a short-term commercial, contractual partnership between a bank and an agent entrepreneur according to which financial capital is provided by the bank and managerial effort by the entrepreneur in order to undertake a specific commercial project. Banks are required to give priority in their Mudaraba activities to co-operatives. Moreover, banks are not allowed to engage in Mudaraba financing of imports with private sectors.

Salaf transactions: To provide firms with the needed working capital, banks can pre-purchase their future output so long as the product characteristics and specifications are determined at the time of the purchase and the agreed price does not exceed the market price of the product at the time of the transaction. Banks, however, cannot sell the product until they have taken physical possession of the same. The delivery date of the product, which is to be fixed at the time of the transaction, cannot exceed one production cycle or one year, whichever is shorter.

Installment purchases: Banks are authorized to purchase raw materials, machinery and equipment for firms and resale the same to them on installment. The volume of raw materials cannot exceed that necessary for one production cycle and the repayment period for the same cannot exceed one year. The price of the product is to be determined on a cost-plus basis. The repayment period for machinery and equipment cannot exceed their useful life, which is considered to begin on the date of their utilization in the production process and the duration of which will be determined by the central bank. Residential housing can also be built and sold by banks on installment.

Lease-purchase transactions: Banks can purchase the needed machinery and equipment, or other moveable or immovable property, and lease the same to firms. While signing contract agreement the firm has to provide guarantee to take possession of the property at the end of the contract period, if the conditions of the contract are fulfilled. The time period involved in this transaction cannot exceed the useful life of the property (to be determined by the Bank Markazi). Banks, however, cannot engage in transactions in which the useful life of the property is less than two years.

Ju’alah (transaction based on commission): Banks may provide or receive services on requirement and charge or pay commissions or fees for such services. The service to be performed and the fee to be charged must be determined at the time of the transaction.

Muzara’ah: Banks may provide agricultural lands that they own or are otherwise in their possession (e.g., as a trust) to farmers for cultivation for a specific period and a predetermined share of the harvest. Banks may also provide seed and fertilizer along with the land if they so require on the same basis.

Musaqat : Banks may also provide orchards or trees that they own or that are otherwise in their possession (e.g., as a trust) to farmers for a specific period of time and a predetermined share of the harvest.

Qard Hasan loans: Banks are required to set aside a portion of their own resources for extending interest-free loans to (i) small producers, entrepreneurs, and farmers who would otherwise be unable to find alternative sources of financing investment and working capital and (ii) needy consumers. Banks are permitted to charge a minimum service fee to cover the administrative cost.

General Regulations Governing Asset Acquisition by Banks



The Law of Usury-Free Banking, along with the promulgation of regulations concerning modes of transactions, specifies additional regulations that govern asset acquisition by banks (Ibid, p.108).

Banks can only extend credits when they are reasonably assured that the principal sum granted and resulting profits are returned within a specific period of time. Banks are responsible for the control and supervision of the activity to which their own resources and/or the resources of their depositors are contractually committed.

Credit can be extended, conditional upon observance of proper procedures that ensure the security of the financial resources extended by the banks. Banks must ensure that the value of physical assets obtained through the use of their resources by their clients and the value of collateral is, at all times, equal to the remainder of the outstanding principal. To this end, banks may take steps to ensure the value of such assets or collateral during the lifetime of the project.

While banks may engage in joint venture projects with other banks, one specific bank must assume the responsibility of supervision and control of the project undertaken. Banks must take necessary steps to ensure that their clients understand that contracts mutually consented to are binding legal documents and will be treated as such by the courts.

Supervision of the Banking System



The Law placed the responsibility of supervision of the entire banking system of the country with Bank Markazi. Bank Markazi can exercise the following means for exercising its authority. It determines:
(a) Legal reserve requirements for various types of bank deposits of the banks;
(b) Bank-by-bank credit ceilings on aggregate and sectoral credit;
(c) Minimum and maximum expected rates of return from various facilities to the banks;
(d) Minimum and maximum profit shares for banks in their Mudaraba and Musharaka activities
(e) Maximum rates of commission the banks are to charge for investment accounts for which they serve as trustees;
(g) The maximum amount of credit facility granted by banks to each applicant;
(h) The ratio of credit facilities granted by each bank to various deposits; and
(j) The maximum amount of commitment made by each bank emanating from open letters of credit, endorsements, issuing guarantees, as well as the type and amount of collateral for such commitments (Ibid, p.109).
Moreover, Bank Markazi is authorized to audit and inspect banks’ accounts and documents and is further empowered to devise additional regulations to enhance its supervisory authority as the need arises to ensure and safeguard against threats of banks’ insolvency. Bank Markazi has developed procedures based on these guidelines for commercial banks to follow their transactions.

The New Monetary Policy



The new Law and its by-laws and regulations have maintained the powers and rights of the monetary policy so far as they are not in contradiction with Islamic principles. In Iran, monetary policy is implemented independently of fiscal policy and follows the same objectives as those followed by classical monetary policy (Mahdavi 1986). To implement monetary policy, except the rate of interest, all monetary policy instruments, such as legal deposits, the global and sectoral ceilings of credit facilities, discount rates, and so on are still applicable in Iran (Mahdavi 1995, p.226).

Along with the elimination of interest rate certain other completely new monetary instruments have been created by the Law and put at the disposal of the monetary authorities. A number of these new instruments included in the Law to perform functions similar to those of the interest rate in implementing monetary policy may be described as below:

Minimum Anticipated Rate of Return (MARR): Anticipated return is future net income arising from certain banking operations. MARR is a yardstick by which to judge the acceptability of credit applications submitted to the bank. In fact, MARR, which reflects the opportunity cost or hurdle rate to finance the opportunities, is one of the new instruments incorporated in the Islamic banking regulations in Iran. The rate may play a major role in implementing monetary policy. Banks are authorized to finance if, and only if, the anticipated calculated rate of return on such financing is at least equal to MARR. In other words, projects whose anticipated calculated rate of return is below MARR are rejected (Ibid, p.227). That means, an increase or decrease in MARR will lead to contraction or expansion of the credit volume granted by banks.

Maximum Rate of Profit (MRP): Another new monetary instrument embodied in the Law is MRP. The monetary policy authorities determine the rate. MRP is used by Islamic banks in Iran as a “mark-up” or “cost-plus” on the price of the assets and/or commodities sold to customers on credit. The MRP has the similar kind of impact as that of the MARR so far as its use as monetary tool.

Unique Features of Islamic Banking in Iran



The unique features of Islamic banking in Iran may be identified in the following contexts (Ibid, p.227).
a) Banks’ Credit Portfolio
One of the main features of an Islamic bank in Iran is the content of its portfolio. Each bank’s portfolio is composed of a vast number of investments in a variety of economic activities e.g., agricultural, industrial, mining, housing, etc. Certainly, such a portfolio is well diversified. The risk and return on such a portfolio would seem to be very close to those of a market portfolio. A portfolio with this feature signifies minimum risk and maximum return. This finally leads to an assured and stable return to the bank’s depositors.
Efficiency is another feature of the said portfolio. Each investment project and/or subject accepted by the bank complies with the standards set up by the monetary authorities. One of the standards is MARR. Thus, the projects with highest rate of return, i.e. the highest efficiency, have priority in credit facilities. Such procedures will eventually force the economic units concerned, and the economy as a whole, towards efficiency.

b) Probability of Losses on Capital
A stable return with low risk on an Islamic bank’s portfolio makes the profit-and -loss account of such a bank in Iran less vulnerable. Hence, the risk on equity capital of these banks will be minimized. Moreover, one should bear in mind that the depositors in an Islamic bank will receive, proportionately, the bank earns. This, in turn, can help banks in avoiding even more losses.

c) Distribution of Income
An Islamic bank’s portfolio in Iran contains a huge volume of investments in the activities of society. The income of those activities is shared, firstly, between the banks and the customers and, secondly, between investment depositors, i.e., a large number of the population in the society.

d) Uses of Banks’ Resources
The mechanism of Islamic banking is such that the resources are used for the purpose of granting credit facilities. The credit facilities are supplied indirectly in the form of assets and/or commodities. Based on these procedures, the financial needs of any sector of the economy are supplied by the banks in exactly the volume dictated by the monetary authorities. As a result, the method of financing of the type as in Iran is of great assistance to the achievement of monetary policy objectives.

e) Supervision and Control
The Islamic banking system in Iran has its built-in supervision and control in both use and repayment of credit facilities. The following phased out procedure automatically facilitates supervision and control. In the phase of study and examination of the application, confirmation of the feasibility of projects and conformity of the application with the rules and regulations ensure the necessary control. During the stage of use of funds, banks act as buyers and sellers, which also gives them control. During the last period of financing, however, supervision is rather difficult. During this stage, the resources if not controlled, may be diverted to other uses. Hence the supervision at this stage needs to be tighter.


Implementation of the Law



Much of the trend in Islamic banking in Iran has been influenced by factors, which have their roots in the pre-Revolutionary economic structure, as well as post-revolutionary external and internal political developments. The post revolution economy had inherited a host of difficult economic problems. Before the revolution, the Iranian economy had become highly dependent on oil revenues as well as on the imports of raw materials, intermediate goods and food. The industrial sector was organized without due attention paid to efficiency or comparative advantage and with very weak forward and backward linkages to the rest of the economy. The agriculture sector, which was producing surplus commodities until late 1960s, began to contract and there was a massive migration of farmers into the cities (Khan & Mirakhore 1989, p.8).
The revolution brought with it a host of economic problems including, inter alia, massive capital flight, which almost led to the collapse of the banking and financial system (Bank Markazi). The problems began to multiply for the economy at a rapid pace as the revolution took place. The economy, already vulnerable to internal and external shocks, faced the freezing of foreign assets, economic sanctions, interruption in production, the influx of nearly two million Afghan refugees, and the war with Iraq, drastic reduction in oil revenues (Behdad 1988, p.p.3-4). Concurrently, the constitution of the Islamic Republic of Iran specified objectives for the economy to be pursued—such as income redistribution, self-sufficiency in production, strengthening the economy, and reduced reliance on oil revenues—all of which required fundamental restructuring of the society’s economic behavior and institutions. The fall in oil revenues, plus the political objective of non-reliance on external financial resources, inevitably meant that the banking system would have to be relied upon to play a role far broader than that of pure intermediation (Khan & Mirakhore 1989, p.8).

The banking system has been used as an instrument of restructuring the economy—away from services and consumption toward production—in four ways. First, credit to the service sector, which constituted 55 percent of the GDP (1984-85), has been drastically reduced to halt its expansion in the short-run and curtailed its size in the medium-term. The policy went into effect during the second phase and continued in the later phase. Second, using all available modes of Islamic financing to help farmers improve and expand production has used bank credit to encourage the growth of the agriculture sector. Coupled with substantial government subsidies for seed, fertilizer, machinery, and crop insurance, the credit policy of the banking system is aimed at reviving the agriculture sector. This policy was initiated during the first phase and strengthened in the later phases. Third, Islamic banking has been used to create incentives for the development of a cooperative sector spanning agriculture, industry, and trade (Ibid, p.9). Cooperatives are given priority in credit allocation and in direct investment as well as in Musharaka financing by the banking sector.

The banking system also has been used as an instrument of income redistribution through the provision of Qard Hasan loans for the needy, financing for the building of low-income housing, and financing for small scale agro-business and industrial cooperatives often without stringent collateral requirements. Additionally, the banking system has financed government deficits, which obviously has distribution impacts. It is clear that with reduction of oil revenues from 27 percent of GDP in 1977/78 to only 4 percent in 1986/87, the banking system has been a major source of finance for achieving many of the social and economic goals of the Islamic revolution.

Given the extraordinary circumstances in which the Iranian economy has found itself since revolution, the performance of Islamic banking since its implementation in 1984 has been remarkably smooth (Ibid, p.9).

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2007/02/10

Islamic Banking in Pakistan

Strategy for Eliminating Interest from the Economy


The gradual process of Islamisation of the banking system in Pakistan started in February 1979 when the President of Pakistan announced that interest was to be removed from the economy within a period of three years (CII 1980). In 1977, the government had appointed the Council of Islamic Ideology (CII) with the responsibility of preparing a blueprint of an interest-free economic system in the light of Islamic teaching. To assist in this task, CII set up a panel of economists and bankers consisting of 15 highly qualified economists, experienced central and commercial bankers and financial experts. Considering the complexity of the task of eliminating interest from the economy, the panel proposed a gradual approach. In the first interim report it recommended immediate removal of interest from those financial institutions whose transactions were relatively less complex and from where interest could be eliminated with the greatest ease. Thus three of the specialized credit institutions - the House Building Finance Corporation, National Investment Trust, and Mutual Funds of Investment Corporation of Pakistan were selected for removing interest from their financing operations immediately (Khan & Mirakhore 1989, p.15).
The final report contained recommendations for eliminating interest from all domestic financial transactions. The panel recognized the difficulty in eliminating interest from foreign transactions all of a sudden and advised reduction of dependence on interest-bearing foreign loans. The CII scrutinized both the reports, brought out changes in them in order to ensure complete conformity with Islamic injunctions, and submitted them to the Government in November 1978 and June 1980, respectively (IPS 1994, p.66).
The CII report emphasized that “the ideal Islamic techniques to replace interest in the banking and financial fields are profit-loss sharing and Qard Hasan. However, it gave due recognition to difficulties that may arise in changing the whole system to profit-loss sharing in one step and also the fact that there are certain spheres where it may not be possible to use the system of profit-loss sharing. It, therefore, gave qualified approval to certain other methods being used in conjunction with profit-loss sharing like leasing, hire purchase, Bai-Muajjal, investment auctioning and financing on the basis of normal rate of return. However, cautioning against the danger that such methods could be a back door for interest, it emphasized that their use should be kept to a minimum and that their use as a general techniques of financing must never be allowed (Ibid, pp.66-67).
The CII report further stressed that lack of proper accounting practice due to illiteracy and tendency to conceal profits on the part of the business concerns would act as a hindrance in widespread adoption of the system of profit sharing by the banks (Ibid, p.67).

Phased Transformation

The government of Pakistan planned to remove interest from the economy within a period of three years starting with the task from House Building Finance Corporation, National Investment Trust and mutual funds of the Investment Corporation of Pakistan. These specialized financial institutions took the necessary steps to re-orient their activities on a non-interest basis within few months of the announcement from the government.
Considering the complexity in converting operations of commercial banks into non-interest based operations, a longer period was envisaged. On July 1, 1979, the government introduced a scheme under which the nationalized commercial banks had to provide interest-free loans to small farmers for meeting their seasonal agricultural finance requirements.
The next major step towards the elimination of interest from the operations of commercial banks was taken in January 1981 when the government ordered banks to set up separate counters for accepting deposits on a profit-loss sharing basis in all five nationalized commercial banks. It was also announced that the deposits received on PLS basis would not be used by the banks in interest-bearing operations and that these accounts would be maintained separately. The parallel system, in which savers had the option to keep their money with the banks either in interest-bearing deposits or PLS deposits, continued to operate till the end of June 1985. In June 1984, the government announced that the parallel system would be discontinued during the course of 1984-85. Accordingly, the entire assets side of the banks was converted into non-interest-based modes of financing, except foreign currency deposits, which continue to earn fixed interest allowing their maturity according to the original terms of the contract. The other exception was foreign loans, which continued to be interest-based and governed by the terms of the loans. No banking company was allowed to accept any interest-bearing deposits after July 1, 1985 with the exception of foreign currency deposits. All banking companies were required to share in profit and loss from that day except deposits received in current account that were not entitled to receive either interest or profit.
It is observed that a circular of the State Bank of Pakistan permitted the use of mark-up technique in wide range of activities in the private sector. However, banks were instructed to discontinue the practice when wide spread criticism mounted on charging of mark-up over mark-up in case of default as it was considered incompatible with Islamic teaching. Other modes of financing specified in the State Bank circular were as follows: loans free of interest but carrying a service charge; Qard Hasan (loans given on compassionate grounds free of interest and repayable if and when the borrower is able to pay); purchase of trade bills on the basis of mark-down or mark-up in price; purchase of moveable property by the banks from their clients with buy-back agreement or otherwise; leasing; hire-purchase; financing for development of property on the basis of a development charge; Musharaka; equity participation and purchase of participation term certificates and Maharaja certificates; and rent-sharing in the case of housing finance (Ibid, p.70).1.3 Legislation
Mudaraba technique of financing was introduced as a result of enactment of the law “Mudaraba Companies and Mudaraba (Floatation and Control) Ordinance” in June 1980 followed up by issuance of implementation regulations in January 1981. Companies, banks, and other financial institutions, under this law, can register themselves as Mudaraba companies and mobilize funds through the issuance of Mudaraba certificates. Funds so mobilized are restricted for use in only such businesses which are permitted in Shariah requiring prior clearance from a religious board established by the government. The law safeguards the interest of the Mudaraba certificate holders by mandating quicker and simpler adjudication of disputed matters by a tribunal specially set up for this purpose. Moreover, the law provides a condition that the auditors will certify that the business conducted by the Mudaraba Company is in accordance with the objects, terms and conditions of the Mudaraba. Promulgation of the Mudaraba law paved the way for new type of financial instrument in the form of Mudaraba certificates and helped in broadening the dimensions of the newly emerging Islamic financial market.
Contending that the existing legal framework in the country could not adequately protect the banks against undue delays and defaults, the government enacted a law called Banking Tribunal Ordinance in 1984. According to this ordinance 12 banking tribunals with specific territorial jurisdictions, and each headed by a high-ranking judge to be appointed by the government and required to dispose of all cases within 90 days of the filing of the complaint, were to be set up. The law also provided for an appeal procedure under which the verdict of a tribunal could be appealed to the High Courts within 30 days.

Non-Banks within Pakistan

Prior to Islamisation of banking, investment companies in Pakistan offered an outlet for long-term funds generated in the economy. They invested in common shares and in long-term debt. As a result of the move to interest-less finance they exchanged the interest-bearing debentures they owned for common shares of the same companies. They thereby became fully-equity-based but were free to acquire Participation Term Certificates (PTC) a new kind of financial instrument developed on the basis of Musharaka. Ownership of their shares is legal for banks and other intermediaries, as well as individuals. New close-end companies formed in the future will add to the amount of long term funds available in the economy, and all companies of this type, old or new, will compete with commercial banks for the available supply of PTCs.

a) Islamisation of Commercial Banking in Pakistan

The Islamisation of the banking system of Pakistan applies only to the domestic activities of its commercial banks: their foreign branches were free to accept deposits and make loans at interest. In their dealings within Pakistan, each of the 17 exchange banks were required to operate under Islamic codes of finance, following regulations of the State Bank of Pakistan.

b) Commercial Banks as Intermediaries

Under the new banking arrangement, commercial banks are to accept funds on a no-interest basis, subject to withdrawal by cheque, and return of the principal amount of each deposit is guaranteed. For services provided in maintaining chequing accounts and in meeting customer needs for other services banks are to charge fees to recover administrative costs. In the case of allowing overdraft, it is required to be interest-free. The argument is that overdrafts allowed to current borrowers or to current account holders to enable them to meet the unspecified needs or in cases of genuine hardship are really benevolent loans.

On funds deposited into PLS accounts, banks participate in profit/loss outcomes with their depositors according to ratios stated in the contracts between depositors and banks. The percentage of profit/loss taken by the bank is supervised by the State Bank of Pakistan, which has the authority to reduce the ratio(s) in effect at a bank. For itself and the depositors, the bank negotiates a sharing of the profit/loss on the use of funds provided to users. This sharing must not be stated as interest or in a form that may be interpreted as interest; for example, the bank may not be guaranteed a stated amount or rate of return regardless of how successfully the funds were used. The share allocated to it and its depositors must always be related to the amount of profit/loss resulting from the use of funds provided (Harrington 1994, p.183).

In addition to funds provided for their depositors, banks also invest their own funds in loans provided to their customers. Banks thereby participate in the profit/loss results of their use, receiving the same proportionate results per unit of capital provided as their capital accounts do (Ibid, p.183).

i) Financing and Credit Operation of Banks

While bank liabilities (other than foreign currency deposits) are composed of either current account deposits, on which the bank distributes no profit, or PLS deposits, three broad categories of non-interest modes of financing have been allowed to guide banks’ asset operations. First, there is financing by lending, that is, loans not carrying interest, on which banks may recover a service charge, and Qard Hasan (interest-free loans on compassionate grounds). Second, there is trade related financing, including mark-up, purchase of trade bills, lending on a buy-back basis, leasing, hire purchase, and financing for development of property on the basis of a development charge. The State Bank of Pakistan fixes minimum and maximum rates of charges from time to time. Third, lending can take place under investment financing, including Musharaka, equity participation and purchase of shares, participation term certificates, Mudaraba certificates, and rent sharing. While the State of Bank of Pakistan determines the ratio for sharing profits, losses are proportionately shared among all the financiers.

ii) Participation Term Certificates

A Participation Term Certificate (PTC) is a transferable corporate instrument with a maximum maturity of ten years and allows for a temporary partnership or Musharaka. It is a financial arrangement between a financial institution and the business entity on the basis of profit-loss sharing over the maturity period of the certificate. It was introduced as an alternative to a debenture (which typically carries a fixed rate of return) for raising medium term financial resources. Conceptually, since the financial and economic relationship envisaged under PTCs is that of a partner in a business venture, portfolio selection for the banks requires extensive knowledge and experience with business involved. Funds under a typical PTC arrangement may be obtained either from a single institution or from a consortium. The business entity is expected to pay to the financial institution or bank, provisionally on a semi-annual basis, an agreed percentage of anticipated profits with a provision for final adjustment at the end of the financial year. In the event of loss, the financial institution shall refund the share of profit that it had received on a provisional basis. However, the loss sustained by an entity in any accounting year will first be adjusted against the reserves of the company, and the remaining loss, if any, shall be covered in the subsequent years by the two parties in agreed proportions. The financial institution is also permitted to convert up to 20 percent of the principal amount of the PTCs into ordinary shares at par value, so long as funds against PTCs are outstanding. Lending is secured by a legal mortgage on the fixed assets of the company.

So far, the specialized credit institutions, including the Bankers’ Equity Limited and the Investment Corporation of Pakistan, have handled most PTC operations. PTCs can be traded on the capital market.

iii) Application of Musharaka in Pakistan

Like PTCs, no statutory definition of Musharaka has been specified. However, a Musharaka contract is bilateral between the financial institution and the user of the funds. Moreover, Musharaka contracts are not negotiable instruments and can be traded like the financial assets on the capital market. While Musharaka companies typically provide long-term capital for industrial investment, they have so far been used to fund the working capital requirements of the industrial and trade sectors not as a loan but as a cash credit or overdraft account in which operations could be carried out by depositing and withdrawing of funds. Musharaka companies are deemed to be temporary partnership under which the commercial bank and the client share in the profit or loss generated by the working capital supplied by each to the project. In practice, the profit sharing arrangement is drawn up on the basis of future profit projections that, in turn, are based on past averages, duly adjusted according to the future plans and projections and overall state of the economy and industry in which the firm operates. The client, for his managerial responsibilities, receives an agreed proportion of projected profits from the partnership, with he balance divided between the bank and the client in a mutually agreed ratio within the maximum and minimum ratios laid down by the State Bank of Pakistan. If a loss results, it is to be shared by the client and the bank in the ratio of their contributions to the funds employed in the project.

iv) Mudaraba as Applied in Pakistan

Under the law authorizing the establishment of Mudaraba companies, Mudaraba can be floated to meet the term-financing needs of the private sectors. Under this arrangement, subscribers participate with their funds, and the manager of funds, with his efforts and skills. Profits on investments made out of Mudaraba funds are distributed among the subscribers on the basis of their contribution, the manager of the fund earning a fee for his services. Conceptually, a Mudaraba is an investment fund for which resources are obtained through the sale of certificates to subscribers. Commercial banks can serve either as managers or as subscribers. There can be two types of Mudaraba: multi-purpose, that is, a Mudaraba having more than one specific purpose or objective, and specific purpose. All Mudarabas, however, are independent of each other and none is responsible for the liabilities of, nor is entitled to benefit from the assets of any other Mudaraba or of the Mudaraba Company. The companies are subject to comprehensive regulations and safeguards under the Mudaraba Company Law including the requirements that (a) each must subscribe at least 10 per cent of the total amount of Mudaraba certificates offered for subscription, and (b) certificate holders must be provided detailed balance-sheets and profit and loss statements of the company at specified intervals.

So far Mudaraba have been managed primarily by the specialized credit institutions, specially the Bankers’ Equity Limited, and have been for specific purposes. The first Mudaraba Company in the private sector was incorporated in November 1982 and floated its first Mudaraba enterprise in early 1985, valued at Rs 25 million. Mudaraba certificates are traded and quoted on the stock exchange.

v) Application of Mark-up in Pakistan

When financing on a PLS-basis is not feasible owing to difficulties in determining profits or the short-term maturity of funds required, banks have been authorized to lend on the basis of mark-up. Under this arrangement, the margin of profit or mark-up to the seller is mutually agreed upon between the buyer and the seller in advance. The bank arranges for the purchase of the goods requested by the customer and sells them to him on the basis of cost plus the agreed profit margin. The payment is deferred and is made either in lump sum or in installments over a specified period. The mark-up is mutually agreed but must be within the minimum and maximum rates specified by the State Bank of Pakistan. The mode is of short-term in nature and oriented towards financing domestic and import trade, as well as financing input requirements.
While banks are authorized to charge a mark-up within the limits specified by the State Bank of Pakistan, they cannot charge mark-up on mark-up in the event of delays in repayment; mark-up on mark-up is viewed as interest.

vi) Choice of Instruments

Although modes of financing are to be determined by agreement between the bank and the client, the authorities recommended certain preferred combinations of modes and types of transactions. Financing for trade and commerce, which is primarily short term, should be handled through mark-up and markdown operations, and through trade and loan on commissions and service charges. Fixed investment in industry, trade and commerce is to be financed through Musharaka, PTCs, leasing, and hire purchase; working capital requirements are to be met through Musharaka and mark-up. Given the varied nature of financing requirements in agriculture, modes available for this sector cover a broader spectrum than in other sectors. While short-term financing is to be provided largely on a mark-up basis, the choice of medium-term and long-term lending modes will depend on the purpose. Leasing and hire purchase are to be the primary instruments for purchase of machinery and equipment, and for dairy and poultry needs. Financing for land, forestry, etc., could be on the basis of development charges, mark-up or PLS modes, depending on the nature of development undertaken. Advances for housing are to be on a rent-sharing basis with flexible weights to banks’ funds, or on a buy-back and mark-up basis; personal advances for consumers durable are to be on a hire-purchase basis. For purchasing consumer products, financing would be solely against tangible security with buy-back arrangements. Basis of financing in Pakistan against types of activity is grouped in Table-1 as below:


Central Banking and Monetary Policy in Pakistan

(a) Functioning of the Central Bank

The Federal Shariah Court judgment does not directly impugn the functioning of the State Bank of Pakistan except for section 22(1) of the State Bank of Pakistan Act, 1956. But this apparently minor repugnance to Shariah involves the most important role of the central bank that governs interest rate chargeable by all the financial institutions in the country, it cannot remain unconcerned with the judgment relating to:

Negotiable Instrument Act XXVI of 1981.
Agricultural Development Bank Rules, 1961.
Banking Companies Ordinance (LVII of 1962).
Banks (Nationalization) Payment of Compensation Rules, 1974.
Banking Company (Recovery of Loans) Ordinance (XIX of 1979).


The court has declared that the sections in the above laws or rules involve charging of interest or mark-up which, according to the court, resemble interest. Interest rate is governed by the bank rate. Mark-up is one of the modes of financing which the State Bank recommended to the banks (Hasanuzzaman 1994, p.197).

(b) Rates of Return and Charges

Rates of return on deposits and charges on bank financing, including profit sharing ratios, are ultimately to be determined by market forces. However, to ensure an orderly transition from the previous system, in which interest rates were closely regulated, the new system provides for a methodology to determine rates of return on PLS deposits and also lays down maximum and minimum charges for various types financing modes; banks and clients are free to negotiate charges within these limits.

Banks and other financial institutions receiving PLS deposits are required to declare rates of profit on various types of liabilities, including PLS deposits on half-yearly basis with prior authorization of the State Bank of Pakistan. To protect the interest of both borrowers and lenders, the State Bank of Pakistan is empowered to establish ranges within which financial institutions, including banks and specialized credit institutions, and borrowers would be permitted to negotiate rates of charges and profit-sharing ratios. The determination of these ranges is also guided by considerations relating to sectoral credit allocation priorities and the need to minimize dislocations arising out of a sharp change in the cost of funding for borrowers. Therefore, the concern so far has been to keep the costs of funding as close to those under the interest-based system as possible, while allowing market forces a greater role.

For financing by lending, where loans do not carry interest, banks may recover a service charge not exceeding the proportionate cost of the operation, excluding the cost of funds, provision for bad and doubtful debts, Qard Hasana and income taxation. The State Bank of Pakistan also specifies ranges of profit that should guide banks and the specialized institutions in their lending operations under both trade-related and investment-type modes of financing. Under the interest-based system, ceiling rates were specified for a wide variety of loan operations; under the new system considerable flexibility is given to the banks and the clients. Despite this flexibility, a large proportion of financing, according to banks, has so far been provided at about the same cost as under the previous system.

Achievements and Failures in Islamising the Banking System of Pakistan

Pakistan initiated a process of the Islamisation of its financial system in 1979. Though the financial system of the country had undergone significant changes since then, the process of Islamisation is yet to take its full course. The measures adopted for this purpose have been characterized by a number of shortcomings and deficiencies. The Federal Shariah Court in November 1991 declared that a number of existing financial laws and practices were repugnant to the injunctions of Islam and called upon the government and other concerned agencies to take appropriate measures to bring them in conformity with the Islamic tenets by the end of 1992.

Over a decade passed away by now that the first step towards Islamisation of the financial system of Pakistan was put forward. The period 1979 to 1985 saw a fairly active policy on the part of the government to Islamise the financial system. The original intention of the government was to eliminate interest from all domestic banking and financial transactions within a period of three years beginning from February 10, 1979. It appears that the time frame was not practicable yet the government was earnest to move speedily towards attaining the goal of an interest-free economy. It has been mentioned that a parallel system was introduced in which savers had the option to keep their savings with interest-bearing mechanism or in profit-loss sharing savings scheme. In June 1984, it was announced by the government that the parallel system would end in course of 1984-85 in so far as operation of commercial banks and other financial institutions were concerned. All banking companies were actually forbidden to accept any interest-bearing deposits as from July 1, 1985, except foreign currency deposits. Banks were also instructed to invest their PLS deposits only in interest-free avenues of investment and financing. Serious consideration was seemingly being given to the issue of eliminating interest from government transactions in 1984-85 as the then finance minister stated in his budget speech that the government proposed to consult scholars on the subject. However, the matter was not pursued vigorously and the movement towards a completely interest-free economy lost its dynamism and even its sense of direction after 1984-85 (Z. Ahmed 1994, pp.71-72).
The movement towards an interest-free economy suffered a setback when in August 1985 banks were allowed to invest even their PLS deposits in interest-bearing government securities. The present position is that the return on PLS deposits contains a substantial element of interest. Since 1984-85, there has been no policy pronouncement as regards elimination of interest from government transactions. To achieve the goal of interest-free economy it is necessary that government should end its dependence on interest-based borrowing. There are no indications so far this aspect has been given due consideration in formulating government budgetary and other policies. In fact, instead of reducing dependence on interest-based borrowing there has been increased resort to such borrowing in recent years.

The Islamisation in the field of banking and finance in Pakistan has been marked by another serious deficiency in that no institutional mechanism exists for a continuous scrutiny of the operating procedures of banks and other financial institutions from the Shariah points of view. Individual scholars examining these operating procedures have pointed out several areas where the actual banking practices show deviation from Shariah even in the case of modes of financing. Thus, even Musharaka agreements, which banks ask their clients to sign, contain features that have been called into question by several commentators. The provision, for example, that in the event of a company suffering a loss in any accounting year, it would be first adjusted against the existing reserves of the company has been found inconsistent with the spirit of the Shariah.

Although the idea of floating PTCs was fine, no legislative framework was provided for standardizing the features of this new financial instrument in the light of principles of Shariah. The CII report had provided a broad outline of the features of such financial institutions but the actual form in which PTCs have been issued does not fully conform to the suggested outline. Some features of PTCs as introduced by certain financial institutions have been widely criticized as being inconsistent with the requirements of Shariah. Provisions made for payment of a pre-production discount rate during the gestation period of a project and the stipulation of the share of profit, equivalent to a percentage of the outstanding PTC funds, have evoked strong criticism in this respect.

Among the 12 modes of financing allowed by the State Bank to replace interest-based lending, banks have made predominant use of what has popularly come to be known as mark-up financing. Mark-up financing has taken two main forms. The first form is similar to Mudaraba financing being practiced by a number of Islamic banks in other countries. Under this form, a transaction takes place in the following manner:

a) The client approaches the bank with the request to purchase for him certain specified goods;
b) The bank makes the purchase;
c) The bank sells these goods to the client at a price, which includes a mark-up over the cost of

the goods and agrees to receive payment at a future date in lump sum or in installments; and
d) The client pays the amount due as agreed in lump sum or in installments and the
transaction comes to an end.


The second form involves a buy-back agreement. The practice followed is that a client sells his goods to the bank for cash and simultaneously buys back the same goods from the bank at a higher mark-up price payable at a future date either in lump or in installments. The second form of mark-up financing has been severely criticized by scholars well versed in Shariah and the Federal Shariah Court in its judgment has held it to be manifestly against the Islamic teaching.

Though it is generally agreed that Mudaraba and Musharaka are the ideal substitutes for interest in an Islamic economy, no special efforts have been made to accord prominence to them in the policies adopted. This seems to have given rise to an attitude of passivity on the part of the banks and led them to use mostly such modes of finance, like mark-up, that are more akin to interest-based banking and require the least modifications in the old lending procedures.

The liability side of the banking system has undergone a comprehensive change since the introduction of interest-free banking in Pakistan. Saving and time deposits no longer earn a fixed return. Banks declare profits payable on these deposits at six-monthly intervals based on their operating results and these vary from period to period and from bank to bank. The rates of profit are worked out by a formula that determines net profit accruing to a bank and allocates them to the remunerable liabilities according to their maturities. Allocations are based on differential weights assigned to liabilities according to their maturities. The system has in general been found to be compatible with Islamic teachings except that, as mentioned earlier, profits declared by banks contain a substantial element of interest.

Experts in Shariah and other writers on Islamic banking have identified certain other challenging features of the present state of the Islamisation of banking in Pakistan that also deserve attention. Some of the observations as reported by Ziauddin Ahmed are as follows:

"A tendency seems to have developed to replace PTCs by TFCs (term finance certificates). As against PTCs, which are based on the concept of Musharaka, TFCs are based on a system of fixed mark-up. This has been considered a retrograde step as the objective should be to expand profit-loss sharing modes of finance rather than to restrict them further".

Financial institutions undertaking leasing business are making greater use of financing lease than of operating leases. Experts in Shariah consider financing leases to be incompatible with Islamic teaching.

Many 'development finance institutions' (DFIs) are mobilizing savings through schemes that give returns, which are hardly distinguishable from interest. Grey areas are developing even in the operation of institutions like National Investment Trust, which were previously thought of having eliminated interest completely. It seems that there is no agency to oversee the working of the various schemes being employed by DFIs to mobilize savings from the viewpoint of Shariah.

Lately, the State Bank of Pakistan has laid down the minimum and maximum rates of profit a bank can share in the case of Musharaka or purchase of PTCs or Mudaraba certificates. Experts in Shariah consider such a stipulation incompatible with Islamic teachings. Due attention has not been paid to eliminate un-Islamic features characterizing the operations of several constituents of money and capital market in Pakistan other than banks and DFIs. Nothing has been done so far, for example, to reform the insurance business and the stock exchange operations in the light of Islamic teaching.

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