Islamic banking by Amir Sajjad Khan

amirsajjadkhan_ibms@yahoo.com

Islamic Banking
(An interest free banking system)

Table of contents:
Definition of economics
A brief overview of economic systems
Capitalism
Communism
Islamic economic system
Factors of production in Islam
The objectives of the distribution of wealth in Islam

Riba, usury, interest

Introduction
Historical background
Nature and meaning

Prohibition of Riba
Riba in the Quran
Riba in the headith
Riba in the fiqa

Rationale in prohibition of riba

Arguments in favor of interest
Arguments against interest
Analysis of the arguments in favor of and against interest

Interest free banking system

Objectives, reservations
Evolution of the objectives and reservations

Islamic banking
Philosophy, development
Areas of operations
None fund based transactions
Investment activities
Social activities
Financing under profit and loss sharing system
Potential of Islamic banks

Islamic modes of financing

Musharakah
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Definition of musharakah
The basic rules of musharakah
The management of musharakah
Basic rules of distribution of profit and loss

Powers and rights of partners and musharakah

Termination of musharakah
Termination of musharakah without closing the business
Distinction between interests based financing and musharakah

Mudarabah
Definition
Types of mudarabah
Difference between mudarabah and musharakah
Investment
Mudarabah expenses
Distribution of profit and loss roles of mudarabah
Termination of mudarabah

Diminishing musharakah
Meaning and concept
Uses of diminishing musharakah

Murabaha
Definition
Difference between Murabaha and sale
Issues in Murabaha
Basic mistakes in Murabaha financing
Bai’muajjal

Salam and istisna

Salam
Purpose of use
Conditions of Salam
Parallel Salam
Istisna
Concept of istisna
Difference between istisna and Salam

Ijarah (leasing)
Basic rules
Lease as a mode of financing
Difference between Murabaha and leasing
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Expenses consequent to ownership
Lessee as amen
Ijarah WA iqtina

Applications of Islamic financing

Project financing
Working capital financing
Import financing
Export financing

Islamic investment
Securitization
Securitization of musharakah
Securitization of murabaha
Securitization of Ijarah
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Islamic banking

Major economic systems in the world:

Before going to discuss this topic in detail….we must assure….that we know the answers of the
following four Questions.
a) What is economics?
b) What is economic system?
c) Why an economic system is needed?
d) What are the basic economic problems?

a) economics: so there are three major school of thought about economics…i.e.

1) Classical school of thought.
2) New classical school of thought
3) Modern school of thought.

1) Classical school of thought: presented by Adam smith. ….he says….economics is

the science of wealth…..means...Science that teaches how to produce. Multiply
and distribute wealth.
2) New classical school of thought: by Alfred marshal ….he just criticize the
classical school of thought….and says that its selfishness if economics is the
science of wealth….actually it’s the science of study of human welfare…and this
welfare can be established and mentioned.
3) Modern school of thought: Robin presented this theory, this theory states that we
have limited resources and unlimited wants. And that’s what economics is all
about.

Coming to question number 2...which is what is economic systems?

Economic system: the systematic performance of economic activities to solve the
individual or stats economic problem….so called as economic system.

Now the answer to the question that why an economic system exist. So the answer is
clear…..that it exist to solve our economic problems…

Now a question arises that what are our basic economic problems….so here are some
of the basic economic problems we are facing right now.
a) Determination of priorities…and the problem is how?
b) Allocation of resources….and the problem is again how?
c) The distribution of wealth…. (Factors of productions) the problem is how?
d) Development.

So there are three economic systems exist theoretically. I.e. capitalism communism/socialism
and Islamic economic system.
We will discuss all these in details further…so here they are in detail
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• Capitalism
It’s a free economic system. Based on three principles….
o The freedom of personal property
o The freedom of private ownership
o The principle of lazziesfair.

Mechanism of capitalism to solve the basic economic problems…..are that they use
blindly the market forces, i.e. demand and supply.
So as we discuss the four basic economic problems…so the first one is that
deciding the priorities. So this system tells us to give priority to those activities,
which have greater demand...as compare to those having less demand.
For the second problem….allocation of resources. So still same…..allocate
resources to those economic activities…which have more demand.
For the third problem….which is distribution of wealth…so we got four factors of
productions here in this system..That is…land, labor, capital, and organization…so
as land is concern……we got less demand and determined supply. So pay more to
landlords..Same is the case with capital...Give more to capitalist.coz it’s too have
more demand. And less supply……….as for as labor is concern…..give less wages
to labor.coz we have abundance of labors and demand is relatively low ……and
we left organization here…so anything left with u…..remains yours….
Now we got the last problem…..I mean economic development. So here….this
system says...When u solves the rest of three problems….automatically u achieves
economic developments.

It’s totally morally neutral economic system...And a money oriented economic

system….means….focused on money…and money is considered as commodity.

• Socialism/communism
It’s a planned/controlled economic system.
This system is based on three principles…i.e.
1. The principle of collective property
2. The principle of collective interest.
3. The principle of equitable distribution of wealth.
This system is having a mechanism of planning to solve the basic economic
problems… so as for as the first problem is concern. that is deciding the
priority so for this problem this system suggest that we have to planned for
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which problem should be given the priority, the second is the allocation of
resources so for this we again planned for which activity and how much
resources are allocated , now for third problem. Which is the distribution of
wealth, so here we distribute wealth on the need base, and same is the case of
the last problem, which is economic development.So for that as the first three
problems are solved….automatically this problem is solved.

• Islamic economic system

A guided system…based on Islamic ideology…and Islam is the complete
way of life. That deals with all aspects of life…i.e. personal life, social life,
political life and economic life. An asset oriented economic system…means
to focus on assets as compare to money. There are three sources of guidance
in Islam...That an individual need to take guidance from …in performing any
activity.
And these sources are:
1) The Holy Quran
2) the Ahadis
3) the fiqah

So these sources guides us that there are certain activities that are permissible
in Islam, and certain activities that are not permissible in Islam. And Islam
tells us that the performances of those activities which are permissible in
Islam are equal to worship.
Now we have factors of productions in Islam…so these are two in nature…
i.e. land and labor.
As far as the land is concern it’s the God gifted factor of production and we
can’t change it. And it’s full of productive reservoirs, so in order to bring out
these resources we need the second factor of production. So to proper utilize
these resources.
Further its says that as for as labor is concern it’s the basic factor of
production …because we need labor to dugout these hidden resources in
land.
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The basic principles of Islam

as we know the provider of these sources of guidance is The Almighty Allah. So
the first principle is
 All resources on the Earth belongs to Allah
 Human beings are the trustees of Allah in the use and management of these
resources.
 All these resources are utilized as per as the directives of Almighty Allah
 The economic aspects of human life is not completely free (free only in the
lights of guidance)
 All these productive resources must be available every time, anytime for the
benefit and welfare of society.

Salient features of Islamic economic system

I. It is a guided system
II. It is morally directed system
III. It has a clear goal of social welfare , solidarity and organization for the
needy people of society
IV. Work(labor) the basic factor of production
V. An asset oriented Islamic system
VI. It focused on circulation of wealth as compare to concentration of
wealth through the use of Zakat.

Prohibited activities in Islam

 Monopoly of all types are prohibited in Islam
 Hording is also discouraged in Islam.
 Misrepresentation in quantity, quality, weight and any other
specification is prohibited. i.e. window dressing
 Gambling, betting, and activities like these are also non-
permissible in Islam
 Speculation is also not allowed in Islam
 All kind mal practices or deals in prohibited items, such as alcohol
etc.
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Riba, usury and interest

These are three different words as we speak it but actually these all have
the same meaning and here is a controversial about these words in
modern Muslim bankers and that is that to them Riba and usury are the
same things but interest is something else.
Furthermore they say that as interest is different than Riba and only Riba
is prohibited which is same as usury…so we can allow interest in our
business transactions.
So in order to prove them that these three words are used for the same
thing, we need to discuss two things i.e.
• The historical background of interest
• The true meaning of Riba , usury and interest

The historical background of interest

The philosophy behind this topic is that we must know that interest is
not something that is forbidden not only in Islam but also before the
light of Islam and in prehistoric era.
We all are well aware of that there was a barter system exist in the world
for purchase and selling transactions…in which only exchange of
desired products could only possible…hence it’s difficult to perform a
transaction easily…so then…papar money was invented to facilitate the
transactions…so it’s clear that the only purpose of money was to
facilitate transactions …and not used as a commodity and after the
creation of money “interest” came into being.
Now here are some historic background/events that can prove that how
interest is prohibited and treated before.
Two Greek philosophers i.e. Aristotle and Pluto…they were before
Islam and they reject interest…they were person who always reject or
accept a phenomenon with the help of logic…and in interest their
rejection logic was that
Aristotle says the sole purpose of money is to facilitate the transaction…
and a piece of money cannot be getting double. Money itself is sterile.
While Pluto condemned money lending at interest for society.
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Then in 340 BC lex Genucia (Jewish king) prohibited interest in

Republic of Rome.
In biblical times (Hazrat Isa (A.S)) “All payments for the use of money
is forbidden.”
In 4th century when Rome was Christianized
“The church forbade clergies from money lending at interest”
This does not mean that poor people are allowed to lend money at
interest….the concept behind this is that lending money is not possible
for poor people…they themselves lend money from clergies.
The teachings of Jesus on the subject are very clear.
“Love your enemies and do good lend, expect nothing in return”
The charging of interest is also prohibited in real Judaism.
“If you lend money to any of my people you shall be to him as a creditor
and shall not extract interest from him”
Before Islam in Arab in 605AD on a stormy day the Holy Building
damaged due to spark of fire.
To reconstruct the holy building –they just announced that only purely,
clean and honestly earned money should be donated –further there are
two professions whose donation is not accepted
Usurers and prostitutions.
And interesting fact is that those were considered as the dark days of
civilization.
In 1311AD pope clament v made the prohibition of usury absolute i.e.
there is no space for its permissibility and also he declared all the
legislation in the favor of interest as null and void.
These were middle ages.
The end of 13th century saw the decline of Orthodox Church and the
secular power rise. As a consequence the charging of interest gradually
started being tolerated (prohibited by church before).
In the mercantile Era (industrial revolution 1500-1700) money began to
be used on large scale for commercial transactions and receive the status
of factor of production in the form of capital and we need to compensate
capital too.
In 1740 the city of Verona (Italy)-city government issued a bond at 4%
interest. The issuance of bond led to a lot of controversies among
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religious group. I.e. Benedict XIV (christen) wrote to the bishop of Italy
firmly emphasizing that it is a sin to take interest on loan and condemn
various pleas (it is productive loan, rate is moderate, interest is on rich
people) …he reject all these pleas.
So it is significant that when Islam flourished in
most parts of the word interest was strictly prohibited and this is not
something new done by Islam…actually its proven above that interest is
forbidden in every religion before Islam.

The true meaning of Riba, Usury and Interest

Recently there is a controversy among people that there is difference
between Riba and Interest and that interest is having categorization.
Categary1 says Riba and usury are same –prohibited
Category2 says interest-not prohibited
And this is the concept of modern bankers (they do not know the
complete shariah of Islam) as interest comes in second category having
different scope as compare to Riba and usury…so its permissible…so in
order to solve this controversy we will discuss the true meanings of
these three different words one by one…

• Riba
An Arabic word…literally means increase, addition,
Expansion, or growth.
“It refers to additional amount which a lender recovers from
a borrower according to a fixed rate over and above the
principle amount.”
According to Quranic illustration the lateral meaning of Riba is increase.
In shariah, Riba means an addition however slight over and above
principle amount (means both simple and compound interest are
prohibited)
So Riba is there for the premium that is recover by the lender from
the borrower along with the principle amount as a lending arrangement
Or for an extension in the credit period.
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• Usury
An old English terminology
Reference –Britannica – usury is explained as compensation
for the use of money regardless of the amount, according to
earlier English law.

• Interest
Modern language-American
Reference-encyclopedia-Americana
Means “interest is a charge for the use of money. Further it
explain that interest is not always been considered a
legitimate or even a moral payment.”
Until the end of middle ages any charge for a loan was
generally consider to be usury – this means interest and usury
are same.
So the difference between usury and interest starts from
Middle Ages, we can say it mad man made concept.
The teachings of Christians, Judaic and Islamic religion all
condemned charging of interest in varying degree.
In more recent times usury however comes to be regarded as
the illegal rate while interest is regarded as legal rate on loan.
And they believe that if rate is higher than it is called as
usury…while if the rate is low it is called as interest which is
legal.
So we conclude that controversy is baseless and interests in all forms are
prohibited.

Prohibition of Riba
Prohibition of Riba in holy Quran
The following are the relative verses from the holy Quran on the subject. It is to be
noted that the holy Quran has used the Arabic word Riba in the verse, which has
been retained in the English translation.
1.Sura Rome Para 21, versa39.
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“That which we give in Riba in order that it may increase on

(other) people’s property hath no increase with Allah: but
that which ye give in charity, seeking Allah’s countenance,
bath increase manifold.”(30:39)

2.Sura Nisa, Para 6, verse 161.

“That they took Riba, through they were forbidding; and that
they devoured men’s substance wrong fully. We have
prepared for those among them who reject faith, a grievous
punishment.”(4:161).

3.Sura al Imran, Para 4, verse 130 to 132.

“o ye who believe ! Devour not Riba, double and multiplied;

but fear Allah; that ye may (really) prosper”. “Fear the fire,
which is prepared for those who reject faith.” “And obey
Allah and the messenger; that ye may obtain
mercy.”(3:130).

4.Sura Baqara, Para 3, verses 275 to 281.

“Those who devour Riba will not stand except as stands one
whom the evil one by his touch hath driven to madness. That
is because they say: trade is like Riba. But Allah hath
permitted trade and forbidden Riba. Those who after
receiving direction from their lord, desist, shall be pardoned
for the past; their case is for Allah (to judge). But those who
repeat (the offence) are companion of the fire; they will
abide there in (forever).” (2:276)

5.“Allah will deprive, Riba of all blessings, but will give

increase for deeds of charity; for he Lovett not creatures
ungrateful and wicked.”(2:276)

6.“Those who believe, and do deeds of righteousness and

establish regular prayers and regular charity, will have their
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reward with their lord: on them shall be no fear, nor indeed

believers.”(2:277)

7. “Oye believe! Fear Allah and give up what remains of your

demand for Riba, if ye are indeed believers.”(2:278)

8. “If
you do it not, lake notices of war from Allah and his
messenger. But if ye turn back, ye shall have your capital
sums. Deal not unjustly, and ye shall not be dealt with
unjustly.”( 2:279)

9.“If the debtor is in a difficulty, grant him time till it is easy for
him to repay. But if ye remit it by way of charity, that is best
for you, if ye only knew.(2:280)

10. “And fear the day when ye shall be brought back to

Allah .then shall every soul be paid what it earned, and none
shall be dealt with unjustly.”(2:281)

Prohibition of Riba in Ahadith

There are numerous ahadith (sayings, deeds or approvals of the holy prophet of
Islam, peace be upon him) on the subject of Riba. The ahadith containing the
directives of the holy prophet, peace be upon him, have been narrated by
authorities including imam Malik, Bukhari, Abu baud, Tirmizi, Nasa’j, Musnad,
Ibn Majah,Ahmed bin Hanbal, Dar Qutni, Kitab Al Buyua e.t.c.in their collections
of ahadith .some of the ahadith on the subject are :
1. From Jabir: The Prophet, peace be upon him, cursed the
receiver and the payer of Riba, the one who records it and
the two witnesses to the transaction and said; “they are all
alike (in guilt)” Tirmizi

2. From Abu hurayrth: the prophet, peace be upon him, said:

“on the right of ascension I came upon people whose
stomachs were like houses with snakes visible from the
outside’s asked Gabriel who they are. He replied that they
were people who had received Riba.”(Musnad Ahmad)
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3. From Abu hurayrth: The Prophet, peace be upon him said:

“there will certainly come a time for mankind when everyone
will take Riba and if he does not do se, its dust will reach
him.”(Abu Daud)

4. From Abu hurayrth: The Prophet, peace be upon him, said:

“Allah would be justified in not allowing four persons to enter
paradise or to taste its blessings: he who drinks habitually,
he who takes Riba, he who usurps an orphan’s property
without right, and he who is undutiful to his parent.”(Kitab al
Buyua)

5. From ibn Masud: the prophet, peace be upon him said: “even
when Riba is much, it is bound to end up into
paltriness.”(Musnad ahmad)

6. From Anas ibn Malik: The Prophet, peace be upon him said:
“when one of you grants a loan and the borrower offers him
a ride on an animal, he should not ride, unless the two of
them have been previously accustomed to exchanging such
favors’ naturally “ (Kitab al Buyua)

7. In his last sermon during the pilgrimage, the Holy Prophet

(S.A.W) ,in the presence of about one hundred thousand
reverend companions declared:

“Every form of Riba is cancelled” (Musnad Ahmad)

It is, therefore clear, the interest, Riba and usury, in all

forms of intent are strictly prohibited, as per teachings given
herein above.

Prohibition of Riba in fiqah

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All the schools of thought of Muslim jurisprudence held the

unanimous view that Riba, usury and interest are strictly
prohibited in Islam.