CHAPTER NO.

01

1
 1-PROBLEM & ITS BACKGROUND

1.1 Introduction

In any economy banks play very important role. A bank is a reliable financial institution,

which has core business of mobilizing the savings of people for investment purposes. It

receives the money from one group and lends to other group of people. So bank performs

the duty of financial intermediary.

Usually there are two types of banks, conventional banks and Islamic banks. In simple

words Islamic banks operate in interest free system. Prohibition of interest is ordained in

Islam in all forms and intent. This Prohibition is strict, absolute and unambiguous.

The Holy Qur'an in verse 278 of Surah Al-Baqarah states:

"O ye who believe! Fear Allah and give up what remains of your demand for Riba, if ye

are indeed believers."

Verse 2: 279 says:

"If you do it not, take notice of war from Allah and His Messenger. But if ye turn back,

ye shall have your capital sums. Deal not unjustly and you shall not be dealt with

unjustly."

2
It therefore, follows that interest is prohibited as it leads to injustices and Islam is against

all forms of injustices and exploitations and pleads an economic system, which aims at

securing extensive socio-economic justice. The Islamic law of prohibition of Riba, which

includes interest, was originally not based on economic theory but on Divine Authority,

which considers the charging of interest as an act of injustice (Dr. Siddiqui).

The main issue here is to know about the differences between operations of a

conventional bank and an Islamic bank by focusing on the principles and instruments of

Islamic banking.

It is difficult to say with accuracy, which was the first such company or bank that

pioneered this concept of Islamic banking in practice. Some analysts and experts in the

field are of the opinion that, Islamic banking and finance, in the modern context, first

emerged in 1963, when Mit Ghamr Saving Bank began an experimental project offering

interest free banking in Egypt. The project was a success and lead to the bank opening

four new branches by 1967. In the same year, eight new banks mushroomed offering

interest free banking. Due to the political climate prevailing in Egypt during that period,

the success of these Islamic banks was seen as a threat, and they were forced to close

down in 1971.

Some observers are of the opinion that the concept of an "Islamic bank" was born at the

Islamic Summit of Lahore, Pakistan in 1974, which recommended the creation of an

Islamic Development Bank. Since then Islamic banking and financial institutions have

3
grown rapidly. In 1993 report from the International Association of Islamic Banks

estimated the then industry to be valued at $80 billion. A more recent article appearing in

the Wall Street Journal estimates the potential market for Islamic investments to be up to

$150 billion.

Malaysia in 1983 passed an Islamic Banking Act to facilitate the growth of indigenous

Islamic banks and finance companies thus became the first Muslim economy to issue

bonds on an Islamic basis. Since then, some 50-60 institutions have been established, and

are now in the process of forming an Islamic inter-bank market (i.e. in which banks

borrow or lend to each other). Within 10 years of introducing the Islamic Banking Act,

the Malaysian government has taken further steps to popularize Islamic banking and

finance, by allowing conventional banks to offer Shariah-compliant instruments. The

most distinctive feature of Islamic banking in Malaysia is that it is being embraced by its

Chinese and non-Muslim population who are opting to deposit their savings or borrow

money on an Islamic basis.

The momentous decision of the Pakistani Supreme Court, in Ramadan 1420, to strike

down all laws that condone interest and their orders to the Federal government to bring

all existing financial organizations in line with Islamic principles is truly path breaking.

The world is watching with bated breath to see how the whole economy faces this

challenge (www.alrajhibank.com.sa/islamicebanks.htm).

These trends in Malaysia and elsewhere are having a profound effect on the banking and

4
financial world as a whole. For example, America's Citibank was the first major

conventional bank to establish an Islamic bank in Bahrain, with an operating capital of

$20 million (The Economist, 1996). It may be a puny sum, but it does suggest to some

degree that conventional banks have begun to embrace Islamic banking on a moderate

scale. Here again the point arises, that, there is some difference between the operations of

two banking systems and also there is something, which is attracting conventional banks

towards Islamic banking system.

A significant proportion of the banking system has been Islamized in Pakistan. Recently

the State Bank of Pakistan has allowed Commercial Banks to set up Islamic banking

subsidiaries or provide full Islamic banking facilities through dedicated branches (Dawn

economic & business review).

Meezan Bank of Pakistan had conducted a research last year to ascertain, is Islamic

banking really a need of the people? The main findings of the research were that there is

a strong need for a Riba-free banking system. People perceive a number of emotional

benefits from a product that is based on the tenets of Islam. The objective is to alleviate

the feeling of guilt by following the tenets of Islam. There is also a belief that Islamic

banking will help fight the ills of the economy of the country.

1.2 Rationales for the Study

An Islamic bank is a financial institution which identifies itself with the spirit of Shariah,

5
as laid down by the Holy Qur'an and Sunnah. Normally from Islamic banking it is meant

the interest free banking system, while conventional banking is perceived as interest

based banking system. To replace interest, the ideal mode of financing under the Islamic

banking system is "Financing on Profit & Loss Sharing" (PLS) basis.

There could be no denying of the fact that under the interest-based system of banking or

in a system not strictly based on the principles and spirit of Shariah, depositors as well as

borrowers are exploited in one form or the other. (Dr. Siddiqui)

Interest is usually paid on borrowed money or in other words on debt. In last decades

debt is considered as most effective resource of financing. It was contended that debt has

a better control function because the “threat of failure to make debt-service payments

serves as a strong motivating force” (Jensen, 1988).

On the other hand it is considered that, although an increasing level of debt helps the

economy grow faster for a while, it foments endogenous instability and financial fragility.

Minsky (1982) has propounded and popularized the idea of endogenous instability and

financial fragility. That is, initially when the debt equity ratio of a corporate is low, it

really pays to finance expansion by borrowed funds. At this stage, expectations of both

borrower and lender are usually satisfied, or existing debt is validated without any

problem, which provides the basis to go further deep in debt. As a result, demand for

borrowed funds grows faster than the ability to pay, or in Minskian terminology, the

6
economy moves from hedge to Ponzi finance. Also demand for further borrowing

becomes inelastic because initially, due to the positive slope of term structure, borrowers

themselves prefer to borrow on a short-term basis, but later they have to borrow to keep

their existing debt rolling and to fulfill their other committed payments, which in turn,

pushes the interest rate up. However, the problem starts when at some point along the

line, the supply of credit lags behind the demand. This happens because on one hand

lenders become pessimistic about future prospects of underlying projects or they no

longer share euphoric expectations with borrowers or, on the other hand, the net worth of

borrowers and the value of their collateral erode because of high interest rates. As a

consequences, their relationship become strained, lenders may want to extend minimum

credit or may even want to liquidate what they have already loaned, while debtors

scramble for liquidity. Minsky calls this a financially fragile situation because borrowers

become vulnerable to disruption of their economic activity.

1.3 Problem Statement

From the rationale given in the previous section, it is now clear that attention must be

given to the viability of Islamic banking as compared to conventional banking system

while focusing on the problem statement:

“Comparison of conventional banking system with Islamic banking system”

Focusing the problem this study will answer the following questions:

7
 1. What is Islamic banking system with respect to its principles and instruments?

2. How Islamic banking system is different from conventional one?

3. What are the advantages of Islamic banking system, and what is its future?

4. Why Islamic banking is more viable than conventional banking system?

1.4 Objectives

This research report or thesis is the basic requirement of Federal Urdu University Arts,

Science and Technology Islamabad, for any student to obtain the degree. This is a way

to help students enhance their knowledge by making them learn from the practical

environment and also to apply the learned theoretical concepts in the practical field.

Thus, the main objective of this research is to fulfill the partial requirement of the

University for obtaining the degree.

An attempt is made in this research:

• To highlight salient features of Islamic banking system.

8
 • To compare Islamic banking system with conventional banking system.

• To investigate whether Islamic banking is at least as viable as

conventional banking system on economic grounds.

• To simulate future prospects of Islamic banking system, if people are

made aware of the difference between Islamic banking system and

conventional banking system.

• To simulate future prospects of Islamic banking system, if people are

made aware of the viability of Islamic banking system.

1.5 Significance of the Study

It is true that external financing is utmost important almost for every kind of business in

an economy and banking industry is the main facilitator in this regard. Islamic banking

system plays its role in the banking industry as its minor part. Even though it’s a minor

part it can’t be left behind because banks are the citadels of the economic growth. So,

studying Islamic banking system in detail will not only benefits the researcher but also

will be a source of effective information for many classes of bank customers. It will help

better understanding Islamic banking system and its salient features.

9
Only a minority of Muslims strongly believes in efficacy of Islamic banking system,

whereas a majority of Muslims and non-Muslims have doubts about its viability on

economic grounds. They are not convinced to its practicality and viability. Description of

Islamic banking in this study will clarify such doubts about the system and will speed up

the process of Islamizing of banking industry. This study will be of great help for

students of banking to understand deeply the Islamic banking and to differentiate it from

conventional banking system. It will be a contribution to the existing literature of

administrative sciences and will serve as a base for further research. This project will also

give the idea to reader, which type of investment is forbidden in Islam and which type is

good for Muslim investors. It will be helpful for bankers and investors too.

1.6 Limitations of the Study

The research is conducted within the following limitations:

• To keep the study manageable research is conducted on limited grounds.

• The study is conducted on small level and only the important aspects are

considered.

10
 • There was a shortage of time that’s why limited data is collected. Still the

researcher has tried to collect sufficient data to make an effective analysis.

1.7 Definition and Meanings of Terms

Al-wadiah; means safekeeping.

Bai'muajjal; means deferred-payment sale.

Bai'salam; means pre-paid purchase.

Baitul mal; means treasury.

Fiqh; means jurisprudence.

Hadith; means prophet's commentary on Qur'an.

Halal; means lawful.

Haram; means unlawful.

Ijara; means leasing.

11
Iman; means faith.

Mudaraba; means profit sharing.

Mudarib; means entrepreneur-borrower.

Murabaha; means cost-plus or mark-up.

Musharaka; means equity participation.

Qard hasan; means benevolent loan (interest free).

Rabbul-mal; means owner of capital.

Riba; means interest.

Shariah; means Islamic law.

12
CHAPTER NO.02

13
 2-LITERATURE REVIEW

This chapter deals with two parts, first part consists of basic explanation of Islamic

banking system its principles and instruments and the second part is concerned with

summary of previous researches being done on these respective research areas. It

includes the general information about the banking sector and Islamic banks.

2.1 Banking and Financial System (Fredric Mish-kin)

A healthy and vibrant economy requires a financial system that moves funds from people

who save to people who have productive investment opportunities.

There are many different types of institutions: banks, insurance companies, and so on, all

of which move funds from savers to investors.

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 SOURCES OF EXTERNAL FUNDS
80
60 Series1
Series2
40 The system based on these institutions is called the “financial
Series3system”. And this Financial
20 Series4
System is complex in structure and function throughout the world.
Series5
0 Series6
loans FigureBonds Stock
2.1 indicates how the different Other
countries financed their business activities using

external funds, in the period of 1970-1985.

1) Loans à Made up primarily of bank loans but also includes loans by other

non-bank institutions.

2) Stock à Consist of stock market-shares

3) Bonds à Includes marketable debt securities.

4) Others à Includes govt. loan and Foreign loan etc.

As seen in the picture the main source of fund has been loan and mostly banks make

loans. So this institution will be discussed in detail.

Figure 2.1

15
2.2 What is Bank? (Fredric Mish-kin)

Bank is defined as an institution, which deals with money. The bank draws the surplus

money from the people i.e. excess of income over consumption, which is a form of loan

to the bank and in return pays interest on it for the loans of those who have saved or

deposited their money. The bank then gives out loans to those who need it particularly for

productive purposes, and charges interest on returning it.

In present days the banking system has been familiarized as an organized organization.

This organization by giving greed of different benefits induces peoples to deposit their

money in banks. Then the bank lends this money on huge interest to others. A portion of

the interest money is awarded to the creditors of savings and the rest of money is spent by

bank for its own expenditures.

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2.3 What are Islamic Banks (RIIC by Prof. Khursheed)

Unlike their counterparts elsewhere, Islamic bankers do not expect to advance money and

receive a predetermined sum on a fixed date in the future. Under the Shariah, the bedrock

of the Islamic faith, they are instead responsible for ensuring that money is invested in

viable projects, with reliable borrowers. If the project succeeds the banker shares in the

profit. If it fails he suffers the losses.

The Shariah, which dictates the activities of the banks as well as forming the basis of the

daily lives of all Muslims, requires that reward come from risk sharing. Profit must be

justified through the creation of value that the banker brings to complement the value of

the borrower’s efforts and skill as mentioned in report on Islamic ideology council.

Islamic financial techniques have been employed successfully in a growing number of

major projects in the West. Al Rajhi Bank has completed deals for the financing of ships

and aircraft (using the Ijara - lease financing technique), and many industrial projects

including the building of power stations, a refinery and schools, and the expansion of an

aluminium smelter in Bahrain (using the Istisna - deferred financing technique).

Given the huge potential for development in the Islamic world and the increasing amount

of funds being invested according to the Shariah, it seems perfectly reasonable to suppose

that the recent growth in Islamic banking will continue at an accelerated pace. (Colin

Willis).

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2.4 Knowledge about Islamic Bank

A research on “Bank Patronage Factors of Muslim and Non-Muslim Customers”

Conducted in Malaysia in 1994 shows that almost 100 per cent of the Muslim population

was aware of the existence of the Islamic bank; the sources of knowledge are mainly

newspapers and magazines, television and radio, and family members. Many of the

Muslim respondents visit the bank’s branch and seek information about the bank services

and operations on their own initiative. For non-Muslims, about 75 per cent of the

respondents know of the existence of the Islamic bank from information derived mainly

from newspapers and magazines. Other sources of information are not so effective for the

non-Muslims.

Even though it has been nearly a decade since the Islamic bank was first established in

the country, only about 63 per cent of the Muslims have understood either partly, or

completely, the differences between the Islamic bank and conventional banks. Non-

Muslims showed much less understanding. Only 12 per cent of the Muslims and 32 per

cent of the non-Muslims believe that the Islamic bank is for Muslims customers only. In

terms of why people patronized the Islamic bank, about 39 per cent of the Muslim

respondents believe that religion is the only reason why people patronize the Islamic

bank, and, surprisingly, the percentage is much lower for non-Muslims. More than half of

both respondent groups have indicated the possibility of establishing a relationship with

18
the Islamic bank if they have a complete understanding about the operations of an Islamic

bank (International journal of bank marketing, 1994).

The changes in the banking system have created a new dimension in the banking industry

within which the institutions in the banking system have to compete, not only with

financial institutions outside the banking system, but also with themselves to remain in

business. Indeed, the fiercer level of competition is not only faced by the banking

industry in Pakistan, but also it is becoming the most influential factor in the structure

and activities of the banking system around the globe.

2.5 History of Islamic Banking

Haqiqi & Pomeranz in their article “Accounting Needs of Islamic Banking” gave the

history of Islamic banking. They explained that, In Muslim communities, limited banking

activity, such as acceptance of deposits, goes back to the time when the Prophet

Muhammad was still alive. At that time, people deposited money with the Prophet or

with Abu Bakr Sedique, the First Khalifa of Islam. The first modern Islamic bank,

established in Egypt in 197, was called Nasser's Social Bank. Islamic accounting, an

essential tool for the success of Islamic banks, is said to have been developed

contemporaneously at the University of Cairo (Crane).

The desirability of abolishing fixed interest rates and the Islamization of financial

systems were discussed at the first meeting of the Islamic Organization Conference (IOC)

19
in Jeddah in 1973. Subsequently, many Islamic banks were founded under the profit-and-

loss sharing system (PLS), which will be discussed below.

Modern Islamic banking has undergone three phases of development:

• Emergence-1972 through 1975: This period was marked by a surge in oil

revenues and great liquidity. Parallel events included a resurgence of

fundamentalist Muslim movements, reemphasis on the Wahabi School of

Brotherhood and Pan-Islamism, and establishment of IOC.

• Expansion-1976 to the early 1980s: Islamic banking spread from the: Arabian

Gulf eastward to Malaysia, and westward to England. More than Accounting

Needs of Islamic Banking 155 20 Islamic banks were established, including

international and intercontinental institutions.

• Maturity--1983 to the present: The Arab world was confronted by economic

setbacks, including slowdowns in oil revenues, the collapse of Kuwait's Souk al-

Manakh, the relative strength of the U.S. dollar, higher interest rates in the United

States, and capital outflows from OPEC nations. At the same time, Arab banks

opened branches in the United States and Islamic banking practices were

implemented in both Pakistan and Iran.

Islamic banking operations are not limited to Arab soil, or Islamic countries, but are

20
spreading throughout the world. One reason is the "growing trend toward transcending

national boundaries, and unifying Muslims into a political and economic entity that could

have a significant impact on the pattern of world trade. ...Since Muslims are inclined to

follow Islamic traditions, there is a tendency to establish an Islamic economic system in

every Islamic nation, And to restore Shariah Law as the basic source for legislation"

(Abdul-Magid).

2.6 Islamic Banking System (Fredric Mish-kin)

“Islamic banking system deal with money and not deal in money”

It is argued by Muslim scholars that whereas traditional banking is concerned with

financial intermediation on the basis of lender-borrower relationship between depositors

and banks, on one hand, and banks and the fund-seekers, on the other hand, Islamic

banking is about addressing genuine concerns of the owners of funds and needs of the

resource-strapped through Shariah permitted forms of transactions.

The argument is built on the following premise.

“What is permitted for an individual is also permissible for the banks (that are groups of

individuals – shareholders) unless there are reasons to conclude otherwise”.

2.7 Instruments of Islamic Banking. (Fredric Mishkin)

21
The Islamic instruments which govern the operations of Islamic banks are also known as

Shariah instruments. The applicable instruments are called Mudharabah, Musharakah,

Murabahah, Al-Bai Bithaman Ajil, Al-Ijrah, Al-Takjiri, Qard Hasan, Al-Wakalah, Al-

Kafalah and Wadiah.

Foundations for modern banking operation in Shuri’ah are defined in terms of trade,

leasing and partnership based arrangements and collateral and guarantees. The following

options are pro-posed to be initially made available for banking system.

Trade-related modes………………. Bai-mu’ajjal (sale on deferred payment basis),

Bai’salam (sale with cash payment with future

delivery)

Leasing modes……………………... Ijarah (operating on lease)

Partnership modes…………………..Modarabahah & Mosharakah

Lending …………………………… Qard (loan)

Collateral and Guarantees

Shari’ah requires that not only the ends be Shuri’ah compatible but that the means to

achieve those ends be right as well. In the light of this principal the above modes can be

22
adopted.

2.7.1 Trading-based arrangements

Bai’mu’ajjal is the Arabic acronym for “sale on deferred payment becomes debt against

the buyer payable in lump sum or in installments (as per agreement with the seller). In

addition to the concurrence of the seller, conditions for a valid Bai’mu’ajjal are as

follows:

1. The price to be paid must be agreed and fixed at the time of the deal. It may

include any amount of profit without qualms about Riba.

2. Complete/total possession of the thing in question must be given to the buyer,

while the deferred price is to be treated as debt against him.

Bai’ salam involves advance payment to a party for delivery of a thing in future a

converse of Bai’mu’ajjal. It applies to the case in which things come into the possession

of the seller due to his being their producer or towards discharging his occupational

functions—for instance, wholesaler acquiring goods from a manufacturer and supplying

them to the retailers.

Bai’salam is a valid transaction with the following three basic conditions:

23
1. The nature, quality and quantity of the merchandise (to be delivered in future)

must be clearly specified along with the delivery date.

2. The price to be paid in advance should also be fixed.

3. The transaction should be settled with the delivery of goods, not on the margin.

2.7.2 Leasing-based arrangements

Ijarah or leasing is a contract for the usufruct of an asset while its ownership still remains

with the original owner, i.e., the lessor. In this case, the lessor leases his asset to another

party, the lessee, against a predetermined rental for a prescribed period. Thus, besides the

concurrence of the concerned parties, there are three fundamental conditions for a valid

Ijarah contract:

1. The asset is the property of the lessor.

2. The period of contract is specified.

3. The rental and its payment schedule are precisely stated.

That the asset remains in working condition (during the period of lease is the lessor’s

responsibility.

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2.7.3 Partnership-based arrangements

Modarabah and Musharakah are two partnership modes that allows two or more parties to

share both the contributions to and the fruits of economic activity, albeit in varying

degrees, trough mutually agreed arrangements. The bank can adopt both of these modes.

It can act as Mudarib as well as a partner.

Critical points and conditions about Modarabah and Musharakah from the Shari’ah

perspective are as follows:

1. All these arrangements represent a situation in which (a) ownership of capital is

shared, albeit for the duration of the contract, (b) rewards are addressed through a

share in the outcome of the activity, and (c) material losses are shared in

proportion to ownership stakes of the various partners along with labour going

totally unrewarded.

2. The Mudarib should not lay any material claims against the joint venture except

those necessary for discharging the required functions according to the letter of

the contract.

3. In the settlement of accounts, the first claim on revenues, over and above the

operating costs, would be in lieu of the capital contributions. After this, the

residual or operating profit can be distributed among all partners according to the

25
 prescribed profit-sharing ratios.

2.7.4 Collateral (Rehn) guarantees

Creditors may seek collateral to protect their interests. In this regard, the following

principles need to be observed:

Collateral should not be of the same kin as the object of the loan/debt.

Creditors may not draw benefits from the object of collateral.

The collateral may be liquidated as per agreement. However, if the liquidation proceeds

exceed the quantum of debt, the balance has to be paid to the debtor. Likewise, if the

value of liquidated collateral falls below the amount of debt, the balance would stand as

unpaid debt against the debtor.

2.10 Commercial Banks or Conventional Banks (Fredric Mish kin)

Despite the classical origin, banking in its modern form and structure started in British
when many of the Lombardy merchants came to England and settled here. They were so
resourceful that even the kings had to depend on them for loans despite the fact that the
church was firmly against usury. They dealt with not only keeping the money safe but
also changing money for travelers etc.

Consequently this business was taken over by the goldsmiths, who up to that time, were
dealing only in gold & silver.

26
Over a period of time, these goldsmiths discovered that large sums of money were left in
their custody for long periods therefore, they started the use of this cash to advance loans
to others persons for a fixed period of time & at high rate of interest. Thus began the
“issue” and “deposit” banking of modern times up to non, this institution, bank became
the need of the time and it provides so many functions for the economic activities of any
country.

2.10.1 Objectives of commercial banking

Main objectives of commercial banks are as follows; earning profit, that is the main
purpose of banks. For this purpose the bank charges very high rate of interest in it
businesses.

With this main objective, the bank has to full fill some other commitments also e.g.

• Issuing new currency

• Providing loans to businesses

• Operate for the stability of economy

• Benefited their major clients who pay more interest.

• And providing a set of services like check clearing, record keeping, credit
analysis and soon.

2.10.2 Function of Commercial Banking

As we already know that how banks performs their i) primary and ii) secondary
functions. Hove the most important point is to make clear how these banks operates.

To understand how a bank operates, first we need to examine its “Balance Sheet” a list
of the bank’s assets and liabilities, i.e.

27
Current Account Saving Accounts
1-Accepting Deposits
Fixed
Deposit

Total assets = Total liabilities + Capital,

This sheet lists sources of bank funds (liabilities) and uses to which they are put (assets).

a) Liabilities

A bank acquires funds by issuing (selling) liabilities. These funds are used to purchase
income earning assets.

b) Bank Capital

It is a bank’s net worth, which equals the difference between total assets and liabilities it
is a cushion against a drop in the value of its assets, falls below its liabilities, meaning
that the bank is bankrupt.

c) Assets

Bank assets are referred to as “else of funds” and the interest payments earned on them
are what enable, banks to make profit.

In general terms the basic operation of a bank is that it makes profits by selling liabilities
with one set of characteristics (a particular combination of liquidity, risk and return) and
using the proceeds to buy assets with a different set of characteristic this process is often
referred to as “asset transformation”.

A COMMERCIAL BANK GENERALLY PERFORMS THESE FUNCTIONS

28
 By over drafting
opening a loan account
2-Advancing of bill
LoansPurchasing
Discounting of exchangebonds and securities

3à Transference of money

4à Creation of safest medium of exchange

5à Agency services

6à General utility services

7à Financing of foreign trade

These functions are briefly discussed as under:

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1. Accepting deposits

Main function of commercial banks is to receive surplus balances of the individuals,

public institutions and households there are three types of accounts in which it receives

deposits i.e. current account consist of those deposits that can be drawn at any time. Bank

do not pay interest money can be drawn with out notice.

Fixed deposits are repayable after the contracted period. High rate of interest is allowed

at their deposits.

In saving account, it is the responsibility of the bank to repay deposit on demand up to a

certain limit. Further withdrawal needs permission from bank.

2. Advancing of loans

Bank advances loans against securities at certain fixed rate of interest. It takes none

interest from people on loans and gives low to depositors. And the difference between

these two is the profit of the bank.

Bank gives loans by opening new account it do not gives money in cash form same time

for reliable customers, bank with draw money by over drafting their accounts i.e.

withdraw money none than amount saved in the account.

30
Bank may also give out loans against bills of exchange presented before it upon which

these bills are discounted at their market work.

Same times it purchases bonds and securities in the stock market. For record of

transaction the bank then requires who sold shares to open account in the bank.

3. Transference of money

The bank also transfers the money internally and externally for different purposes.

4. Creation of safest medium of exchange

It creates safe medium of exchange by means of cheque, because it represents very high

value with one not etc.

5. Agency services to customers

It may act as an agent by collecting and paying money on cheque for its customers.

6. Utility services

It also provides services like locker services foreign exchange business etc.

31
7. Financing of foreign trade

It provides incentives to be involved in the export business by lowering interest rate on

loan for this business

2.11 Concerns with Financial Stability (Abbas Mirakhor & Mohsin Khan, 1986)

For a number of reasons Islamic finance has become relevant for the stability of the

global financial system. Financial stability is an important prerequisite for sustained

economic growth and social development. Experiences of past financial crises show that

economic progress achieved over several years can be significantly reversed during a

very short period of time. The international financial system has been experiencing

recurring crises over the last two decades. As a result, there have been large losses in

gross domestic product of the countries concerned with a serious adverse implication for

the stability and growth of the world economy.

In response to these crises, the international financial community has reiterated the need

to strengthen financial institutions by appropriate measures including effective regulation

and supervision, better corporate governance, risk management and enhanced disclosures

and transparency so that the crises can be prevented from occurring and they can be

managed efficiently if they happen.

The implication of Islamic finance for stability of Islamic financial markets has some

32
special considerations. First, investment deposits of Islamic banks are based on risk

sharing and the financing extended by the Islamic financial institutions is asset-based. For

this reason, Islamic finance has inherent positive implications for financial stability.

Second, the practices of the Islamic principles of finance have taken a number of forms.

Some Muslim countries have made an endeavor to implement the Islamic principles

economy-wide. A number of countries have allowed establishment of Islamic financial

institutions side by side with conventional institutions. Some other countries have

allowed their traditional financial institutions to write Islamic banking contracts as well.

As a result, Islamic banking and finance has become important for the stability of

financial systems in several countries.

Finally, the infrastructure of the Islamic financial system is in the evolutionary process.

Hence despite the fact that the industry is fully regulated and supervised, there could be

unwarranted misconceptions in some circles due to the lack of familiarity with the

industry. Due to the requirements for financial transactions to comply with the Shari'ah,

some risks of the Islamic financial contracts are unique. The Islamic financial industry

can be strengthened by suitably adapting the international standards to its unique risk

characteristics. In its part, the inherent features of the Islamic financial industry can

contribute to strengthening the global financial architecture provided the basic supportive

infrastructure is established.

2.12 Causes of Financial Instability (Abbas Mirakhor & Mohsin Khan, 1986)

33
Various causes of financial crises can be identified depending on the specific situations

and circumstances in which the crises might have occurred. Some common causes of

financial crises are:

(a) Lack of proper regulation and supervision

Due to lack of proper regulation and supervision, in several developing countries

financial institutions are not properly capitalized, loan loss provisions are not prudentially

maintained, there are large amounts of imprudent connected lending, transparency and

disclosure standards are low, risk management and internal control systems are weak, and

the public sector's influence is large. As a result, financial institutions at times are not

able to absorb even small shocks from internal or external sources.

(b) Non-compliance with standards

For a sound financial system, compliance with the international standards on the part of

governments as well as public and private sector institutions is extremely important.

Noncompliance by public and private sector institutions with the best practice standards

in financial reporting, accounting, auditing, transparency and disclosures make financial

systems vulnerable to instabilities.

(c) Currency crises

34
As a result of an unrealistic exchange rate regime or excessive speculation, the exchange

rate of a currency may depreciate below normal levels. Consequently, the value of

financial assets/liabilities held in foreign currency will appreciate and the value of those

held in local currency will depreciate. Since in the developing countries there is always a

scarcity of foreign exchange, a currency mismatch leads to banking and payments crises

and creates contagion effects.

(d) Maturity mismatch

Maturity mismatch between short-term liabilities and short-term assets of the public and

private sectors is also known to be an important cause of financial crises. If short-term

foreign exchange liabilities are high as compared to the availability of liquid foreign

exchange assets, foreign contractual obligations cannot be met in time, causing a larger

financial crisis.

(e) Moral hazard

Considerable part of financial instability is attributed to deposit insurance schemes and to

not allowing inefficient financial institutions to fail. As a result of such policies, some

financial institutions are motivated to practice imprudent policies, which weaken the

overall state of the financial system. Several other causes of financial crises can be cited

depending on the circumstances of their occurrences. It can be seen that the interest-

mechanism is central to most of these causes. As mentioned above the fast movement of

35
short-term interest-based funds is an important cause of financial instability. Furthermore,

high leverage and expansion of credit without any linkage to the real sector of the

economy also contributes to instability. Interest based credit finances undesirable

speculative activities in stock, commodity and foreign exchange markets. Hence if the

interest mechanism is avoided, the major cause of financial crises may be contained.

2.13 Overall Effects of Interest

(Text from Historic judgment on interest given by Supreme Court of Pakistan)

Section Written by Justice Muhammad Taqi Usmani. Interest-based loans have a

persistent tendency in favor of the rich and against the interests of the common people.

It carries adverse effects on production and allocation of resources as well as on

distribution of wealth. Some of these effects are the following:

(a) Evil effects on allocation of resources

Loans in the present banking system are advanced mainly to those who, on the strength of

their wealth, can offer satisfactory collateral. Dr. M, Umar Chapra (Senior Economic

Advisor to Saudi Arabian Monetary Agency) who appeared in this case as a juris-consult

has summarized the effects of this practice in the following words:

36
“Credit, therefore, tends to go to those who, according to Lester Thurow, are ‘lucky

rather than smart or meritocratic. The banking system thus tends to reinforce the unequal

distribution of capital. Even Morgen Guarantee Trust Company, sixth largest bank in the

U.S. has admitted that the banking system has failed to ‘finance either maturing smaller

companies or venture capitalist’ and ‘though awash with funds, is not encouraged to

deliver competitively priced funding to any but the largest, most cash-rich companies.

Hence, while deposits come from a broader cross-section of the population, their benefit

goes mainly to the rich” (Dr. Chapra’s written statement under the caption “Why has

Islam prohibited Interest?”).

The veracity of this statement can be confirmed by the fact that according to the statistics

issued by the State Bank of Pakistan in September 1999, 9269 account holders out of

2,184,417 (only 0.4243% of total account holders) have utilized Rs.438.67 billion which

is 64.5% of total advances as of end December 1998.

(b) Evil effects on production

Since in an interest-based system funds are provided on the basis of strong collateral and

the end-use of the funds does not constitute the main criterion for financing, it encourages

people to live beyond their means. The rich people do not borrow for productive projects

only, but also for conspicuous consumption. Similarly, governments borrow money not

only for genuine development programs, but also for their lavish expenditure and for

projects motivated by their political ambitions rather than being based on sound

37
economic assessment. Non-project-related borrowings, which were possible only in an

interest-based system have thus helped in nothing but increasing the size of our debts to a

horrible extent. According to the budget of 1998/99 in our country 46 percent of the total

government spending is devoted to debt servicing, while only 18% is allocated for

development, which includes education, health and infrastructure.

(c) Expansion of artificial money and inflation

Since interest-bearing loans have no specific relation with actual production, and the

financier, after securing a strong collateral, normally has no concern how the funds are

used by the borrower, the money supply affected through banks and financial institutions

has no nexus with the goods and services actually produced on the ground. It creates a

serious mismatch between the supply of money and the production of goods and services.

This is obviously one of the basic factors that create or fuel inflation.

2.14 The Viability of Islamic Finance (Nejatullah Siddiqi)

It has been demonstrated that all market activities can be financed by using the various

Islamic modes, such as Musharaka, Mudaraba, Murabaha, Salam, istisnac, and Ijara. No

stratagems are needed. The author has argued that interest-free Islamic modes of finance

can replace the conventional interest based finance with certain added advantages. By

synchronizing entrepreneurial payment obligations and accrual of revenues, sharing-

based modes of finance remove a major source of instability from freely functioning

38
markets. Also by linking financial intermediaries' returns to the actual revenue of the

fund users, allocation of funds to invest is redirected to projects expected to produce

more value than their alternatives.

CHAPTER NO.03

39
 3-RESEARCH METHODOLOGY AND DESIGN

The following chapter presents the detail of the research approach adopted, methods and

instruments exploited and the techniques used for analysis. First of all the problem is

identified. Then related data is collected and then the collected data is analyzed &

interpreted and finally conclusions have been made.

3.1 Type of the Study

This study is basically descriptive in nature, and this would explore & review the

research done on Islamic banking by different researchers and scholars.

This study would describe mainly what Islamic banking is all about, its instruments,

principles, viability, riskyness as compared to conventional banking system, and

difference between the two systems.

40
3.2 Methods of Study

This study utilized the descriptive technique because its main objective is to find out

“what exists” and “what is” about a certain existing problems. Different theories were

compared and contrasted with one another to know the causes of existing problem and to

get final conclusions.

The information regarding the Islamic banks has been collected from Secondary Data.

Different books by famous scholars and researchers are reviewed and most of data is

collected from net after the detailed discussion with the supervisor.

41
 CHAPTER NO. 04

4-INTERPRETATION AND ANALYSIS OF DATA

Basically in this chapter the collected data is analyzed and interpreted. As this is

descriptive research so this section will only give the answers of the research questions

given in first chapter in the light of the research done previously in the same area.

The findings of the studies are as follows:

42
 1. What is Islamic banking system with respect to its principles and

instruments?

Islamic banking, an alternate to interest based banking is not banking in the traditional

sense of the word. It derives its inspirations and guidance from the religious edicts of

Islam and has to conduct its operations strictly in accordance with the directives of

Shariah.

It is, therefore, not merely refraining from interest based transactions but the objective is

to make a positive contribution to the fulfillment of socio-economic objectives of the

society in all spheres, including trade industry, agriculture, science, technology,

employment, benevolent sector and the environment, with special focus on the ‘human

factor’.

An Islamic bank is a financial and social institution which identifies itself with the

principles of Shariah, as laid down by the Holy Quran’s and Sunnah, as regards its

objectives, principles, practices and operations. An Islamic bank does not normally lend

money except the interest-free loan, which is termed as Qard Hasan. Islamic bank is a

partner in trade, industry and agriculture for production and development financing. This,

therefore, implies that an Islamic bank should also share in the risk with the entrepreneur,

which is in sharp contrast with interest-based bank. Islamic banking implies zero rate of

interest but no zero rate of return as Islamic banks do not deal in money but deal with

money.

43
Islamic banks are required to pay Zakat (poor’s due) @2.5% of their capital and profits

each year for the poor and needy. It will also be observed that by their very nature of

operations, Islamic banks have to be more cautious and more efficient, as they transact

business on profit and loss sharing. They are subject to the supervision and control of the

Central Bank as is the case with other interest-based banks. Further, in addition to

internal and external audit, Islamic banks are also generally subject to supervision by an

Islamic Religious Board. The Islamic banks obtain their inspiration from ethical values of

Islam and do not deal in business declared illegal like alcohol, drugs and gambling, etc.

It can, therefore, be concluded that Islamic banks, in essence, are development

institutions, which are established according to the objectives of Islamic economics.

Islamic banks, therefore, not only refrain from involving themselves in interest

transactions, but also adhere to the Islamic principles of social justice. These banks,

therefore, introduce systems, procedures, practices and products, which contribute to the

attainment of the socio-economic objectives prescribed by Islam.

The investors and depositors are thus able to participate in the development and

production process for the benefit of the community as a whole, as well as have a share in

the profits of the institutions with which funds are placed or invested. Islamic banks like

other conventional banks publish audited balance sheets and profit and loss accounts.

They are owned by shareholders who expect sufficient dividends on their holdings. The

depositors of Islamic banks, on the other hand, hope to get higher returns on their

44
investments with these banks. The higher returns announced by a bank would obviously

attract more funds from depositors and investors.

The real aims and objectives of establishing Islamic banks are to put the Islamic

economic system into practice through banking and financial institutions. These banks

operate within the framework of Shariah and their systems and procedures are tailored to

meet the challenges posed by the present complex and competitive market. At present,

there are bout 100 Islamic banks and financial institutions in different parts of the world.

Principles and Instruments

Different writers explained the principles and instrument of Islamic banking in different

way but the basic idea is same, both principles and instrument are described in details in

literature review, so here they are summed up briefly.

The board principles of Islamic banking system are:

a) Any predetermined payment over and above the actual amount of

principal is prohibited.

b) The lender must share in the profits or losses arising out of the

enterprise for which the money was lent.

45
 c) Making money from money is not Islamically acceptable.

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

e) Investments should only support practices or products that are not

forbidden in Islam.

(For details look at section 2.8)

The instruments of Islamic banking system are: Mudharabah, Musharakah,

Murabahah, Al-Bai Bithaman Ajil, Al-Ijarah, Al-Tijarah, Qarad Hasan, Al-wakalah and

Wadiah.

a) Mudharabah

This is basically an agreement between a lender and an entrepreneur, in which the lender

agrees to finance the entrepreneur’s project on a profit sharing basis according to a pre-

determined ratio agreed on in the negotiation between the two parties. The lender will

bear any loss incurred.

b) Musharakah

This is a partnership for a specific business activity with the aim of making profit,

46
whereby the lender not only provides the capital but also may also participate in the

management. As in the case of Mudharabah, all parties agree, through negotiation, on the

ratio of distribution of profits generated from the business activity, which need not

coincide with the ratio of participation in the financing of the activity. However, in the

event of a loss, all parties bear the loss in proportion to their shares in the financing.

c) Murabahah

This is basically the sale of goods at a price covering the purchase price plus the profit

margin agreed on by both parties concerned, which transforms a traditional lending

activity into a sale and purchase agreement, under which the lender buys the goods

wanted by the borrower for resale to the borrower at a higher price agreed on by both

parties.

d) Al-Bai Bithaman Ajil

This is a variant of the concept of Murabah, whereby the borrower is allowed to defer

settlement of the payment for the goods purchased within the period, and in the manner,

determined and agreed on by both parties.

e) Al-Ijarah

This is the Shariah’s concept of leasing finance whereby the bank purchases the asset

47
required by the customer and then leases the asset to the customer for a given period, the

lease rental and other terms and conditions having been agreed on by both parties. Al-

Takjir: This is a variant of the concept of Al-Ijarah, which, however, provides for the

acquisition of the leased asset by the lessee.

f) Qard Hasan

This is a “benevolent loan” which obliges a borrower to repay the lender the principal

sum borrowed on maturity of the loan. However, the borrower has the discretion to

reward the lender for his/her loan by paying any sum over and above the amount of the

principal.

g) Al-Wakalah

This is an agreement between a customer and his/her bank in which the former appoints

the latter as his/her agent in undertaking a certain transaction on his/her behalf.

h) Al-Kafalah

This is an agreement between a customer and the bank whereby the later guarantees the

fulfillment of the obligation of the former to a third party.

i) Wadiah

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This is an agreement to deposit an asset, excluding immovable fixed assets, in the

custody of another party who is not the owner, or any such asset deposited with a non-

owner for custody.

2. How Islamic banking system is different from conventional one?

Islamic Bank system & conventional Bank system can be compared by identifying

similarities and differences between both of the banks.

a) Similarities

• Both are governed by the general rules of the regularity authority covering

establishment, control and general operations.

• Both operate within the context of professional efficiency cost effectiveness

and lost / benefit.

49
• Both are directed towards useful employment of resources for the society.

• Both are usually established as shareholding companies.

• Both types of banks give incentive to increase the level of savings in the

country.

• Provide training facilities to their employees.

• Motive of profit maximization is same for both banks.

• Both banks try to maximize the utility of their customers to attract and

increase their client.

• Both banks increase investment modes of financing.

• Both try to prevent the crisis & stabilize the economy.

• Both provide the security services like lockers for the ornament etc, to their

customers.

• Providing loan to customers is the main function of both banks, despite their

difference in operation.

50
 • Both promote business activities in a country.

b) Differences

• Islamic bank has a different moral basis i.e. jurisprudence (Shari’ah)

• Consequently, targets, objectives and mode of operations are different.

• Islamic bank is universal “comprehensive” bank where as in conventional

framework; there is commercial, investment, merchant or specialized bank.

• Structures of assets and liabilities i.e. sources and uses of funds are different

and consequently the earnings and expenses structures are different.

• In Islamic Banking, Bank play a role of a trader or an entrepreneur but in

conventional banking system, bank just play a role of issuing loans to

customers, Modern Banks issue loans and they are not very much interested in

what the borrower will do with that money. That’s why, there is always a risk

of not getting back the loan but it is not so in Islamic banking. As it provide

Finance on participatory basis or it directly links Finance to the economic

activity so in this case both the lender and borrower has to share risk equally.

51
 It also increased the scope of economic activity in economy.

• In conventional banking system interest rate is involved on the other hand in

Islamic banking system involved partnership, so the advances of Islamic

banks are contingent on profit & loss sharing basis. Interest based system

encourage instability in the economy because there is a chance of high

inflation etc, but on the other hand Islamic banking system encourages a

stability in the economy

• Islamic banking system increases the investment. In conventional banking

system, higher the level of interest the lower the level of investment and vice

versa. Thus financing the business on the basis of profit and loss sharing

instead of interest will increase level of productive investment.

• Today all costs for example those occurred due to time log in a deferred

payment, default risk and the inflation rate are covered under the interest rate

and margins added to it. Such costs are likely to appear in an Islamic Riba free

framework too, but the media through which there costs will be met is

different.

• At present, commercial banks are mostly financing to the large size or

medium to large size projects but in Islamic framework it is not so. The

management of Islamic banking system has to give incentive to increase small

52
 and medium size investment to generate revenue and profits so they give

incentives to small and medium size entrepreneurs and in turn the prospects

for mudarabah and Musharaka will increase.

• It is important to appreciate the high interest rates penalize entrepreneurs, as

the cost of borrowed funds goes up. The low interest rate on the other hand,

hurts the savers who place funds with interest based institutions, as the net

interest rate further go down and even may become negative due to inflation.

There is injustice in both situations in conventional financing system. The

Islamic system of financing may not eliminate or change the level of these

uncertainties in all cases and at all times, but would definitely redistribute the

consequences of these uncertainties over all the concerned parties in a just

manner.

• Because of the Shari’ah restrictions and the prohibition of usury the detailed

relationship to the Regulatory Authority is different.

• Target customers are partly different.

• In a conventional interest-based banking system the revenue of a bank arises

from market imperfection as well as fees and commissions while in an

Islamic-based banking system the revenue is generated by fees and

53
 commissions (administered prices).

• In Islam, there is a clear difference between lending and investing; lending

can be done only on the basis of zero interest and capital guarantee, and

investing only on the basis of Mudaraba (profit-and-loss-sharing).

Conventional banking does not, and need not, make this differentiation. But

an Islamic bank has to take this into consideration in devising a system to

cater to the Muslims. Therefore such a system has to provide for two sub-

systems, one to cater to those who would “lend” and another for those who

wish to invest.

3. What are the advantages of Islamic banking system, and what is its future?

This section examines Islamic banking from several sides, including efficiency, stability,

moral hazard, role in economic development, integrity, equity and sustainability. All

these are the characteristics of Islamic banks which help in proving that Islamic banking

system is less prone to business cycles which is the main advantage of Islamic banking

system, along with this these characteristics give many advantages to the economy of a

country and the bank itself.

a) Efficiency

As the modern banking system is interested based but, the economies which are

54
following this system, do admit that the reason of decline in banking industry in the past

few decades are, high rates of interest & increase in uncertainty. As Fredric s. Mishkin

has mentioned in his book (see literature review) .At the macroeconomic level, Islamic

banks avoids the use of interest-based lending. The rate of interest is replaced by the rate

of profit on equity and profit-sharing finance, by markups on credit-purchase finance and

by rental rates on leasing finance. While the time-value of money is maintained, there is

no need to handle the complicated questions of how to bring the rate of interest down to

zero in order to reach the optimal allocation of resources. While, Conventional banks

allocates financial resources with paramount regard for borrower's ability to repay loan

principal and interest. In modes of Islamic finance that are based on equity and profit

sharing, focus would be on the profitability and rate of return of the concerned

investment. This type of finance has the potential of directing financial resources to the

most productive investments. This would increase the efficiency of the financing process

and reinforce efficiency in the real sectors.

b) Stability

A conventional bank has on the one hand liabilities that include demand, time and saving

deposits, which the bank guarantees. On the other hand, it has assets that are mostly

composed of debt instruments each of which has a quality that depends on the ability of

the corresponding debtor to repay. Default on the asset side, if it happens in significant

proportion, would imply inability to meet the bank's obligations on the liability side. Such

55
default can be expected at times of crises, be it of macroeconomic nature or caused by

circumstances specific to the bank. A bank operating according to Islamic rules of

finance has liabilities of different nature. Only demand deposits are guaranteed.

Meanwhile, investment deposits are placed on profit-and-loss-sharing basis. When such

bank faces macroeconomic or specific crises, investment depositors automatically share

the risk. The bank is less likely to fall and a bank run is less probable. It can therefore be

said that an Islamic banking system is relatively more stable when compared to

conventional banking.

c) Morality hazard and selection

It is mentioned above that Islamic banks hold equity and trade in goods and services as

they operate as universal rather than commercial banks. Universal banks are defined as

"large-scale banks that operate extensive networks of branches, provide many different

services, hold several claims on firms (including equity and debt), and participate directly

in the corporate governance of the firms that rely on the banks as sources of funding or as

securities underwriters" (Calomiris, 2000).

d) Economic development

Given the characteristics of Islamic banks mentioned above, particularly the fact that

Islamic banks operate according to the rules of universal rather than commercial banking,

it can be conclude that the practice of universal banking by Islamic banks put their

56
financing activities right in the center of the development process. Bankers in this case

become both partners and financiers of entrepreneurial efforts to develop the economy.

e) Integrity

Risk is known to be one of the most important ingredients of making investment. Those

who finance investment share a good part of the risk involved with those who carry out

actual investment activities. Conventional banks leave risk to be borne by specialists.

Banks provide investors with loans guaranteed by collateral. In this fashion, they keep

themselves apart from certain kinds of risk, like those attached to production, marketing

and distribution, and limit their exposure to risk related to collateral only.

Islamic banks allow savers who deposit their funds to share with banks the risks

associated with choosing the right investment and how successful it would be. Banks

advancing funds share risk with those receiving finance, including producers, traders etc.

Islamic bank with proper corporate governance allows depositors some influence on

banks investment decisions and allows a share in the decision-making process. Thus the

risk as well as decision-making is spread over a much larger number and wider variety of

concerned people. Risk sharing is balanced by sharing in decision-making. This allows

for wider involvement in economic activities, so that people will eventually feel they are

partners rather than spectators. The benefit of wider involvement goes beyond the mere

57
feeling of involvement. It adds to the stability of banks. Holders of investment deposits

with banks share in both the profits and losses.

f) Equity

Islamic financial institutions and Islamic banks must be viewed as basically private

profit-seeking business enterprises that operate according to the market mechanism. By

themselves, they cannot reduce or eradicate poverty. However, if given the right tools,

they can contribute to the efforts taken by the whole society in that regard. Islam

prescribes a tax-subsidy approach to reducing poverty. A levy called Zakat is paid out by

the wealthy (those whose wealth exceeds a certain minimum level) in proportion to their

Property. Zakat collection would be expected to be carried out mostly by

nongovernmental and sometimes by governmental organizations. Islamic banks can help

by acting as custodians and in the disbursement of the proceeds. In addition, non-banking

financial institutions can also take part in collecting Zakah, using Islamic banks as

depositories, and invest the proceeds allocated to the poor in special accounts with

Islamic financial institutions, to which they would also add a proportion of Zakat due on

their shareholders equity.

58
Income maintenance is provided within narrow limits to those incapable of work and

wealth maintenance is provided to the rest of the poor. The latter policy entails giving the

poor productive assets, which they can use to produce goods and services and sell them

for profit. This method of poverty reduction can be closely intertwined with that of

economic development, as redistribution is mostly directed towards making the poor

more productive, which in turn contributes to economic development. Income

maintenance would involve regular (monthly) payments to the needy. Wealth

maintenance, meanwhile, involves transferring to the poor a combination of productive

resources, which would be capable of generating sufficient income to maintain at least

one household. As to income maintenance, Islamic banks can credit the accounts of the

prescribed poor with monthly payments. Wealth maintenance can be implemented

through the establishment of micro enterprises that would be owned and operated by the

poor. While, the titles to such enterprises are transferred to the poor, certain measures

must be taken to insure that the new businesses would not be immaturely liquidated to

finance consumption outlays for their owners. The experience of Islamic banking in

project financing should come in handy in eradicating poverty and increasing equity

through proper use of Zakah proceeds.

Conventional lending gives utmost attention to the ability to repay loans. To ascertain

such ability, it depends overwhelmingly on the provisions of collaterals and guarantees.

Thus those already rich would have most access to finance. In contrast, Islamic banks

provide funds on equity or profit-sharing basis would be more concerned about

59
profitability and rate of return and less concerned about collateral as the primary

consideration. Those who are not wealthy, but have worthy investment projects, would

have more access to finance. So this characteristic is another advantage of Islamic

banking and society itself.

g) Sustainability

Conventional debt has certain characteristics that could place debtors in difficulties if

circumstances do not allow them to repay in time. Interest is usually calculated on the

outstanding balance of debt, usually compounded annually and sometimes at shorter

intervals. Delinquent debtors are often subjected to penalty rates of interest, which are

higher than regular rates. It is not uncommon to find borrowers who end up paying debt

service that is many folds the original principal they borrowed. This is particularly

symptomatic of developing countries debt, as they continue to face debt problems that

sometimes reach crisis levels. Creditor countries and institutions have often sought to

find ways and mechanisms to provide debt relief to debtor countries. Despite continuous

efforts, the debt problems faced by developing countries seem to be ever-present. Thus it

can be concluded that interest based banking and finance lacks a great deal of

sustainability. Creditors have to stop every few years to give debtors relief in terms of

rescheduling and forgiveness.

Unconventional debt created through Islamic banks has characteristics with which debt

crises are less likely to rise. Particularly, the total value of debt, the total value of debt can

60
be repaid in installments, without increase in its total value, as there is no compounded

interest to pay on outstanding balance. When debtors face unavoidable circumstances that

would make them temporarily insolvent, they are often granted grace periods to help

them bring their finances back to order. No penalty fees can be levied in this case. In

other words, debt rescheduling, when justifiable, would be granted at no extra cost to

borrowers. Therefore, it can be concluded that Islamic banking and finance is sustainable

and less liable in itself to cause undue hardship to debtors.

4. Why Islamic banking is more viable than conventional banking system?

From the characteristics and the advantages of Islamic banking given in the previous

section, it can be easily concluded that Islamic banking is more viable than conventional

banking system. The main reasons for its viability are:

a. Islamic banks have some definite edge over conventional banks because

their capital is secure. While, the capital of the conventional banks is at

risk, due to high leverage with their liabilities. The investments and

deposits in an Islamic bank are not the liability of the bank and can, at

best, be termed as a contingent liability as these funds are in trust with the

bank. The liability of the Islamic bank arises only when gross negligence

is proved in carrying out the trust functions as distinct from business

61
 losses. Islamic banks are, therefore, highly leveraged institutions, unless of

course their current account balances are several times their paid up

capital and reserves.

b. Secondly, the main selling point of Islamic banking, at least in theory, is

that, unlike conventional banking, it is concerned about the viability of the

project and the profitability of the operation but not the size of the

collateral. Good projects which might be turned down by conventional

banks for lack of collateral would be financed by Islamic banks on a

profit-sharing basis. It is especially in this sense that Islamic banks can

play a catalytic role in stimulating economic development. In many

developing countries, of course, development banks are supposed to

perform this function. Islamic banks are expected to be more enterprising

than their conventional counterparts. In practice, however, Islamic banks

have been concentrating on short-term trade finance which is the least

risky.

c. Thirdly, it is less cyclical as compared to conventional banking system

because of interest free trend as high interest is considered the basic cause

of business cycles in any economy.

d. As Islamic banks do not have to pay fixed amount to borrowers, they need

not to keep additional liquidity with them. Thus they can lend more as

62
compared to conventional banks because they do not have to keep excess

money with them.

63
 CHAPTER NO.05

5-SUMMARY, CONCLUSION AND RECOMMENDATIONS

This section consists of the conclusion and recommendations of the addressed problem.

64
5.1 Conclusion

Findings and conclusion are in fact the summary of chapter 4.

Theoretically speaking, there is no concept of loans and credits in Islam for financing

trade, industry and agriculture except Qard Hasan and where profit and loss sharing is not

feasible like interest-free loans by the federal government to provincial governments for

their developmental needs. Islamic banks, therefore, involve themselves in financing

(short, medium and long term) for the working capital requirements, and also contribute

to the capital of an enterprise by participating in its equity. These financings are on profit

and loss sharing basis. Islamic banks also mobilize resources on profit and loss sharing

basis as distinct from interest payments to depositors on predetermined rates.

Islamic banking is a part of over-all value system of Islam. It is, therefore, imperative

that simultaneously genuine efforts are made to ensure that the people are imbued with

honesty of purpose and their actions conform to Islamic values. The basic values that

Islam seeks to establish are: (a) Freedom (b) Brotherhood (c) Equality (d) Justice (e)

Trust i.e. treating the God – given capabilities and resources as trust. (f) Honest

Consciousness i.e. sense of responsibility and care for one’s obligations.

In a system based on profit and loss sharing, it is to the advantage of banks and financial

institutions to invest in those projects where higher rates of profits are anticipated. The

financing by Islamic banks under this system is done within the framework and keeping

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in view the social considerations, the requirements of priority sector and the safety of

funds. The Islamic banking system, therefore, induces savings and capital formation and

lead to optimum allocation of resources.

Islamic banks operating on profit and loss sharing basis are definitely in a stronger

position to absorb the shocks to their assets position (bank’s financing), as the losses are

simultaneously absorbed by the changes in the value of deposits placed with the banks.

The nominal value of deposits of Islamic banks is not guaranteed like investment in

shares of a bank or for that matter of a joint stock company. The real value of “Assets and

Liabilities” (Uses of Funds and Sources of Funds) of Islamic banks is, therefore, equal at

any point of time. It is, however, to be ensured through prudent and professional banking

practices, procedures and systems that the losses in the financing portfolio are as low as

possible and that highest possible returns are paid to the depositors and investors.

It emerges from all this that Islamic banking has following distinguishing features: (a)

Islamic banks deal with money and do not deal in money, (b) it is interest-free, (c)

Lending and investing are treated differently; loans are interest-free but carry a service

charge, while investing is on a profit-and-loss-sharing (Mudaraba) basis, (d) it is multi-

purpose and not purely commercial, (e) it is strongly equity-oriented, and (f) Value

erosion of capital due to inflation is compensated.

Theoretically and empirically, it is not difficult for specialists in economics and finance

to find Islamic banking in not only viable and acceptable, but also efficient and

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significantly effective. It is not therefore surprising to see large multinational banks and

institutions are providing Islamic financial services to their customers in significant

amounts. As an innovation, Islamic banking has been practiced for more than a quarter of

a century.

Theories reviewed in chapter 2 show that interest is the basic cause of business cycles

and financial instability, these theories also prove the bad effects of the interest on

resources, production, distribution, and on the economy as whole. On the other hand

theories presented by Fisher, Minsky…etc show the bad effects of debt, Similarly the

research and work of many researchers and scholars like Lloyd Metzler, Mohsin Khan,

Nejatullah Siddiqi…etc have also proved that Islamic banking system is more stable than

conventional banking systems. The problem statement of this research was “why some of

conventional banks moving towards Islamic banking system”, findings of all these

theories and answers of all research questions discussed previously clearly show that

Islamic banking system is more stable, secure, sustainable, less cyclical in nature and

better for economy, that’s why Islamic banking system is becoming more popular and

many of conventional banks are moving towards Islamic banking system.

Islamic banks share with their conventional counterparts similar specialization and

business interests. Differences that exist between their modes of operations afford them

excellent opportunities to cooperate and collaborate. Areas like joint financing and

financial market operations can be the stage of daily collaboration. As conventional

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banks have been first in the field, they can be a valuable source for professional

techniques and standards. In other words, Islamic banks have a lot to learn from

conventional banks in this regard. Islamic banks, being aware of their innovative

methods, have toiled to develop the new modes of finance. That included a lot of work to

formulate new contractual arrangements on both their asset and liability sides. In

addition, they have been able to acquire a niche that conventional banks do not have. The

latter can participate and make use of such new and innovative techniques that would

help them better serve their customers.

Although, Islamic banking system is more viable than conventional banking system it has

some challenges also, like: The well-known fiscal prejudice against profit and in favor of

interest is just an example, where interest payments are partially or fully tax exempt, and

profit gets no such advantage. Similarly New instruments are needed, a uniform

regulatory environment and legal framework have yet to be developed. The total

implementation and success of Islamic banking in a country needs re-shaping the society,

re-structuring of the economic system and re-framing of the laws according to the

dictates of Islam. Islamic banks also face a challenge of developing innovative services

and products for mobilizing deposits and utilizing them effectively and efficiently for

financing under profit and loss sharing system. Islamic banks like all other modern

conventional banks under interest-based system have to remain competitive and tailor

their services and products according to the needs and requirements of their clients,

ensuring that the products designed by them remain within the framework of Shariah.

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International operations would have to be continued on interest basis till such time, that a

suitable and mutually acceptable alternate is found. This will, however, depend upon the

success of Islamic banking on the domestic fronts in a large majority of Muslim countries

of the world. While taking steps to enforce Islamic banking, it will have to be seen that

interest is eliminated in such a way that it does not abruptly disturb the basic structure of

the economy. It has also to be ensured that initially the confidence of the people is

developed and strengthened in the new system. This approach would also provide an

opportunity to refine the newly formed laws to support the Islamic system of banking in

the light of experiences gained during the process. The development of an interbank

market is another challenge. With the establishment of the Islamic Fiqh Academy (IFA)

in Jeddah and wide spread growth of specialized training centers dedicated to train people

in Islamic Finance and banking practices, and a series of International conferences, the

challenges are being addressed with vigor. With the forced opening up of the economy

and gradual removal of barriers, Governments and regulatory bodies, too, are co-

operating in making Islamic banking a part of mainstream banking. In the years to come,

as Islamic banking breaks new ground and expands into new areas, there is sure to be an

increased effort in broadening its principles and scope.

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5.2 Recommendations

It, however, appears that although tremendous efforts for Islamization of banking system

and for streamlining and enhancing the scope of the activities of Islamic banks are beg

made in many Muslim countries, but effective steps for reformation of the societies in the

respective countries are not being taken up with the same zeal and enthusiasm. This is an

essential prerequisite for the success of Islamic banking and deserves serious

considerations by all those who are involved in the process of Islamic banking.

The following are the suggestions for future growth and success of Islamic banks. Which

be successful and produce full dividends, if the society in which it operates, is geared on

Islamic principles. It is, therefore, of utmost importance that sincere and effective efforts

are simultaneously made to transform the existing societies, in the Muslim countries, into

truly Islamic societies.

1. A basic tenet of commercial banking is capital guarantee. The capital entrusted to

the bank by a depositor must be returned to him in full. Conventional banking

system fully complies with this requirement. While Islamic banking as practised

today does not provide capital guarantee in all its deposit accounts. In many

countries, this is one of the two main objections to permitting the establishment of

Islamic banks. There is no objection to paying zero interest on deposits. Thus, by

paying zero interest and guaranteeing capital, the proposed system satisfies both

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 the Riba-prohibition rule of Islam and the capital guarantee requirement of

conventional Banking Acts. This enables it to obtain permission to set up and

operate as a deposit bank in all countries of the world, while obeying the Riba-

prohibition rule and qualifying to be an “Islamic” bank.

2. All relevant laws in Muslim countries who have established or are in the process

of establishing Islamic banks should be reviewed so as to bring them in

conformity with the Shariah. Necessary laws also need to be framed for providing

legal cover to the transactions, services and products developed under the Islamic

banking system.

3. The research and training centers for Islamic banking established in various

Muslim countries should pass on their findings to their Muslim countries to assist

them in establishing new Islamic banks and enhancing their existing capabilities.

4. Muslim scholars, bankers and economists should explain, to their counterparts in

Western / American countries as also to various international financial and

monetary agencies like The World Bank and International Monetary Fund, the

salient features of Islamic banking. It should also be a good idea to invite their

suggestions for achieving the objective of socio-economic justice, in the context

of Islamic baking.

5. There is an urgent need for more extensive cooperation among Islamic banks

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 throughout the world. There should, therefore, be more organized and systematic

meetings, seminars, conferences and workshops to exchange experiences and

expertise and to foster closer cooperation in all spheres of operations.

6. Muslim countries, who have established Islamic banks, should transact the

imports and exports business between them on Islamic principles. This would lead

to handling more and more international transactions under interest-free system

and would provide a model for other conventional banks to deal with Islamic

banks on interest-free basis. This will also help in developing the much needed

International Islamic Financial Markets.

7. The central banks of Muslim countries should prepare themselves more

vigorously for fulfilling their new and enhanced responsibilities under Islamic

banking system. In addition to their normal functions of supervising the

operations of banks and the quality of their financing portfolio, central banks

should also regulate the ratios of profit sharing, by prescribing a range within

which, the banks would be free to deal with their clients under the Islamic system.

8. Islamic Development Bank has to adopt a very innovative approach to gear

themselves for assuming a global role on the footprints of The World Bank. It has

accordingly to establish a number of affiliates and subsidiaries for carrying out the

multi dimensional functions and responsibilities, under the Islamic banking

system.

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9. A Monitoring commission for Islamic banks should be constituted by all Muslim

countries. Prominent Muslim scholars of all school of thought, economists, jurists

and bankers should be the members of this commission. The commission should

have a number of committees to deal with various issues of Islamic banking and

should be entrusted with responsibilities mainly the following:

a) Developing by Ijma (a secondary source of Islamic jurisprudence

through the process of consensus of opinion) a uniform banking code

with in the prescribed regulatory framework of Shariah. This banking

code would provide legal certainty had would also develop uniform

banking practices to be adopted by Islamic banks.

b) Ensuring that all the existing modes of financing are appropriately

amended, wherever necessary, so that they are bought within the

purview of Shariah.

c) Developing of uniform accounting systems and standards for

providing consistency in accounting treatment of various operations

and products of Islamic banks.

d) Designing new and innovation services and products for financing on

profit and loss sharing basis.

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 e) Standardization of the systems, procedures, charge forms and other

documents for handling various banking transactions under Islamic

banking system.

f) Providing solution to any problem or guidance on any matter referred

to it, by any bank.

10. Finally, conclusion is that, being a Muslim we should discontinued the interest

based Financial and banking system. So that we may be saved from the

punishment of “Riba" described in Quran and Hadith. E.g.

The Prophet peace be upon him said as follows “on the night of ascendance to

The Heavens, I passed by a group of people who had tummies as big as houses,

filled with snakes that could be seen from outside. I asked The Arch-Angel Jibrael

as to who they were. He said that they were the people who ate “Riba.” And the

earlier it is realized better it would be for all.

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 REFERENCES

• Bank patronage factors of Muslim and non-Muslim customers,

international journal of bank marketing, vol 12.pp 12-40.

• Accounting needs of Islamic Banking, Abdul Wassay History of Islamic

Banking, Haqiqi & Prof. Felix Pomeranz.

• Principle of Islamic Banking, 10th issue of Nida'ul Islam Magazine,

November-December 1995, source: msa-usc.

• What is Islamic Banking (http://www.islamic-

banking.com/ibanking/whatib.php).

• Mishkin, S. Fredevic (1995) the Economic of Money, Banking and

Financial Markets.

• Siddiqui, H. Asrar (1975) Practice and Law of Banking in Pakistan.

• Khan, Abdul Wadood. (1999) Interest Free Banking. Lahore.

• Khawaja, Abdul Haleem (1994) Economic Theory Lahore: Naveed

Publications.

• www.alrajhibank.com.sa/islamicebanks.html

• Commercial banking in the presence of inflation by Abdul Gafoor.

• Mudaraba-based investment and finance, Abdul Gafoor.

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• http://www.islamicconferences.com

• http://www.islamicbanking-finance.com

• http://www.islamic-banking.com

• Islamic banking, Abdul Gafoor.

• http://www.islamic-finance.net

• http://www.albaraka.com/islamicinfo/islamicbooks/instruments/table.html

• http://www.worldbank.org/fandd/english/0697/articles/0140697.htm

• Islamic-economics.com

• Riba-free-economy.com

• Interest-free commercial banking, Abdul Gafoor.

• Islamic-economy.com

• Riba-free-banking.com

• www.islamicbankingnetwork.com

• www.my-muslim.com/dir/business_and_economy

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