Overview to Islamic Finance and Banking

Overview to Islamic Finance and Banking By Dr Asmadi Mohamed Naim

Objectives • To discuss about Islam as the Way of Life. • To explain about underlying philosophy of Islamic Banking and Finance • To familiarize the students with the principles of Syariah in Islamic Finance and Banking. • To enumerate the latest development of Islamic Banking & Finance in Msia

Understanding Islam as the Way of Life. • This day have I perfected your religion for you, completed My favour upon you and have chosen for you Islam as your religion (al-din/ way of life) (al-Baqarah:208) • Enter into Islam wholly. (al-Maidah: 5) • The emergence of Islamic financial system was driven by the revival of Islam and the increasing number of Muslims who want to lead their lives in accordance with the shari’ah, including in the area of banking and finance.

The Economic & Philosophical Principles of Islam for Banking • Two key elements to the economic philosophy of Islam • Allah SWT is the creator of everything on earth and in the heavens. Human beings are only trustees who should utilise these resources in an efficient way to fulfill Allah’s will for establishing prosperity on earth for the good of all mankind. • A Muslim entrepreneur is considered only a ‘vice-regent’ on earth. Man’s right to ownership is obtained by proxy from Allah, and as Allah made man ‘his ‘vice-regent’, man must function according to his teachings and in the end be accountable to Allah for all deeds, be they good or bad.

Islam, Shari’ah and Islamic Banking, • Shari’ah literally means ‘way to water’ – the source of all life – and signifies the way to God, as given by God. • Shari’ah is the code of law derived from the Koran and from the teachings and example of Prophet Mohammed (Pbuh) i.e. sunnah. • Shari’ah has its correlation with the words ‘din’ and ‘millah’. Shari’ah covers the total way of life that includes faith and practices, personal behaviours, as well as legal and social transactions. • The name of this Shari’ah is Islam. • Shari’ah can be divided to three main branches (i.e aqidah, fiqh and akhlaq). • Aqidah means a strong belief in a person’s heart in Allah s.w.t. and His last prophet, Muhammad peace be upon him (p.b.u.h). • Fiqh concerns all aspects of all forms of practical actions by a Muslim. • Akhlaq covers all aspects of Muslim behaviour, attitude and work ethics with which he performs his practical actions. It consists of ‘man to man’ and ‘man to Allah s.w.t.’ relationships.

The Islamic jurisprudence is called fiqh. • Islamic jurisprudence, Fiqh (فقه) in Arabic, is a science of practicles rules which derived from specific evidence from al-Quran and al-sunnah. • There are four Sunni schools or mazhab of fiqh. • Fiqh is divided into two parts: the study of the sources and methodology (usul al-fiqh - roots of the law) and the practical rules (furu' al-fiqh - branches of the law). • Later on, the word Shari’ah or Shari’ah law is used generally to describe the Islamic jurisprudence or fiqh. • Fiqh (i.e.Islamic jurisprudence or Shari’ah law) comprise two types of relationships. • Ibadat i.e relationship with god. Ibadat is concerned with the practicalities of a Muslim’s worship of Allah. • Muamalat i.e. relationship with human being. Muamalat is concerned with the man to man relationship.

Five categories of Ahkam in Shari’ah Law. • Wajib (Obligatory): The terms wajib conveys an imperative and binding demand addressed to the mukallaf in respect of doing something. Action upon something wajib leads to reward, while omitting it leads to punishment in this world and in the hereafter. • Sunnah/ masnun/ mandub/ mustahab(recommended): Mandub denotes a demand to perform deeds which is, however, not binding on a mukallaf. To comply with the demand earns the mukallaf spiritual reward, but no punishment is inflicted for failure to perform. • Mubah/ jaiz (permissible): Mubah is where the Lawgiver has granted a choice of omission or commission, without blame or praise for either. • Haram (prohibited): Haram is the omission required in binding and certain terms. Committing a haram deed is punishable, and omitting it is rewarded. For example, riba’ is prohibited to every Muslim. • Makruh (reprehensible): Makruh is a demand which requires the mukallaf to avoid something, but not in strictly prohibited terms. Committing in makruh deeds is not punishable, although omitting it is rewarded.

ISLAMIC BANKING, ISLAM AND SHARI’AH ISLAM AKIDAH/ belief SHARIAH/ Practical rules AKHLAK/ behaviour IBADAH MUAMALAT Political activities Economic activities Social activities Banking and financial activities The relationship between Islamic financial system with Islam and Syariah

The Objectives of Islamic finance & banking • To put before to all Muslims, contemporary Islamic financial dealings in strict respect of the ethical individual and social values of Islamic Shari’ah, without contravening the heavenly imposed prohibition of dealing in riba (interest or usury). • To serve all Muslim communities in mobilising and utilising the financial resources needed for their true economic development and prosperity within the principles of Islamic justice assuring the right and obligations of both the individual and the community. • The serve the ‘ummat al-Islam’ (Islamic communities) and other nations by strengthening the fraternal bonds through mutually beneficial financial relationships for economic development and the enhanced environment for peace.

Principles of Shari’ah in Islamic Finance & banking • Muslim jurists suggested a numbers of shari’ah principles which can be classified into four categories: • Profit and loss sharing principles a. mudarabah b. musyarakah • Fees or charges based principles a. Murabahah b. Bay al-Muajjal/ bay bithaman ajil c. Ijarah/ al-ujr/ Ijarah wa iqtina’ d. al-Wakalah . iii. Free service principle (Qard hasan) • Ancillary principles a. Wadiah b. Rahn c. al-salam

Contracts in Islamic Law

Musyarakah/ Sharikah • Musyarakah or sharikah or shirkah can be defined as a form of partnership where two or more persons combine either their capital or labour together, to share the profits, enjoying similar rights and liabilities. • There is a consensus of opinion among the jurists of all schools of thought (including Hanafiyyah, Malikiyyah, Shafi’iyyah and Hanbaliyah) that musyarakah is a valid and legitimate contract in Islam.

Types of Musyarakah • Originally musyarakah (partnership) was of two types, namely: • Shirkah al-milk (non-contractual partnership) Shirkah al-milk implies co-ownership and comes into existence when two or more persons happen to get joint-ownership of some asset without having entered into formal partnership agreement. (example: two persons receiving an inheritance or a gift of land or property which may or may not be divisible). • Shirkah al-Uqud (contractual partnership) Shirkah al-Uqud can be considered a proper partnership because parties concerned have willingly entered into a contractual agreement for joint investment and the sharing of profits and risks.

Shirkah al-Uqud • Shirkah has been divided into four kinds: • Al-Inan (restricted authority and obligation). Inan implies that all partners need not have an equal share in capital. They are not equally responsible for the management of the business. Accordingly their share in profits may be unequal, but this must be clearly specified in the partnership contract . Their share in losses would be in accordance with the capital contribution.

ii. Al-Mufawadah (full authority and obligation). In the case of Mufawadah the partners are adults, equal in their capital contribution, their ability to undertake responsibility and their share of profits and losses. They have full authority to act on behalf of the others and are jointly and severally responsible for the liabilities of their partnership business, provided that such liabilities have been incurred in the ordinary course of business. iii. Al-Abdan (labour, skill and management) is where the partners contribute their skills and efforts to the management of the business without contributing to their capital. iv. Al-Wujuh (goodwill, credit-worthiness and contracts). In shirkah al-wujuh the partners use their goodwill, their credit-worthiness and their contracts for promoting their business without contributing to the capital.

Types of Musyarakah in Islamic Law

Mudarabah • Al-Mudarabah is a type of contract that prevailed between the Arabs in the pre-Islamic era of paganism (jahiliyyah) and later Islam endorsed it as a mean of investment and profit-loss sharing. • Three Arabic terms are used to designate this kind of business organization: I. qirad (قراض ), ii. Muqaradah (مقارضة), and iii. mudarabah (مضاربة)

Definition of Mudarabah • Al-Mudarabah implies that one person hands over money to another for the purpose of investment. • The first party is called the investor or money owner (rab al-mal/ sahib al-mal) while the second party is called the mudarib. • Therefore, the mudarib is a trustee or agent. The money lender or money owner (rab al-mal) is normally a sleeping partner. • The nets profits realised are divided between the two parties according to certain ratios agreed upon in advance. • Any loss on capital is borne by the owner of the money and the mudarib’s only loss his efforts and the expected profits.

Types of Mudarabah • The shari’ah distinguishes between two types of mudarabah: • a limited mandate (mudarabah muqayyadah): In this type of contract, the agent’s freedom of action is somewhat restricted. ii. An unlimited mandate(mudarabah mutlaqah): A Mudarabah contract with unlimited mandate is one in which the investor authorizes the agent to act completely at the latter’s discretion in all business matters.

Ijarah • An al-Ijarah contract is where the financier buys and leases equipment or other assets to the business owner for a fee or more often called rental income, or where the agent serves the customer for a fees or commissions (al-ujr). • The duration of the lease, or the type of work, as well as the fee must be set in advance and mutually agreed in both rental income (al-ijarah) and al-ujr. • The basic security under the ijarah arrangement is the “ownership of the equipment”. • The title of ownership to the equipment remains with the leasing company and in case of serious default the equipment is repossessed.

Ijarah…cont.. • To be acceptable as an Islamic financial product, the leasing contract (al-ijarah) must meet the following conditions: i. The service that the asset is supposed to provide and for which it is being rented should be definitely and clearly known to both parties; ii. The asset remains in the ownership of the lessor who is responsible for its maintenance so that it continues to give the service for which it was rented; iii. The leasing contract is terminated as soon as the asset ceases to give the service for which it was rented. If the asset becomes damaged during the period of the contract, the contract will remain valid; and iii. The price of an asset that may be sold to the lessee at the expiry of the contract cannot be pre-determined. It can be determined only at the time of the expiry of the contract.

Ijarah wa iqtina’ (iktina)/ijarah thumma al-bay’ • Ijarah wa iqtina’ / Ijarah thumma al-bay’ or ‘lease purchase financing’ refers to a contract where the bank purchases an asset for the purpose of renting the same to the customer against an agreed rental, together with the client’s agreement to make payments which will eventually lead to the transfer of ownership from bank to customer.

Al-Ujr • Al-Ujr is payment for services rendered. The difference between the al-ijarah and al-ujr • The services- In equipment leasing, the benefits of equipment is to be sold, but in al-Ujr, the human services are to be sold. • The existence of contracted assets- In equipment leasing, equipment is existed, but the work is not existed in al-Ujr. • The duration of al-ijarah- The lessor and lessee must mention the specific period for their ijarah contract, and the type of work must be stated between employer and employee in al-Ujr contract.

Murabahah • Murabahah is generally defined as the sale of commodity for the price at which the vendor has purchased it, with the addition of a stated profit known to both the vendor and the purchaser. • It is a cost-plus-profit contract. • The legality of murabahah is not questioned by any of the schools of law. There are of course differences in the details. • Islamic financial institutions aim to make use of murabahah in circumstances where they will purchase raw materials, goods or equipment etc. and sell them to a client at cost, plus a negotiated profit margin to be paid normally by installment.

Bay’ al-Muajjal (muazzal)Deferred Payment sale. • This transaction allows the sale of a product on the basis of deferred payment in installments or in lump-sum payment. • The price of the product is agreed to between the buyer and the seller at the time of the sale and cannot include any charges for deferring payments.

Bay’ al-Inah • In the bay al-‘inah, the customer purchases an asset from the bank at a credit price (mark-up price) and sells it back in lower price to the same party at a cash price. • This buy-back agreement will ensure that the customer will receive the money in cash while bank will be paid a prefixed or contracted amount in a future date. • Debt payment will be maid by installment or in lump-sum payment. • The difference between cash and mark-up price will represent the profit due to the bank (financier).

BAY’ AL-INAHcont Customer purchases asset valued RM 50000 from bank at a credit price Customer Bank The customer sells it back to the bank at RM40 000 in cash price

Bay’ al-Dayn • It means debt-trading. • The sale of debt- where the debt must arise out of a contract of exchange or uqud al-mu’awadat al-maliyyah such as asset sale (base on bay’ bithaman Ajil) or trade financing (based on Murabahah). • The sale of debt (i.e. commercial certificates, notes or bonds) to another party. Only documents evidencing real debts arising bona fide commercial transactions can be traded.

Bay al-Salam( Purchase with Deferred Delivery) • In this transaction the buyer pays the seller the full negotiated price of a specific product which the seller promises to deliver at a specified future date. • This transaction is limited to products whose quality and quantity can be fully specified at the time the contract is made. • This type of contract is also suitable for future and forward contracts.

Bay’ Al-Istijrar (supply contract) • An agreement between the client and the supplier, where the supplier agrees to a supply a particular product on an on going basis, for example monthly, at an agreed price and on the basis of an agreed mode of payment. • It is a type of Bay’ al-Salam’/ al-istisna’.

Bay’ al-Istisna’ • A contract of acquisition of goods by specific or order. Where the price is paid progressively in accordance with the progress of job completion.

Sarf • It refers to exchange of two types of money between buyer and seller. Eg: Exchange of gold with gold, or silver with silver, or gold with silver. • It also refers to today currency exchange, i.e. buying and selling of currencies. • This type of contract has to be completed in the place/time of contract. • Postponement of surrendering of any contracted item (i.e. currencies) is consider interest (i.e. riba al-yad).

Al-Wadiah • Wadiahis the deposit of goods or funds with another person, who is not the owner, for safekeeping. • As wadiah is a trust, the depository becomes the guarantor, who guarantees the return of the whole amount of the deposits, or any part thereof, outstanding in the account of depositors, when demanded. • The depository is not entitled to use the funds without permission from depositors.

Benevolent Loans (Qard Hassan) • Qard hassan means an interest-free loan, which is the only loan permitted by shari’ah principles. • Funds are advanced without any profit or charge for humanitarian and welfare purposes. • Repayments are made over a period agreed by both parties. • A levy of a modest service charge on such a loan is permissible provided it is based on the actual cost of administering the loan.

Al-Wakalah (Agency) • A situation where a person (authorizer) nominates or appoints another person to act on his behalf to purchase something. • The authorizer (Muwakkil) have to place a deposit to the full amount of the price of goods to be purchased / imported which the agent (wakil) or entrusted person accepts under the contract of Wadiah. • The agent (wakil) pays to the third party utilising the customer’s deposits to buy the goods. • The ‘Wakil’ (agent) is free whether to take al-ujr (commission) or not, but al-ujr must be mentioned and the amount must be stated earlier.

Al-Kafalah(Guarantee) • A guarantee provided by a person to the owner of goods, who had placed or deposited his goods with a third party. • The guarantor and the third party must meet any subsequent claim by the owner for his goods.

Al-Hiwalah(Remittance) • It means debt transfer. • It refers to a transfer of funds (debt) from the depositor's (debtor's) account to the receiver's (creditor's) account where a commission may be charged for such a service. It is applicable to remittances.

Al-Rahn(Collateralised Borrowing) • It means collateralised borrowing. It refers to an arrangement whereby a valuable asset is placed as a collateral for a debt. • The collateral may be disposed in the event of default. • It is being applied for Islamic Pawning, currently offered by Bank Islam Malaysia Bhd and Bank Kerjasama Rakyat Malaysia Bhd

Two categories of the Islamic banking contracts

The latest development of Islamic Banking & Finance in Msia • The Attempts to establish an interest-free bank • The first attempt came in Malaysia mid-1940s. A plan to invest prospective pilgrim savings in real estate and plantations in accordance with Syariah was, however, unsuccessful. • The first experimental local Islamic bank was established in the late 1950s in a rural area of Pakistan that charged no interest on its lending. • The establishment of Mit Ghamr Local Savings Bank marked a new milestone in the revolution of the modern Islamic banking system. The bank was considered to be the most innovative and successful experiment with interest-free banking.

List of Islamic Banks

Development of Islamic Finance and Banking system in Malaysia

Cont…

Cont..

Conclusion • The development of philosophies and objectives in Islamic banking are in line with the principles of Islamic business as highlighted in the al-Quran and Sunnah. • As institutions whose foundations are based on Islamic doctrines, Islamic banks must conforms to Islamic rules and regulations. • Islamic business entities are required to engage themselves in legitimate and lawful business, and to fulfill all obligations and responsibilities. • Islamic bank have to uphold both profit and moral principles.

Main References • Saad Abdul Sattar Al-Harran (1993) Islamic Finance-Partnership Financing. Pelanduk Publications. Kuala Lumpur. • Sami Hassan Homoud (1985). Islamic Banking. Arabian Information. London. • Sudin Haron and Bala Shanmugam (2001). Islamic Banking System- Concepts & Aplication. Pelanduk Publications. Kuala Lumpur. • Islamic Finance Bulletin. March 2004. Rating Agency Malaysia Berhad. Kuala Lumpur.

Overview to Islamic Finance and Banking