RIGA TECHNICAL UNIVERSITY

THE MANAGEMENT OF FINACIAL OPERATIONS

IN ISLAMIC BANKING
Sardorbek Mirzaev

Riga
5/27/2014

Abstract
The globalization of finance has allowed Islamic finance to thrive and there has been in
recent years a fusion of sorts between Islamic and conventional banking. My task includes to
provide the apprehensible and intelligible description for Islamic financial terms, specifications
and peculiarities of financial transactions; to explain the non-interest system in Islamic banks
and the substitutions and alternatives of them. At last but not least, to analyze the interactions of
Islamic and conventional banks in modern society, pertaining to corporate finance; to
distinguish the advantages and cons in financial operations; elicit the competitive prevailing
advantages of techniques and methods of allocation of assets and liquids both in Islamic and
conventional banking system. Primarily, to proper analysis of the issue in details I have divided
my paper into two main parts: Analytical (Theoretical) Part and Practical Part. In analytical
part I have covered main theories and definitions related to Islamic banking and Islamic
financial operations, transactions. Also it covers existing methods and techniques of Islamic
financial operating system and gives information about results and success of the management of
financial operations in Islamic banking system in early stages, before and after the world crisis,
interaction between Islamic banks and conventional ones, their current status quo in
contemporary economic and financial world, respectively. The second main part is about Islamic
banks and financial institutions operating throughout the world, their annual financial reports
and statistical data. To investigate their efficacious performance and amelioration of their
reputation in the financial market Ive researched apposite data from a few Islamic financial
institutions. In addition to it, Ive exampled a typical leasing situation in both Islamic and
conventional banks. Prioritizing the benefit from client-costumer side, I have proved the possible
outcomes depending on clients decision on which of the financial institutions are suitably meets
his expectations. The examples create pictures of the ordinary banks credit-borrowing
transparent procedures and distinct conditions in Islamic banking and conventional financial
institutions, respectively.This paper includes 7 formulas, 16 figures and 7 tables. The total
volume of it is 65 pages.
1


CONTENT
INTRODUCTION...2
1. ANALITICAL PART.4
1.1. Uzbekistan banking overview.4
1.2. The Principles and Characteristics of an Islamic Economy......10
1.2.1. Principles of Islamic Economy.....10
1.2.2. The Elements and Superstructure of Islamic Financial System...12
1.2.3. The Role of Islamic Banking and Finance: a Global View and Trend16
1.3. The Role Non-interest Philosophy of Islamic Finance.....19
1.4. Islam, Economics and Finance..20
1.4.1. Historical and Religious Background..20
1.4.2. Islamic Economics...22
1.4.3. Reconciling Islam and Finance....23
1.5. The Ethical Framework of Islam ..24
1.5.1. Riba and Gharar.24
1.5.2. The Moral Economy of Islam25
1.6. Financial Products and Instruments in Islamic Banking and Their
Conformity with Conventional Banks27
1.6.1. Murabaha27
1.6.2. Leasing ...30
1.6.3. Profit and loss Sharing..............................31
1.6.4. Sukuk Islamic Bonds...33
1.6.5. Islamic Mutual Funds.36
1.6.6. Mircro-lending or Mirco-finance37
1.7. The management and Control, the Islamic Moral Hazard.37
2. PRACTICAL PART.40
2.1. Uzbekistani Leasing Market..40
2.2. Leasing Procedures in Conventional Banks44
2.3. The Leasing in Islamic Banks49
2.4. The Comparison of the Systems: Leasing and Ijarah in Conventional and
Islamic Banks Respectively52
CONCLUSION.55
BIBLIOGRAGHY....57

2

INTRODUCTION
Nowadays, due to the various types of financial crises and mistrust to modern banking
system it is quite popular and well-known such terms as Islamic economy, Islamic banking
system. But, what is it? What it has been built on? What does it underlie? Certainly, it would be
impossible to explicate in a brief description, since Islamic economy is the whole science based
on Islamic jurisprudence. Therefore, I try to reveal this curtain of fundamentally different
system, touching with expository theory such aspects as: principles of Islamic economic theory,
its ethical principles, prohibited trade deals and reasons for these forbiddances and et al. Islamic
banking services.
Islamic finance and banking system have been growing rapidly in recent years. Motivated
by a heightened interest in financial instruments that emphasize risk sharing, it has been
attracting greater attention in the wake of the recent financial crisis. Today, as a consequence of
broad changes in the political-economic environment, a new generation of Islamic financial
institutions, more diverse and innovative, is emerging as the doctrine is undergoing a new
aggiornamento-update. Perhaps the most important development has been the growing
integration of Islamic finance into global economy.
The Islamic banking industry is based on the prohibition of interests, and it promotes just
distribution of wealth whereby all levels of the society would benefit. The Western World, in
particular the Europe has been using and developing the conventional banking system which has
brought a lot of economic instability for many people living there. The conventional banking
system which basically operates on the basis of interest has created social problems because it is
simply not sustainable. Many have written about the conventional banking system which
produced capitalistic society and the financial crisis. Therefore, the existing conventional
banking system is definitely not suitable and the sound of alternative should be sought. Islamic
banking system could be that alternative everywhere in the world because it is an ethical
financing which promotes welfare for everyone [21].
In my thesis Ive tried to reach the objective of presenting the core principles of Islam
finance, that place great emphasis on social justice, inclusion, and sharing of resources between
the haves and the have-nots. Islamic finance addresses the issue of financial inclusion from two
directions: one by promoting risk-sharing contracts that provide a viable alternative to
conventional debt-based financing; and the other through specific instruments of redistribution of
wealth in society; to improve understanding of the perspective of Islamic finance on economic
development, social and economic justice, human welfare, and economic growth.
The author has analyzed the structural difference in management of financial instruments
between Islamic finance and conventional financial institutions. The purpose of the paper is to
3

identify and analyze the affinity for financial operations and tools in two banking financial
institutions, disparate from one another. There have been a great number of discussions
pertaining Islamic finance and its possible future prospective. For this reason Ive decided to
analyze that differences, fluctuations and performances of both financial institutes as my subject
in my work.
In consideration of these prospects and objectives, this research tends to accomplish the
following tasks:
Discuss the banking sector in Uzbekistan, especially it for Islamic finance in the nearest
future
Analyze the theoretical background of Islamic banking and finance instruments
Describe the positioning of Islamic banking in global financial market and its role
Study the elements of Islamic financial products and the possible corresponding products
in conventional banking sectors
Explain the problematic issues concerning expansion of Islamic banking in Europe
Overview the implications of regulatory standards on bank capital adequacy, stress
testing and market liquidity risk, and related Islamic baking indices
Define pros and cons of leasing in Islamic and conventional banking sectors.
The paper itself is divided into two major parts. Analytical part reviews the Uzbekistans
banking sector in brief, including an analysis of them. Moreover, in the first part the reader can
discover the origin and foundation of Islamic financial system, its technics, products, and
regulations. The second part is about the calculations and practical analysis; opportunities for
leasing operation are analyzed in conventional banks of Uzbekistan, also, in Islamic banks in
example of Turkish participation bank BankAsya.
The author used in his work the methods of grouping, processing statistical data related to
the theme of the thesis. The author confined by analyzing leasing operation procedures in
Uzbekistan as well its alternative transaction in participation bank BankAsya based on Islamic
non-interest principle. The author does not consider the features and problems of value added tax
(VAT) describing formulas and solutions in his calculations. In design of this work, the writer
uses internship experience gained in BankAsya, Istanbul, Turkey in 2013. The paper ends
with brief concluding remarks and appendix after the second part.


4

1. ANALYTICAL PART

1.1. Uzbekistan banking system overview
Uzbekistan has traditional two level banking systems, headed by the Central Bank of the
Republic of Uzbekistan (CB). Main functions and objectives of the Central Bank are defined in
the Law on Central Bank, issued in December 1995. At present, the CB is fulfilling functions of
central monetary-lending institution. Main goal of the Bank is to maintain stability of the
national currency. The priority objectives of the Bank are as follows:
development / maintaining monetary-lending, credit and currency policy of the
country;
introduction of efficient payment system in Uzbekistan;
licensing and regulation of banking and financial activity;
management of cash flow of the state budget and performance of commercial
activities on behalf of the Government (together with the Ministry of Finance);
Management of state reserves of the Republic of Uzbekistan (currencies,
precious metals and etc.).
Aggregate capital of commercial banks of Uzbekistan in 2010 increased by 44% versus
2009 and reached 4.1 trillion Soums (about US 18 billion) by the 1 January.
The domestic financial sector was not directly affected due to the isolated and
underdeveloped nature of the financial system. The banking sector and capital market in
Uzbekistan is not yet well developed. The government has taken a gradual approach in economic
reform. Similarly, reforms in the banking sector and capital market are slowly undertaken. The
deposit base and penetration (ratio of loans and assets to GDP) are one of the lowest in CIS
countries. Credit to economy/GDP and broad money /GDP are quite low. Credit to economy was
about 38% of GDP in 2001, however, it declined to around 14% in 2007, which was low
compared to other CIS countries. The state-owned banks are predominant in the banking system .
Over half of the assets, capital, and loan portfolio in the Uzbek banking are possessed by state
banks. The banking system is concentrated in Uzbekistan since the five largest banks own 70%
of assets. Government guaranteed loans are still significant, albeit they are declining every year
22].
Uzbekistans state-dominated banking sector has promoted industrial development by
channeling public investment to strategic industries and increasing total bank lending, while
keeping banks sound. At the end of 2013, the sectors capital adequacy ratio reached 24.3%.
Aggregate capital in the banking sector rose by 25%, helping expand total credit by 31%.
In August 2013, Moodys Investors Service issued a stable outlook for the countrys banking
5

Source: based on information from[33]
2009 2010 2011 2012 2013
GDP 8.1 8.5 8.3 8.2 7.4
Inflation (%) 7.8 7.2 7.3 7 7.2
Investment FDI(%) 2.5 4.2 3.6 1.7 1.7
Labor remittances (%) of GDP 3.9 4.5 6 6.8 6.5
Debt (%)of GDP 15 14.8 13.4 13 13
0
2
4
6
8
10
12
14
16
18
Uzbekistan Key Economic Indicators
sector, citing healthy bank profits, improvements in asset quality, stable liquidity, limited
reliance on wholesale funding, and few problem loans, averaging less than 10% of total lending.
The government reported a budget surplus of 0.3% of GDP in 2013, though the surplus in the
augmented budget, which includes the FRD, is estimated to have narrowed to 1.8% of GDP from
the 4.7% recorded in 2012 Budget revenues (including the FRDs estimated revenues) are
estimated to have declined slightly, from 38.6% of GDP in 2012 to 35.8% in 2013, in line with
declining international prices for key export commodities (Figure 1.1). Rising government
spending, particularly for health and education, helped slightly raise budget expenditures
(including the FRDs estimated expenditures) from 33.9% of GDP in 2012 to 34.0% in 2013.
The government adopted a new budget code in 2013, streamlining legislation on public finance
management and strengthening the enforcement framework [3].
The government raised public sector wages and pensions by 21% in 2013 and
maintained large-scale public investment in industry and housing. State investment spending
grew by 11.0% to $11.3 billion, enabling gross fixed capital formation to rise by 19.8%,
following 11.1% growth in 2012. An increasing share of investment is financed by the Fund for
Reconstruction and Development (FRD), a sovereign wealth fund with assets exceeding $15
billion [33].


Figure 1.1 Key economic indicators of Uzbekistan


There are following banking system and insurance market in Uzbekistan:
I. Commercial banks - 30:
3 state-owned banks
13 joint stock banks
6

NBU
31%
Asaka Bank
12%
AgroBank
7%
UzPSB
8%
Ipotekaban
k
4%
Microcredit
bank
7%
People'sBan
k
6%
Others
25%
Capital
NBU
32%
Asaka
Bank
11%
Agrobank
10%
UzPSB
11%
IpotekBa
nk
5%
Microcre
ditbank
3%
People's
Bank
6%
Others
22%
Assets
5 banks with foreign capital
9 private banks
Over 4600 branches and retail offices all over the country
II. Nonbank financial Institutions:
110 Credit Unions
82 Microfinance Entities
III. Fund for Reconstruction and Development

Since the Uzbek government saw the banking sectors role as an important instrument in
the implementation of the countrys import substitution policies, the sector was dominated by
state- 9 owned and state-controlled banks. The assets of the three banks that are directly owned
by the government comprised 65 to 80 per cent of the assets of the banking sector over the period
1996 to 2005. Among these three, the National Bank of Uzbekistan stands out. Since 1996, this
giant bank has controlled over 50 per cent of assets of the banking system. Thus, since 2004 the
National Bank has shown positive dynamics of development and strengthened its position in the
Republican financial market. The consolidated balance of the National Bank in terms of US
dollars comprised 2,929 million. However, nowadays the tendency of private banks, for instance,
Hamkorbank, Trastbank, et al. have shown escalating progress in financial operations in both
medium and large scales of banking economic sector of Uzbekistan.






Figure 1.2 Assets and capital of Uzbekistan banking system according to Fund for
Reconstruction and Development of Uzbekistan


The following Figure 1.2 illustrates the distribution of assets and capital of Uzbekistan
banking system among national and commercial banks [5710].
Source: based on information from [10]
7

1386
4904
1181
934
0
1000
2000
3000
4000
5000
6000
7000
2005 2011
Domistic sources External Debt
Stable banking and financial system are in strict compliance with the Basel Core
principles of banking supervision sustaining the stability of banking system in Uzbekistan. The
one of the fundamental rations as bank capital adequacy ratio is over 23%, which indicates the
positive efficiency of banks and being almost 3 times higher than international standards. The
banks total assets of banks are more than 2 times higher than the total balance of the population
and legal entities deposits, insuring complete protection and guarantee of timely payments.
For the last 10 years domestic sources channeled to financing the real sector of the
economy )increased by 25 times Total current liquidity of the banking system is 10 times higher
than external payments due (Figure 1.3).
Figure 1.3 Credit portfolio of commercial banks (USD mln)


The Islamic Development Bank (IDB) is an international financial institution established
in pursuance of the Declaration of Intent issued by the Conference of Finance Ministers of
Muslim Countries held in Jeddah in Dhul Q'adah
1
1393H, corresponding to December 1973. The
Inaugural Meeting of the Board of Governors took place in Rajab 1395H, corresponding to July
1975, and the Bank was formally opened on 15 Shawwal 1395H corresponding to 20 October of
1975.
The purpose of the Bank is to foster the economic development and social progress of
member countries and Muslim communities individually as well as jointly in accordance with
the principles of Shariah i.e., Islamic Law.

1
Dhu al-Qi'dah is the eleventh month in the Islamic calendar. It is one of the four sacred months in Islam
during which warfare is prohibited, hence the name Master of Truce.
Source: The authors idea based on information from[10].
8

Uzbekistan became an IDB member in 2003; an exemplary step in this direction is the
recent IDBs US$37 million 14-year nancing that will be used to purchase medical equipment
for the modernization of oncological institutions in the country. The project, whose total amount
is US$83 million, is one of the 15 projects currently jointly implemented by the Uzbek
government and the IDB in the elds of health, education, agriculture, energy and transport, with
a total value exceeding US$400 million.
In the past three years, IDB has sponsored several important projects and signed many
significant treaties:
US$30 million in loan financing, co-financed with the Asian Development
Bank, to improve water supply to major cities around the country, including Bukhara and
Samarkand.
US$54 million grant: Of this amount US$15 million will go the National Bank
for Foreign Economic Activity to finance small business projects; US$12.5 million will
be spent on modernizing an asphalt factory, constructing roads and buying equipment for
these purposes; US$25 million will be spent on the construction of an electricity line
from two existing power stations; and US$143,000 will be spent on preparing a project
on setting up an investment company.
In 2005, the Islamic Corporation for the Development of the Private Sector, a
member of the IDB Group, and the National Bank of Uzbekistan signed an agreement of
cooperation to further develop the Uzbek private sector.
In the three years following Uzbekistans induction into the IDB, the IDB has already
established a strong presence within the country providing the Uzbek government with
considerable financing and sponsorship of numerous projects. This trend will likely continue in
the future.
In just over a decade, Uzbekistan has proven to be prime candidates for the establishment
of Islamic banking and finance. Although primarily landlocked, the countries of this region for
the first time are being linked to a greater network of commerce and trade throughout the Muslim
world with the help of not only the IDB but also the just-flourishing Islamic banks . Not only
has an organization like the IDB effectively demonstrated its support for socio-economic
development, but it has also provided the six Muslim republics of this study with a means to
remain Islamic-compliant when running various banking and finance projects that promote
national development. [11].
On the other side, the private-owned bank Hamkor Bank is gearing up to provide
Islamic banking services across the country leveraging on the banks wide network.Hamkor
Bank is open joint-stock commercial bank, was established in 1991. Since its inception, Hamkor
9

Bank is focused on private and corporate customers. The bank's customers are companies who
are attracted to sound banking philosophy, which allows ensuring the stability, efficiency and
security of financial transactions.
Hamkor Bank, being a universal financial organization provides services to customers
regardless of their activity and size of business. Current customers are representatives of large
and small businesses, leading manufacturers of consumer goods and construction companies,
telecommunication and transportation companies, trading organizations and representative
offices. In previous years, Hamkor Bank was looking to collaborate with selected international
organizations to become the first entity to provide Islamic banking solutions to the countrys 29
million Muslims to develop its human capital base to ensure that its Islamic banking initiatives
and, to a greater extent, Uzbekistans Islamic banking and finance aspirations, can be kick-
started with "sound foundations". He added that the bank, which focuses mainly on SMEs, is the
only bank in Uzbekistan which is looking to collaborate with international financial institutions,
such as the World Bank, Islamic Development Bank and Asian Bank for this purpose.
In May 2010 the International Finance Corporation (IFC) acquired a 14.5% stake in
Hamkor Bank, at US$0.09 cents per share, for US$3 million. The stake was then diluted to
12.59% in 2012 when the bank issued additional equity worth US$3.4 million.
In February 2013 the Chief Executive Officer of Al Huda Centre of Islamic Banking and
Economics Muhammad Zubair Mughal recently has met with Ikram Ibragimov, the chairman
of supervisory board of Hamkor Bank in Uzbekistan's capital, Tashkent. There was a detailed
discussion on affairs of their mutual interest for the advancement of Islamic banking in
Uzbekistan. Unfortunately, Hamkor Bank is the only bank is Uzbekistan which is working in
collaboration with international organization e.g. World Bank, Islamic Development Bank, Asian
Development Bank, European Bank, KFW, Triple Jump and others Hamkor Bank will cooperate
and be supervised by Al Huda CIBE Pakistan, especially advising and consulting in Islamic
Banking; Shariah advisory; and Human Capital Development in this field. Consequently, Islamic
banking can be initiated in Uzbekistan with sound foundations. Furthermore, Hamkor Bank,
though not as big as leading banks in Uzbekistan, has a wide network in the country through
which they wish to render the services of Islamic Banking.
Shariah compliance and Islamic human capital development will be privileged so
that Islamic banking can be initiated in Uzbekistan with sound foundations [15]. Uzbekistan is
not the only country in the region to have realized the opportunities offered by Islamic nance
and competition is rife between countries to conquer the Islamic nance pole position in central
and north Asia [2].
10

It should be noted that Hamkor Bank is a part of a large financial group of Uzbekistan.
The group comprises of a bank, insurance company, 4 leasing companies and other institutions.

1.2. The principles and characteristics of an Islamic economy

1.2.1. Principles of Islamic economy
The Islamic economy is an economic, social and political model based on the theological
doctrines and values promoted by the Quran and Sunnah
1
. In other words, as Islamic economy is
an approach to, and progress of, interpreting and solving the economic problems of human
beings based on the values, norms, and institutions found in, and derived from sources of
islam.
2
While the Quran is considered prescriptive, the Sunnah and hadith literature is
considered descriptive. These two textual sources serve as the foundation of Islamic law.
There are no compete economic or financial systems described in Islam. If to locate
economics and finance in Islam, one could visualize the connection as seen in Figure 1.4.















Figure 1.4 Economics and Finance in Islam


Another useful definition is following: Islamic financial institutions are those that are
based, in their objectives and operations, on Koranic Principles [Ibrahim Wade, Edinburgh
University Press, 2001]. They are thus set apart from conventional institutions, which have no
much preoccupation. This definition goes beyond simply equating Islamic finance with interest-
Islam
Faith and Belief Practices and Activities Morality and Ethics
Worship to God Social Interaction
Political
Activities
Economic Activities
Social Activities
Banking and Financial Activities
Other Activities
Source: Designed based on the ideas of the author


11

free banking. It allows to take into account operations that may or may not be interest-free, but
are nonetheless imbued with certain Islamic principles: the avoidance of riba (in the board sense
of unjustified increase) and gharar (uncertainty, risk, speculation); the focus on halal (religiously
permissible) activities; and more generally the quest for justice, and other ethical and religious
goals. Two aspects of Islamic finance must be signed out. Fist is risky-sharing philosophy: the
lender must share in the borrowers risk. Since fixed, predetermined interest rates guarantee a
return to the lender and fall disproportionately on the borrower, they are seen as exploitative,
socially unproductive and economically wasteful. They preferred mode of financing is profit-
and-loss sharing (PLS). Second is the promotion of economic and social development through
specific business practices and through zakat (almsgiving).

















Figure 1.5 Islamic Concepts of a Market Economy between Economics and Law
Source: Designed based on information from[25].
.

Most but not all Islamic institutions have a Shariah board- a committee of religious
advisers whose opinion is sought on the acceptability of new instruments, and which conduct a
religious audit of the banks activities as well as other features reflecting their religious status.
In sum, the defining difference is that while conventional finance usually seeks profit-
maximization within a given regulatory framework, Islamic finance is also guided by other,
religiously-inspired goals.
Secular Economics
Koran
Sunna
Fiqh (jurisprudence)
Islamic Economics
Shariah
(Islamic law)
Concept of market Economy
Principles
Rules
Systems
Design
I
s
l
a
m
i
c

S
y
s
t
e
m

S
e
c
u
l
a
r

L
a
w

12

Islamic banking also involves more than banking more than banking. It includes mutual
funds, securities firms, insurance companies and other non-banks. Where once - in the mid-
seventies Islamic banks were few numbers and easily identifiable, the phenomenon has become
quite amorphous with the proliferation of Islamic institutions and the blurring of the lines
between traditional banking and other forms of finance (Figure 1.5). Another complicating factor
is that growing number of conventional institutions, inside and outside the Islamic world, have in
recent years created Islamic subsidiaries or have been offering Islamic windows or products in
addition to conventional ones.
For the outside observe, the inevitable question is: how can a financial system operate
without interest rate? The answer is that it can through the development of profit-and-loss
sharing mechanisms, or through alternatives such as imposing fixed service charges or acting as
young agents for clients.

1.2.2. Elements and Superstructure of Islamic system
Over the past decade, public duties (both of society and the state) have broadened to
include safeguarding sustainable economic activity and protecting the environment. Finally, the
state should create favorable framework conditions for a private economy consistent with the
requirements of Islam, something which can have particular implications [25].
Essentially, this list contains all the elements that constitute a social market economy,
which have been summarized in the Konrad-Adenauer-Stiftungs publication entitled
Guidelines for Prosperity, Social Justice and Sustainable Economic Activity. The prevalent
doctrine of Islamic economics today can be summarized as follows:
Islam conveys a positive outlook on this life in general and provides a supportive value
system for economic activities in particular
Islamic economic ethics exhibits considerable overlap with Western-Christian
perceptions in the field of individual ethics. Great importance is ascribed to personal
achievement.
Individuals are expected to earn their living through their own work. A persons own
achievement (physical and intellectual work) is the most important basis for legitimately
obtaining material goods and wealth. Neither individual human skills nor natural
resources should lie idle unnecessarily, and it is forbidden to waste or wantonly abuse
resources.
Legitimately acquired wealth should not be used to maximize the pursuit of a persons
own wants (in this life): luxury is frowned upon; Islam preaches moderation; and the use
of surpluses for social aims is meritorious.
13

The needy have their own claim to solidarity from the community, which is
institutionally protected and based on the Quran: Muslims are required to pay zakat, i.e. a
two and a half percent levy on assets or a five or ten percent levy on agricultural produce,
which is used for specific (social) purposes. This is an obligation for the individual, and
the claims of the needy should be satisfied by the community or the society (and only
then by the state); this is very similar to the principle of subsidiarity.
The needy have their own claim to solidarity from the community, which is
institutionally protected and based on the Quran: Muslims are required to pay zakat, i.e. a
two and a half percent levy on assets or a five or ten percent levy on agricultural produce,
which is used for specific (social) purposes. This is an obligation for the individual, and
the claims of the needy should be satisfied by the community or the society (and only
then by the state); this is very similar to the principle of subsidiarity.
Since Allah has made the goods of this world available to all human beings, inequalities
in the distribution of income and wealth must not be allowed to become too great. If
needs be, the state must intervene with corrective measures to fight poverty.
Humans, as Gods custodians of the earth, only have the right to use creation. They must
not inflict lasting damage on it and must consider the legitimate claims of future
generations in what they do. This principle gives rise, among other things, to a collective
ownership of non- renewable resources (natural resources, but also water) and, more
recently, a duty to protect the environment.
Islamic law recognizes private ownership of the means of production. Nationalization and
state control of the economy are only permissible in exceptional circumstances.
Land and capital become productive only as factors of production when combined with
labor. Therefore, income may not be derived from merely owning land or capital. Financing,
lease, and other contracts, which allocate returns and risks to the owners of factors of production,
must meet particular criteria of justice. [4].
For the outside observe, the inevitable question is: how can a financial system operate
without interest rate? The answer is that it can through the development of profit-and-loss
sharing mechanisms, or through alternatives such as imposing fixed service charges or acting as
young agents for clients. By this means of information, a following chart can be structured to
properly understand the Islamic economic system (Figure 1.6.).
Legal framework
Law and the rule of law are important: linking government action to a superior law
Shariah (which only contains some directly applicable economic content) and Shariah compliant
secular law (the formulation of which gives great creative leeway). Concepts of an Islamic
14

Source: Designed based on information from [25]
economic system are compatible with different forms of government (democracy, monarchy,
etc.).

















Figure 1.6. Elements and Superstructure of an Islamic Economic System



Competition as a basis
Justice is important: price fairness; state protection of competition against
monopolization; occasional state intervention in the case of sensitive prices.
Solidarity and social security
Poverty reduction is as a primary economic objective. Zakat at the core of a social
security system that is independent of the family (claim of the needy in respect of society state
is subsidiary).
Sustainability
Allah is the ultimate owner, human beings are merely custodians, and duty extends to
future generations (idea of sustainability).
Open markets
Science
Ideology
Religion
Prescriptiveness Mobilization
Open and Competitive Markets, Competition Policy

Financial and Monetary Economy
Prohibition of riba
Stable money ( gold, 100%,)
Individual social Security
Zakat (social security contributions)
Takaful (mutual insurance)
State and the Public Sector Economy
Legal Framework
Infrastructure, environment

Legitimacy
Functionality
15

In principle, for all open goods, services, and labor markets, but reservations with capital
markets (issue of interest, speculative transactions).
Therefore, the special regulations in Islamic economy lead to sustain development of the
social market and life of the nations. For that reason there were the formal restrictions, which
stem from the requirements for Shariah-conformity, do not prevent the construction of a
sophisticated and efficient financial system and capital market without which the social market
economy could not function. In view of the current global financial crisis, such a strong link
between the financial sector and the real economy, and a limit to the development and
application of synthetic financial products for speculative and high-risk purposes is, perhaps,
more beneficial than detrimental for a social market economy. Against the backdrop of
replications of problematic, conventional techniques and products that conform to Shariah law,
the calls by Islamic economists which perhaps go a little too far for every financial
transaction to be based on a real economy transaction, can also be understood in some respects as
self-criticism, or at least a warning to Islamic financial engineers.
The Islamic economic systems are indeed compatible with the concept of the social
market economy, and that Islamic economics can act as an advocate of such a concept transfer.
Nevertheless, this alone would not bring much benefit as the political effectiveness and the
practical relevance of Islamic economics as an academic discipline is relatively weak at a
systems level, and this influence has tended to wane rather than wax over the past twenty years.
It is an obvious fact that the social market economy is a concept that was created for
highly developed and structurally differentiated economies only in the twentieth century in the
Western world, where it has proved itself. In Islamic countries, most of which only gained their
independence in the middle of the twentieth century, this concept was rather unknown.
In the light of the lasting development problems of many countries of the Muslim world
stretching from North Africa, across the Middle East to Southeast Asia these states have by
no means ruled out the search for economic concepts that promote development. Not least as a
result of disappointment with the results of the capitalist and socialist economic systems, since
the mid-1970s people have been progressively formulating ideas about an Islamic economic
system, propagating them as an alternative to the unsatisfactory status quo. Against this
backdrop, therefore, it is worth investigating the general principles of the social market economy
and their compatibility with such economic systems in order to share the experiences of our own
economic system as part of the dialog surrounding development policy.



16

1.2.3. The Role of Islamic Banking and Finance: a Global View and Trend
Over the last three decades, the concepts of Islamic Finance and Islamic economics have
captured the attention of researches. The growing market for transactions compatible with
Islamic law (Shariah) is further evidence of growing interest in this mode of finance. Although
Islamic finance is one of the fastest growing segments of emerging global financial markets, it is
often stated that the market is far below its true potential. At the same time, the concept of
Islamic finance are not fully explained and exploited especially in the areas of economic
development, inclusion, access to finance, and public policy. Over the last two decades, by some
estimates, the total volume of Islamic financial assets has grown by 15-20 percent a year and
now exceeds $1.3 trillion [7].
There are more 267 Islamic financial institutions (IFI) worldwide with capitalization in
excess of $13 billion. This includes banks, mutual funds, mortgage companies & Takaful
Shariah-compliant financial products estimated to exceed $250 billion with annual
growth rate of 23.5%over the past 5 years
There is approx. $1.5 trillion of GCC funds held in investment assets worldwide
(Treasuries/corporate bonds/equities/funds etc). Of this $1.5 trillion, $250 billion
constitutes of High Net Worth Individuals
The potential is huge. By 2020, there will be 2.5 billion of Muslim population worldwide
from the current 1.5 billion level
Islamic banks are expected to manage 40%-50% of total savings of Muslim
Population in 8 to 10 years. Therefore, potential for Islamic financial services is
estimated at $4 trillion by 2020
It is crucial these huge amounts of funds are channeled towards productive use into
GCC infrastructure/economic sectors and other emerging economies.
Following on from the significant developments that have occurred in what we view as
the core area for this market the predominantly Muslim countries we are now witnessing the
globalization if Islamic finance. In recent years, significant interest in Islamic finance has
merged in the worlds leading financial centers, including London, New York, and Hong Kong,
and Western investors are increasingly considering investment in Islamic financial products. The
growth of this market has been driven by the high demand for Shariah-compliant products, as
well as increasing liquidity of Gulf States. The table 1.1 shows the growth trend in Islamic
finance for banking sectors by different regions, with estimates of total Islamic banking assets
reaching $1.8 trillion by the end of 2013 [7].


17

19
9
34
20
25
42
22.5
8
5
18
13
15
31
14
0
10
20
30
40
Malaysia Indonesia Turkey Saudi Arabia United Arab
Emirates
Qatar Median
Islamic banking Conventional Banking
Table 1.1.
Total I slamic Banking Assets (in $ billion)
Global Islamic banking assets 1.334
Growth estimates by the region through 2013
Southeast Asia 89
Gulf Cooperation council (GCC) countries 131
Rest of the world 257
Global Islamic Banking assets (2013, est.) 1.811

In the following figure 1.7 we can see trends promoting the growth of the Islamic
financial sector in the 2006-2010 periods surpassed the growth of the conventional financial
sector in all segments of the market, ranging from commercial banking, investment banking, and
fund management to insurance in several Muslim-majority countries [6].
Islamic banking continues to be an exciting growth story characterized by robust macro
outlook of core Islamic finance markets and increasing share of system assets. It is increasingly
gaining acceptance, especially in high-growth emerging markets, as an effective means to build
an inclusive financial system and replace the shadow economy. Figure 1.8 illustrates the global
distribution of Islamic assets in worlds financial market.
One of the recent developments in Islamic finance is the introduction of Islamic bonds, or
sukuk, which are structured as a securitized product. The key feature of sukuk is that they are
structured following principle of linking the financial return to the real sector activity. We will
Figure 1.7 Growth of Islamic Banking and Conventional Banking Assets in Selected
Countries (in percent)
Source: based on information from [3,33]
18

Saudia Arabia
16%
Malaysia
8%
UAE
5%
Kuwait
4%
Qatar
3%
Turkey
2%
Indonesia
1%
Bahrain
1%
Rest of the world(inc.
Iran)
60%
50 50
100
180
300
370
420
685
831
794
825
0
100
200
300
400
500
600
700
800
900
2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012
Volume ($ billion) Number of issues

describe more explanatory about this special financial product later on, however there is a room
to mention about important value of the introduction of sukuk escalated the financial stability of
Islamic liquidityin world market. Figure 1.9 shows the total number of sukuk and their volume
over the last ten years, which is testimony to the rapid growth of this market, and its quick
recovery during global downturn. The sukuk market has been used by both the public sector and
corporate sector to mobilize finance [21].
Figure 1.8 The Global Distribution of Islamic Assets
Source: based on information from[3,33]
















Figure 1.9 Total Sukuk Issuance 2002-2012
Source: based on information from[29]
19

1.3. The Role non-interest philosophy of is Islamic Finance

Most definitions reduce Islamic banking to interest-free banking. Islam prohibits
interest but it does not means, that it prohibits all gains on capital. The only increase stipulated or
sought over the principle loan or debt is prohibited in Islamic shariah law. Islamic principles
simply require that performance of capital should also be considered while rewarding the capital.
The prohibition of a risk free return and permission of trading, as enshrined in the Holy Quran,
makes the financial activities in an Islamic set-up real asset-backed with ability to cause value
addition.
Islam deems profit, rather than interest, to be closer to its sense of morality and equity
because earning profits inherently involves sharing risks and rewards. Islam encourages shearing
of risk among lender and borrower, Islamic financing system is based on this principle, it has
also another character of owing and handing of real assets, its involvement in trading,
construction and leasing using Islamic mode of financing. As such, Islamic banks deal with asset
management for the purpose of income generation. They will have to prudently handle the
unique risks involved in management of assets by adherence to best practices of corporate
governance. Once the banks have stable stream of Halal income, depositors will also receive
stable and Halal income. Profit has been recognized as reward for (use of) capital and Islam
permits gainful deployment of surplus resources for enhancement of their value. However, along
with the entitlement of profit, the liability of risk of loss on capital rests with the capital itself; no
other factor can be made to bear the burden of the risk of loss. Financial transactions, in order to
be permissible, should be associated with goods, services or benefits. At macro level, this feature
of Islamic finance can be helpful in creating better discipline in conductive of fiscal and
monetary policies [30].
The most important prohibition is riba (usury/ interest). The subject of riba is a difficult
for many scholars. There is huge number of literature discussing the topic of riba in accordance
to Islamic teachings.
Islam, however, strongly and precisely prohibits interest, but permits trade. Doing interest
business is viewed equal to rebel against God and His prophets. In Koran
2
it states: Those who
take riba (increased amount, i.e. usury / interest) will not stand but as stands the one whom the
devil has driven to madness. That is because they say: Trade is like usury, but Allah has
permitted trade and forbidden riba. Those who after receiving direction from their Lord, desist
(from indulging riba), shall be pardoned for the past; their case for Allah to judge; but those who
repeat (the offence) are companions of the Fire: They will abide therein (forever) [17]. Allah

2
Koran (Quran) is the scripture, the holly book of Muslims and was verbally revealed from God to his
prophet Muhammad.
20

will deprive usury of all blessing, but will give increase for deeds of charity: for He loves not
creatures impious and sinning.[17]. O you, who believe, do not eat up the amounts acquired
through Riba, doubled and multiplied. Observe your duty to Allah, that you may be
successful.[17].
At the same time, there is a notable number of hadith explicitly pointing of the
prohibition of interest, e.g. the Prophet Muhammad (BPH) cursed the one who accepted
interest, the one who paid it and the one who recorded it and the one who witnessed it, and said
that they are all alike (i.e. they are equal partners to the sins).[5].
Trade on the other hand is permitted, furthermore, encouraged. It says as follows in
relevant verses: There is no sin on you that you seek the grace of your Lord (by trading) [17].
Despite numerous proofs and easily accessible information presented, the question of
whether interest is prohibited in Islam seems to be the most frequently asked question in regard
to Islamic finance. The main reason Islam has delivered such a harsh rulings against interest that
it is set to establish economic system in which all forms of exploitation are eliminated, and
particularly the injustice in the form of financier being assured of a positive return without doing
any work or sharing risk, while entrepreneur, in spite of his management and hard work, is not
assured such a positive return. In this regard, Islam wishes to establish justice between the
financier and the entrepreneur. The difficulty to understand the prohibition comes from lack
appreciation of the whole complex of Islamic values, and particularly its emphasis on socio-
economic justice and equal distribution of income and wealth. [20].

1.4. Islam, Economics and Finance
1.4.1. Historical and Religious Background
Any successful belief system, whether religious or secular, has seemingly contradictory
characteristics: it is malleable enough to adopt to a variety of geographical settings and survive
the test of the time, yet it must be able to maintain its specificity, or else it would disappear or
become fused with competing belief systems; it is idealistic, sometimes even utopian, yet
capable of adjusting to human imperfection and making the kinds of compromises that are
endemic to political and economic life. With this in mind we can better understand hoe a system
rooted in the Middle Ages could survive, and thrive, in the global economy [14].
Following, a board of overview of the parallel evolution of religion and history we can
now deepen into the mechanisms by which Islam adapted to changing circumstances, and
explains how Islam could accommodate itself with modern economic and finance.
The tenets of the Islamic religion can be conceived as a pyramid. At the top stands Koran,
considered by Muslims to be Gods word as conveyed to the Prophet Mohammed. Below it are
21

the Hadith and the Sunna. Often interchangeably, the first actually refers to the words and deeds.
In other words, the Hadith, in the form of a large and ill-defined number of short texts, relates
stories about and sayings (specific pronouncements, deeds, or approvals of other peoples
actions) of the Prophet, whereas the Sunna consists of the practices and rulings deduced from
such narratives.
In order to examine the impact of Islamic banking it is important to understand the
historical origins of the banking system in predominantly Muslim countries and the evolving
divergences from conventional banks. The modern conventional banking system in Islamic
countries is a product of colonizers using the support of financial institutions for mining,
agriculture, and manufacturing. The initial banks were predominantly used for the funds of
foreigners and as a means to increase foreign-owned industries that spread through imperial rule.
These institutions were used to finance the expansion of the public sector in the Middle East and
North Africa, huge portions of the population made up of devout Muslims [23].
Throughout its golden age (roughly the seventh to tenth centuries in the Middle East, and
the eleventh to fourteenth centuries in North Africa and Spain), the Islamic world did not fit the
imagine of a narrow-minded theocracy. Great libraries and translation centers were established
where great works of philosophy, literature, medicine and science from East and West were
collected and translated. Such knowledge was improved upon and formed a necessary link to
later advances in the West.
So where does the persistent image of an Islam incapable of separating mosque and state
indeed incapable of dealing with the modernity and change come from? The answer lies in
the parallel evolutions of Islam and the West, starting with the end of the golden age.
However, due to the industrial revolution in the West countries in the late nineteenth
centuries, most countries followed a path of Westernization and secularization that led to adopt,
under foreign tutelage, Western models in politics, economics, law, and education. Muslims
were divided. While some did not see a necessary contradiction between Islam and
Westernization, a number of political and religious movements emerged throughout the Islamic
world, calling for a return to Islamic values and traditions. There was no clear consensus, insofar
as some wanted a return to the past while others called for an update of Islamic doctrine. Islamic
modernists shared with traditional Islamist groups the belief that the ills of the society were
caused by the betrayal of Islamic ideals. While they shared with secularists the embrace of the
reason, science and progress, what set Islamic modernists apart their belief that political
liberalization and intellectual reawakening could be, indeed had to be, rooted in a return to Islam
[14].
22

In sum, modernity undertaking a radical reinterpretation of Islam to suit modern
conditions is not easy to dissociate from a quest for authenticity. And traditional
fundamentalism if defined as the effort to return to the fundamentals of the religion is not
necessarily the same as literalism.

1.4.2. Islamic Economics
The commerce is central to the Islamic tradition. The Prophet Mohammed was himself a
merchant. In his day, the economic system was quite simple. Mecca, at the time wealthiest
Arabian city, depended heavily on trade. The continuous spread of Islam soon brought the
regions lucrative trade routes, previously controlled by Byzantium and Sassanid Persia, under
Islamic control. As the expansion of trade in Islamic world, the economy became increasingly
complex institutional innovation occurred, for example with the creation of hisbah, an office in
charge of supervising markets, providing municipal services, and settling petty disputes.
By the time passed, Muslims in the liberal era who had studied Western-style economics
tried to transpose that knowledge to the Islamic world. With decolonization and the nascent tend
toward a return to Islam, religious scholars attempted to rethink economics and the social
sciences in the light of their religious training, with the goal of creating an authentic or at least
indigenous brand of economics. It is usually agreed that the most original work in Islamic
economy is that of Mohammed Baqer as-Sadr, whose book Iktisaduna (our economy) is an
attempt to develop an Islamic approach to economics.
With the newfound wealth of oil-producing countries and the rise of Islamic militancy,
the need to promote further thinking on economic matters gained new urgency. A number of
fiqh
3
academies sprouted throughout the Islamic World, have settled a majority based decision
making processes. Gathering in convocations, scholars deliberate collectively and decide
questions by the majority vote.
First time the Islamic economics conference was held in 1976, in Mecca, where the
conference dealt exclusively with economic matters. King Abdul Aziz University established
the International Center for Research in Islamic Economics in 1979. Starting with Pakistan in
1977, a growing number of countries sought to Islamicize their economic systems. Islam would
typically be presented as offering a third way between capitalism and socialism that would be
not only different, but also superior to, and no less efficient than, the two others.
In Islam, strict definitions have typically prevailed. But as its economy grew more
complex, the Islamic world was able to find proper substitutes, justifications, or subterfuges.

3
Fiqh is Islamic jurisprudence, based on the expansion and interpretation of Shariahh; deals with the
observance of rituals, morals and social legislation in Islam
23


1.4.3. Reconciling Islam and Finance
Muslims Holy book Koran states that despite superficial resemblance, profits from
commerce are fundamentally different from profits from money-lending [Surah Al-Baqarah,
275]. Muslims, unlike other nations, have traditionally looked favorably at commerce, while
being suspicious towards finance. While the reconciling between other religious representatives
and finance was long-drawn and fraught with theological and philosophical disputes, in Islam
however, riba would occasionally be interpreted not as interest [14], but the usury or excessive
interest, severe and accurate descriptions have, in common, as a rule dominated. The early years
of Islam, jurists devised an impressive array of contracts designed to circumvent interest-riba, the
most important ones being profit-and loss contracts (mudarraba or qirad).
Modern finance entered the Islamic world alongside wit Western colonial expansion.
Foreign banks financed trade and development, and in due course Islamic governments, strapped
for cash, had become debtors, therefore paying interest to foreign creditors. For example, the
Ottoman Empire in the middles of 19 century had been issuing interest-bearing treasury bonds
[28]. In Egypt foreign banks played a crucial role: in 1920 Banque Misr was established, the first
ever to be formed exclusively with local capital. Egypts thriving stock-market made it a favorite
among early twentieth-century emerging markets, which promoted to be a third largest stock
market in the world after World War 2. Perhaps most importantly, it is in Egypt that interest was
legitimated by religious authorities in 1904.
The riba controversy was temporarily ignored but not to rest. Many legal codes adopted
by Islamic countries observed an eloquent silence on the issue of interest-bearing loans.
The world finance took a new tern with the end of colonialism: newly independent states
established national monetary authorities and central banks, issuing local currencies.
Thus, until resent attempts at Islamicizing economic systems, all countries regardless of
ideological learnings, learned to live with interest and with modern finance. With the advent of
Islamic finance, prevailing consensus among Islamic scholars was that dealing with conventional
banks was acceptable if Islamic institutions were not accessible to them. The transformation of
modern finance that has taken place since 1980s has also reopened the debate about the
acceptability of new financial instruments. But rather than a wholesale rejection, the trend has
been towards a now ijtihad designed to separate those products that are acceptable from those
that are not, and to create financial instruments adapted to the need of Islamic societies [9].



24

1.5. The Ethical Framework of Islam
1.5.1. Riba and Gharar
Most definitions reduce Islamic banking to interest-free banking. While the injunctions
against riba are indeed the cornerstone of Islamic finance, debates persist as to the exact
significance of the word. Since the early days of Islam, the majority of scholars have adopted a
restrictive definition: any form of interest constitutes riba. The debate is nonetheless still keeps
actual topicality in modern world. The most common way of financing throughout recorded
history is where the owner of money loans it to someone in need and receives the principal plus
an agreed upon amount of interest after an agreed upon time.
The riba debate has been approached from many angles. One set of discussions contrasts
interest, a moderate economically justified remuneration of capital, with usury, an excessive,
sometimes extraordinary rate. A few scholars have argued that only latter constitutes rib,
however the majority of Islamic scholars still consider that any increase in the amount of money
returned by a borrower constitutes riba and is therefore prohibited.
Another angle is the requirements of modern economy. As one of the Islamic modernist
Fazlur Rahman says: As long as our society has not been reconstructed on the Islamic pattern, it
would be suicidal for the economic welfare of the society and the financial system of the country
and would also be contrary to the spirit and intentions of the Koran and Sunna to abolish bank-
interest [16]. Despite argues and long debates; in 1986 the Fiqh (jurisprudence) Academy of
Islamic Conference supported the restrictive interpretation of early jurists, condemning all
interest-bearing transactions as void. But in 1989, while an economic and rhetorical debate
between Islamic financial institutions and conventional banks was raging, the mufti (religious
scholar) of Egypt A. Tan2tawi, issued what he considers fatwa (code), one legitimizing
capitalization certificates, which are interest-bearing government bonds underwritten by
Egyptian banks. There is little difference between Western-style bans which offer fixed interest
rates, and Islamic banks in which depositors share the risk of investing projects, for Islam
simply requires financial transactions to be market by clarity and justice.[29]. On the other hand,
the Egyptian fatwas had paradoxical impact on Islamic finance, insofar as they added the
legitimacy to more pragmatic approaches, but the intellectual debate on riba is still raging. It is
all the more inconclusive that unassailable, factual elements about the origin of riba are scarce.
Islamic scholars have insisted that the prohibition of the riba is not an isolated religious
injunction but an integral part of Islamic economic order with its overall ethos, goals and values.
Based on the definitions it comes out the riba is not necessarily about interest rates as
such and it certainly is not exclusively about interest rates. It really refers to any unlawful gain
25

derived from the quantitative inequity of the counter values. Interest or usury would then be only
one from riba.
The meaning of the word Gharar, however is not mentioned as riba in Koran,
etymologically relates to the words deception or delusion. The principals are the same as
prohibition of riba: unequivocal though the concept itself is somewhat vague. The Gharar in
addition to deception and delusion also connotes peril, risk and hazard. In more financial terms it
can be interpreted as uncertainty, risk or speculation. Any gain that may result from chance,
from undetermined causes, is here prohibited.
There are some examples to clear up with this definition. It would be wrong to get a
worker to ski an animal by promising to give him half the skin as the reward, or to get him to
grind some grain by promising him the bran separated out by the grinding process. It is
impossible to know for certain whether the skin may not be damaged and lose its value in the
course of the work, or to know how much bran will be produced.
More accurately, Gharar refers to aleatory transactions, that is, transactions conditioned
on uncertain event. Gharar should not be used interchangeably with the broad concept of risk.
Gharar is prohibited yet it would be nonsensical to prohibit risk.
There are Hadith goes much further, extending the concept of commercial transactions
involving uncertainty. The meanings of most significant of them are following:
Do not buy fish in the sea, for it is Gharar.
To sell grapes until they become black, and sale grain until it is strong.
Do not sale what in wombs, contents of the udders, pebble.

1.5.2. The Moral Economy of Islam
The three pre-requisites for an economic system as being a set of rules, an ideology to
justify them, and a conscience in the individual which makes him strive to carry them out [ 27].
The Ethical dimension is not all too often forgotten, though it exists, as well in any society.
Hard work and participation in economically creative activity is obligatory for every
Muslims [17]. Economic activity is not to be confined to earning or producing enough to meet
ones personal needs only. Muslims are expected to produce more because they cannot
participate in the process of purification through providing security to others (zakat or alms tax)
unless they produce more than what themselves consume. The most recommended use of fairly
earned wealth is to apply it to procuring of all means to fulfill a Muslims covenant with Allah
[18].
The broad ethical/economic system emphasizes fairness and productivity, honesty in
trade and fair competition, the prohibition of hoarding wealth and worshipping it, and protection
26

of human beings from their own folly and extravagance. Such a system, although rooted in
ancient tradition, is not, at least in its broad outlines, far moved from many contemporary
approaches to ethical business practices.
As for the ethical/economic justification for the prohibition of riba, it is three-pronged:
riba is unfair, it is exploitative, and it is unproductive. Due to this relation the lender and
borrower are in equalized balance of economic chain. Islam prefers the risks of loss be shared
equitably between the two both lender and borrower. In other words, rather than collecting a
fixed, predetermined compensation in the form if interest, leaders should be entitled to a share
from any profits from a venture they have helped to finance. The broader argument is that any
point should be morally and economically justified. As in other religions riba was also seen as
exploitative, since it tended to favour the rich, who are were guaranteed a return, at the expense
of the vulnerable who assumed the risk.
A number of economists and philosophers disagreed with the idea of marking capital gain
without any effort and living off other peoples work unethical. The prominent ancient-Greek
philosopher Plato (424-347 BC) pointed out immortality of interest and argued that in an ideal
society interest should be forbidden as it leads to inequity, egoism and egotistical conflicts
among people. Another Greek philosopher Aristotle (384-322 BC) like his teacher did not agree
the idea of exploiting money interest. According to him there was a natural and unnatural way
of income. Shepherding, fishing, farming, hunting and alike were natural ways. Unnatural ways
on the other hand were those done with the sole purpose of making profit. The worst way of
gaining wealth through unnatural ways was interest. In this regard he recorded: Very much
disliked also is the practice of charging interest: and the dislike is fully justified for interest is a
yield arising out of money itself, not a product of that for which money was provided. Money
was intended to be a means of exchange; interest represents an increase in the money itself.
Hence of all ways of getting wealth, the most contrary is to nature. [32].In the early times of
Roman Empire there were laws forbidding interest. Even later under the Law of the Twelve
Tables interest rates was fixed, and loan sharking was illegal.
Significantly, the issue of fairness is related to the issue of productivity and efficiency.
Earning a profit is legitimate when one is engaged in an economic venture and thereby
contributes to the economy. By certain accounts, Meccan merchants in the days of the Prophet
routinely engaged (usually in-between arrivals and departures of caravans) in interest-based
lending, speculation and aleatory transactions [13]. This would account for the sharp distinction
drawn in the Koran between profit from trade and profit from riba. While the former benefited
the community and enhanced welfare, the latter diverted resources towards non-productive uses
and contributed to illiquidity and scarcity. The modern-day economy equivalent of that debate
27

contrasts the real, productive economy with the financial, speculative one. Some Islamic
economists have also argued that an interest-based economy was inherently inflationary and
caused unemployment and poverty because of money was not linked to productive investment.

1.6. Financial Products in Islamic Banking and Their Conformity with
Conventional Banks

Most Islamic financial institutions engage in a variety of financial operations. Besides
their range of equity, trade financing and lending operations, Islamic banks worldwide also offer
a wide array of wholesale and retail products including loans, partnership investments, foreign
exchange transactions, fund transfers, letters of credit, securities safe-keeping, investment
management and advice, and other conventional banking services. Many are also in active
derivatives, fund management and insurance. There are favourable investment climate on
liability side in Islamic banks for depositors as well. Current accounts are operated on the
principles of al-wadia (safekeeping) and are not remunerated. In this term, depositors are
provided with the cheque-books and can withdraw their funds at any time without any
restrictions or conditions, unlike in conventional banks. Investment in profit-and-loss (PLS)
deposits linked to bank mudaraba investments are in the theory though not in practice the
principal instruments offered to depositors. Banks usually offer a variety of accounts PLS
deposit accounts, PLS special notice deposit accounts, etc. (Figure 1.10).
Yet in classical Islamic tradition, the only acceptable loan was the qadr hasan (meaning-
good loan) or interest-free loan in the only common form of deposit was al-wadia
(safekeeping). By creating new products that pose no religion objections, or by invoking custom,
or overriding the general interest to justify the creation of somewhat controversial instruments,
Islamic bankers have been able to devise new products and instruments by updating or
combining contracts that go back to classical Islam. In Appendix, the reader can find more
information about differences of products and techniques in Islamic and conventional banks.

1.6.1. Murabaha
The best-known Islamic banking instrument is murabaha a cost-plus contract in which a
client wishing to purchase the equipment or goods requests the financial provider to purchase the
items and sell them to him at cost plus a declared profit. It is thus a financing-cum-sale the items
and sells them to him at cost plus a declared profit. It is thus a financing-cum-sale: the bank
purchases the required goods directly and sells them on the basis of fixed mark-up profit,
agreeing to defer the receipt of the value of the goods. While the interest-based bank would lend
the money on interest to client, and he would go and purchase the required commodity from the
28

Shariah Sources
Koran
Sunna
Ijtima juristsconsensus)
Qiyas (Analogy)
Ijtihad (Reasoning)
Shariahh
Filter
islamic
products
transations
Islamic Trade/ Financial
Contracts
Musharaka ( partnership)
Murabaha (purchase-sale)
Ijarahh (lease)
Takaful (insurance)
Salam( forward sale)

market, in Islamic bank, as it does not operates on interest basis, the bank therefore, purchases
the commodity in cash and sells it to the client on an agreed mark up. Thus, the client gets the
commodity on credit for which financing required and the Islamic bank makes profit on the
amount it has spent in acquiring the commodity and selling it to the client on installments. There
are a number of requirements for a murabaha transaction to be a legit transaction and meet
Islamic standards of a legal sale. The whole murabaha transaction is completed in two stages. In
the first stage, the client requests the bank to undertake a murabaha transaction and promises to
buy the specified commodity from the bank. A promise under Shariah, however, is not legally
binding. Which means, if the client goes back on the promise to purchase, the bank risks the loss
of the full or part of amount it has spent to acquire the goods. To eliminate such situations,
Islamic banks sign legally binding agreements with their clients beforehand, which also can




Figure 1.10 Islamic Finance in Ethical and Religious Framework

Banking and financial needs
Asset-backed
transactions with
investments in real
durable assets
Islamic Banking and finance
Prohibition of certain
investments:
- Sectors: (e.g.: alcohol,
armaments, tobacco
pork pornography )
- Instruments(e.g. no
forward transactions,
no derivatives, short
selling
Credit debt
products are not
encouraged
29

Supplier
Financial Institution
Costumer
Sell asset at purchase
price
Make upfront payment
Deferred payment
Sell asset at purchase price +
markup
be understood as a promise between the two parties. In the second stage, the client purchases the
good acquired by the bank on a deferred payments basis and agrees to a payment schedule.
Another important requirement of a murabaha sale is that it consists of two sales contracts, and
through which the bank acquires the commodity for the client, and the other through which it
sells the acquired commodity to the client. The two contracts should be separate and real
transactions (Figure 1.11).
Murabaha form of financing is being widely used by the Islamic banks to satisfy various
kinds of financing requirements. It is used to provide finance in various and diverse sectors
such as consumer finance for the purchase of consumer durables, for example, cars and
household appliances, the real estate to provide housing finance, the production sector to
finance the purchase of machinery, equipment and raw materials. Murabaha contracts are also
used to issue letters of credit and to provide financing to import trade at Islamic banks.
A Murabaha transaction has the following characteristics:
The cost price of the asset is known to both the buyer and seller
The buyer pays the seller at a fixed agreed time after receipt of the asset for an agreed
mark-up
The mark-up may be a lump sum or a certain percentage of the purchase price
The mark-up can, and often does, relate to the prevailing LIBOR (or equivalent) rate
Payment default will require the buyer to cover the seller's stated cost of capital for this
period
A Murabaha transaction is a debt based transaction and is therefore not tradable (as
Figure 1.11 Murabaha transaction structure


30

Shariah forbids trading in debt) but can be transferred at par value.
Generalizing the incidental closeness between profit shares and interest rates, which
appear in some periods, and thereby reaching some conclusions will not give correct results. A
conventional bank determines the interest rate it will pay clients at the time of depositing money.
A Islamic banks on the other hand utilizes the money through applicable profit margins, and
shares the money it earns. Event in case that the distributed profit shares are close to the interest
rates of conventional banks, this does not mean that the work done is the same. Important here is
not the rate of interest and profit sharing, but the source of each. While interest steams from a
source forbidden by all theistic religions and condemned by many prominent philosophers and
economics, profit sharing at participation banks is a result from permissible economic activity.
In order for earning yield to be interest, it is necessary that income is known beforehand,
and that money earned in return for lending out money. For instance, a conventional banks
collect money from the depositors in return for a certain interest, and yet again present it in terms
of cash loans to those in need for financing, subject to current interest rates. But on the other
hand, there is neither a promise made for income nor a guarantee for principal capital of the
people under profit sharing.

1.6.2. Leasing
Ijarah
4
or leasing is probably the fastest growing activity in Islamic financial institutions.
The principle is well knows and virtually identical to conventional leasing: the bank leases as
asset to a third party in exchange for specified rent[1]. The amounts of payments are knows in
advance and the asset remains the property of the lessor. Only in a few respects do Islamic
contracts differ. A variation of basic principle is ijarah wa iktina, a lease- purchase agreement
whereby at the expiration of the lease, the lessee becomes the owner of the asset (Figure 1.12).
From the standpoint if classical Islamic fiqh, ijarah is understood as the sale of usufruct
(manfaa) and, as such, its rules closely follow those of ordinary sales. In order to avoid the
elements of riba and gharar, there are minor differences between ijarah and commercial leasing.
The law views some benefits and burdens of the property as belonging naturally and
unchangeably to the lessee, others to the lessor. For example, law provides that the duty to repair
the goods always fall on the lessor since the repair benefits him as the owner. Also, the usufruct
is not something existent and tangible, but a stream of the use extending into the future, which is
risky and unstable. Islamic law thus gives broad scope to the lessee to cancel the lease if the

4
Ijarah or in various literature ijara, which are identical in definition.
31

usufruct proves less valuable than expected. Finally, the price at which the asset may be sold to
the lessee at the expiration date of the contract cannot be predetermined.
Main characteristics of Ijarah:
It is necessary that the lessor own the asset and holds valid title to it.
Operating lease the asset is returned to the lessor
Financial lease the asset is sold to lessee be lessor upon completion of lease term
Lease rent is fixed by parties updating to market competitiveness
Lease will terminate upon total loss of asset or damage







A number of reasons account for the repaid growth of leasing : it is an acceptable
instrument in the eyes of the most scholars; it is an efficient means of financial intermediation;
by financing assets, it is useful tool in the promotion of economic development; because it is a
well-established instrument that lends itself to standardized mechanisms and procedures, and
because the similarity to conventional leasing, it is a flexible mode pf financing that lends itself
to securitization and secondary trading and to collaboration with conventional institutions.

1.6.3. Profit-and-Loss Sharing
The basic principle of profit-and-loss is that instead of lending money at a fixes rate of
return, the banker forms a partnership with the borrower, sharing in a ventures profits and
losses. The partnership can be one or two types: mudarraba (commenda partnership or finance
trusteeship) and musharaka (long term equity-like arrangements). In both cases, the bank
receives a contractual share of the profits generated by business ventures.
The principle is at the core of the Islamic banking philosophy. It is at once the most
authentic form of Islamic finance since it replicates transactions that were common in the early
days of Islam, the one that is most consistent with the value system and moral economy of Islam,
and the most modern one. Indeed, venture capital and merchant banking both among the
Bank
(Lessor)
Client
(Lessee)
Asset
Purchases
Bank leases
Asset to Client
Client pays rent to Bank
Figure 1.12 Ijarah (Leasing) transaction structure

32

fastest growing segments of contemporary finance would be conventional equivalents of profit-
and-loss sharing arrangements. The bank, being an investor, as opposed to a lender, has a stake
in the long-term success of the venture. The entrepreneur, rather than being concerned with debt-
servicing, can concentrate on a long-term endeavor that in turn would provide economic and
social benefits to the community.
Mudaraba partnership (entrepreneur based partnership) is a type of partnership where one
party supplies the capital and the other the labor. One party who owns capital rabb al-mal
(beneficial owner or the sleeping partner) entrusts money to the other party, called the mudarib
(managing trustee), who is to utilize it in an agreed manner. After the operation is concluded, the
rabb al-mal receives the principal and the pre-agreed share of the profit. The mudarib keeps for
himself the remaining profits. The rab al-mall also shares in the losses, and may be in position of
losing all his principal. Among the other rules od mudaraba are the following: the division of the
profits between the two parties must necessarily be on proportional basis and cannot be lump
sum or guaranteed return; rab al-mal is not liable for losses except for the losses beyond the
capital he has contributed; the mudarib does not share in the losses except the loss of his time
and efforts.
Musharaka is similar in its principle to mudaraba, except for the fact that the financier
takes an equity stake in the venture. It is in effect a joint-venture agreement whereby the bank
enters into a partnership with a client in which both share the equity capital, and sometimes the
management, of the project or the deal. Participation in a musharaka can be either in a new
project or in an existing one. Profits are divided on a pre-determined basis, and any losses shared
in proportion to the capital contribution. Under certain circumstances, for example if the mudarib
has engaged in religiously illicit activities (speculation, production of forbidden goods), or of the
bank has imposed a collateral for its investments, the mudaraba or musharaka contracts can be
considered null and void.
Recent variations of mudaraba (mudaraba mutanaqisa) and musharaka (musharaka
mutanaqisa), where the banks capital or the banks share increase his share in he projects.
Although many scholars consider profit-and-loss sharing as the most authentic and most
promising form of Islamic contracts, there are a few dissenting voices. In addition, profit- and-
loss sharing arrangements create managerial and regulatory problems that have yet to be fully
mastered.
To finance such arrangements, most Islamic banks offer accounts that act like investment
funds. Depositors can reap profits from a ventures success, but risk losing money if investments
perform poorly. The return paid on investment accounts is determined by the yield obtained from
all financial activities of the bank. After deducting such administration costs as wages, provision,
33

and capital depreciation, the bank pools the yields obtained from all ventures, and the depositors,
as a group, share the net profits with the bank, according to a predetermined ratio that cannot be
modified for the duration of the contract.
Perhaps the greatest strategic challenge of Islamic financial institutions is to increase their
involvement in PLS activities and overcome the institutional and cultural obstacles that have so
far stood in the way [14].

1.6.4. Sukuk Islamic Bonds
Sukuk market is one of the fastest growing segments of the Islamic capital market
(direct funding market) usually translated as Islamic bond is the most active Islamic debt
market instruments (in addition to Islamic equity market). The development of the sukuk market
has accompanied the transformation of the economy that has now become more diversified and
private sector driven. The market, initially dominated by the Government debt securities, now
reflects the growing demand for the long term financing requirements of the private sector. In
this highly competitive environment, the presence of a deep and liquid of sukuk market thus
contributes towards the stability of the financial system.
Nowadays, sukuk or Islamic fixed-income securities that have emerged over the past 15
years become as an increasingly important asset class. Sukuk may be defined as certificates of
equal value that represent an undivided interest (proportional to the investors interest) in the
ownership of an underlying asset (both tangible and intangible), usufruct, services or investments
in particular projects or special investment activities. Through this concept, sukuk enjoy the
benefit of being backed by assets, thereby affording the sukuk holder or investor a level of
protection which may not be available from conventional debt securities. Furthermore, unlike
conventional debt securities that mirror debts or loans on which interest is paid, sukuk can be
structured based on innovative applications of Islamic principles and concepts. Sukuk share some
similarities with conventional debt securities, in that they are similarly structured based on assets
that generate revenue. The underlying revenue from these assets represents the source of income
for the payment of profit on the sukuk [19].
Modern sukuk emerged to fill a gap in the global capital market. Islamic investors want
to balance their equity portfolios with bond-like products. Because sukuk are asset-based
securities not debt instruments they fit the bill. Each sukuk has a face value (based on the
value of the underlying asset), and the investor may pay that amount or (as with a conventional
bond) buy it at a premium or discount.
With sukuk, the future cash flow from the underlying asset is transferred into present
cash flow. Sukuk may be issued for existing assets or for assets that will exist in the future.
34

Source: based on information from[8]
Investors who purchase sukuk are rewarded with a share of the profits derived from the asset.
They dont earn interest payments because doing so would violate Shariah.
As with conventional bonds, sukuk are issued with specific maturity dates. When the
maturity date arrives, the sukuk issuer buys them back. However, with sukuk, the initial
investment isnt guaranteed; the sukuk holder may or may not get back the entire principal (face
value) amount. Thats because, unlike conventional bond holders, sukuk holders share the risk of
the underlying asset. If the project or business on which sukuk are issued doesnt perform as well
as expected, the sukuk investor must bear a share of the loss.
Table 1.2.


Most shariah scholars believe that having sukuk managers, partners, or agents promise to
repurchase sukuk for the face value is unlawful. Instead, sukuk are generally repurchased based
on the net value of the underlying assets (each share receiving its portion of that value) or at a
price agreed upon at the time of the sukuk purchase [8].
Distinguishing Sukuk from Conventional Bonds
Conventional Bonds Sukuk
Asset
ownership
Bonds dont give the investor a share of
ownership in the asset, project, business, or joint
venture they support. Theyre a debt obligation
from the issuer to the bond holder.
Sukuk give the investor partial
ownership in the asset on which the
sukuk are based.
Investment
criteria
Generally, bonds can be used to finance
any asset, project, business, or joint venture that
complies with local legislation.
The asset on which sukuk are
based must be shariah-compliant.
Issue unit Each bond represents a share of debt. Each sukuk represents a share of
the underlying asset.
Issue price The face value of a bond price is based on the
issuers credit worthiness (including its rating).
The face value of sukuk is based on
the market value of the underlying
asset.
Investment
rewards and
risks
Bond holders receive regularly scheduled (and
often fixed rate) interest payments for the life of
the bond, and their principal is guaranteed to be
returned at the bonds maturity date.
Sukuk holders receive a share of
profits from the underlying asset
(and accept a share of any loss
incurred).
Effects of
costs
Bond holders generally arent affected by costs
related to the asset, project, business, or joint
venture they support. The performance of the
underlying asset doesnt affect investor rewards.
Sukuk holders are affected by costs
related to the underlying asset.
Higher costs may translate to lower
investor profits and vice versa.
35

In practice, some sukuk are issued with repurchase guarantees just as conventional bonds
are. Although not all shariah scholars agree that this arrangement complies with Islamic law, a
product called sukuk ijarah may come with a repurchase guarantee.
The key characteristic of sukuk the fact that they grant partial ownership in the
underlying asset is considered shariah-compliant. This ruling means that Islamic investors
have the right to receive a share of profits from the sukuks underlying asset.
When you have the basics about how conventional bonds and sukuk work, its time to put
them next to each other. Table 1.2 offers a quick look at the key ways in which these investment
products compare. The sukuk bonds can be applied to all other Islamic transactions and
agreements, and therefore, potentially gain the profit of invested capital.
In a mudaraba sukuk, the sukuk holders are the silent partners, who dont participate in
the management of the underlying asset, business, or project. The working partner is the sukuk
obligator. The sukuk obligator, as the working partner, is generally entitled to a fee and/or share
of the profit, which is spelled out in the initial contract with investors.
With sukuk that are based on the murabaha contract, the SPV (Special Purpose Vehicle)
can use the investors capital to purchase an asset and sell it to the obligator on a cost-plus-profit-
margin basis. The obligator (the buyer) makes deferred payments to the investors (the sellers).
This setup is a fixed-income type of sukuk, and the SPV facilitates the transaction between the
sukuk holders and the obligator. The murabaha contract process begins with the obligator (who
needs an asset but cant pay for it right now) signing an agreement with the SPV to purchase the
asset on a deferred-payment schedule. This agreement describes the cost-plus margin and
deferred payments (Figure 1.13).
The basic idea of ijarah sukuk is that the sukuk holders (investors) are the owners of the
asset and are entitled to receive a return when that asset is leased. The ijarah contract process
begins when a company that needs an asset but cant afford to purchase it outright contracts with
an SPV, which agrees to purchase the asset and rent it to the company for a fixed period of time.
In this scenario, the SPV receives the sukuk proceeds from the investors; in return, each
investor gets a portion of ownership in the asset to be leased. The SPV buys the title of the asset
from the same company that is going to lease the asset. In turn, the company pays a rental fee to
the SPV.
Istisna is a contract between a buyer and a manufacturer in which the manufacturer
agrees to complete a construction project by a future date. The contract requires a fixed price and
product specifications that both parties agree to. If the end product doesnt meet contract
specifications, the buyer can withdraw from the contract. Istisna sukuk are based on this type of
contract. The sukuk holders are the buyers of the project, and the obligator is the manufacturer.
36

The obligator agrees to manufacture the project in the future and deliver it to the buyer, who
(based on a separate ijarah contract) will lease the asset to another party for regular payments.
The process of issuing istisna sukuk begins when the obligator (manufacturer or contractor) and
the SPV sign an istisna contract.













Another innovative type of sukuk is hybrid sukuk which has new complicated structures.
Based on various demands of investors, a more diversified kind of hybrid sukuk or mixed sukuk
emerged in the market. The assets can comprise of istisna, murabaha as well as ijarah. Islamic
Development Bank issued the first Hybrid Sukuk for US$400 million. The assets comprised 66%
ijarah sukuk, 31% murabaha and 3% istisna sukuk. The hybrid sukuk structure represents the
potential of new structures and benefits to the investors.
Sukuk has now become the strongest segment in Islamic finance, are involved in the
international market and generate significant cross-border flow of funds as may be achieved
beyond domestic markets. Along with hard work, growth and balanced development agenda, all
countries have the potential to expand the role of Islamic finance is increasing in contributing to
global growth and financial stability. Investment sukuk are the ideal investment for investors
requiring a fixed investment return with low risk and the Shariah Compliant.

1.6.5. Islamic Mutual Funds
Islamic investment funds are similar to socially responsible mutual funds n that they
select their placements bot in bases of profitability alone, but on non-economic criteria in this
Investor (seller)
SPV
Asset or commodity
supplier
Obligator (Buyer)
1. Cash proceeding 2. Sukuk
certificate
issuance
4.Delivery of
asset
3.Purchase of asset
for spot
payment and delivery
5. Differed payments on
installment or lump sum
(cost+profit)
6. Periodic distribution
of deferred payments
Figure 1.13 Murabaha sukuk structure
Source: Designed based on the ideas of the author

37

case, compatibility with Islamic values. Driven by abundant liquidity and the boom in financial
markets, thousands of investments funds were started in recent years. In addition to Islamic
financial institution, virtually every major Western financial institution such as Merrill Lynch,
Goldman Sachs, Flemings, etc. now offers Islamic investment funds. In 1990, Dow Jones and
Company has created the Dow Jones Islamic Market Index or DJIM, which track 600 companies
whose products and services do not violate Islamic law.
An Islamic mutual fund is similar to conventional mutual fund in many ways. However,
unlike its conventional counterpart, an Islamic mutual fund must confirm to shariah investment
precepts. The Shariah encourages the use of profit and loss sharing and partnership schemes, and
forbids riba (interest), gambling and gharar (selling something that is not owned or cannot be
described in accurate detail in terms of size, type and amount). Shariah guides and supervises the
several aspects of Islamic mutual funds, including its asset allocation (portfolio screening),
investment and trading practices, and income distribution.
Any Mutual Fund falls roughly into the following two sub-groups:
Income Funds. The investor receives a regular income (monthly/quarterly) by investing
in securities that provide income (e.g. dividend paying stocks, etc.).
Growth Funds. The main aim of this type of fund is to grow the capital invested by
appreciation of the underlying securities, and not to provide any annual/quarterly income.
The following Mutual Funds presented below are ones of best prospective funds advertise that
they operate according to Islamic Shariah principle. Most have a Shariah Advisory board that
oversees its compliance with Islamic teachings:
Azzad Asset Management is a financial services firm specialized in providing ethical
(halal only) financial solutions. The company offers the Azzad Funds as well as an
ethical (halal) separately managed program using asset allocation. Clients can choose
from a variety of retirement, college savings, and managed investment accounts. In
addition, the company assists affluent investors with their estate planning needs.
Businesses and individuals depend on Azzad to help them turn their wealth into their
goals by using only halal investing.
Amana Mutual Funds. They offer two Mutual Funds (Growth and Income) operating
according to Islamic Principles, with an Islamic Advisory Board.
Allied Asset Advisors. These are an Islamic Mutual Fund that tracks the Dow Jones
Islamic Markets USA (DJIM-US).
Wright Islamic Equity Investment. Their objective is to "provide competitive Shariah
compliant investment returns utilizing a globally diversified portfolio of high quality
equity investments rigorously screened for Shariah compliance.
38

1.6.6. Micro-lending or Micro-financing
Most micro-lending or micro-finance institutions (MFI) are not, technically, Islamic
banks. Yet they may be closer to the moral of economy of Islam than many self-styled Islamic
banks, and will no doubt be a source of ideas and concepts for Islamic finance in the future. The
micro-financing idea has gained a number of adherents, in particular among governments and
international organizations in recent years.
Micro-finance purports to provide a market-based solution to one of capitalisms
thorniest problems: integrating the poor into the economy. This finance scheme focuses on
moving people off the dole and into productive enterprise. Self-helped and self-reliance are at the
center of the system. The scheme turns the conventional banking logic on its head: rather than
looking for creditworthy customers and basing lending decisions on credit history and collateral,
MFIs lend small amounts of money to people principally women with no resources, as means
of integrating them in the productive economy.
The best known experience in micro-financing is Muhammed Yunuss Grameen Bank,
which was initially started in Bangladesh and has since been replicated in more than 50
countries. Although interest-based and devoid of explicit references to Islam, Grameen Bank
concept not to mention the fact that it was created in an overwhelmingly Islamic country by a
Muslim is based on a central tenet of the moral economy of Islam.
The MFIs are in the process of destroying several very old myths: the poor are not
creditworthy; they are not reliable borrowers; they are not successful enough to make saving;
they are bad investors and even worse entrepreneurs. Grameen Bank boasts that 98 per cent if its
loans are repaid on time [14].
The main objection of Islamic scholars to micro-lending banks is that they lend at
interest.

1.7. The Management and Control, and Islamic Moral Hazard

The notion of moral hazard is commonly use in the connection with financial regulation.
It refers to policies that many encourage reckless behavior. For many, it is axiomatic that bank
and their customers are people of virtue, who act at all times in a righteous manner. While it is
undeniable that religious fervor was for many people a reason to work for an Islamic bank, or to
conduct business with it, it was soon discovered that religion could be a double-edged sword. In
the Koran there are numerous references to hypocrisy [17]. Since time immemorial, con artists
have used the cover of religion as a means of rapid enrichment. Even when the overwhelming
majority of people are honest, all it takes is a few bad apples a few dishonest customers or
employees for banks to incur serious difficulties.
39

There are four factors of special importance in this regard. One is the assumption of
righteous behavior on the part of employees and customers, which sometimes turns certain
institutions into magnet for dubious characters [14]. The second is the use of religion as a shield
against scrutiny. The third is the religious and legal ambiguity that often allows borrowers to
escape their obligations with impunity. The fourth involves conflicts of interest involving the
bank and its clients.
In the early years, Islamic bankers failed to act prudently and exercise the kind of due
diligence expected of bankers, because implicit assumptions about the virtue of their employees,
and customers Internal control has also been a problem for the same reasons. A number of failure
in management of banking was seen in Dubai, the worlds centre of Islamic commercial banks
and regulations in last decade of twentieth century.
A Second type of Islamic moral hazard occurs when financial activities of certain Islamic
institutions or group become immune to scrutiny or criticism, whether for political or religious
reasons. A more subtle but equally pervasive form of Islamic moral hazard is the advantage that
can be taken from ambiguity. Unlike specular systems, the legal system of Islam incorporates
both an economic and religious logic. In the religious law of Islam, equitable considerations of
the individual conscience in matters of profit and loss override the technicalities of commercial
dealings. It is harmonization of these two very different approaches which poses the real
challenge for developing Islamic law today [24].
Islamic banks face serious problems with late payments, not to mention outright defaults,
since some people take advantage of every dilatory legal and religious device. However, it
should be notes that same problems often hurt conventional banks in Islamic countries. In Saudi
Arabia, problems of late payment are endemic, and banks receive little help from juridical
system. In Pakistan, many borrowers took advantage of the ambiguity of a multilayered legal
system to avoid repaying much of their debt.
The last type of Islamic moral hazard is related to the banks relation with its depositors.
Islamic banks share their profits with those of their customers who hold investment deposits. For
example, 80 per cent of the net profits may be distributed to the depositors, and 20 per cent to the
shareholders. Empirical surveys have shown that banks often arbitrarily change distribution
ratios.
Perhaps the most vexing managerial issue is the lack of qualified personnel. Bank
officers at once management skills appropriate to conventional institution and religious training.



40

2. PRACTICAL PART

2.1 Uzbekistani Leasing Market

The leasing and housing finance sectors have been developed in line with international
best practices, with the value of lease financing increasing from US$265 million in 2007 to over
US$890 million in 2012.
Analyzing the leasing market of Uzbekistan in 2012, we can identify the following
trends. Factor outpacing GDP growth, despite a significant increase in the volume of leasing
transactions the share of leasing in GDP for the previous year has not increased and amounted to
0.6 %. However, the leasing market has huge potential for growth. Every year the lessors
competition in the market is growing, which means an increase in the level of provided leasing
services. Also, it should be noted, the role of public-private cooperation in the leasing sector,
which contributes to the development of diversified and specialized companies in leasing market
of the country, such as Uzkishlokhuzhalikmashlizing, Taiba leasing, O`zavtosanoat-
Leasing, and et al.One of the determining factors in the development of the leasing sector is
lessors access to the source of financing [26].
The total volume of leasing operations in Uzbekistan in 2013 increased by 36 percent
compared to 2012, up to 805.2 billion soums and the volume of the leasing market rose by 16.5
percent, up to 1.511 trillion soums, the Uzbekistan Lessors Association told Trend on Feb .13
(Figure 2.1).
In late 2013, the share of leasing in the country's GDP was 0.7 percent compared to 0.6
percent a year earlier, the specific weight of the leasing portfolio in GDP remained at the
previous year's level of 1.3 percent and the specific weight of leasing transactions in investments
to the main capital increased by 0.1 percent to 2.8 percent.
In total, last year Uzbek lessors concluded 6700 transactions versus 7000 transactions a
year earlier. The Table 2.1 shows the snapshot for Uzbekistani leasing environment for last year.
In 2013 agricultural equipment prevailed amongst the leased property. The agricultural
equipment's share in total transactions stood at 37.5 percent compared to 33.1 percent in 2012.
Among all the leased properties, motor vehicle leasing deals stood at 24.8 percent,
technological equipment at 21.4 percent and the real estate and property complex was at 16.3
percent.
In all the leasing deals on technological equipment in 2013, the major place belonged to
construction machinery and equipment for building material manufacturing (35.4 percent), land
reclamation equipment (22.9 percent) and equipment for light industry (12.8 percent).
41

37
45
149
245
337
818
1122
1135
1258
1297
1511
2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013
In 2013, some 99 lessors operated in the country's leasing market, including 24
commercial banks and 75 leasing companies.
The major leasing companies on the market last year were: Uzselhozmashlizing (271.5
billion soums), Uzavtopromlizing (65.9 billion soums), Uzmeliomashlizing (38.5 billion soums),
Uzbek Leasing International J.V. (36.2 billion soums) and the Artum Leasing Group (20.9
billion soums).
















The most active commercial banks in leasing services included the State joint-stock
commercial bank Asaka (65 billion soums), joint-stock commercial bank Ipoteka (32.3 billion
soums), the Rural Construction Bank (20.3 billion soums), open joint-stock commercial bank
Mikrocreditbank (16.2 billion soums) and Uzpromstroybank (15.9 billion soums).
Uzbekistan abolished customs duties during the import of modern technological
equipment on leasing terms and the lease payments are exempt from VAT with the lessees
released from taxes on leased property.
Moreover the recent foundation of leasing company with Islamic financing related basics,
has escalated the improvement of leasing possibilities in the country. The TAIBA LEASING
LLC was established in 2010 as the 100% subsidiary of The Islamic Corporation for the
2006 2007 2008 2009 2010 2011 2012 2013
No. of lessors
28 33 49 64 86 83 84 99*
*Banks - 24, Leasing Companies - 75
Figure 2.1 Leasing market in Uzbekistan
Source: based on information from[26].

42

Development of the Private Sector (ICD), Member of the Islamic Development Group. FC
TAIBA LEASING LLC was incorporated in line with ICDs vision to set up Islamic leasing
companies across its member countries. Aim of TAIBA LEASING is to support private SME
companies in Uzbekistan.
Table 2.1.
Leasing performance in Uzbekistan
Number of operations to date 54
Net cumulative Bank Investment 709.8 million
Cumulative disbursements Portfolio 503.7 million
Portfolio 34.3 million
Number of active portfolio operations 11
Operating assets 34.0 million
Private share of portfolio 49%
Equity share of portfolio 2%


Leasing portfolio of the company is formed in areas such as light industry, medical
equipment, transportation, and manufacturing. The average estimated cost of leasing object
varies from $ 50 to $ 400 thousand credit portfolio TAIBA LEASING for the year 2012
amounted to more than 3 billion soums ( about USD 1.32*10
6
). Presently held by the transaction
currency and leasing contracts, also are working to increase the leasing contracts in national
currency.
Leasing companies and banks provide leasing services exclusively to legal entities of
different forms of ownership. In addition, banks prefer to customer's current account is in the
same bank as the companies one. Some private companies provide leasing and individual
entrepreneurs as well.
The timing of leasing services has no special distinction, and are provided to 1 year to 5
years, except such as leasing companies " Uzkishlokhuzhalikmashlizing ", " Uzmeliomashlizing
" and " Uztranslizing " whose lease term can be up to 120 months . In the banking sector to
provide long-term conditions may differ from leasing banks such as "Asaka " OJSCB "
Microcredit " OJSCB "Hamkorbank" whose period can last up to 7-8 years. Interest rates leasing
companies and banks do not have specific differences in size. And their range varies from 8% to
30% in SLE, and from 5 to 30 % of sums. The magnitude of the interest rate also affects the
requirement for size and type of collateral. Companies that do not require collateral, interest rates
are significantly higher than those companies that have requirements for collateral . Advance
Source: Review of leasing operations in Uzbekistan, 2013

43

payment, in % of the value of the lease is an average of 20% and above. Lessors mainly finance
in domestic currency amounting to an average of 500 million sum for leasing transactions.
The share of leasing in investment to fixed capital by the end of 2012 was 2.67%. Also,
there is stability of GDP per share of leasing 0.61%. The indicator leasing share of GDP portfolio
tends to decline, and by the end of 2012 was 1.34%.
The growth rate of the volume of leasing on the basis of 2012 amounted to 22%. If in
2011 the volume of leasing amounted to 484.5 billion sums, by the end 2012, it rose to 106.1
billion sums to $ 590.6 bln and was observed a significant increase in the number of leasing
transactions, more than 12% (Figure 2.2).

Figure 2.2 Dynamics of property transferred to the leasing (millions of UZS)
Source: based on information from[26].
There a number of banks and leasing companies providing services in medical equipment
agriculture transport building and construction etc. More than half of the leasing market by the
end of 2012 owned by leasing companies - 64.5%, however, this figure decreased by 2.6%
compared to the previous year. The total amount of transactions of leasing companies in 2012
amounted to more than 381 billion sums, and the remaining amount of 209.6 billion sums are
owned by banks.(Figure 2.3).
In conclusion, it should be noted that in our country the leasing sector is gaining
momentum and there is great potential for growth. In the near future leasing, ensuring an orderly
and secure relationship between all participants of the chain of financial investment,
modernization of industries and regional infrastructure, may be one of the most promising tools
351.66
401.65
430.33
484.51
590.63
0
100
200
300
400
500
600
700
2008 2009 2010 2011 2012
44

for sustainable development and the development of innovative economy of the Republic of
Uzbekistan.


Figure 2.3 The share of players in leasing market
Source: based on information from[26].

2.2 The leasing procedures in commercial banks

For better understanding of the procedures of financial leasing transaction we assume
hypothetical model of leasing example.
The private dental clinic is willing to buy new equipment for their renovated building. It
is located in the center of the city and enjoys a great success among the clients. In order to step
aside to the innovations the clinic decided to order the medical equipment from Switzerland. The
goods are following:
Dental chairs: KaVo Primus 1058 CLEO II (AIR)
Stools: Estro L Stool
Multimedia: SOPRO 617 INTRAORAL TELECAMERA
Accessories: VITALI PORTABLE NEGATIVOSCOPE
Operatory Lights: The Marus
KaVo dental instrument
Descriptions:
KaVo Primus 1058 is designed for specialty and available space.
Treatment unit is perfectly designed for both specific treatment protocols and surgeries with:
63.20%
66.70%
67.70%
67.10%
64.50%
35.20%
33.10%
32.40%
32.90%
36%
2008 2009 2010 2011 2012
Leasing companies Banks
45

Hanging tubing
Continental Style
Knee Break
Cart System
Benefits that are tailored to requirements:
Eerything directly to hand: The workplace adapts to the dentist and not vice versa
Use of proven KaVo technology (Progress backrest, one-hand system, stability through floor
mounting)
Ease of operation
Compact: Also fits into smaller surgeries
Optimal for treatment of children through height adjustable chair base
Fully multimedia-prepared
Outstanding ergonomics
CLEO II (AIR). Treatment Centre facilitates multiple working methods and a variety of
dental procedures. Cleo II Chair Features include:
Unique Knee Brake chair design
Twin-articulating headrest
2 preset positions
Last-position memory (LP) and auto-return
Automatic extendable leg rest with manual override and auto safety stop
Foldaway, detachable armrest
Integral service centre with air and water regulators and pressure indicators
4 handpiece outlets and 3 in 1 syringe
Stools. Estro L Stool sliding on a polished aluminum 5-spoke base, equipped with 5 swiveling
and self-braking casters. Wrapping polyurethane backrest with upholstered central insert. Gas
shock-absorber ranging of 200 mm. Handle available on the right or left side.
Multimedia. SOPRO 617 INTRAORAL TELECAMERA DSP is digital technology, electronics
integrated in the hand-piece with reduced overall dimensions, extreme manageability (weight of
hand-piece: 50 g), automatic adjustments, LED lighting without fibre optics, 80 field of vision,
no upside-down image and depth of field of 5 to 30 mm, automatic focus, possibility of stopping
1 to 4 framings by foot, easy mounting both on the instrument table and nurse's console.
Accessories VITALI PORTABLE NEGATIVOSCOPE Accessory completely independent of
the unit that backlights radiographic photographs, thus allowing for their easier visualization.
The radiating surface (85x75mm) is lit by led diodes, thus obtaining a cold light, low
46

consumptions and high reliability. The device, of small dimensions (about 165x115x65 mm), is
battery operated.
Operatory Lights The Marus Compact, yet powerful, two intensity settings with a color
temperature of 4400K.
KaVo dental instrument Dental turbines, surgical instruments, straight and contra-angles
headpieces.
The clinic researches the market of leasing in the country and decides to apply for the
leasing in XX Leasing Group. According to legal acts and code of leasing operations, XX
Leasing Group offers the following option:
At the final year or date of the leading contract the object of leasing becomes the
property of the lessee ;
Terms of leasing contract exceeds 80 percent of useful life of the lease or
residual value of the leased object at the end of the lease is less than 20 percent of
its original value ;
the lessee has the option to purchase the leased object at a fixed price or price
determined at the end of the lease ;
total amount of payments for the period of the leasing contract exceeds 90 percent
of the cost leasing object.
The lessor is obliged to acquire the property under the lease agreement and pass it into
possession and use to the lessee; notify the seller that property intended for leasing a particular
person acquiring the property for the lessee; timely and fully perform its obligations to the lessee
on the content of the object of leasing, repairs and maintenance service if such conditions are
required by the treaty [31].

Calculation
The Clinic company have been acknowledged with the regulations of the leasing procedures now
is presenting the dentistry equipment they would like to buy (Table 2.2).
The XX Leasing Group is interested in the project of financing and make decision to offer the
leasing transaction in following terms:
Advance payment in amount of two monthly payments at signing leasing contract;
Interest rate of 6.5 % , within the period of 36 month;
Frequency of payment is 12/year;
Residual value of equipment equals $10000;
The lessee is obliged to buy the equipment at the end of the leasing contract.

47

Table 2.2.
The clinic required medical equipment


At the beginning we dont know the monthly payments amount. The principle of value
additivety states that the present value (lease amount) is equal to the present value of the monthly
payments (an annuity) plus the present value of the residual value (a lump sum). Therefore, we
have the following formula (2.1) as starting point:
[

Where
PV present value, in our case is the lease amount;
Pmt is monthly payments;
FV future value, residual value in our case;
i is (nominal) interest rate;
N is number of month due to payment.
According to this formula (2.2) we can get the equation of monthly payment:

]



However, we are still challenged with the advance payment that makes a minor trouble in
our calculations. The advance payment serves to reduce the effective lease amount and also
reduces the number of monthly payments to be made by the number of advance payments. This
insight makes it relatively simple to solve the problem using a variant of our PV equation above.
In the equation below (2.3), A is the number of advanced payments:
Name of equipment Production Condition Quantity Price Total
KaVo Primus 1058
KaVo(Germany) new 2 21,430.47 42860.94
CLEO II (AIR) Belmont (USA) new 1 27,769.03 27769.03
Estro L Stool
Vitali(Italy) new 3 587 1761
SOPRO 617
INTRAORAL
TELECAMERA Vitali(Italy) new 3
2,421.86
7265.58
VITALI PORTABLE
NEGATIVOSCOPE Vitali(Italy) new 2 5,074.48 10148.96
The Marus Lights
Marus(USA) new 4 1,749.87 6999.48
KaVo dental instrument KaVo(Germany) new 20 480 9600

Total
needed
$
106,404.99
48


[

So, we are simply subtracting the number of advance payments from the lease amount (because
they are both at period 0), and reducing the number of payments from N to N A. Now, we
simply need to solve the equation for the monthly payment. After some algebraic manipulation,
we get the following formula (2.4):

Lets apply these formulas to our data. According to terms from XX Leasing Group and the
information from the dental clinic we have the following:
PV- (leasing amount) is $106,404.99;
i (Nominal) interest rate is 6.5%;
A
5
2 advance payments;
FV- Residual value
6
is $10000.
Converting the annual rate to a monthly rate (0.065/12 = 0.0054) with monthly payment
frequency, we can calculate the monthly payment amount as follows (2.5):

As it is shown in the table 2.3, the dental clinic has to pay following installments to the
XX Leasing Group within 34 month:
$ 5670.18 first payment at closing signing the leasing contract
$ 2835.09 monthly regular payment
$ 10000 for buying out the goods (dental tools) at the end of contract



5
A Advance payment, In calculation the two-monthly-payment is subtracted from 36 payments as it is
considered as payment at close date of contract.
6
Residual value the value of the goods is estimated by bank, defining how much it is worth at the end of its
lease, or at the end of its useful life, ensuring the client to purchase it.
49

Table 2.3.
Leasing payment schedule in conventional bank

Number
of
payments
Payment
date
Leasing
amount Installments Interest Principal Balance Residual
0

$(106404.99) $ 5670.24

$
100734.8
1
1/1/2014

$ 2835.12 $ 545.68 $ 2,289.44 $ 98,445.31
2
2/1/2014

$ 2835.12 $ 533.28 $ 2,301.84 $ 96,143.47
3
3/1/2014

$ 2835.12 $ 520.81 $ 2,314.31 $ 93,829.16


.
34
10/1/2016

$ 2835.12 $ 98.88 $ 2,736.24 $ 15,516.88
35
11/1/2016

$ 2835.12 $ 84.05 $ 2,751.07 $ 12,765.81
36
12/1/2016

$ 2835.12 $ 69.15 $ 2,765.97 $ 9,999.85 $ 100000

Totals $ 102064.32 $ 11329.42 $ 90,734.90

The dental clinic agrees to sing for the conditions of the leasing contract of XX Leasing
Group or decides to know the other alternatives for purchasing the dental instruments and
machines via Islamic bank.

2.3 Leasing in Islamic bank

As described in the first part of the paper, we now that in Islamic banking most of the
transactions are based on interest-free or partnership conditions. Consecutively, there is an
alternative of leasing transaction in Islamic banking system. It is ijarah. The term ijarah literally
means rent, the Shariah process is known as ijarah-wal- iqtina , rent with an acquisition or rent to
own. The process of ijarah can be used for equipment as well as property. This Islamic
finance process is very simple. A single asset trust is created whereby the bank purchases the
property, and then leases the property to the customer. A portion of each monthly payment goes
towards ownership, until the customer owns 100%.
The following basic principles are to be followed in order to fulfill the requirements of
ijarah transaction:
Parties of contract what they can and cannot do
Subject of the matter what can be used as basis of valued ijarah contract
Consideration/rent the rent that will be payable
Period/termination when the ijarah will be valued and ruled regarding its termination
The basic difference between a Shariah ijarah-wal-iqtina Islamic loan process and a
conventional lease is the ijarah process obligates the bank (seller) to sell the property to customer
under a promise to purchase. While the same contract entitles the customer to purchase the
property, the customer is not obligated to do so.
50

The conditions for an ijarah contract to be valid are that the asset to be leased should have
a tangible presence, be visible, and capable of being transferred back to the lessor after the
termination of the contract. Furthermore, the asset should have some usage value. From here it
follows that the lessor should transfer the asset to the lessee, for use only, in a condition that
enables it to be used to achieve its stated objectives. In this context, it is worth mentioning that
lessee should put to use the asset only in the way specified in the ijarah contract.
The purchase price agreed in contract is equal to the original purchase price less the down
payment made by the customer plus $1.00. For example, if the value of the property is $200,000
and the customer makes a $40,000 down payment (advance payment), the initial amount the
customer has to pay the investor for 100% ownership is $160,001. As the customer makes more
payments, this amount reduces, until the final ownership payment of $1.00 is reached.
For dental clinic type of ijarah as ijarah-thumma-al-bay(lease-sale or financial lease) is
suited. This is one of the most commonly entered-into of all ijarah, which is preferred by
businesses. These form of ijarah contract shares many points of similarity with the conventional
form of the financial lease agreement, however the differences are present.
The clinic lessee has the option to buy the asset or the piece of property for which he
had been paying a specified amount of rent, at the end of the contractual period, at a pre-fixed
price. This type of contract presents a convenient situation for both parties and hence is one of
the most popular of all ijarah contracts. Although the bank basically funds the buy of the asset or
the property, it still gets to earn some money out of this contract, by way of the rent. The client
or lessee, on the other hand, is not only able to use the asset without having to pay its full price
all at once or bear the risks during the leasing period, but also can become its owner after the
contract terminates.
The initial ijarah Islamic finance amount financed by the customer earns profit for the
investor through monthly rental payments
7
. The calculation of the ijara is based on amortization
principles as the mathematical formulas are acceptable as there are no Shariah issues with
calculations. The major difference between a traditional amortization and an ijarah transaction is
that the ijarah transaction is based upon a reverse amortization calculation.
The Islamic bank purchases the property at the agreed-upon purchase price. The customer
gives the down payment which serves as an advance rent payment to the bank. The customer
pays a percentage of the price every month as rent until they have paid off the purchase price (if
they do not sell the property before then). Therefore the customers percentage of ownership
increases each month.

7
The rental payments are also commonly considered as profit rate in bureaus of statistical calculation
agencies.
51

Although conventional amortization schedules are used to calculate the amount of rent,
the process is really a reverse mortgage. With a conventional leasing the customer is paying off
the amount owed until the contract is finished. With an ijarah loan, the customer is basically
saving up to take over ownership; so with each payment, their share of ownership increases.
When they have paid the entire amount, the customers can buy the property for $1.00. The bank
collects the insurance and property taxes as part of the rent payments.

Calculation of the ijarah
Assuming the same situation as in conventional bank, we need to calculate the ijarah
scenario for the dental clinic as Islamic financial instrument providing the services. As above
mentioned the calculation of the ijarah is conceptually the same as reverse amortization. First we
find out the monthly payment. The formula for calculating the payment amount is shown
below(2.6):

Where
Pmt = payment Amount per period;
P = initial Principal (loan amount);
i = rate of rental payments;
n = total number of payments or periods.
monthly payment frequency 12/year
Thus, it comes out after converting the annual rate to a monthly rate (0.065/12 = 0.0054)
with, payment for dental clinic is calculated (2.7):

From the Islamic banks side this calculation can be interpreted as following. The banks
has amount of 106404.99 and purchase the machine and other instruments for the clinic. The
dental clinic, meanwhile, pays for usufruct of the goods monthly rental payments. The bank after
generating the rent payments gains the profit from the transaction.
As the table 2.4 shows us the declining of the financed capital, it can be whereby stated
the lessee ownership of the commodity increases ascending the end of the contract the full
acquirement of property. Nonetheless, the question may arise as if the bank charges the rates it
isnt an interest? Then, the answer is approved both logically and methodically; it is clearly it is
52

rental payments on property since it is based upon a business transaction. From a Shariah
perspective it is acceptable to describe the profit on an Islamic ijarah transaction as a percentage;
any profit earned on a rental ijarah finance transaction should be described as a percentage so a
customer can clearly understand what the overall cost of the financial transaction is.
Figure 2.4.
Ijarah payment schedule
8

Date Principal Installments
Rental rate
per month
Balance
(0.0054) $ (106,404.99)
1/1/2014 $ 3,834.83 $ 3,260.24 $ (574.59) $ 102,570.16
2/1/2014 $ 3,814.12 $ 3,260.24 $ (553.88) $ 99,309.92
3/1/2014 $ 3,796.51 $ 3,260.24 $ (536.27) $ 96,049.68

10/1/2016 $ 3,303.57 $ 3,260.24 $ (43.33) $ 4,762.96
11/1/2016 $ 3,285.96 $ 3,260.24 $ (25.72) $ 1,502.72
12/1/2016 $ 3,268.35 $ 3,260.24 $ (8.11) $ 00.00

Where
Rental rate = 0.0054 previous balance;
Principal = monthly payments rental rate;
Balance = Principal previous balance.
The above practical applications of ijarah make it clear how this mode of Islamic
financing aids both cash-strapped start-ups find their footing and establish them in an
increasingly competitive business environment. The dental clinic can whereby buy the
equipment in more convenient way in payments:
Monthly payment: $ 3,260.24
Total of 36 payments: $ 116,943.49
Payoff date: Dec. 2016
And preferability and increase their ownership of the property, ignoring the buying them
for a quite different price $1.00 or alike, at the end of the contract.

2.4 The Comparison of the systems: leasing and ijarah in conventional and
Islamic banks respectively

The comparisons between ijarah and conventional operating lease contracts throw up
several points of similarities. With regard to ownership of the asset, the lessor retains the right to
own in both ijarah and conventional operating lease contracts. The lessor bears the risks and

8
The author used the calculations that have no advance payment in conditions of the contract
53

liabilities and the costs of maintenance of the asset in both forms of contracts. This responsibility
also pertains to instances where the asset has been damaged due to factors that were beyond the
control of the lessee. Comparisons between ijarah and conventional operating lease contract
sprovide an interesting insight into the working principles of ijarah in particular and reiterate the
soundness of this mode of Islamic financial agreement arising out of its adherence to the basic
tenets of Shariah. For instance, in a conventional operating lease contract, the lessor is entitled to
penalize the lessee for delaying or defaulting on payments. The ijarah contract also states the
same but modifies it to include the condition that the lessor can use the amount received as
penalty only for charitable causes, thereby avoiding interest-riba (Table 2.6).
Table 2.5.
Comparison of leasing transactions in two systems
Conventional Leasing Ijarah
In conventional lease agreement the lease
commences on the very next day on which the price
is paid by the lessor whether the lessee has taken the
delivery of the assets or not

Where as in ijarah rent should be charged after the
delivery of asset.

In conventional banks lease the lessor does not bear
all the expenses incurred on the purchase of assets
e.g. freight charges, custom duty etc.

In Ijarah lessor is the owner of the assets therefor he
bear all the expenses incurred on the purchase of
assets and include them in the cost of assets

In Conventional lease if the lessee makes late
payment then penalty will be charged and added to
lessors account that is not allowed in Shariah

But in case of Islamic Lease penalty on late
payment will be charged but given to some charity
account and in no case it will be a part of lessors
income.

At the expiry of conventional lease the leased asset
is normally transferred to the lessee because the
lessor has recovers his cost along with an additional
profit. Asset is transferred free of cost or nominal
token price

In Islamic lease as the asset is the sole property of
the lessor and after the expiry of leased period the
lessor is at liberty to renew the lease agreement or
take the asset back and lease it out to another party
or sell it to the lessee.


Advantages of ijarah for financial institutions must be studied from two varying
perspectives the ethical angle that harps on the Shariah roots of these Islamic financial products
and the commercial angle that harps on the ease-of-use and administration of these loans.
The Ethical Perspective
The priorities of ijarah for financial institutions from the ethical perspective stem from
the fact that the working principles of these loans are deeply ingrained in the guidelines laid
down by the Shariah. Shariah is an Islamic body of law containing rules and regulations that
govern the private and professional lives of Muslims all around the world. This brings on
dual benefits of ijarah loans for financial institutions.
54

One of the most integral benefits of ijarah loans for financial institutions can be
understood after analyzing the Shariah laws that govern financial transactions. Here are the
principal rules:
Financial institutions are barred from charging and receiving interest.
Financial institutions cannot engage in any speculative or risky behavior.
Banks and other Islamic financial institutions that offer ijarah loans must draw up
transparent and detailed contracts that explicitly mention the terms, conditions, rights,
duties, obligations, and/or promises binding on each party that has entered into the
contract.
Compliance to these rules of the Shariah imparts a considerable degree of transparency,
integrity, and consistency to ijarah loans, thereby making them lucrative even in times of
recession. Thus by offering ijarah loans, many financial institutions have been able to do
business even when people around the world turned away from conventional loan agendas. One
of the crucial and most noticeable benefits of ijarah loans for financial institutions is that by dint
of these loans, many financial institutions have been saved from downing their shutters during
those turbulent financial times.
Secondly, many Islamic financial institutions are able to reap the afore-mentioned
benefits of ijarah loans for financial institutions without having to violate their religious
affinities.
The Commercial Perspective
There are dual benefits of ijarah for financial institutions from the commercial viewpoint.
Firstly, the ease-of-comprehension and execution of these types of loans make them far more
time-saving and cost-efficient than conventional types of loans. The efforts thus spared on the
resources fronts translate into greater revenues for banks and other Islamic financial institutions
that offer ijarah loans.
Ijarah incorporates a provision whereby the lessee can exercise his right to purchase the
leased asset at the end of the rental period or after making all the payments. The dental clinic can
make use of this right. The benefits of ijarah for financial institutions arise from the fact that
financial institutions are not only saddled with the responsibility of owning an asset for which
they have no use in many instances, but they are also able to accumulate some profits by leasing
out the asset.
The benefits of ijarah loans for financial institutions that have been highlighted above are
only some in a list of many. But they suffice to prove the role these loans have played in
furthering the interests of Islamic financial institutions.

55

CONCLUSIONS

Islamic banking is continuing to grow as a viable financial institution in areas with
Muslim populations across the world, yet its effect on economic growth and the deepening of
financial systems was previously undetermined. In the process of the work the author has
analyzed the allocations of Islamic financial instruments and their alternatives and similarities
with conventional banks and has come up conclusions.
The early stages of formation banking system in Uzbekistan had particular difficulties but
favourable climate for flourishing of the country with its reforms and reorganizations of financial
sector of the country after post-soviet regulation. The rapid grow and development of the
banking sector were positively affected the economy and financial investment opportunities for
investors and other foreign direct investments. Moreover, on the scene of these reforms the
Islamic banks and Islamic (ISDB) non-profit organizations such as Islamic Development Bank
International Monetary Fund (IMF) have been integrating into Uzbekistani. The promotion of
Islamic banking in the state is being operated in the system of introduction as first initiative to
launch Islamic bank is the Hamkor Bank, which tends to create a new reliable system of banking
services. That will be supervised by the board of Shariah compliant advisers to preserve in sound
interest-free regulation.
We have also analyzed the origin of Islamic finance from simple trade relations to
advanced modern Islamic financial instruments. The soundless, ethical and moral principles are
the fundamental basics of the Islamic finance and therefore we have acknowledged with the
regulatory mechanisms of Islamic banking and finance. Also the study shows the performance if
Islamic banks, or conventional banks with Islamic financing windows in non-Muslim and
Muslim countries. We have found out that the religion is not only the way of belief, but the way
of life: in economic relations, social interactions and political statutes.
Since, the Islamic finance has begun to compete with conventional banks in roughly last
decades there are immense prospective development that will probably achieve a one of the
dominant role in providing financial operations in different states. The study shows that a variety
of Islamic instruments such as murabaha, mudaraba, ijara, salam, etc. have cardinal different
attitude and method of gaining profit and sustain the generation of adequate leverage in the
banks.
The work reviewed the leasing operations in conventional and Islamic banks, assessed
the advantages and bottle necks of the systems. The essence of the bank regulation in
Uzbekistan, clearly stating the codes and articles has been presented; also, the leasing reforms to
enhance the middle oriented business in the country.
56

Any objective assessment of Islamic finance can only be mixed. Islamic fianc is a
success, considering that it is no longer an uncertain experiment, but a reality. This work has
attempted to unveil a more completing picture of Islamic finance by presenting its many facets,
by exploring it from empirical, comparative and historical perspectives. The agenda for the
future research is daunting and includes topics that many analysts, steeped in literal and legalistic
interpretations, have shunned [14]. Yet identifying the moral economy, and addressing issues of
culture, Islamic moral hazard, etc., is more useful than parsing medieval contracts, or engaging
in irrelevant apologetics. We tried to introduce the reader to Islamic finance and banking
regulations in order to widen and enlighten his acknowledgement and we hope that this modest
work will stimulate the readers and researches in relevant areas of Islamic finance.



57

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APPENDIX


60

APPENDIX
Comparison of Islamic and Conventional banking systems


Conventional
banking system
Islamic banking system
Charge interest on loans. Do not charge interest. Riba (interest) is an unjust return. interest or
usury. The term applies to any financial gain by the lender as a
condition of a loan and in a commodity trade. It also applies to any
disparity in quantity or time of delivery. as such transactions are
illegal under Islamic Zero-return loans. Prohibits the charging or
receiving of interest. A unique feature of Islamic banking is its
profit-and-loss sharing (PLS) paradigm. which is based mainly on
the mudarabah (profit-sharing) and musharaka (joint venture)
concepts of Islamic contracting

Principal stakeholders are
shareholders.
The principal stakeholder is God. The aim is to sen/e God. while
the stakeholders are the clients and the general public. Clients are
partners and the decisions are in the interest of society.
Support arms industries and
industries that pollute the
environment and exploit children.
Shariah law places restrictions on business activities. The law
further prohibits trading in alcohol. tobacco. products that contain
pork. defense and weapon production and certain entertainment
activities like gambling and pornography
Gives loans to whoever has a
guarantor or collateral.
Gives loans to those who need loans. Do not need collateral to get a
loan.
Decisions are made in the interest
of shareholders.
Islamic principles advocate for an economic system in which all
forms of exploitation are eliminated. The other principle is
Mudaraba (trust financing). a profit-sharing agreement between
two parties in which one provides the finance and the other
provides entrepreneurial and management skills. Profits are divided
according to a predetermined ratio. Losses are borne by the
provider of capital.
Designed for those who have
money and who do not care what
it is used for. Consumers have no
opportunity to choose where
money is invested. Provides no
information about what it does
with depositors money.
Islamic banks have an interest in how the money borrowed is used.
The Islamic banks have a stake in the financial activities so that
money is not used for economic activities that are injurious to
society. Those who lend to the Islamic banks expect the banks not
to invest their money in business activities that are not Shariah-
compliant. Islamic banks invest only in business activities that are
Shariah-compliant.
Its investment rewards
companies even if they act
irresponsibly.
Islamic banks share profits and losses. Murabaha (cost-plus
financing) is a contract sale between the bank and its client for the
sale of goods at a price that includes a profit margin for both
parties. As a financing technique. it involves the purchase of goods
by the bank as requested by its client.
Seeks to satisfy demand.
Conventional banks open
branches in those areas that have
sufficient demand but not needs.
They open accounts for
individuals whose income levels
can create demand for banking
services and not for those that
might be in need of such
accounts.
Seeks to satisfy need