Islamic Finance

Author(s): Imtiaz A. Pervez

Source: Arab Law Quarterly, Vol. 5, No. 4 (Nov., 1990), pp. 259-281
Published by: BRILL
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Imtiaz A Pervez*
ISLAMIC BANKING
Introduction
Islamic banking has only recently emerged in the contemporary financial world. From
the first example of Egypt's Mit Ghamr Savings Bank in 1963 it has grown steadily to
today's 100 or so Islamic financial instituiions worldwide. However, we must quesiion
whether this growich necessarily reflects the system's complete maturity or even its
wider operational scope. There are still a large number of unanswered questions and
Isla}nic banks are faced with several unresolved problems.
However, the conventional banking system has evolved over a period of time on
the basis of research and experience and stands instintionalised. It is supported by
sophisiicated infrastructure and regulated by coherent legislaiion.
To address the quesiions posed, it would be periinent not only to exanune and
explain the nanJre and ingredients of the system's processes, the rationale behind the
prohibiiion of interest ("riba"), but also to obtain an overview of the Islamic religion
itself from which the principles of Islamic economics, and in turn of Islamic banking,
are basically drawn.
Samuel Butler (Elementary Morali@, 1902) believed that the true laws of God are the
laws of our own well-being. And well-being of humanity, in its individual or collective
form, remains the ultimate objective of all religions. To prevent injustice, deliberate
or otherwise, religion identifies and separates the lawful from the prohibited. This
concept has been known to all mankind smce ancient times. However, people have
differed, in relation to supersiition and myths, in the deflniiion of the scope, variety
and causes of taboos and F>rohibitons. The divinely-revealed religions that followed
spelt out clearly the laws and injunctions through which to ensure the rights of
individuals and thereby allow digIiity to humty. Islam enumerates these in great
detail. Muslims believe this was the mission of all prophets and messengers in human
history and it was the same fundamental faith revealed to Moses, Jesus and Mohamed
(peace be upon them).
According to Godfrey Jansen, Islam is not merely a religion. It provides for
Muslims a complete code catering for all areas of human existence; iu}dividual and
social, material and moral, economic and poliiical, legal and cultural naiional and
. *
nternatona ..
*General lWanager, Faysal Islaniic Bank of Bahrain E.C. Paper submitted to the Internaiional Bar
Association SexIiinar, on "Internaiional Finance and the Arab World in the l990's" Pans, France, 2s22
June 1990. Other papers presented at the seminar are available from: 1BA, 2 Harewood Place, Hanover
Sq., London WIR 9HB.
ISLAMIC FINANCE
260 ARAB LAW QUARTERLY
It iS a comprehensive way of life, religious and secular; it is a set of beliefs and a way
of worship; it iS a vast and integrated system of law; it iS a culture and a civilisaiion; it
is an economic system and commercial norm; it is a polity and a method of governance;
it is a society and a family conduct; it prescribes for inheritance and divorce, dress and
eiiquette, food and personal hygiene. It is a spiritual and human totality; thus worldly
and other-worldly.
The Holy Qu'ran and the Sunnah (word and tradition of the Holy Prophet peace
be upon him) together are the source for these laws. Qiyas, Ijma, and iitihAd are
meant to provide unterpretation, and thereby facilitate future development and
implementation of the Islamic judicial system.
Qiyas is a deductive analogy by which a jurist applies to a new case a ruling made
* . * a
prevlous y m slml ar cases.
Ijma is the consensus of the Islamic communlty, umma. It is through this principle that
democracy makes its impact on the conduct of Islamic polity. While it opens up law tO
popular opiIiion, it is a conservative exercise as the consensus has to be by a very large
proporiion of the umma. The Holy Prophet's firm belief in his umma is evident from
his famous saymg, "my commty will not agree on what is wrong".
Ijtihad, on the other hand, is independent judgment provided by scholars of Islc
laws for which clear prlnciples and procedures are siipulated in the Qu'ran and
Sunnah. It is an extremely important tool that provides development and adaptaiion
through research.
Some visible developments in the world of Islam in the past couple of decades
synchronise with the so-called Islamic revival that has taken place at about the same
time, attrsbuted mainly to the following reasons:
(1) Muslim populaiions discovermg identity of their selves and religious values
following independence from coloIiial regimes;
(2) Dissaiisfaciion of Muslims with the materialist ideologies of capitalism and
commllnism;
(3) The recent unprecedented boost in the oil-related income of many Muslim
Arab naiions giving them economic recogniiion.
An outcome of this revival is the emergence of a new academic discipline, i.e.,
Islamic economics. This discipline is based on the hlowledge and applicaeon of
the injunctions and norms of Shari'a which prevent injustice ln the acquisition,
management and disposal of material resources.
The Islc economic system encourages trade and enterprise but is inimical to
self-interest and undue profiteering. It is non-discriminatory to human society and
builds a relaiionship between the individual and the cornmunity through co-operaiion,
integraiion and duty. Being largely humanitarian in character and socially orientated,
it provides saisfaction for human beings by enabling them to perform their obligaiions
to Allah and Society. This is contrary to the dictates of modern economics that have,
over iime, become more or less a value-free empirical social science akin to applied
ISLAMIC FINANCE 261
mathematics without much relevance or regard to the needs of inclividuals.
Islaltiic Shari'a provides rules that cover the allocation of resources, property rights,
management, production, consumption, the functions and working of markets and the
distribution of income and wealth. It also defines, in broader terms, the framework
for the design of monetary and banking systems. Since the Islamic econoniic system
was not implemented in its entirety in a diversified environment for a significant
duration in the past, its analysis, the requirements respecting its implementation
in the present-day environment, and its economic consequences, are not as yet well
elaborated or verified.
As Creator, God is The Owner of the Universe. Man is His Vice-Regent and must,
therefore, carry out his duties as prescribed by the Creator. Wealth is a trust from the
Owner and is best used in a manner which will lead to the enlarging of the interests
and welfare of humanity, in accordance with the rules laid down for the purpose.
Islam is not an ascetic religion. Neither miserliness nor prodigality are encouraged.
It advocates an healthy balance between the material and spiritual aspects of life. Thile
it dictates strictly for the periodic, even quotidian, performance of spiritual duties, it
provides for, and in fact details dispensation for, materials things. It permits humanity
to avail themselves of the bounties provided by God but in a manner whereby others are
not deprived either by discrirnilation or exploitation, and that the prescribed values
* .
are mamtamec .
When the prayer is ended, then disperse in the land and seek of God's bounty . . . (Qu'ran 62.10)
Zakat, an obligatory tax on the wealth of Muslims, is a mechaIiism that forces
productive use of wealth since cash or near-cash accumulation is fully taxable on an
annual basis while deferral is permitted for most long-term productive investments.
It provides for the equitable distribution of wealth, and ensures subsistence for the
needy. Coupled with other taxes and charges which an Islamic state may levy, it meets
the needs of the state for the welfare of its people.
Private enterprise is given full approval. Application of money in asset-related
commercial activities is meant to allow for the generation of real wealth, and in turn ffie
filtering through of the benefits of such additional capital generation to all the human
factors of production, including the grower, labourer, trader, user and the investor etc.
Doubts have been expressed as to the ability of the Islamic economic system to
effectively respond to the challenges of such a fast changing time. The example
given is that of today's Muslim countries generally lagging behind the advanced
nations in industrialisation and technology. Against the Industrial Revolution that
transformed North America, Europe and the Far East in the past two centuries, no
comparable development took place in Muslim countries. To Western observers, the
Ottomans' inability to evolve and umplement the economic policies needed to promote
industrialisation are attributed to the inadequacies of the system.
While it is true that Islamic countries have not kept pace in industrialisation and
technology with developed non-Muslim nations, it is not justifiable to ascribe this
failure to the Islamic system itself for the following reasons:
(1) The Islamic economic system was never implemented extensively in the
262
ARAB LAW QUARTERLY
past except for a short time in the very early period of Islam. During that
time, Muslims actually obtained phenomenal social, poliiical, economic and
geographical development and expansion;
(2) C'iiMa and "iitihaS' wich provide de ab tO meet chaXenges of changmg
es were not fully utilised by Muslims. These are two major aspects of
Islc religion that ensure that it is widely acknowledged as the most modern
of the religions;
(3) It was the political and alministrative failure of Islamic regimes in the past
that resulted in most of their populaiion being subjugated for long periods to
colonial or other inimical regimes during which time their development on all
counts remed ignored<
Prohibition of Illterest
The prohibition and elimination of interest is the core of the Islamic financial system.
God's ense disapproval of interest is evident from some of the verses from the Holy
Quran:
O you who believe, fear Allah ald give up what remnins due to you of interest if you are indeed
believers. And if you do not then be warned of war (against you) by Allah and His Messenger,
while if you repent you shall have your capital. Do not do wrong and you shall not be wronged.
(2.27>279)
Those who swallow usury caot arise except as he arises whom the devil prostrates by (his)
touch. That is because they say trading is like usury. And Allah has allowed trading and
forbidden usury. (2.275)
In Jlldalsm, interest was prohibited or not encouraged as per the following:
If you lend money to any of My people with you who is poor, you shall be to him as a creditor,
and you shall not exact interest from him. (Ex.22:25)
He that hath not given this money upon usury; nor taken reward against the innocent. He that
doei these things: shall never fall. (Psalm 15)
To a foreigner you may lend upon interest, but to your brother you shall not. (Deut. 23.19)
The moral teaching of Jesus in this direciion was clear and absolute:
Love your enemies and do good, lend, expect nothing iIl return. (Luke 6.35)
Aristotle rejected interest on the basis that sCmoney is sterile". Cato even compared
it with homicide. In biblical iimes all payments for the use of money were forbidden.
In 340 B.C.) Lex Genucia prohibited interest in Republican Rome. When the Roman
Empire became Chrisiianised in the fourth century, the Church forbade the clergy
from taking interest. In 594 B.C., Solon cancelled all private and public debts when he
reformed the Athenian constitution. In the eighth century, Chariemagne made usury
a cral offence. St Thomas Aqumas believed that money was invented chiefly for
the purpose of exchange and that its principal use was its consumption and alienation
whereby it is sunk in exchange. Hence, it was unlawful to make payment for the use
263 ISLAMIC FINANCE
of money lent. In the early Middle Ages, Popes and Councils continued to fulminate
against it and civil governments passed laws forbidding interest. The anti-usury
movement reached its height in 1311 when Pope Clement V made the prohibition
of usury absolute and declared all secular legislation in its favour null and void. By
the 1700s, interest had become an acceptable business practice but still most people
opposed it until 1945 when King Henry VIII changed national laws to permit charging
some form of interest.
According to Dr Mahmoud Abu Saud, money, under Islamic laws, is considered as
a means of exchange. It cannot be equated with commodity for the following reasons:
(1) Money has a technical (or ariificial) property of yielding its owner real income
simply by holding it, i.e., without exchanging it against other goods;
(2) It is liquid and has no carrying cost, no production cost (almost), and no
substitute;
(3) Demand on money is not genuine as it is derived from demand for goods
that money can buy;
(4) Money is exempt from the law of depreciation to which all goods are subjected;
and
(5) Money is the product of social convention having a purchasing power derived
mainly from the sovereignty as against the intrinsic value of other goods.
Interest is construed by Islamic economists as only a theoretical concept that
does not correspond to or is representative of real growth of capital. Any excess
of money paid by the borrower to the lender over and above the principal amount
for the use of the lender's liquid money over a certain period of time will count as
interest.
In more precise terms, Dr Mohsin S Khan defines interest as:
(1) That which is positive, fixed ex-ante and tied to time-period and amount of
loan;
(2) That its payment is guaranteed regardless of the outcome of the venture in
which the capital is invested; and
(3) That the state apparatus provides for and enforces its collection.
According to him, Islam recognises two types of individual claims to property:
(1) The property rights that are a result of the individual's labour and natural
resources; and
(2) The property that is obtained through exchange, remittance of the rights of
those less able to utilise the resources to which they are entitled, outright
grants and inheritance.
Money represents the monetised claim of its owner to property rights created by
assets that were obtained either by (1) or (2) above. Lending money is a transfer of
these rights from the lender to the borrower. All that can be claimed in return for
it is, therefore, its equivalent. Interest on money loaned, therefore, represents an
unjustifiable property rights claim because it is outside the legitimate framework of
individual property rights recognised by Islam.
264
ARAB LAW
QUARTERLY
Bohm-Bawerk tried to
explain the
rationale of
interest and the rate of
interest in
terms of tinle
preference, i.e., the
concept of
technical
superiority of
present over
future.
According to him, an
average
person
prefers
present over
future and if
he is
required to
forego the
present
comfort or use of his
funds, he
should be
entitled to some
remuneration, i.e.,
interest.
However, it is not clear what rate of
remuneration.
Some argue that the
nominal
interest rate is
justified being a fair
compensation for
inflation,
otherwise value of
money is
depreciated by time.
According to the
Fisher
equation,
nominal rate of
interest is the real rate of
interest plus
inflation rate. While
it is
practically
impossible to
accurately
predict an
inflation rate for a
reasonable
subsequent period of time, or is
customary to do so, there is much more to it than
compensation for
inflation alone. How much above
inflation is
something
depending
on
priorities?
Monetary
authorities use
interest as a tool to
control the
demand and
supply of
money, to
influence
currency
exchange rates and
inflow or
otherwise of
international
investments. In these
circumstances, the
proportions to
which the
nominal rate
extends itself are
llnlimited. The
following
example of a
situation that
so often
appears in
today's
environment will
illustrate the
discriminatory
properties
of
arbitrary
nominal
interest rate and in turn its
devastating effects on
certain
sectors
of
society.
Example
To tackle high
inflation
persisting for some time, acute
anti-inflationary
measures
are in effect.
Inflation is down to 7% but
interest base rate is still high, say at
15%.
Market
demand has
declined
considerably and
recession set in. Due to
reduced
demand, the
borrower's
earnings from the use of
borrowed funds have
declined to
say 8%, i.e., much lower than at a time when
demand was high or even
normal.
Banks are
commitiing on
average say 14%
interest to
depositors and
charging
18% to
borrowers, i.e., 11% above the
inflation rate. The
borrower ends up
paying
10%
(interest rate of 18% less 8%
increment
obtained on the
borrowed funds) from his
personal assets. If this
situation
persists, the
borrower will have, over time,
exhausted
all his
personal assets.
Meanwhile, to
safeguard the
depositor's
interests, the bank calls in
receivers and
initiates
bankruptcy
proceedings
against the
borrower well
before his assets are
exhausted.
Since the
interest rate
offered on
deposits did not have any
relevance to the rate of
actual capital
generation, the
system
discriminates in favour of the
cash-surplus
section
of
society at the
expense of the
producer/provider of
goods/services.
Under this
example, it is the user of the funds who ends up
discriminated
against
despite the fact that it is he who
provides
immense
benefit to
society
by
creaiing
employment,
adding
value, and
thereby
creating real
wealth,
which
eventually
contributes to the
general
welfare of
society.
After a fsed
pre-determined
return has been
guaranteed to
depositors, the
conventional bank is
forced to
charge the
borrower a
nominal rate to cover the
265
ISLAMIC
FINANCE
cost of
funds
and to
provide
return to its
shareholders.
When
the
actual
generaiion
of
wealth is
higher, it is
tantamount to
discliniination
agst
the
investor
and
when
lower,
against
the
user.
Socio-economic
justice in
Islam is
not an
isolated
phenomenon
but a
way of
life.
Islam
considers
interest in its
present
form as
unjustified
and
hence
injurious to
the
health of
society.
For
conslunption
loans
interest
nolates
one of the
basic
funciions
for
which
God
created
wealth,
i.e., so
that
the
needy
can be
supported
with
surplus
wealth. In
the
case of
production
loans,
pre-deterniined
nominal
rate of
interest is
unjust
because of the
uncertainty
surrounding the
entrepreneurial
profits. At
the
same
time,
interest
encourages
creation of an
idle
class of
people
who
receive
income
without
having to
put in
any
labour for it.
Society is,
therefore,
deprived of
their
labour
and
enterprise.
Islamic
Finance
The
Islamic
financial
system
allows
for
the
replacement of
mterest by a
return
obtained
from
investment
activities
and
operaiions
that
actually
generate
extra
wealth.
Under
this
system,
capital) or
any
mcome
thereen, is
guaranteed in
advance to
the
depositor.
As
such,
the
Islamic
bank
has
no
pre-deterniined
cost of
funds
and is
not
under
pressure to
put up an
arbitrary
price on
the
cash
that it
leds.
The
lncome
generated
from
the
assets
underlying
the
invested
funds is
passed to
investment
depositors
("Investors")
after
deducting
the
Islamic
bank's
management
fee.
When
higher
retutn is
obtained
from
investment
activiiies,
Investors in
terms of
their
risk-sharing
relationship
with
Islamlc
banlcs
receive
the
relevant
higher
benefits
of
such
investments. In
the
event of
loss,
however,
the
bank
loses its
fees
while
the
Investors
absorb
the
loss
unless
such
loss
was
due to
gross
negligence on
the
part of
the
bank,
proved as
such.
To a
classical
banker,
business is
first
and
foremost an
economic
aciivity
that
converts
resources
into
goods
and/or
services
which
meet
che
needs of
society. In
certain
aspects,
financial
instituiions, in
ffieir
capacity as
trustees of
oders'
assets
have
over
iime,
moved
away to
some
extent
from
their
classical
role
and
approach.
Today's
aggressive
fund
manager
has
overtaken
traditional
investors,
i.e.,
pension
funds
and
insurance
companies.
To
conservativeness
and
produce of
the
classical
investment
banker,
has
been
added
certain
speculative
aspects
and
high
leveraging
which
has
given
rise to
volatility.
Too
many
instruments
move
across
trading
floors
without
adequate
inherent
econoc
substance. In
the
options
market, a
fraction of
the
whole
business is
actually
concluded by
delivery
while so
many
make
and
lose
money in the
meantime.
Leveragmg is
one of the
key
factors
facilitating
take-overs,
mergers
and
acquisiisons
to
alarniing
proportions. A
corporate
eniity
on its
own
today
finds it
hard to
stave
off
acquisiiion
fnendly or
hostile-whecher
such
acquisitions are
for
genuine
and
fair
economic
reasons or
merely
aimed at
erasing
compeiiiion or
stripping of
assets.
Today's
financial
institutions in
their
typical
form are
generally
quite
vulnerable for
the
following
reasons:
266
ARAB LAW QUARTERLY
(1) Their capital is at great risk due to high leveraging with their liabilities
generally 12 to 30 times their capital. This is well opposed to their own
yardstick under which a corporate gearing of even 2 is deemed uMealthy.
(2) The definition of a bank has undergone many changes. The modern-day
commercial banks are no longer operating in their classical form by confining
their operations mainly to short-term. Against their shorter term liabilities, a
part of their assets are of longer maturities. While, these guarantee repayment
of deposit plus interest, some of their assets may be of unsound quality. Upon
forced sale, these could deteriorate in value or be unconvertible quickly.
Should unusual payment calls be received from depositors due to any negative
developments or rumours, it may be impossible for these financial institutions
to easily convert all their assets into cash and honour their commitments.
With the liberalising of and opening of domestic banking and capital markets,
the increasing range of borrowers as well as the instruments, regulatory authoriiies
continue tightening policies and malcing stringent prudenual ratios. However, it
cannot be denied that even today, should a general crisis develop, it may not always
be effectively possible for an authonty to bail out the country's entire financial sector
despite its commitment, best efforts and mteniions. Mini crises have occurred in
the recent past and continue to occur while there are fears of major crises loog.
Too much fmancial, rather than commercial and economic, consideration of these
operations renders the markets inherently weak, prone to high volatility, which could
contribute to future crisis.
Within the scope of the existing basis of the relationship, Investors have no stake
or commitment with the financial institutions or the assets acquired against their
investment funds. A small crisis could, therefore, grow by their panic withdrawals.
As a consequence, such financial assets will depreciate in value shattering the economic
order of society.
Islamic barlks generally perfollll the same functions as conventional banks. They
act as financial mtermediaries, mainly in a trust capacity, as well as altninistrators
of the economy's payments and transfer system. While conventional banks exploit
market imperfections (surplus, deficits, information, transaction costs, search and
acquisition, financial claims etc.) solely to obtain maximum results for the benefit of
their shareholders, the Islamic bank maintains a greater balance between the interests
of the Investor, shareholder, user and society. This is because it is required to
contribute to socio-economic justice within the framework of its functions of financial
* * *
mtermec latlon.
Due to the very nature of its contractual relationship with the Investors, the Islamic
bank is not exposed to the same vulnerability on the following grounds:
(1) For the Islamic bank, the Investors' deposits ("Investment Funds"), being on
a trust basis, do not count as its own liabilities. Since the Islamic bank is liable
only in the case of gross negligence in the performance of its trust functions, if
proved as such, Investment Funds may count only as its contingent liability.
In this sense, the Islamic bank is not a highly leveraged institution unless
267
ISLAMIC
FINANCE
current
account
balances
in its books are several
times its capital
base, which
is not normally
the case.
(2) Certain
ratios such as Gearing
Ratio and Return on Assets ("ROA")
have no
particular
relevance
to the Islamic
bank, Gearing
Ratio for the reason that
Investment
deposits
do not constitute
the Islamic
bank's liabilities.
Lower
ROA of a conventional
bank reflects
weakness
and vulnerability
in the case
of volatility
of conditions
on both sides. Even a slight negative
interest-rate
mismatch
between
those guaranteed
to depositors
and obtained
from assets
could erode profitability.
In the case of the Islamic
bank, there are no
guarantees
to investors
and, therefore,
no fLxed cost of funds.
Variation
in
income
from assets remains
to be for the account
of the Investors
whose funds
are originally
employed
for the acquisition
of such assets.
This provides
for
automaiic
and, in fact, natural
adjustment
of assets with liabilities
without the
need for any external
*ntervention.
(3) The Islamic
bank as trustee
has full discretion
on the application
of the
Investment
funds under its mutual contractual
relationship
with the Investors.
On the other hand, Investors
as, more or less, equity
holders
or sleepmg
partners,
have natural
cotment
in the trustee's
decisions,
and in turn to
the underlying
assets.
RAISING
OF CAPITAL
As m the case of all developed
economies,
capital remains
one of the key resources
in
the Islaniic
economy
m that there are not many commercial
activities
which can be
carried
out without
capital.
However,
it requires
the financial
intermediary
to allocate
capital in a manner
which will provide
socio-economic
justice to society
by the creation
of wealth and avoidance
of discriniination,
exploitation
or any other form of injustice.
Monopoly,
unfair price manipulation
and hoarding
are some of the anti-social
practices
opposed
by Islam, as is interest
as a pre-deterlIiined
nominal
rate.
Funding
is raised by Islac
banks basically
through
two vehicles,
current
accounts
and investment
accounts.
Current
accounts
Current
Accounts
with the Islamic
bank do not earn any income
for the depositor
directly
or indirectly.
The Islamic
bank receives
these funds as a loan and their
repayment
to the current
account
customers
is absolute
and unconditional
on its
part. If these funds are used by the Islamic
bank for productive
purposes,
the Islamic
bank and not the customer
bears the risk and reward,
and the former
assumes
full
responsibility
for all consequences
of their use. The Islamic
bank may, if conditons
require,
charge fees to cover expenses
to service
current
account
customers.
Balances
in current
accounts
are direct liabilities
of the Islamic
bank. Accordingly,
these balances
are reported
above the line of the Islamic
bankss
balance
sheet as its
own direct liabilities
and are guaranteed
by its capital resources.
268 ARAB LAW QUARTERLY
Inveshnent Accounts
In these accolmts are the amounts received from Investors to be invested by, and
generally under the full discretion of, the Islamic bank, on a trust basis strictly in
conformity with the terms and conditions of the relationship between the Investor
and the Islamic bank. The Investors assume all the risks and rewards relevant to
such investments.
As trustee, the Islamic bank receives a fixed percentage of the
profit earned as its management fees, the maximllm extent of which is provided for
in the relationship contract, although the Islamic bank may, at its sole discretion and
without any obligation whatsoever, forego a part of its share of profit for the benefit
of the Investors.
If at any time, assets acquired by the Islamic bank for the benefit of the Investors
through their Investment Funds obtain a net loss, it is borne by Investors on a pro
rata basis. For that time, the Islamic bank is deprived of its management fee since such
fee can only be a percentage of the profits obtained. The Islamic bank is liable for loss
only in the event of its gross negligence in the perfotmance of its trust functions, if it
is proved as such.
Reserve Account
It is also customary within the provisions of the contractual relationship between
Investors and the Islamic bank to permit the bank to deduct and provide up to a
maximum of a certain percentage from the profits earned as a donation to a reserve
account. The balances in this account are meant to offset any unforeseen losses that
may be caused to existing assets or those to be acqliired in the future. The reserve
account provides a safety net and enhances stability to income stream for the Investors.
Reserve Account balances are maintained only for the benefit of the existing and
future Investors and the Islaniic bank is barred from obtaining any benefit and
comfort for its own capital unless it was invested along with investment accounts
under the same conditions as for investment accounts. In the event of winding up
of the portfolio of Investment accounts, unappropriated
balances in a reserve account
after meeting all claims of the Investors may be donated to recognised charities.
Modaraba Investment Accounts
It is a pool of funds similar to conventional mutual funds. Investment Funds are
received into the Modaraba which are generally represented in units. Periodically, the
assets underlying the Modaraba are revalued and any increment in value thus obtained
is indicated by a relevant change in the unit price of the Modaraba. If the Modaraba
terms permit, new Investors enter the Modaraba by buying units at the latest price
prevailing at the time of their entry. The existing Investors leaving the Modaraba
receive the latest value of the units held by them. The difference between their
initial deposit and the value received according to the new unit price will represent
the Investor's profit or loss from the relaiionship.
269
ISLAMIC
FINANCE
The
Investor's risk in the
Modaraba is
confined to the extent of his
individual
amount of
participaiion.
Should losses ln a
Modaraba exceed the total capital
resources
there is no
recourse
against the
Investor's
personal assets
outside the
Modaraba.
Islamic
banks as
trustees
maxlage the
Modarabas with the
utmost care, using
prudent
policies and
conservatse
practices
diversifying risk m such a
manner that any
unfavourable
development in any one
investInent sector will have
minimum
overall
effect on the
Modaraba
profitability.
In many
countries,
Modarabas are
established as
separate
compaxiies under
special
laws and are listed on stock
exchanges. These
marketable
securities are an
esseneial
part of
Islamic
financial
markees. Many
scholars of
Islamic
economics
consider
Modaraba as the major
inserument
contributlng to the
replacement of
interest.
Theories have been
produced under
which the
Modaraba
instrument can be used
as a tool for
market
operations and hence the main
instrument for
effecing
monetv
policies of
Islamic states.
If an
Islamic bank has also
committed its own funds along with other
investment
funds, such funds are
subject to the same terms and
conditions as are
applicable to
Investrnent
Funds. In order to
provide
liqliidity,
Islamic banks do
commit their own
funds on the basis of unit value and accept all the risk and
rewards
relevant to such
amounts under the
principles of
Islamic
banking.
Under the
relai}onship
contract
Investors have no
votjilg rights or say in the
management of the
Modaraba which rests with the
Islamic bank under the
provisions
of the
relaionship
contract.
Depending on the terms of the
Modaraba, the
Islamic bank may raise
financing
for the
benefit of the
Modaraba to
conduct
profitable
transactons which
cannot
otherwise be
undertaken
within the capital
resources of the
Modaraba. In
countes
where
Modaraba
companies exist under
special local
statutes, such
conduct for the
benefit of the
Modaraba
Investors is dllly
regulated by local laws.
Levsng
CertiNcates
Leasing sn the
conventional form with a few
modificaiions is an
acceptable mode of
investment for
Islamic banks A
striking
difference of the lease
contract from other
financing
vehicles is that rental can be
periodically fixed by
mutual
consent for each
subsequent
period.
Secondary
markets can be
created for
certificate which carry the
ownership of good
assets and when
external
financial
institutes
providing
redempiion
faciliies for such
certificates are
saiisfied with the
quality and health of such assets, their proper use and
mtenance, since it
provides
fiqWity and is
conducive to ie
development of
Islamic
financial
markets, such an
instrument meets the
SpeCiflC needs of the
Islamic bank and
Investors. A brief outline is
discussed under the Use of Funds
section
below.
Use of fullds
On d}e one hand, the use of funds under the
Islamic mode of
financlng is
expected
to meet
socio-economic
objectives. On the other, it is
imperative that the
interests of
270
ARAB LAW QUARTERLY
the Investors are duly safeguarded by a sound and efficient
decision-malsing process
as well as a management process that governs careful maintenance and moIiitoring of
assets to mininnise losses and enhance increment in value of unvestments.
The healthy balancing of these two objeciives is obviously a monumental task facing
Islamic banks. It requires a full
understanding of the economic needs of society at
all levels, of various sectors and factors, an excellent grasp of credit assessment
techniques and closer involvement tSough sustained exercise of financial arlalysis
of the enterpnse receiving funds well) and to ensure that the use of funds is proper
and iimely. The Islamic bank is, therefore, expected to perform the dual funciions
of: i) an investment bank, in the sense that it performs trust, corporate managerial,
financial planning, advisory and consultative funciions along with the provision of
medium-to-longer term equity and project finance: and ii) a commercial bank in
relation to its short-term investments) financing functions, as well as providing
customer services of varied type and scope.
Against the wider scope of its financing
responsibilities and operaiions, the Islc
bank even now has access to very limited forms of fmancmg. major forms of flnancing
follow.
FORMS OF FINANCING
Modaraba financing
Modaraba is a contract bebreen an Islamic bank and a Client whereby the Islamic bank
provides a specific amount of funds to the Client for an enterprise for defined purposes
in exchange for a reasonable and higSy predictable profit. The Client receives a share
in the profit as compensaton or a fee for his know-how and management.
Entrepreneurs with strong technical and managerial skills but without adequate
financial scrength find it extremely difficult in ehe
contemporary financial world
to raise capital for the
establishment of viable economic unies, or execuiion of
contracts which provide for such sufficient cash flows and earning capability as will
allow attracive renlrn on the Investors' capital, m addition to permittg reasonable
compensaiion to the entrepreneur for his know-how and management.
Under this contract, the entire capital is provided by the Islaic bank who looks
to the user of funds ("Client") for the management and technical know-how and
basically to the feasibility (technical, commercial, financial and legal) of the economic
unit providing adequate cash flows and earnings that will pet the repayment of
principal, return on investment, and in addition incentive to the entrepreneur within
a reasonable time-frame. Depending on the viability of the enterprise, this form of
fmancing is highly conducive to the creation of new
entrepreneurs who are technically
proficient and have the ability to efficiently run specific enterprises to the highest
levels of efficiency and productivity but have no cash resources of their own. In fact,
it encourages conversion of know-how and services into capital.
The Islamic bank allows all costs of production including management expenses of
the Client himself and his labour as deductible expenditllre. In addiison, the Client
271
I S LAMIC FINANCE
is permitted a fixed percentage of profit as a fee for his know-how and management
without which the economic unit would not be in existence and producing. It is
normally 15-30% of the profits, depending on the extent and quality of technology,
management efforts and expertise involved. This form of remuneration provides
considerable incentive to the Client to earn high income and buy out the Islamic
bank from the management fees earned out of net profits of such enterprise.
However, it remains a high risk method of financing. Although the Client has
sufficient incentives to make the uIiit a success, he has no capital committed
to the enterprise. The Islamic bank, therefore, puts in extraordinary efforts to
carefully scrutinise feasibility and projections provided by the Clients using the
most sophisticated credit risk evaluation, analysis techniques and criteria for its
decision-making process.
Following credit approvals, the Islamic bank takes necessary steps to guard, as
far as possible, against completion and operational risks and such common causes
of project failures as completion delays, cost-overrun, technical obsolescence and
failures, changes in regulatory risk factors, raw material shortages and ineffective
marketing while it requires the enterprise to be managed to the highest standards to
ensure that the projections are achieved.
After the project's completion, the Islamic bank maintains a strict check on
operational risks such as the quality, quantity, availability and price of raw materials,
any changes in the regulatory and environmental conditions, productivity and effective
output at desirable cost levels, adequacy of infrastructure and continued availability of
qualified and skilled labour and managerial personnel. If required, Islamic banks may
put a member on the Client's board of directors to keep abreast of the developments
within the unit.
Cross-border Modaraba financing entails varied types of risks. Political and
regulatory risks are among the most important as are tax burdens. Consequently,
this most desirable form of Islamic finance has not found favour in taxable societies
in the West and in unstable environments of developing countries. Local laws
in certain countries do not permit baSs to take equity stake in the manner
prescribed.
The following are some of the characteristics of the Modaraba relationship:
(1) The relationship is entered into between the parties for a certain duration
in which the repayment of capital is provided for on the basis of mutual
agreement.
(2) Deterniination of profit distribution and principal repayment is mutually
agreed for a certain fixed duration and the date on which such deterlIiination
is carried out. On such date of determination, audited financial accounts
including balance sheet and income statements are submitted to the parties
for necessary deterlIiination.
(3) From the net profit after payment of all costs including management costs
(including the salary of the Client hitnself) the Client is paid his management
Fee at the rate prescribed under the relationship contract. The balance of the
profit goes to the Islamic bank for distribution to Investors.
272
ARAB LAW QUARTERLY
(4) While fixed ratios are permissible, fixed amounts of profit for either party are
not permitted under this form of financing.
(5) Liability for loss rests solely with the Islamic bank unless it is proved that the
Client was grossly negligent in the performance of his trust functions in which
case the entire loss will have to be borne by the Client.
(6) If two or more Islamic banks are involved in providing capital for the
Modaraba, the distributable part of the profit, i.e., after payment of
management fees, will be distributed between them pro rata to the amount
invested by each.
(7) Each party exercises business discretion strictly in terms of the relationship
contract and discretionary authoriiies so approved. This avoids confusion and
provides clear-cut functional process.
(8) The Modaraba capital is only consumed for the purposes approved under the
relationship and the Client has no authority to invest such capital in other
ventures without prior approval of the Islamic bank.
(9) During the relationship, the Client is not permitted to introduce his personal
and any other external capital in the unit ualess provided for and previously
approved by the Islamic bank.
(lO)It is expected that the Client achieves the projections provided to the IslalIiic
bank at the time of the initiaton of the relationship on the basis whereby the
Islamic bank decided to enter such a relationship. Should the actual results
fall far short of these projections, the Islamic bank will be within its rights to
seek full explanation for such variance and the Client is obliged to provide the
same. Should such explanation be found unsaiisfactory, the Islamic bank may
seek recourse against the Client for misrepresentation.
(ll)The Client is not allowed to appoint another management for the enterprise
unless it is provided/approved by the Islaniic bank as being necessary for the
success of the enterprise.
(12)The Modaraba is not permitted to obtain financing from third quarters
without prior express permission of the Islamic bank. However, the client
may engage in normal trade credit operations which are normal for such a
type of business and were duly provided for in the feasibility study previously
submitted to the Islamic bank.
(13)Liabilities of the Islamic bank under the Modaraba are limited to the extent
of its capital provided to the Client under the Modaraba contract. Creditors
have no recourse to other assets of the Islamic bank should any of their claims
remain unsettled against the resources of the enterprise.
(14)Either party in the Modaraba contract has the right to terniinate the contract.
If there be more than two partners, the contract may continue in favour
of the remaining partners. Many Islamic jurists agree that at the time of
termination of the contract, all the goods and capital should have been
converted into cash. Even in the case of a fexed-period contract, it will
not be legitlmate to bind the partners not to terIninate the contract until
the date of maturity. The Modaraba also terminates upon the death of any
one of the partners.
273 ISLAMIC FINANCE
This principle renders the Modaraba contract relationship weak, pariicularly when
the Modaraba contract covers a long-term project. Modern scholars of Islamic
economics have recommended review of certain principles, including this one, in
order to eliminate such weaknesses whereby undue advantage or disadvantage to
either parw is eliminated.
Conveniional equities are one of the most desirable Islamic flnancing vehicles.
However, all the equiiies are not approved for IslaxIiic banks for the following
reasons:
(1) The main line of business of a number of corporate eniiiies such as
banks, insurance companies, other conventional financial institutions, alcohol
manufacturing/trading etc.? is itself prohibited under Islam.
(2) A number of corporate entities themselves issue interest-based debt instru-
ments. Since equity ading, howsoever small, of such entities means part
ownership, the same is permitted.
Investment in equities is generaXy risky due to volatility of markets and acute
fluctuaiion in prices. To cover such volatility through diversificaiion, eqwty portfolios
comprise a large number of selected equiiies picked from diverse business sectors.
Some of these may belong to the above-meniioned nvo groups Someiimes, even
when an eniity was not engaged in issg a debt instrument at the time an Islac
bank joins such portfolio, there is no guarantee that it will not opt to do so while
the Islamic bank is still involved in the equities portfolio and leaving at the time
may not be in the interest of the portfolio. Due to these constraints it has not been
possible for Islamic banks to freely engage in equity-related investments. Besides,
certain types of operations such as "puts" without ownership of the equity are not
permitted in Islam. Constraints in the seleciion of equities and transactional processes
due tQ strict stipulations of Islamic law do not allow diversificaiion, a Viti essence for
such investment type. These factors have rendered equity invesjunent unsafe and hence
unattraciive to Islamic banks.
Accounttng Treatment
Income from a Modaraba relaiionship is entered in the books of the Islamic bank
when cash represeniing the same is actally alised. It may also be booked when it
is recopsed or when there is reasonable certainty of its realisaiion after it has been
duly deterniined and quaniified.
.
Musharaka Financlng
Musharaka financmg is the same fnancing contract as Modaraba except that the
Client also provides a part of the capital, in addition to providing management and
know-how. On the other hand, the Investor may provide a part of the management
arld know-how, in addition to capital. In that case, the sharing of the profit from
the unit is adjusted accordingly on both sides and the discretionary authority of each
274
ARAB LAW QUARTERLY
parmer and a relationship framework is clearly defined. It has also the same relevant
implicaions as listed under Modaraba Financlng.
. * n
Ihorabaha Fmancmg
Under this contract, the Islamic bank as Investor purchases goods, raw materials,
equspment) machinery or any other items of economic significance from a third
party at the request of a Client and sells such goods to the Client on a spot or
deferred payment basis at its own price. The difference between the purchase cost
of the Islamic bank and the sale price to che Client forms the profit available to the
Islamic bank from the relaiionship.
The contract normally caters for short-term financing requirements of Clients
tbrough legsate trading praciices. Without the fmancmg from the Islamic bank,
it will not be possible for the Client to undertake his trading aciiviies to the required
extent of his business proporiions.
Followlng the Islamic bank and che Client entering into a contract for such a
relaiionship, the bank issues a letter of credit or any other relevant document ordering
the pu:rchase of the goods irl question from the manufacturer or supplier for onward
delivery to the Client.
Since Morabaha entails a fLxed pre-deterlIiined rate of retum to the Islamic bank,
arguments have been raised as tQ its sitnilarity with conventional interest. However)
since the Islamic bank bears several risks untfl the compleiion of the delivery which
equates it with actual trading, such transactions are considered as legite under the
provisions of Islamic banking. This contract has the following implicaiions:
(1) The customer has the right to reject the goods should these not conform tO
the required qualit;y.
(2) The Islamic bank is not permitted to assign the benefits of, and recourse under,
the manufacturer's warranty to the Client. The Islamic bank is responsible for
providing services under such warranty to the Client and may) therefore have to
act as an intermediary between the Client and the manufacturer andlor supplier.
(3) The Islamic bank is obliged to provide the break-down of its cost and profit and
all other expenses involved as are charged to the Client under the sale price.
(4) The Client only promises to purchase the goods and is not legally bound tO
necessarily take delivery of the goods upon arrival at the port of destaiion
should it have a reasonable and justifiable excuse for such refusal.
(S) The Islamic Bank always obtains iitle to the goods before passirlg these on tO
the Client.
(6) In countries where imports are subject to duiies and taxes the Islaic bank's
profit is treated as a part of the purchase price and is, therefore, subject to such
levies and taxes as are charged on imported items thereby increasing the cost of
import to the Client. This is because financing by the Islaniic bank is treated as
tradirlg and not recognised as "debt". Due to this difficulty, trade fmancing by
275 ISLAMIC FINANCE
Islamic banks with such countries where import taxes and duties on imported
goods are charged, has not developed satisfactorily.
The Morabaha contract prondes mostly for short-term financing needs of Clients. Due
to the inherent liqwdity element that this form of financing carries with it, Morabaha
financing has been quite widespread with Islamic banks. Unfortunately, due to che
non-existence of the inter-Islamic bank market, Islaniic banks are hard-pressed to
maintaln higher liquidity posiiions than their conveniional counterparts. This is one
of, the m reasons why a large part of the Islamic banks financing portfolio comprises
morabaha.
Accounting Treatment
Where the ultimate income is both contractually deterniinable and quaniiflable at the
commencement of the transaction, the same is accrued on a straght-line basis over the
period of the transaction.
Qard Hassan Financing
This type of financing is a benevolent type of loan provided free of any charge to cert
Cliexlts This form of Islamic financing for commercial purposes is normally made to
an enterprise in difficulty which is separately receiving financing for defined puIposes.
Such a loan provides financial assistance to the enterprise at no extra cost whereby the
viability and profitability of such enterprise itself is considerably enhanced. After the
enterprise has reverted to profitability and the two parties agree, Qard Hassan may be
converted into eqliity but not with retrospective effect.
This type of fmancing is also used to provide loans to the needy on humanitarian
grounds if the resources of the Islamic bank allow the provision of such loans without
uxlduly affecting its profitability for the Investors and shareholders.
This is one form of Islamic finance which incorporates an unconditional obligation
on the part of the Client to repay the amount loaned. The Islamic bank has the right
to ask for collateral as security. It may also seek full recourse against the client for the
recovery of amounts due from him.
* * .
IXara Flnancmg
This is a contract whereby the Islamic bank purchases an asset and leases it to a Client.
The lease contract specifies the leasing period, the amount and iiming of lease payments
and the responsibilities of both parties during the life of the lease. Leases can be simple
rentals or more elaborate contractual arrangements committing the parties to future
actions.
Islamic prlnciples of finance permit the purchase of an asset for subsequent rental
which may include cert profit to the Investor. A commercial or individual Client
wishing to acquire the use of capital equipment may request the Islamic bank to
purchase such asset and oblige itself to rent such asset from the Islamic bank.
2?6
ARAB LAW
QUARTERLY
Subject to the
fulfllment of certain
conditions, the Client has the opiion to
purchase
the asset duriDg the term of the lease. The
opiional
purchase price
declines over the
term of the
agreement. As the
customer is not
obliged to
purchase the asset
funanced
under the Ijara
contract at the expiry of the lease, the
Islamic bank will not
noImally
take a
substanti risk with
respect to itS
residual value at the expe of the lease.
Two most
frequently used types of leases are the
operaiing lease and the
financing
Iease. Full
amoriisation of cost
differentsates the
funancing lease from the
operating
lease, both of which are
acceptable under
Islamic
principles of
finance under
specific
conditions.
The
Islamic bank's
standard Ijara
contract
differerltiates
bet:ween the
operating and
financing lease with regard tO itS oMm
responsibiliiies and
liabilities. In the
former the
Islamic bank is
esseniially acting as
warrantor of the asset leased
although the Client
makes
undertalcings as to the
utilisation of the asset and its
maintenance etc. In the
flnancing lease, the Client must deal
drectly with the
manufacturer or
supplier in all
matters
relating to the leased assets and
assumes risk of loss on
receiving
possession in
terms of the
stipulaiions of the lease
contract.
The Ijara Wa Iktina type lease is a
vanation of the
standard
financial Ijara
agreement.
The
Islamic bank
purchases the
equipment and leases it tO the Client but the Client is
obliged tO
purchase the
equipment at the end of the lease term.
Ijara
funancing is ideal for the
securitisation of the
Islamic
financial paper,
provided
that the paper
carries
adequate
redempiion
underwriiing
support from
financial
insti^aons
facilitating
redemption on
demand. On the other hand, the
underlying
asset should be easily
convertible into cash and so it is
imperaiive that the asset is of
high
quality, is
marketable, is used and
mainted to high
internaiional
standards
which are
specified,
malntalns
demand and
therefore
normally adds its
market value
above its book value) is
movable and easily
repossessable in the event of
default.
The
instrument also
permits some
mismatching of
short-term
liabilities with long-
term assets
because:
(1) The
instrument is
marketable and is
converiible into cash on
demand.
(2)
Periodic rent
reviews are
permitted.
Accordingly, even
though it is a
longer-
term form of
financing, the
Investor will never be tied down to a ftxed type
Of return which may not meet its
snvestment
objeciives. Rent
review can be
tied by
mutual
consent to any
internaiional index that
reflects
relevant
market
* *
conc ltlons.
If the asset is of high
quality, the
Islamic bank may not have to rely so much on the
credit risk of the client as on the asset itself. This allows a
relaiively
weaker credit risk
Client to obtain Ijara
financing.
These
considerations make
lessing an
attraciive type of
finance for
Islamic banks
and there is
growing
interest on their part in this fonn of
financing.
However, the
main
quesiion is the
selection of the assets which meet the
criterion. At
present,
Islamic banks tend to opt for
commercial
passenger
aircraft
although it is a very big
iicket ieem and
financing for such an asset
involves very long
periods. Also
impOrtaIlt
is ehe
quesiion of
taxation smce the
Islamic bank's
sncome from this form of
financing
is
taxable in many
developed and
under-developed
countries.
ISLAMIC FINANCE
277
Islamic Syndication
It is usually a large financing facility granted to a key industrial or trading organisation
lead-managed by an international bank of standing which is also often the "agent".
Since the amount involved is large, a mlmber of financial institutions pamcipate by
lending money andlor by taking one of several different management functions.
It is impossible for Islamic banks to pariicipate in conventional syndicated
transactions since these are mostly interest-related or involve such other forms as
are prohibited by Islamic principles. The first ever Islamic syndicated transaciion
was recently launched by Faysal Islamic Banlc of Bahrnin E.C. through a composite
structure which has now found considerable interest among many Islamic and
conveniional financial insiitutions worldwide.
Special Modaraba
A Special Modaraba is floated by the Agent bank ("Modareb") in which other financial
institutions-Islamic and conventionalz pcipate with their participaiion amounts.
The Special Modaraba condiiions siipulate not only the conditions of pancipaiion
but also clearly spell out the relevant use of funds, the contract documentation
used for such use of funds, the Client, the guarantor to the Client's obligaiions
and all other legal documentation required in the relaiionship from the parties to
the wansaciion.
Agent
The Agent performs his functions strictly in accordance with the terms of the Special
Modaraba contract.
Morsbahs Agreement
Bemg normally short-term, it is normally under the Morabaha contract, as provided for
under the Special Modaraba contract, and is signed between the Agent and the Client
for the transaciion relaiionship.
Guarantee Document
The stipulated guarantee on the approved legal form is obtained by t}le Agent
from the guarantor to the Client's obligaiions before releasing the syndicated
facility.
Other Legal Documents
The Agent obtains legal opixiions from his own international lawyer, his lawyer in
the country of the Client, the Client's own lauryer, and the guarantor's lawyer
278 ARAB LAW QUARTERLY
relevant to the covenants, conditions precedent and other relevant terms of
the relationship reqtiiring legal opunions for the satisfaction of the Agent and
partlclpants.
Upon completion of this documentation, the Agent proceeds accordingly and
maintains the relaiionship. The pariicipating banks do not have any direct
relationship with the Client as the Agent acts for them for all purposes under his
own name.
The entire management responsibiliiies are carried out by the Agent except
in the begnning when the pariicipant banks decide on the credit risk and
legal docllmentation. Thereafter, there is very little aslministrative work, and
in turn adnzinistrative costs, involved for the pariicipants. Therefore, the
instrument is very popular among Islamic and conventional banks alike. Seven
syndicated transactions for a total amount of US$600 million offered by the
Faysal Islamic Bank of Bahrain E.C. were all immediately consumed. The last
transaction for US$100 million was 100% oversubscribed within a week of the
first solicitation.
This experience indicates the viability of Islamic financial products among Islamic
and conventional financial instruments. Provided that legal requirements of today's
complex environment are met effectively and loopholes adequately plugged, there
is no reason why other forms of Islamic finance should not be accepted by the
financial institutions and the financing clients. On the other hand, Islaniic banks
also look to conventional financial institutions for instruments and portfolios that
meet their objectives and are wiffiin the prescribed bounds of the principles of
Islaniic banking. Islamic banks are also willing to join hands with conventional
institutions in order to produce such instruments and portfolios in which Islarnic
financial institutions can participate. There are already a number of examples in this
respect and it is hoped that this co-operation will grow further in the due course of
time.
Meanwhile, from experience Islamic banks are endeavouring to iron out problems
and weaknesseoperational, structural and legal in order to make their own
instruments viable. In this regard, Islamic economists and jurists are meeting
together at various forums trying to investigate the considerations of Shari'a in this
respect.
General Problems Faced by Islamic Banks
Islamic banks suffer from a number of problems-operational, legal, and infra-
structural. Some of these follow.
Loss of Opportuniw
In the event of failure on the part of the Client to repay its fixed obligations
to an Islamic bank on the due date, damages are permitted under Islam for
payment to the Islamic bank. However,- these are subject to the following
. .
conc 1tlons:
279 ISLAMIC FINANCE
(1) Several warning letters are issued in a certain iime to the client asking him tO
repay the amounts overdue.
(2) The first occurrence of non-payment will not count as admissible for charging
damages.
(3) It is to be ensured that the Client has the flnancial capacity to meet his
commitment. A temporary cash flow problem will not be regarded as
the Client's genuine inability to repay but rather be treated as financial
mismanagement on his part.
(4) Such damages will be equal to the rate of profit which the Investors under the
relevant Modaraba would have otherwise received had the repayments been
made on iime.
These conditions, being protracted, contribute to inefflciency in the collection of
dues from customers. Pariicularly in the retail trade, this process will considerably
increase costs of the Islamtc bank. When larger amounts are involved, a remission
in the first period of default will be substantial in monetary terms. Since margins of
profit in internatonal trade are highly competitive and thin, Islamic banks cannot
afford any opportunity loss. Accordingly, this subject needs considerable further
study, discussion and review by Islamic jurists.
Shari'a Law's Admissibilit in Intentational Courts
The matter of admissibility of legal contracts bound by Shan'a laws in internaiional
courts has many implicaiions. Even when contracts between two pariies may be
acceptable in certain courts, in the event of a dispute, local law will prevail should
any of the Shari'a provisions violate the relevant provisions of the local law. Should
such provisions of the local law mean violaiion of the Shari'a law itself, the same will
not be acceptable to the Islamic bank. This leaves the Islamic bank in a great quandary
as it may not be able to obtain full recourse against the Client under the contract that
was prepared in accordance with the provisions of the Shan'a.
Manpower Shortage
Unwillingness on the part of many to move away from the mainstream of conveniional
banlcing is a situaiion that IslatIiic banks are faced with today which is hampering
the building of their manpower resources md furffier development. This is because
Islamic banking as an alternative financial system is not considered by many
in conventional banlcing as a well established phenomenon. Nor do Islamic
establishments have such a wide network and scope so that a professional m
conveniional banking may comfortably look towards a future career in the same
sense as he looks to the conventional ones. Opting to change over to Islamic
banlEng for a conventional banker amounts to him sacrificing his interests
unless he is religiously committed to the concept. Accordingly, manpower
development within Islamic banking is faced with added difficuliies on that account
alone.
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ARAB LAW QUARTERLY
Track Record
Only a couple of decades old) Islamic banlcing in practice is relatively very yolmg. The
lack of a long established track record in Islamic banlcing does not give investor an
adequate sense of comfort. Even a slight negative movement in results can, therefore,
induce this lack of comfort and may lead to a run on deposits. Islamic banks are,
therefore) forced to maintain an unusually high level of liquidibr which aderersely
affects thew profitability.
Undeveloped Interbank and Financial Markets
Inter-Islarnic-bank markets are almost non-existent so that Islaniic banks cannot place
or raise funds from ong themselves on an established pattern. Only in Pakistan and
Iran do such markets exist, but these are relevant to the local currencies only.
On the other hand, financial markets as exchange systems that allow for trading
of fmancial instruments are not yet well developed in the Islamic financial world.
These markets comprise persons, agents, brokers, instituiions and illtermediaries
who operate under laws) contracts and extensive communication networks, all of
which are not ideal for Islamic fmancial instruments or else ideSy developed within
the Islamic world. Islamic financial insiitutions are, therefore, hard-pressed to produce
instruments which will function and achieve their objeciives within the contemporary
situaiion, or in a more restricted environment such as limited secondary wading
within a certaxn group of financial insiituiions supporiing a certain mstrument.
The development, over e, of Islamic banking in general, and their instruments
in pariicular, as well as a change of regulaiion within Islamic countries, will in d}e
long run contribute to the development of Islamic financial markets. Stock exchanges
are coming illtO existence in many Islamic countries, as are certain instuments, but
there is still a long way to go before Islamic financial markets attain maturity.
Lack of Unifonn Accounting Sundards for Islamic Banking
Among Islamic fmancial institutions, there is generally no uniformity in accounting
policies and standards. As a result, there is no consistency in the accounting treatment
of various operations; even the presentation of their financial statements. In this
situation, the reader of financial accounts of an IslalIiic financial insiituiion finds it
hard to relate the results of one instituiion with another. For example, the Investment
Funds in one insiituiion are expressed as the Funds Under Management and reported
below che liIle of itS balance sheet on the prese that according to the Shari'a, such
funds are invested for the benefit and at the risk of the customer and being fiduciary
in nature do not folLa part of the bank's liabilities. Another bank will report the sarne
above the line within its balance sheet because the relevant regulatory authonty in
whose jurisdiciion it operates requires it to do so for reserve and other prudential raiio
evaluation purposes. Similarly, the treatment of accrual of morabaha profit over the
period of oche transacion also differs. While one IslaIIiic financial insiitution may book
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ISLAMIC FINANCE
the entire transaction profit on the day of the sale, the other may amoriise it over the
transaction period on "straight line" basis to provide relevant income on investment
throughout the period.
Islamic banks have recently agreed to establish an accounting standards board ln
Bahrain which should ultimately solve this problem.
CONCLUSION
Despite the weaknesses, handicaps and problems faced by Islamic banks, they have
proved themselves by their viable operational existence in the past over two decades.
The future looks promising for them if only they adhere to the ethical codes of
their trust functions and hold dearest to them the objectives of Islamic banking.
As Henry Kaiser said, "problems are only opportunities in work clothes" which
Friedrich Durrenmatt describes, in his "21 Polnts", as "what concerns everyone can
be resolved by everyone".
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Chopra, M. Umar; "Towards a Just Monetary System", The Islamic Foundation,
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Khan, Dr Moshin S.; "Monetary Policy in an Islaic Economy", Islamic Banking
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