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Department of Management Sciences COMSATS UNIVERSITY OF SCIENCE AND TECHNOLOGY Abbottabad


Assignment #:

Submitted by:

Registration #
FA08-BBA-057 FA08-BBA-086 FA08-BBA-085 FA08-BBA-104

Submitted to: Jamil Anwar

Submission Date:___ February 27, 2012___


Assignment Question:
Briefly describe the history of Islamic Finance and the models of Islamic finance being followed in different countries.

The objective of this assignment is to understand the history of Islamic Finance and from where it starts to expand in modern economy and to know why the Islamic system is better for the growth of economy rather than the conventional system. And to have better understanding about different models or approaches used in different countries.


Table of contents:
Assignment objective and Question.. Table of Contents History of Islamic Finance. Historical Development.. Interest-Free Banking as an Idea.. The Coming into Being of Interest-Free Banks....... Special Events in 80s And 90s. Post 90s in Pakistan... Models being followed in different countries... Islamic finance in the UK... Islamic banking in Malaysia.. References....

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1 2 3 4 4 5 6 7 7 9 10 11



Modern banking system was introduced into the Muslim countries at a time when they were politically and economically at low ebb, in the late 19th century. The main banks in the home countries of the imperial powers established local branches in the capitals of the subject countries and they catered mainly to the import export requirements of the foreign businesses. The banks were generally confined to the capital cities and the local population remained largely untouched by the banking system. The local trading community avoided the foreign banks both for nationalistic as well as religious reasons. However, as time went on it became difficult to engage in trade and other activities without making use of commercial banks. Even then many confined their involvement to transaction activities such as current accounts and money transfers. Borrowing from the banks and depositing their savings with the bank were strictly avoided in order to keep away from dealing in interest which is prohibited by religion. After many centuries of domination by the West, and the subservience and adoption of Western culture and values as a result of this domination, there has been a revival of Islamic principles and values in Muslim countries. This revival was a result of a growing discontent among the Muslims with the values of the West. This discontent spread to all aspects of life, including the economic aspect. Specifically, there were grave concerns for the conventional banking practices present in these Muslim countries. These banks were involved in the charging and collection of interest (riba) which is strictly prohibited in Islam. The desirability of abolishing fixed interest rates and the Islamization of financial systems is one of the main reasons for the establishment of Islamic banks. Ideally, Islamic banks and other Islamic financial institutions are supposed to adhere strictly with the precepts of the Shariah, the Islamic code of law derived from the Holy Quran, Hadith of the Prophet Muhammad (Peace be upon him), and juristic reasoning (Ijtihad) of Islamic scholars. Due to the prohibition of interest in Islam, they could not offer conventional financial services and had to offer those in compliance with the Shariah. Examples of such services include Mudarabah, Musharakah, and Ijarah. Whereas the goal of conventional banks is to make as much profit as possible and at any means; for Islamic banks, whereas profit is a part of its goals, it isnt the most important goal. To understand the goal of an Islamic bank, one has to


understand the objectives of the Shariah. Imam Ghazali states that the objective of the Shariah is to promote the well-being of all mankind, which lies in safeguarding their faith (din), their human self (nafs), their intellect (aql), their posterity (nasl) and their wealth (mal). Whatever ensures the safety of these five serves public interest and is desirable. From these noble objectives, it can be gathered that the most important role of Islamic banks is to promote the betterment of the society in which they are set up by providing means by which members of the society can better themselves, particularly improving their posterity and wealth.

It seems that the history of interest-free banking could be divided into two parts. First, when it still remained an idea. Second, when it became a reality - by private initiative in some countries and by law in others we will discuss the two periods separately. The last decade has seen a marked decline in the establishment of new Islamic banks and the established banks seem to have failed to live up to the expectations. The literature of the period begins with evaluations and ends with attempts at finding ways and means of correcting and overcoming the problems encountered by the existing banks. INTEREST-FREE BANKING AS AN IDEA: Interest-free banking seems to be of very recent origin. The earliest references to the reorganization of banking on the basis of profit sharing rather than interest are found in Anwar Qureshi (1946), Naiem Siddiqi (1948) and Mahmud Ahmad (1952) in the late forties, followed by a more elaborate exposition by Mawdudi in (1961), Muhammad Hamidullahs 1944, 1955, 1957 and 1962 writings too should be included in this category. They have all recognized the need for commercial banks and the evil of interest in that enterprise, and have proposed a banking system based on the concept of Mudarabha - profit and loss sharing In the next two decades interest-free banking attracted more attention, partly because of the political interest it created in Pakistan and partly because of the emergence of young Muslim economists. Works specifically devoted to this subject began to appear in this period. The first such work is that of Muhammad Uzair (1955). Another set of works emerged in the late sixties and early seventies. Abdullah alAraby (1967), Nejatullah Siddiqi (1961, 1969), al-Najjar (1971) and Baqir al-Sadr (1961, 1974) were the main contributors.


Early seventies saw the institutional involvement. Conference of the Finance Ministers of the Islamic Countries held in Karachi in 1970, the Egyptian study in 1972, First International Conference on Islamic Economics in Mecca in 1976, International Economic Conference in London in 1977 were the result of such involvement. The involvement of institutions and governments led to the application of theory to practice and resulted in the establishment of the first interest-free banks. The Islamic Development Bank, an inter-governmental bank established in 1975, was born of this process. THE COMING INTO BEING OF INTEREST-FREE BANKS: The first private interest-free bank, the Dubai Islamic Bank, was also set up in 1975 by a group of Muslim businessmen from several countries. Two more private banks were founded in 1977 under the name of Faisal Islamic Bank in Egypt and the Sudan. In the same year the Kuwaiti government set up the Kuwait Finance House. However, small scale limited scope interest-free banks have been tried before. One in Malaysia in the mid-forties and another in Pakistan in the late-fifties neither survived. In 1962 the Malaysian government set up the Pilgrims Management Fund to help prospective pilgrims to save and profit. The savings bank established in 1963 at Mit-Ghamr in Egypt was very popular and prospered initially and then closed down for various reasons. However this experiment led to the creation of the Nasser Social Bank in 1972. Though the bank is still active, its objectives are more social than commercial. In the ten years since the establishment of the first private commercial bank in Dubai, more than 50 interest-free banks had come into being. Though nearly all of them were in Muslim countries, there are some in Western Europe as well: in Denmark, Luxembourg, Switzerland and the UK. Many banks were established in 1983 and 1984. The numbers have declined considerably in the following years. In most countries the establishments of interest-free banking had been by private initiative and were confined to that bank. In Iran and Pakistan, however, it was by government initiative and covered all banks in the country. The governments in both these countries took steps in 1981 to introduce interest-free banking. In Pakistan, effective 1 January 1981 all domestic commercial banks were permitted to accept deposits on the basis of profit-and-loss sharing (PLS). New steps were introduced on 1 January 1985 to formally transform the banking system over the next six months to one based on no interest. From 1 July 1985 no banks could


accept any interest bearing deposits, and all existing deposits became subject to PLS rules. Yet some operations were still allowed to continue on the old basis. In Iran, certain administrative steps were taken in February 1981 to eliminate interest from banking operations. Interest on all assets was replaced by a 4 percent maximum service charge and by a 4 to 8 percent profit rate depending on the type of economic activity. Interest on deposits was also converted into a guaranteed minimum profit. In August 1983 the Usury-free Banking Law was introduced and a fourteen-month change over period began in January 1984. The whole system was converted to an interest-free one in March 1985. SPECIAL EVENTS IN 80S AND 90S: The subject matter of writings and conferences in the eighties have changed from the concepts and possibilities of interest-free banking to the evaluation of their performance and their impact on the rest of the economy and the world. Their very titles bear testimony to this and the places indicate the world-wide interest in the subject. Conference on Islamic Banking, Its impact on world financial and commercial practices held in London in September 1984, Workshop on Industrial Financing Activities of Islamic Banks held in Vienna in June 1986, International Conference on Islamic Banking held in Tehran in June 1986, International Conference on Islamic Banking and Finance, Current issues and future prospects held in Washington, D.C. in September 1986, Islamic Banking Conference held in Geneva in October 1986, and Conference Into the 1990s with Islamic Banking held in London in 1988 belong to this category. And the Workshop on the Elimination of Riba from the Economy held in Islamabad in April 1992. Several articles, books and PhD thesis have been written on Islamic Banking during that period. Special mention must be made of the work by M. Akram Khan in preparing annotated bibliographies of all published (and some unpublished) works on Islamic Economics (including Islamic Banking) from 1940 and before. It is very useful to students of Islamic Economics and Banking, especially since both English and Urdu works are included (1983, 1991, and 1992). In 1990s many major Financial Institutions offer Islamic Finance (i.e. Citi Group HSBC), The biggest change in terms of adaptability came in 1991 when the Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI) was established in Bahrain to advice on Islamic finance standards all over the world. During that period the model was further developed and refined. The


liabilities side saw frameworks put in place for handling trust funds, venture capitals, and financial papers based on Ijara ( leasing ) Salam ( forwards ) and Murabaha (mark up ). The special techniques for launching Shariah compatible mutual funds were also developed in this period. This involved selecting companies whose shares could be traded as they did not violate any Shariah norms. This selection was made by screening out the undesirables. The first norm was that the products in which the company dealt should not be prohibited ones like alcohol or pork. The other was that its finances should be free of interest bearing loans and its revenue free of interest income. Since the condition about debt finance would eliminate almost all shares traded on the stock exchange, some scholars allowed a leverage of 30% or less. There could be other criteria also but these two are the main, common to all existing Islamic funds. Once the filtering process was complete, managing a portfolio became a professional job. This is why the phenomenon of Islamic mutual funds, even though endorsed by a group of Shariah scholars, owes itself to the initiative of professional players in the field. As the launching of the Dow Jones Islamic Indexes evidenced, Islamic finance too needed the modern tools designed to handle the complex web of financial transactions. The Indexes track Shariah compliant stocks from around the world. Later, the development of uniform standards was supported by other organizations such as Islamic Financial Services Board (IFSB) in Malaysia in 2002. POST 90s IN PAKISTAN: In early 90s the whole exercise was challenged in the Federal Shariat Court and the procedure adopted by banks in Pakistan since July 1, 1985 was declared un-Islamic by the Federal Shariat Court (FSC) in November 1991. The system was based largely on mark-up technique with or without buy-back arrangement. The FSC declared that various provisions of the laws held repugnant to the injunctions of Islam in its Judgment dated November 14, 1991 would cease to have effect as from July 1, 1992. However, the Government and some banks/DFIs preferred appeals to the Shariat Appellate Bench (SAB) of the Supreme Court of Pakistan. The SAB delivered its judgment on December 23, 1999 rejecting the appeals and directing that laws involving interest would cease to have effect finally by June 30, 2001. In the judgment, the Court concluded that the present financial system had to be subjected to radical changes to bring it into conformity with the Shariah. It also directed the Government to set up, within specified time frame, a Commission for


Transformation of the financial system and two Task Forces to plan and implement the process of the transformation. The Court indicated some measures, which needed to be taken, and the infrastructure and legal framework to be provided in order to have an economy conforming to the injunctions of Islam. Later, the decision regarding transformation of the whole system was set aside in a review petition by the Supreme Court and has been sent to the Federal Shariat Court to start fresh hearings. However, the deferment in the final decision has not dampened The initiative to re-introduce Islamic Banking in Pakistan was launched in 2001 when the government decided to promote Islamic banking in a gradual manner and as a parallel and compatible system that is in line with best international practices. Following the decision of the government to shift to interest free economy in a phased manner without causing any disruptions, the effort was envisaged to be based on a market driven and flexible approach. Furthermore it aims at building a broad based financial system all the country to enable all segments of the population to access financial services. Growth of Islamic Banking industry in Pakistan is tremendous. Currently Islamic Banks industry of Pakistan is operating with: Five full Fledge Banks having 416 branches. 13 Conventional Banks operating with 183 SAIBB and 68 Sub-branches. Despite above all success story, there are several factors that are likely to constrain the development of Islamic finance. The current Islamic banking is based on replication of conventional banking products. While the replication is easy to understand by the customer and to offer by the Islamic banks, it is insufficient to achieve the overall objectives of Islamic financial system which is based on equitable distribution of economic gains on one hand and on the other hand make Islamic financial less efficient than their conventional counterparts. Not all conventional products have an Islamic equivalent like treasury and liquidity management tools.


Necessary changes in legal, regulatory and tax environment to accommodate Islamic finance without incurring additional costs to the customers The different interpretations of Shariah ruling have resulted in lack of standardization. Therefore common understanding is needed to integrated local market with global market. Lack of necessary instruments for liquidity management Limited availability for access to Lender of Last Resort facility by the central bank due to lack of Shariah compliant compatible mode While the Islamic markets have remained resilient to the financial crisis, Islamic secondary market has remained inconsistent due to its infancy. Reasons are dearth of regular issuances of Sukuk. HR and expertise in Islamic finance are scarce. The above considerations for developing of Islamic financial sector in future may be helpful for establishing sound footing of the industry and result in an Islamic financial regime which could compete with the international financial organizations.


ISLAMIC FINANCE IN THE UK: Most of the growth of Islamic finance in the UK has taken place in the last five years, but the existence of Sharia-compliant transactions in the London financial markets goes back to the 1980s. Commodity Murabaha type transactions through the London Metal Exchange were used, in significant volumes, to give liquidity to Middle Eastern institutions and other investors that fostered the development of a wholesale market in the UK. This did not, however, cater for retail Muslim consumers, as the products developed at the time were aimed exclusively at wholesale and high-net-worth investors. These products were relatively uncomplicated in structure and fell outside the scope of the regulators. Retail Islamic products first appeared in the UK in 1990s but only on a very limited scale. A few banks from the Middle East and South East Asia began to offer simple


products such as home finance. However, these compared unfavorably with their conventional equivalents in several respects, including their generally uncompetitive pricing. Most of these products did not fall within the regulatory framework, so consumers did not have the same protection as other consumers, for example, the availability of the Financial Ombudsman Service and the possibility of redress from the Financial Services Compensation Scheme. The growth of the retail market remained slow throughout the 1990s and early 2000s. Much has changed since then. Both on the wholesale and the retail side, the quality of products has improved; a wider range of products has become available; and more players have entered the market. Today, London is seen by many firms, including Islamic as well as non-Islamic, as an increasingly important global center for Islamic finance. REGULATORY DEVELOPMENTS As banking regulators, the Bank of England and, from 1998, the FSA have been open to the development of Islamic finance in the UK for some time. The first important signal was given in a speech by Lord Edward George, then Governor of the Bank of England, in September 1995 at a conference organised by the Islamic Foundation. In this, he recognised the growing importance of Islamic banking in the Muslim world and its emergence on the international stage as well as the need to put Islamic banking in the context of Londons tradition of competitive innovation. AUTHORISATION OF THE ISLAMIC BANK OF BRITAIN In August 2004, the FSA authorized the Islamic Bank of Britain (IBB), the first wholly Islamic retail bank in a country where most of the population is non-Muslim. Inevitably, the process raised new questions and it took some 18-24 months to complete. ISLAMIC BANKING IN MALAYSIA: Today, Malaysia has a full-fledged Islamic financial system operating parallel to conventional financial system. In terms of products and services, there are more than 40 different Islamic financial products currently available in a country. However, differentiating fixed assets and overhead expenses are problematic in case of IBS banks. Usually, an IBS bank consists of a team overseeing Islamic banking transactions. Product development, marketing and other policy issues are conducted at the respective headquarters. At the branch level, there is no


delineation over Islamic and conventional transactions. Each branch officer is expected to deal with both systems. Islamic and conventional transactions share the computers and automated teller machines (ATMs) facilities. To some extent, overhead expenses on wages/salaries, office equipment and furniture etc. can be accounted for at the bank's headquarter, but not at the branch level. The same applies to security systems, land and office premises as these cannot be divided into the Islamic and conventional individual components. Overall Islamic banking industry in Malaysia has continued to register strong expansion during 2003 to account for 9.7% of the total assets of the banking system (8.9% in 2002), 10.4% of total deposits (10.2% in 2002) and 10.3% of total financing (8.1% in 2002). The improved performance was characterized by strong growth in financing activities for the purchase of transport vehicles and residential property. The thrust of Islamic financial policy in 2004 will continue to be directed at further strengthening the fundamental essential for progressive Islamic banking industry. The Central Bank is focusing on strengthening the institutional infrastructure, enhancing the regulatory framework, strengthening the Shariah and legal infrastructure as well as enhancing intellectual capital development and consumer education. In 2003, the Central Bank of Malaysia brought forward liberalization in Islamic banking to allow three full-fledged foreign Islamic banks to be set-up in Malaysia.

Financial Services Authority (2007), Islamic Finance in the UK: Regulation and Challenges Interest-free Commercial Banking (1995), Islamic Banking by A.L.M Abdul Ghafoor retrieved from http://users.bart.nl/~abdul/chap4.html The Nation (2011), Islamic financial industry: Past, present & future retrieved fromhttp://www.nation.com.pk/pakistan-news-newspaper-daily-englishonline/Business/04-Jul-2011/Islamic-financial-industry-Past-present--future