UNDERSTANDING ISLAMIC FINANCE – Book Sample

Contents – UNDERSTANDING ISLAMIC FINANCE

PART I FUNDAMENTALS 1

• Introduction 3
• Economic Scenario in the Neoclassical Framework 3
• Conventional Debt: A Recipe for Exploitation 4
• Growth per se May not Lead to Socio-economic Justice 6
• Social Welfare Activities of the States 8
• The Main Culprit 8
• The Need of the Hour 9
• Economics and Religion 10
• Islamic Principles Can Make the Difference 11
• Regulating Trade and Business 13
• Islamic Finance Passing Significant Milestones 15
• Could it Work to Achieve the Objectives? 16
• About this Book 17
• Distinguishing Features of the Islamic Economic System 21
• Introduction 21
• Islamic Shar¯ı´ah and its Objectives 21
• Sources of Shar¯ı´ah Tenets 21
• Objectives (Maqa¯sid) of Shar¯ı´ah                                                           22
• Why Study Islamic Economics? 25
• The Role of Islamic Economists 27
• Islamic Economics: What should it be? 30
• Islamic Economics Defined 31
• Paraphernalia of Islamic Economics 32
• Ownership of Resources and Property Rights 33
• Islamic Welfare Approach 34
• viii Understanding Islamic Finance
• The Factors of Production 35
• Restrained Individual Freedom 37
• Liberalism versus State Intervention 38
• 2.6 Summary 41

The Main Prohibitions and Business Ethics in Islamic  Economics and Finance 43

• 3.1 Introduction 43
• 3.2 The Basic Prohibitions 43
• 3.2.1 Prohibition of Riba 44
• 3.2.2 Prohibition of Gharar 57
• 3.2.3    Prohibition of Maisir/Qima¯r (Games of
• Chance) 61
• 3.3 Business Ethics and Norms 64
• 3.3.1 Justice and Fair Dealing 64
• 3.3.2 Fulfilling the Covenants and Paying
• Liabilities 67
• 3.3.3 Mutual Cooperation and Removal of
• Hardship 68
• 3.3.4 Free Marketing and Fair Pricing 68
• 3.3.5 Freedom from Dharar (Detriment) 69
• 3.4 Summary and Conclusion 70
• The Philosophy and Features of Islamic Finance 73
• Introduction 73
• The Philosophy of Islamic Finance 73
• Avoiding Interest 74
• Avoiding Gharar 75
• Avoiding Gambling and Games of Chance 76
• Alternative Financing Principles 76
• Valid Gains on Investment 78
• Entitlement to Profit – With Risk and
• Responsibility 81
• Islamic Banks Dealing in Goods not in Money 82
• Transparency and Documentation 83
• Additional Risks Faced by Islamic Banks 84
• Debt versus Equity 85
• Islamic Banking: Business versus Benevolence 86
• Exchange Rules 87
• Time Value of Money in Islamic Finance 89
• Money, Monetary Policy and Islamic Finance 90
• Status of Paper Money 91
• Trading in Currencies 91
• Creation of Money from the Islamic Perspective 92
• Currency Rate Fluctuation and Settlement
• of Debts 94
• Summary 96
• Contents ix

PART II CONTRACTUAL BASES IN ISLAMIC FINANCE 99

• Islamic Law of Contracts and Business Transactions 101
• Introduction 101
• Ma¯l (Wealth), Usufruct and Ownership                                                           101
• Defining Various Related Terms 103
• General Framework of Contracts 105
• Elements of a Contract 106
• Offer and Acceptance: Form of the Contract 106
• Elements of the Subject Matter 108
• Broad Rules for the Validity of Mu‘a¯mala¯t                                                      110
• Free Mutual Consent 110
• Prohibition of Gharar 110
• Avoiding Riba 111
• Avoiding Qima¯r and Maisir (Games of Chance)                                  112
• Prohibition of Two Mutually Contingent Contracts 112
• Conformity of Contracts with the Maqasid of Shar¯ı´ah 113
• Profits with Liability 113
• Permissibility as a General Rule 114
• W‘adah (Promise) and Related Matters 114
• Token Money (Hamish Jiddiyah) and ‘Arbu¯n                                      116
• Types of Contracts 117
• Valid Contracts 118
• Voidable (Fa¯sid) Contracts                                                                    120
• Void (Batil) Contracts 123
• Commutative and Noncommutative Contracts 124
• Uqood-e-Mu‘awadha (Commutative Contracts) 124
• Uqood Ghair Mu‘awadha (Tabarru‘) or Gratuitous Contracts 125
• Legal Status of Commutative and Noncommutative Contracts 125
• Conditional or Contingent Contracts 126
• Summary 127
• Trading in Islamic Commercial Law 129
• Introduction 129
• Bai‘ – Exchange of Values 130
• Legality of Trading 131
• Trade (Profit) versus Interest: Permissibility versus Prohibition 132
• Types of Bai‘ 133
• Requirements of a Valid Sale Contract 133
• The Object of the Sale Contract 135
• Prices and the Profit Margin 138
• Cash and Credit Prices 139
• Riba Involvement in Sales 142
• Gharar – A Cause of Prohibition of Sales 143
• Conditional Sales and “Two Bargains in One Sale” 144
• Bai‘ al‘Arbu¯n (Downpayment Sale)                                                                 145
• Bai‘ al Dayn (Sale of Debt) 146
• x Understanding Islamic Finance
• Al ‘Inah Sale and the Use of Ruses (Hiyal) 147
• Options in Sales (Khiyar) 150
• Summary 152
• Loan and Debt in Islamic Commercial Law 155
• Introduction 155
• The Terms Defined 155
• Illegality of Commercial Interest 157
• Loaning and the Banking System 158
• Guidance from the Holy Qur’a¯n on Loans and Debts                                     159
• The Substance of Loans 159
• Repayment of the Principal Only 160
• Time Value of Money in Loans and Debts 160
• Instructions for the Debtor 161
• Instructions for the Creditor 162
• Husnal Qadha (Gracious Payment of Loan/Debt) 162
• Remitting a Part of a Loan and Prepayment Rebate 163
• Penalty on Default 165
• Insolvency of the Debtor 167
• Hawalah (Assignment of Debt) 167
• Security/Guarantee (Kafalah) in Loans 168
• Risk and Reward in Pledge 170
• Benefits from Pledge 171
• Bai‘ al Dayn (Sale of Debt/Debt Instruments) 172
• Impact of Inflation on Loans/Debts 172
• Summary 174

PART III ISLAMIC FINANCE – PRODUCTS AND PROCEDURES 177

• Overview of Financial Institutions and Products: Conventional and
• Islamic 179
• Introduction 179
• What is Banking or a Bank? 179
• The Strategic Position of Banks and Financial
• Institutions 180
• Categories of Conventional Financial Business 181
• Commercial Banking 181
• Investment Banking 184
• Other NBFIs 185
• Conventional Financial Markets 185
• The Need for Islamic Banks and NBFIs 185
• The Structure of Islamic Banking 186
• The Deposits Side of Islamic Banking 188
• Instruments on the Assets Side 191
• The Issue of Mode Preference 195
• Islamic Investment Banking 199
• Contents xi
• Islamic Financial Markets and Instruments 199
• Islamic Funds 201
• Principles Relating to Stocks 203
• Investment Sukuk as Islamic Market Instruments 204
• Trading in Financial Instruments 205
• Inter-bank Funds Market 205
• Islamic Forward Markets 206
• Foreign Exchange Market in the Islamic Framework 209
• Derivatives and Islamic Finance 209
• Summary and Conclusion 211
• Murabaha and Musawamah 213
• Introduction 213
• Conditions of Valid Bai‘ 214
• Murabaha – a Bai‘ al Ama¯nah                                                                          215
• Bai‘ Murabaha in Classical Literature 215
• The Need for Murabaha 216
• Specific Conditions of Murabaha 217
• Bai‘ Murabaha and Credit Sale (Murabaha–Mu’ajjal) 219
• Possible Structures of Murabaha 220
• Direct Trading by Bank Management 221
• Bank Purchases Through a Third Party/Agent 221
• Murabaha Through the Client as Agent 222
• Murabaha to Purchase Orderer (MPO) 222
• MPO – A Bunch of Contracts 224
• Promise to Purchase in Murabaha 224
• MPO – The Customer as the Bank’s Agent to Buy and
• Related Matters 225
• Issues in Murabaha 229
• Avoiding Buy-back 230
• Khiyar (Option to Rescind the Sale) in Murabaha 230
• Time of Executing Murabaha 231
• Defaults by the Clients 231
• Rebates on Early Payment 232
• Rollover in Murabaha 232
• Murabaha Through Shares 233
• Commodity Murabaha 233
• Precautions in Murabaha Operations 233
• Musawamah (Bargaining on Price) 234
• Musawamah as a Mode of Financing 238
• Summary 238
• Forward Sales: Salam and Istisna‘a 241
• Introduction 241
• Bai‘ Salam/Salaf 241
• Benefits of Salam and the Economic Role of Bai‘ Salam 242
• Features of a Valid Salam Contract 243
• xii Understanding Islamic Finance
• Subject Matter of Salam 244
• Payment of Price: Salam Capital 246
• Period and Place of Delivery 247
• Khiyar (Option) in Salam 248
• Amending or Revoking the Salam Contract 248
• Penalty for Nonperformance 249
• Security, Pledge and Liability of the Sureties 249
• Disposing of the Goods Purchased on Salam 250
• Alternatives for Marketing Salam Goods 251
• Salam – Post Execution Scenarios 252
• Supply of Goods as Per Contract 252
• Failure in Supply of Goods 253
• Supply of Inferior Goods 253
• Salam-Based Securitization – Salam Certificates/Sukuk 254
• Summary of Salam Rules 255
• Salam as a Financing Technique by Banks 257
• Risks in Salam and their Management 258
• Istisna‘a (Order to Manufacture) 263
• Definition and Concept 263
• Subject Matter of Istisna‘a 264
• Price in Istisna‘a 265
• Penalty Clause: Delay in Fulfilling the Obligations 266
• The Binding Nature of an Istisna‘a Contract 266
• Guarantees 267
• Parallel Contract – Subcontracting 267
• Istisna‘a and Agency Contract 268
• Post Execution Scenario 268
• The Potential of Istisna‘a 269
• Risk Management in Istisna‘a 269
• Ijarah – Leasing 279
• Introduction 279
• Essentials of Ijarah Contracts 280
• Ijarah and Bai‘ Compared 280
• General Juristic Rules of Ijarah 281
• Execution of an Ijarah Contract 282
• Determination of Rent 283
• Sub-lease by the Lessee 284
• Security/Guarantee in Ijarah 285
• Liabilities of the Parties 285
• Termination/Amendment of the Contract and Implications 286
• Failure in Payment of Due Rent 287
• Modern Use of Ijarah 287
• Financial Lease or Hire–Purchase 288
• Security or Financing Lease 288
• Operating Lease 289
• Appraisal of Conventional Leases from the Shar¯ı´ah Angle 289
• Contents xiii
• Combining Two Contracts 289
• Takaful/Insurance Expenses 291
• Islamic Banks’ Ijarah Muntahia-bi-Tamleek 291
• Procedure for Ijarah Muntahia-bi-Tamleek 293
• Issues Concerning Modern Use of Ijarah 295
• Assignment of the Leased Assets and Securitization of Leases 297
• Potential of Ijarah 297
• Summary of Guidelines for Islamic Bankers on Ijarah 298

• 12 Participatory Modes: Shirkah and its Variants 307
• 12.1 Introduction 307
• 12.2 Legality, Forms and Definition of Partnership 308
• 12.2.1 Partnership in Ownership (Shirkatulmilk) 309
• 12.2.2 Partnership by Contract (Shirkatul‘aqd) 309
• 12.3 Basic Rules of Musharakah 312
• 12.3.1 Conditions with Respect to Partners 312
• 12.3.2 Rules Relating to Musharakah Capital 313
• 12.3.3 Mutual Relationship Among Partners and Musharakah
• Management Rules 314
• 12.3.4 Treatment of Profit and Loss 316
• 12.3.5 Guarantees in Shirkah Contracts 318
• 12.3.6 Maturity/Termination of Musharakah 318
• 12.4 The Concept and Rules of Mudarabah 320
• 12.4.1 The Nature of Mudarabah Capital 323
• 12.4.2 Types of Mudarabah and Conditions Regarding Business 324
• 12.4.3 Work for the Mudarabah Business 325
• 12.4.4 Treatment of Profit/Loss 325
• 12.4.5 Termination of a Mudarabah Contract 327
• 12.5 Mudarabah Distinguished from Musharakah 327
• 12.6 Modern Corporations: Joint Stock Companies 328
• 12.7 Modern Application of the Concept of Shirkah 330
• 12.7.1 Use of Shirkah on the Deposits Side of the Banking System 331
• 12.7.2 Use of Shirkah on the Assets Side 332
• 12.7.3 Securitization on a Shirkah Basis 334
• 12.8 Diminishing Musharakah 337
• 12.9 Diminishing Musharakah as an Islamic Mode of Finance 339
• 12.9.1 Diminishing Musharakah in Trade 339
• 12.9.2 Procedure and Documentation in Diminishing
• Musharakah 340
• 12.10 Summary and Conclusion 343

• Some Accessory Contracts 347
• Introduction 347
• Wakalah (Agency) 347
• Types of Wakalah 347
• Wakalatul Istisma¯r                                                                             349
• Tawarruq 349
• xiv Understanding Islamic Finance
  • 13.3.1 Use of Tawarruq for Liquidity Management 351
• 13.4 Ju‘alah  351
  • 13.4.1 Parties to Ju‘alah 351
  • 13.4.2 Subject Matter of Ju‘alah and Reward 352
  • 13.4.3 Execution of a Ju‘alah Contract 353
  • 13.4.4 Parallel Ju‘alah Contracts 353
  • 13.4.5 Practical Process in Ju‘alah by Islamic Banks 353
  • 13.4.6 Some Islamic Financial Products Based on Ju‘alah 354
• 13.5 Bai‘ al Istijrar (Supply Contract) 355
• Application of the System: Financing Principles and Practices 357
• Introduction 357
• Product Development 358
• Procedure for Product Development 358
• The Nature of Financial Services/Business 358
• 14.3.1 Management of Deposit Pools and Investments 359
• 14.3.2 Selection of the Mode for Financing 360
• 14.3.3 Tenor of Financing 362
• 14.3.4 Shar¯ı´ah Compliance and Internal Shar¯ı´ah Controls 363
• 14.3.5 Operational Controls 367
• Prospects and Issues in Specific Areas of Financing 369
• Working Capital Finance 369
• Trade Financing by Islamic Banks 370
• Project Financing 373
• Liquidity Management 374
• Forward Contracts and Foreign Exchange Dealings 375
• Refinancing by the Central Banks 377
• Cards: Debit, Charge, Credit and ATM 379
• Islamic Banks’ Relationship with Conventional Banks 384
• Fee-based Islamic Banking Services 384
• Underwriting 384
• Letters of Guarantee (L/G) 384
• Letters of Credit (L/C) 385
• Summary and Conclusion 386
• Appendix: The Major Functions of a Shar¯ı´ah Supervisory Board In the Light
• of the AAOIFI’s Shar¯ı´ah Standard 387
• Sukuk and Securitization: Vital Issues in Islamic Capital Markets 389
• Introduction 389
• The Capital Market in an Islamic Framework 390
• Securitization and Sukuk 391
• 15.3.1 Parties to Sukuk Issue/Securitization 393
• 15.3.2 Special Purpose Vehicle (SPV) 394
• 15.3.3 Risk, Contract and Cash Flow Analysis 395
• 15.3.4 Shar¯ı´ah Bases of Sukuk Issue 396
• 15.3.5 Categories of Sukuk 398
• 15.3.6 Tradability of Sukuk 407
• Contents xv
• Issues in Terms and Structures of Sukuk 409
• Potential of Sukuk in Fund Management and Developing the
• Islamic Capital Market 411
• 15.4 Summary and Conclusion 412
• Takaful: An Alternative to Conventional Insurance 417
• Introduction 417
• The Need for Takaful Cover 417
• Why Conventional Insurance is Prohibited 418
• The Shar¯ı´ah Basis of Takaful 420
• Main Objective of the Takaful System 422
• How the Takaful System Works 422
• Models of Takaful 423
• Issues in the Mudarabah Model 426
• Issues in Wakalah and Wakalah–Mudarabah Models 426
• Takaful and Conventional Insurance Compared 427
• Status and Potential of the Takaful Industry 428
• Takaful Challenges 429
• Appendix: Fata¯wa (Juristic Opinions) on Different Aspects of
• Insurance 430
• An Appraisal of Common Criticism of Islamic Banking and
• Finance 433
• Introduction 433
• The Common Myths and Objections 433
• Appraisal of Conceptual Criticism 436
• The Connotation of the Word Riba 436
• Rent on Money Capital 437
• Inflation and Interest 438
• Time Value of Money and Islamic Banking 439
• Charging Interest from Rich Debtors 441
• Different Shar¯ı´ah Interpretations 441
• Islamic Banks Using Debt-creating Modes 442
• Islamic Financial Institutions – Banks or Trade
• Houses? 444
• Islamic Banks to Act as Social Welfare Institutions? 445
• Appraisal of Criticism on Islamic Banking Practice 445
• Divergence between Theory and Practice 445
• IFIs using Interest Income as Seed/Base Capital 446
• Difference between Islamic and Conventional Banking 447
• Imposing Penalties on Defaulters 454
• Availability of Cash for Overhead Expenses and Deficit
• Financing 455
• Socio-economic Impact of the Present Islamic Banking
• System 455
• Conclusion 456
• xvi Understanding Islamic Finance
• The Way Forward 457
• Introduction 457
• Agenda for the Policymakers 457
• Muslim States and Islamic Finance 459
• Potential, Issues and Challenges for Islamic Banking 461
• Promising Potential 463
• Issues in Islamic Finance 465
• The Challenges 474
• Conclusion 479
• Acronyms 481
• Glossary 485
• Bibliography English Sources 497
• Arabic/Urdu Sources 503
• Suggested Further Readings 505
• Index 509
•  List of Boxes and Figures

• 8.1 Deposit Management in Islamic Banks on Mudarabah Basis 190
• 8.2 Islamic Banking Products and Services 194
• 8.3 Islamic Capital Market Instruments and Operations 207
• 9.1 Risk Management in Murabaha 234
• 9.2 Possible Steps for Murabaha in Import Financing 235
• 9.3 Accounting Treatment by Islamic Banks in Murabaha 236
• 9.4 Murabaha Financing for Exports: Process and Steps 237
• 10.1 Flow of Salam Transactions by Banks 256
• 10.2 The Difference between Salam and Murabaha 257
• 10.3 Possible Risk Mitigation in Salam 258
• 10.4 Case Study 259
• 10.5 Salam – Preshipment Export Financing 260
• 10.6 Salam and Refinance by the Central Banks (CBs) 260
• 10.7 Salam for Working Capital Finance 261
• 10.8 Accounting Treatment by Islamic Banks in Salam and Parallel Salam 262
• 10.9 Risk Mitigation in Istisna‘a 270
• 10.10 Differences between Istisna‘a and Salam and Ijarah (Ujrah) 270
• 10.11 Accounting Treatment by Islamic Banks (as Seller) in Istisna‘a 271
• 10.12 Accounting Treatment by Islamic Banks (as Buyer) in Istisna‘a 273
• 10.13 Housing Finance through Istisna‘a 274
• 10.14 Istisna‘a for Preshipment Export Finance 275
• 10.15 Parallel Istisna‘a for Building Project Finance 276
• 10.16 Parallel Istisna‘a – Government Projects 277
• 11.1 Risk Mitigation in the Case of Ijarah 299
• 11.2 Auto Ijarah Compared with Conventional Leasing Products 300
• 11.3 A Hypothetical Case Study on Ijarah 301
• 11.4 Accounting Treatment of Ijarah 303
• 12.1 Rules Relating to Sharing of Profit/Loss in Shirkah 319
• 12.2 Case Study on the Use of Musharakah for Trade Financing 334
• 12.3 Musharakah-based TFCs Issued by Sitara Industries, Pakistan 335
• 12.4 Construction of a House on a Customer’s Land or Renovation of a House 341

• xviii Understanding Islamic Finance
• Hypothetical Case Study on Housing Finance Through Diminishing
• Musharakah (Partnership by Ownership) 341
• Accounting Treatment of Mudarabah (Financing Side) 344
• Accounting Treatment of Musharakah 345
• Salient Features of Major Modes of Financing 361
• Example of Using Salam and Murabaha Combined 362
• Developing Islamic Depository Receipts (IDRs) 390
• Securitization Mitigates the Risks 395
• Tradability of Sukuk in the Secondary Market 408
• Prominent Sukuk Issues in Various Countries 408
• DP World’s Nakheel Sukuk 412
• yyIjarah Sukuk Offering by the Government of Pakistan 413
• Ijarah Sukuk Issue by WAPDA, Pakistan 414
• Case Study of Hanco Fleet Securitization (Saudi Arabia) 414
• 16.1 Flowchart of the Wakalah with Waqf Model of Takaful 425
• 18.1 Shar¯ı´ah Compliance Framework Introduced by the State Bank of Pakistan 473
• Figures
• Forms of Bai´ with respect to counter values 134
• Elements of valid Bai´ 135
• 13.1 The Ju‘alah process 354
• Flow diagram of the securitization process 394
• Flow diagram of IDB mixed portfolio Sukuk issue, 2003 407

Foreword

The last decade has seen an unprecedented growth not only in the practice of Islamic banking and finance but also in the literature on Islamic finance. This book, however, is not merely another addition to the available literature. It has a marked distinction. It not only places theory and practice in one place along with Shar¯ı´ah (Islamic law) underpinnings, but also provides an objective assessment of conformation of the practice to the theory. A good coverage of recent innovation in Islamic financial products is also a distinguishing feature of this book.

Islamic finance is a subject that has now been recognized as a distinct academic discipline to be included in the curricula of economics, business, finance and management faculties of institutions of higher learning. There are several universities and institutions, both in Muslim and other countries, that are teaching courses on Islamic banking and finance. These teaching programmes, however, have been seriously constrained by the non-availability of a standard textbook to be followed. I can say with confidence that this book carries the status of a textbook to be prescribed in the senior levels of undergraduate programmes as well as in graduate programmes in the relevant faculties.

Islamic finance is still a new subject. There is great interest in conducting research on different aspects of its theory and practice in the contemporary set-up. Students of economics and finance keenly look for topics of research in this field. The analytical approach adopted in this book is conducive to bringing to light potential areas of research. Thus, research students in the area of Islamic finance should find this book a must read.

The author of the book has a long experience of research in the State Bank of Pakistan (the central bank of the country), which has played, during the last decade, a significant role in promoting Islamic finance in the country. By virtue of his position in the research department of the State Bank of Pakistan, he has a very valuable insight into the operations of Islamic banks as well as their feasibility to survive in competition with the conventional banks in the country. His approach in presenting the material in this book is very pragmatic.