INTRODUCTION TO ISLAMIC BANKING & FINANCE

INTRODUCTION TOISLAMIC BANKING & FINANCE By Muhammad Ayub (Former) Head, Islamic Banking, NIBAFState Bank of Pakistan Presented at AlHuda CIBE Workshop at Lahore

Topics to be Discussed • Why Islamic Banking? • The Prohibition and Concept of Riba • Key Misconceptions – General Myths • Features of an Islamic Bank – Overview • Overview of Islamic finance Modes • Shirkah – Musharakah and Mudarabah • Murabaha • Ijarah • Diminishing Musharakah

Islamic Banking? • Banking encompassing Islamic injunctions • To avoid: • Riba –Earning returns from loans and debts or Selling debt contracts at discount • Gharar – Absolute Risk or Excessive uncertainty in contracts, Gambling and chance-based games (Qimar) • General Prohibitions • unethical practices • Shariah Compliance & Prudent Banking

Riba Prohibition • All revealed religions • Severe Prohibition in Quran $ Sunnah • Unanimity on Riba Prohibition; • Problem then? • Interpretation • Consensus

Quran Guides on Def of Riba Financial Liability: Qard (Loan) : to give anything in ownership of other by way of virtue - same or similar amount of that thing would be paid back on demand or at the settled time. Dayn (Debt) : Incurred by way of trade or rent or any other credit transaction - ought to be returned at the settled time without any profit. Verse 2: 279 guides that whatever is over and above the principal of loans or debts is Riba.

Riba? • All increases in wealth or benefits accruing to a person without any labour, risk, or expertise. • One who wishes to earn profit on his monetary investment must bear the loss or damage accruing to the business where his money capital is to be used. • Nature of transaction important. • Trading- Bai- Risk taking, value addition • Leasing – Ijarah - Risk taking, value addition • Exchange transaction – Monetary transactions • Lending – a virtuous act; not a business • Hand to hand exchange of currencies

Misconceptions - Myths • Any Return on deposits is Riba; • Any prefixed return – Riba • Islamic banking: cost-less money available – Approach of Businesses • Repayment of loans not a serious issue –be waived of • Trade profit similar to interest on loans / debts

Reality Differentiating: Trading, loaning and leasing • Return by way of pricing of goods and their usufruct needs to be fixed: permissible. • Islamic banking is also a business, It does not mean availability of cost free money. • Repayment of debts is must. • Time value of money is accepted to the extent of pricing of goods but not in the form of conventional opportunity cost concept.

Riba - Unanimity Banu Thaqif of Taif, not to forego interest on their receivables; Banu Amr ibnal Moghirah refused to pay interest; Referred to the H Prophet, the Revalation came: “O you who believe. Fear Allah, and give up the Riba that remains outstanding if you are (in truth) believer”. (11:278).

Riba - Unanimity (Contd) “If you do not do so, then be sure of being at war with Allah and his Messenger. But, if you repent, then you have your principal”. (11:279)

And if you repent, then you have your principal. Wrong not, and you shall not be wronged ”. {without inflicting or receiving injustice}

And fear the day when you shall be brought back to Allah. Then shall every soul be paid what it earned and none shall be dealt with unjustly.

Riba versus Bai • Those who protested and argued that lending on interest was like an act of trade, were admonished through revelation that while ‘trade’ was permitted, ‘riba’ was forbidden and in loan transactions they were entitled to their principal sums only.

Some other Myths • Credit and cash market prices of a commodity must be same • Profit margin on credit sale by banks resembles Riba. • Sharing vs. Non Sharing instruments: • Permissibility & Priority two different aspects • Money can be rented like other assets

Reality • Profit margin that Islamic banks charge in their trade operations is permissible if trading principles given by Islam are properly taken care of. • PLS modes have preference but Debt creating modes also permissible; Banks can use any modes keeping in view the Risk Profile of the investors and nature of business and cash flow of entrepreneurs. • Money cannot be rented

They used to say that it is all equal whether we increase the price in the beginning of the sale, or we increase it at the time of maturity. It is this objection which has been referred to in the verse by saying “They say that the sale is very similar to Riba.” (Ibn-Abi-Hatim)

Types of Riba • Riba Al-Fadl - sale transactions, • Quality premium in exchange of low quality with better quality goods of same kind; prohibited e.g. dates for dates, wheat for wheat etc. • Riba Al-Nasia - loan transactions. • Riba Al-Nasia (Riba Al-Ouran) involved in credit/delay; modern banking transactions falls under Riba Al-Nasia,

Overall Consensus • Council of Islamic Ideology (CII): Preliminary Work • CII Report on Elimination of Interest from the Economy (June, 1980) – Unanimously Endorsed • Representation of all Muslim sects in Pakistan • Justice Dr. Tanzil-ur-Rahman (J Afzal Cheema) • Mawlana Zafar Ahmad Ansari • Mufti Sayyahuddin Kakakhel • Khawaja Qamruddin Siyalvi • Mawlana Muhammad Taqi Usmani • Mawlana Muhammad Hanif Nadvi • Allama Syed Muhammad Razi • Mr. Khalid M Ishaq

Other Prohibitions • Compensation-based restructuring of debts • Selling debt contracts at discount Excessive • uncertainty in contracts (Gharar) • Gambling and chance-based games • Forward foreign exchange transactions

Gharar • Excessive uncertainty regarding subject matter and the price; • Inadequacy and Inaccuracy of Information - Uncertainty - lack of adequate value-relevant information – Transparency and disclosure . • Any bargain in which the subject matter / result of it is hidden; settlement risk / counterparty risk involved • Only exception: "Salam” (forward sale with prepayment)." and “Istisna´a” (order to manufacture) • Rationale of this exemption.

Gambling • Maysir (game of chance) :getting something too easily or getting a profit without working for it. • Qimar includes every form of gain or money, acquisition of which depends purely on luck and chance. • All Lottery based prize Schemes covered under the definition of gambling and Maysir.

Encouragements • Benevolence • Transparency and disclosures • Purification of income • Comprehensive and universal ethical approach • Documentation

Welfare Economy Framework • Socio-economic Justice • Distributive Justice • Ethics and value system • Functioning of the Market & Role of the State: • Right of ownership, freedom of enterprise, over seeing role of the State. • Transparency and disclosures • Competitive price mechanism • Creating additional value and sharing gains • Closer linkage between real economy & finance • Society happy both materially and spiritually.

Businesses / Modes of Arabs • Trading, Muzara’ah, Musaqat (Gardening with Shirkah), Services (Ujrah and Ijarah) – The Main businesses; • Barter and the Money based transactions; • Individual Businesses, with self capital or arranged on Riba; • Loans, Debts (Credit /Future contracts – Salam/Salf • Partnership

Impact of contracts • Bai: Definite transfer of ownership of goods against payment of price-spot, delayed and forward; Profit permissible • Ijarah (leasing): Transfer of usufruct of goods. Any thing which cannot be used without consuming its corpus, or whose corpus changes its form in the process of its use, cannot be leased out like money, edibles, fuel, etc. Rental permissible • Riba: Exchange transactions involving temporary transfer of ownership of assets against payment. Any return prohibited. • Qadr Hassan / Tabarrue: Temporary transfer of ownership of goods/assets free of any payment;

What Islamic Banking? • Banking encompassing Islamic injunctions • To avoid: • Riba –Earning returns from a loan contract or Selling debt contracts at discount • Gharar – Absolute Risk or Excessive uncertainty in contracts, Gambling and chance-based games (Qimar) • General Prohibitions • unethical practices • Shariah Compliance & Prudent Banking • Achieving the goals and objectives of an Islamic economy.

Conventional Borrowing on interest Lending on interest Money – the Subject matter Services against wages or commission Islamic Trading- Shariah Rules Leasing Doing other real sector businesses through sole proprietorship or Shirkah Services against wages or commission A Paradigm Shift!

Principles of Islamic Finance • Lending a virtuous act – Not a business. • Prohibition of Riba and Gharar; permission of trading. • All gains to principal not prohibited. • Deciding Factor: nature of transaction. • Profit to be earned by sharing risk and reward of ownership through pricing of goods, services or benefits. • Time has value that can be discounted only through price; not in the form of interest, sometimes negative value as well.

Profit linked with Liability • Ownership cannot be separated from the risk of its loss • Al Kharaj Bil daman • The above implies that entitlement to return from an asset is intrinsically linked to the liability of loss of that asset • What that implies for the attitude towards risk? • What that implies for time value of money? • in loans • in deferred sales

Cardinal Principles (Contd) • Ability to cause ‘value addition’. • Differentiating: Trading, loaning and leasing • Ownership Transfer in: Sale of assets, Loans and Leasing; • Any thing which cannot be used without consuming its corpus, cannot be leased out like money, edibles, fuel, etc. • Taking rent on leasing of asset permissible while rent on loan is prohibited. • Repayment of loan- Must. • Husan al qada: Repaying a loan in excess of the principal. • Debt contracts cannot be sold at discount.

Cardinal principles • Risk and return / rights and liabilities must go side-by-side; • The subject of exchange has to be valid and should not involve Gharar; • Notional assets stand no where in Islamic finance; • Non-existing assets can become the subject matter of exchange with the conditions applicable to Salam; • The main objective of exchange transactions has to be completion of the exchange process from the both sides.

Alternative Financing Principles • Participation and sharing principle • Deferred trading principle • Interest free loans • Combination of contracts

Wealth and trading rules

Exchange Rules • Different for different contracts and types of wealth: • Goods, Durable assets, Shares representing pool of assets - Market based pricing • Gold silver or any monetary units (Athman) – Rules of Bai al Sarf • Usufruct and services (Leasing/ Services) • Loans/Debts – Repayment or Assignment of the same amount. • Well-Known Injunction on exchange of six commodities: Gold, Silver, Wheat, Barley, Dates and Salt.

Exchange Rules (Nawawi) • Illah (Effective Cause of prohibition): Unit of value and Edibility • When underlying illah is different, short fall/excess and delay both are permissible, e.g. sale of gold for wheat. • When commodities of exchange are similar, excess and delay both are prohibited, e.g. gold for gold or wheat for wheat, Rupee for Rupee, etc. • When commodities of exchange are heterogeneous but the illah is same, as in the case of gold for silver (medium of exchange) or wheat for rice (edibility), then excess/deficiency is allowed, but delay in exchange is not allowed.

Exchange of Currencies Contd) • Special rules for exchange of monetary values. • Currency Futures: Some scholars forbid them while others distinguish between the two cases: • First, where one currency is delivered on spot and the other is delayed - forbidden. • Second, permitted, involves the future exchange of both currencies at the previously agreed rate.

Banking - A Business • Banking or Benevolence ? • Principle of Islamic banking business: Sharing of profit and loss on post facto basis arising from: • (Deferred) Trading– profit margin for the seller • Rentals on leased assets • PLS • Combination of contracts • Return free (loans)

Main Financial Contracts A. Debt creating Modes (Low Risk Category) 1. Qard Al-Hasan (interest-free loan) 2. Bai Muajjal (Price deferred sale) 3. Murabaha and Musawama 4. Salam (Commodity sale) 5. Istisna´a ((Order to Manufacture) B. Semi-debt Modes 1. Ijara C. Sharing or Non-debt Modes (Full Risk Category) 1. Musharaka (Close to Venture Capital) 2. Specific Purpose Mudaraba 3. General Purpose Mudaraba

conditions for Valid sale • General Rule: Commodity should have come into existence. It should be in ownership of the seller. The commodity should also be under physical or constructive possession of the seller. Two exceptions to this rule- Salam & Istisna´a

Contract of Valid Bai

Principles of Credit Sale • Installments Sale permissible, even if the deferred price exceeds the spot price. • Deferred prices can vary so long as price not finalised. • Sale cannot take place until the parties agree to a particular price & mode of payment. • Not permissible to fix the spot price on cash basis, then to charge interest expressly tied with different periods. • Commercial papers are lawful types of authentication of a debt by putting it down in writing; - Treated by Shariah near to mandatory.

Two main prohibited Sales • Bai al inah – Buy-back arrangement • Creditor purchasing assets from debtor on cash and selling back to him on credit • Bai al Dayn - sale of debt • Trading of debt securities • On face value- Hawalah - Permissible • On premium or discount – Not permissible

Rules in Murabaha • Basic concept: Sale on mutually agreed profit margin on the known cost of goods; payment of sale price is deferred. • Real, tangible goods to be traded and not papers of debt or credit documents. • Murabaha cannot be used as mode in case no commodity is purchased by the client. • Buy-back arrangement: not allowed. • MUAJJAL; Credit price may include margin of mark-up, taking into consideration the deferred payment. As a debt, no return can be charged on the amount of Note/Bill.

MURABAHA Contd • Seller having a good title • physical / constructive possession. • Defaulter: different punishments, penalty for charity. • Solatium through court (out of penalty). • Client as Agent to the Bank; • Better to have a third party as agent; • Roll-over. • Asset price Risk or commodity risk ( client might not take delivery); • Market risk, • Credit risk, • Reputational Risk

Rules in Musawamah • A general kind of sale: Price bargained without any reference to the price paid or cost incurred. • Seller not obliged to reveal his cost. • Different from Murabaha in pricing formula only. • Musawamah can be used for big single deals.

Salam and Parallel Contracts (Future Sale) • Prepayment of price in full for goods to be delivered in future. • Allowed by Holy Prophet (SAW) himself to meet farmers’ money need. • Banks will receive contracted commodities, not money. • Parallel Salam: a bank can sell a commodity purchased through Salam for even the same date of delivery or the quantity; • As long as the two contracts are not made conditional on each other.

Purpose of Salam • To meet the need of farmers who need money to grow their crops and to look after their family up to the time of harvest. • To finance someone who is in need to grow something or acquire something for further sale. • To meet the need of traders for import and export business. • The buyer also enjoys a lower purchase price, since he pays in advance. • Acceptance of Time. Value of Money through pricing of goods

Salam Conditions • Fungible – homogeneous goods • not where delivery has to be simultaneous, e.g. Gold, silver or currencies. • Date and place of delivery must be specified in the contract. In case of a number of commodities, the amount and delivery period should be separately fixed.

Salam Conditions Contd… • The bank can sell the Salam Commodity through a parallel contract of Salam for the same date of delivery. • For a parallel Salam, the two contracts should be independent and separately enforceable. • Bank can also obtain a unilateral ‘promise to purchase’ from a third party. • Agency • To sell anywhere in the market

Istisna’a (Order to Manufacture) • Istisna’a, an agreement for order to manufacture, culminating into a sale at an agreed price; • The things to be manufactured must be known and specified to the extent of removing any ignorance or lack of knowledge of its kind, type, quality, and quantity. • Price be known in advance that can be readjusted only by mutual consent of the parties.

INTRODUCTION TO ISLAMIC BANKING & FINANCE