In the name of Allah(j.j) Chapter # 5 Interest Free Banking

1. In the name of Allah(j.j)Chapter # 5 Interest Free Banking By Kokab Manzoor

2. Contents • Definition of interest • Economic importance of prohibition of interest • Islamic banking • Definition and need of Islamic banking • Supremacy of Islamic banking • Bill of exchange & Interest free loans • Comparison of conventional & Islamic banking • Insurance • Definition, Evolution, importance and Islamic Concept of insurance

3. Definition of Interest • Interest is the price of capital. The Holy Quran uses the word Riba to denote interest which means increase, growth, addition, raise, excess. • Allah deprives interest of all blessing and develops charity [Al-Baqara; 276]

4. Why did Islam forbids Interest..??? In Capitalist Economy there are four factors of Production while Islamic Economic system recognizes only three Factors of Production. CAPITALIST ECONOMY ISLAMIC ECO SYSTEM

5. Economic Importance of Prohibition on Interest • Interest and investment • Capital investment depends on the one hand on the rate of interest and on other hand on MEC. • The process of investment in a country will continue as long as MEC is higher or equivalent to rate of interest, and vice versa…

6. Cont`d….. • Interest and Price • Interest and Distribution of Wealth • Interest and Trade Cycle • Interest and Allocation of Resources • Interest and business • Interest and Efficiency • Interest and Economic Stability • Interest and International Loans

7. BANK • Bank is an institution which deals in credit • Functions of banks • Accepting deposits • Advancing loans • Providing agency services • Money transfer • Safe deposit lockers • Investment • Credit creation

8. Need for Interest Free Banking • Modern banking system gives rise to injustice, oppression, waste of resources and inequitable distribution of resources among nations. • And as modern banking system is based on Riba (interest) and Islam forbids interest. Meanwhile the utility of Banks is acknowledged, so it is necessary to reform the banking system according to the principles of Islam.

9. What is Islamic Banking ?? Since interest is forbidden by Islam, Shirakah (partnership) and Modarbah will be the only alternative basis of banking in Islamic economy. A bank will be established by two or more individual making investments according to a fixed ratio • Islamic banking has been defined as banking governed by the principles laid down by Islamic Sharia’h

10. MECHANISM OF ISLAMIC BANKING • Under Islamic scheme of banking there may two types of depositors. • The one who deposit surplus amount and can withdraw at anytime, bank will charge Zakat or service charges for safeguarding. • They can not withdraw their money without notice as their amount will be invested in short term projects. The depositors will share in profit and loss.

11. Business of the Bank • The business of the Bank may assume three forms, • Services on which a charge is made • Investment on the basis of Shirakah (partnership) or Modarbah basis • Free services

12. 1 Services on which a charge is made Like modern banks, the Islamic banks will also receive fee, commission or fixed charges on various services like; • Facility of lockers • Transfer of Money • Receiving and Forwarding of trade Goods • Services as financial and legal consultants to business corporations

13. 2 Investment on the basis of Shirakah or Modarbah basis • The interest free banks will enter into Shirakah or Modarbah transaction with businessmen. • ShirakahA contract between partners on both capital and profit. • Modarbah A contract between partners in which one provides capital and other provides services. • Note these two will be discussed in detail in next chapter

14. Issue of Loans in interest free Banking system • The bank will issue loans without any charge to businessmen for short period. • Such loans will be issued by the bank out of “Loan Account” • The debtor will provide guarantee • Bank have right to invest the available sum in “Loan Account” in profitable venture. • Banks shall also be entitled to take charge free loans from Central Bank.

15. Bill of exchange & interest-free Loans • Discounting Bills of Exchange would not be permissible; however following procedures may be adopted • Instead of bill of Exchange the businessmen should take loans from Banks on Modaraba basis, • Bank will advance charge free loans • The bank will make no deductions, and will recover the full amount on the date of the maturity of the bill of exchange.

16. Process of Credit Creation in Islamic banking • Bank will keep 10% as reserve of Loan Account for meeting daily needs • Loan advanced, will be again deposited in bank • Bank will hold large amount of deposits and rest will be invested in Modarbah • That amount will be deposited in various other banks, hence bank receives back a large part of the money it lent out or invested. • Hence the process of credit creation is similar to conventional banking but the technique is different

17. COMPARISON Conventional banking Islamic Banking Partnership (Mudarabah) or profit and loss sharing arrangement between the bank and the depositors Profit and loss sharing (Musharaka) or trade and leasing based financing arrangement between the bank and its clients users of funds) • Borrows funds from the depositors paying interest on the liability side of its balance sheet. • Lends the funds to the borrowers, charging interest on the asset side.

18. COMPARISON Conventional banking Islamic Banking Islamic bank entitles the depositors --to be informed of what the bank does with their money --where their money would be invested The profit or the return is based on the actual investment outcome. • Between the depositors and the bank, there is an iron wall. • The interest or the return is predetermined or fixed in advance

19. COMPARISON Conventional banking Islamic Banking Transactions are real asset based as per defined principles of trading or leasing • Money earning money without real sector business: Transactions are financial asset based

20. SUPERIORITY OF ISLAMIC CONCEPTION OF BANKING • Conventional banking • Loan on interest-- chance of unhealthy investment—leads to depression and ultimately unemployment– also acts criminally if borrower fails to repay. • Islamic banking • Interest free loans– banks interested in investment rather than loan--so healthy investment takes place– reduces unemployment rate--less chance of depression-even if, can easily be countered.

21. Summary & Conclusion • Riba, usury, Interest are prohibited. • Saving is the function of investment not the interest. • Islamic banking is based on principles of partnership. • Short term and long term financing can be made through system of guarantee. • Strong relationship of banks with depositors and entrepreneurs. • Islamic banks can contribute better to economic development by performing extra banking activities.

22. Islam and Insurance

23. Definition of Insurance • Definition • “a contract whereby one person, called the “insurer” undertakes, in return for the agreed consideration, called the “premium”, to pay to another person, called the “assured” a sum of money, on the happening of a specified event. • This specified event must have some element of uncertainty about it.

24. Importance of insurance Risk and uncertainty are part of daily life of human being Risk is of two types • (Risk of loss) In any economic activity a person may gain profit or suffer loss • Breakage of crockery, glassware etc, or accidents, injuries, Hazards, sinking of ships etc…

25. Importance of insurance • In business the second kind of risk is the greatest target of insurance. • It gives sense of security to businessmen • Improves efficiency • Raise morale to face risk

26. Evolution of Insurance • Started to meet risk of traders whose ships were often wrecked by storms • Muslims maritime traders during the Islamic rule in Spain were the pioneers. • Arab traders launched a system of insurance on a Shirakah basis.

27. Takaful Islamic concept of insurance • Takaful is an Arabic word that means "guaranteeing each other". • It is a system of Islamic insurance based on the principle that “the risk will be shared collectively by the group Voluntarily”. • This is a pact among a participants who agree to guarantee among themselves against loss or damage to any of them.

28. Basic Principle behind Takaful 1.The principle of “fortunate many helping the unfortunate few" is a concept recognized by Islam. 2.The Quran states in Surah Al-Maidah verse # 2: "Help ye one another in righteousness and piety, but help ye not one another in sin and rancor".

29. Operation of Takaful Fund • The contribution collected by company will be further invested on the principle of Al –Modarbah, through which the element of interest (riba) will be replaced. • All premium holders will participate in pofit and loss. • Profit will be shared on agreed ratio.

30. Thank You !