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HOW ISLAMIC BANKS OPERATE?

Islamic Finance

, by DR. WAQUAR ANWAR

Financial viability and technical feasibility of a commercial bank without interest became a challenge to the scholars of Islamic studies, including economists. Something had to be done to prove that the uncompromising attitude of Islam towards interest has an economic rationale that is relevant to the modern society too. Islam is proactive towards all aspects of human life, including economics and finance. Developing of banking industry in the last three centuries has been done squarely on interest. With the passage of time commercial banks acquired so much importance that it almost became an essential element of a modern economy.
Now with total rejection of interest by Islam there remains no room of the types of institutional growth that developed meanwhile in these areas. Islamic scholars accepted this challenge head-on and produced a series of articles and books delineating proposed commercial banks without interest. Considerable, if not major, portions of books and articles written on Islamic economics in the twentieth century in different languages, particularly after late sixties, were devoted to possibilities of banking on Islamic principles.
Writings of Maulana Syed Abul Ala Maudoodi in Urdu, Baqi-us Sadr in Persian, Dr. M. Nejatullah Siddiqi in Urdu and English, Dr. Umer Chapra in English, Syed Qutb in Arabic and a host of others in these and other languages covered this issue. Almost all the writings related to interest-free banking placed profit and loss model of Islamic banking as the replacement of interest-based conventional banking.
Dr. Nejatullah Siddiqi searched common elements in dispositions of different schools of Islamic jurisprudence (mazhab) in his book Shirkat-o-Mudharbat ke Sharai Usool so that the blueprint of Islamic banking proposed by him may become acceptable to all. Later developments did not follow this acceptable-to-all line. Rather in contrast to this later one, trends were to find anything suitable in any school of jurisprudence (mazhab). Anything suitable in Hanafi, Shafai, Maliki or Hanbali mazhab is deemed acceptable.
For this matter other discussions and deliberations like Zahiri or Jafiri are also referred to in quest for systems that are suitable for today’s situations. It may be said that in this style of functioning any support from any quarter seems to be acceptable!  The true statement for today’s approach will be that Islamic banking is both interest-free and mazhab-free. In this process a new school of jurisprudence (mazhab/fiqh) is developing that has the ability to resolve current issues more effectively. Islamic studies have developed in this process.
 
PRIMARY AND SECONDARY MODES OF FINANCE
Initial writers on the subject who presented blueprints for an Islamic bank (IB), including Syed Qutb, Dr. Nejatullah Siddiqi and Dr. Umer Chapra envisaged that the contract based on Musharakah (Active Partnership) and Mudharabah (Sleeping/Passive partnership). We can refer these to be primary modes that are profit and loss sharing based methods of contracts. Other popular variations in these modes are Muza’arah (Partnership in Share Cropping) and Musaqat (Partnership in Horticulture). These are equity based contracts. Such contracts are popular even today in collecting deposits and arranging funds for Islamic banks but are not in much use for investment of funds so collected.
The contracts that are in vogue for application of funds by Islamic banks may be called secondary modes of finance or trade-based modes of finance. These include Murabaha (Cost Plus Service Charge), Ijarah (Leasing), Ijarah wa Istiqna (Hire Purchase), Bai Muajjal (Sale on Deferred Payment), Bai Salam (Forward Delivery Contract) and Bai Istisna (Contracted Production). Such contracts involve credits.
Another possible sub-classification of secondary modes of contracts Islamic banks enter into is that of goods based contracts and fund based contracts as under:
GOODS BASED CONTRACTS: Bai Salam (Forward Delivery Contract).
FUND BASED CONTRACTS: Bai Muajjal (Sale on Deferred Payment); Istisna (Contracted Production); and Murabaha (Cost plus Service Charge).
Primary contracts are more risky for banks as compared to secondary contracts. Income from investments for a bank in the case of the former is not certain and the possibility of loss in the ventures can never be avoided. In the case of deposits and other forms of collection of fund Islamic banks are willing to enter into primary contracts because the risks are shifted to the depositors or shareholders. Banks are relatively safe. But when it comes to investments and application of funds, these banks avoid primary contracts and prefer secondary contracts so that income can be predetermined.
MUSHARAKAH (ACTIVE PARTNERSHIP): Both Islamic bank and its customer, the party, invest in a venture. The Islamic bank may appoint a person on salary basis to participate in the business on its behalf. Alternatively the bank may appoint the party itself its Managing Partner authorising the person to run the business. Such a contract may be an ongoing method or on diminishing basis wherein the share of the bank diminishes gradually and the bank finally walks out of the deal on predetermined and agreed basis. The Managing Partner gets salary or commission for his services in favour of the bank. Profit in the venture is shared on agreed ratio whereas loss is shared on the basis of respective investments of the parties. However, in the case of loss, the Managing Partner may not get his salary and/or commission.
MUDHARABAH (SLEEPING/PASSIVE PARTNERSHIP): This is the most popular form of receiving funds for an Islamic bank (IB). The account holders who provide fund for IB are sleeping partners while IB itself is the active partner. The account holders are called Rabbulmaal (Owners of Fund) and bank is named as Mudharib (Holder of Fund) and the process is called Mudharabah. Normally IB maintains following types of accounts:
Current Account: IB guarantees refund of money on call. This may also be called Call-Deposit. No profit is credited and no loss is debited in these accounts. IB has to maintain sufficient liquidity to provide money on demand. The portion of current account balances over and above the liquidity requirement is included in the common pool of IB.
Saving Account: Unlike current accounts, withdrawal from saving accounts cannot be served very frequently. Some discipline in this demand is enforced; say weekly withdrawal or one withdrawal a day. The cumulative average balance, calculated on the weighted average of the product of daily, weekly or monthly balances with a number of days, weeks or months, as the case may be, is considered part of the common pool of the fund from which investments are made by IB. Alternatively, minimum balance of a particular period, say month, may be treated as part of common pool for investment.   
Investment Deposit Account: This is akin to the fixed deposits for fixed periods, say three months, six months, one year, etc.
Common Pool of IB comprising average balances of savings accounts and investment deposit accounts and a portion of current account balances is utilised for investment. Profits and losses in different forms of investments are debited and credited in the common pool. Thus losses are spread out on profits earned. Profit is shared on agreed ratios. Naturally Investment Deposit Accountholders enjoy more share of profit than the Saving Bank Accountholder. Investment Deposits for longer periods get more share of profit than those with shorter periods of deposits. Losses remaining after spreading over overall profits will be shared on the ratio of respective balances of the parties in the pool. If the IB has its own fund in the Common Pool comprising share capital, reserves and retained profits then it will also bear the share of the net loss in proportion to its participation in the pool.  
One form of investments by IB is Mudharabah wherein the bank enters into fund management agreement with clients. IB serves as the Rabbulmaal and the client concerned works as Mudharib. In this Mudharabah arrangement bank is the passive partner and client is the active partner. Fund of the bank is invested with the technical expertise of the client.
MURABAHA (COST PLUS SERVICE CHARGE): A simple method of cost plus deal is that a person in need of anything approaches the bank with the request to arrange that item. IB does the purchasing and sells the item after adding its element of profit/service-charge on instalment basis. The person gets the item he needed with the facility to pay the debt in instalments and the bank got the profit in the deal. In this case the element of profit to IB is predetermined under information to the client. A known amount of debt is created that is paid off in instalments.
IJARAH (LEASING): A number of leasing contracts are in vogue in Islamic banking business. One simple example is that of a building purchased by IB and sold with its element of profit to a client on deferred payment cum rental basis. The client pays off his debt in instalments. The periodic instalments paid by the client include a portion of the debt and an amount of rent. The debt goes on decreasing with every instalment and this decreases the rental too because with every payment the client is becoming owner of bigger portion of the property. With the last instalment the client becomes owner of the total properly. The full ownership of the property is transferred therewith. 
Leasing is the second most popular mode of contract practised by IBs. It is estimated that Cost Plus and Leasing account for more than 90% of the business done by IBs.
BAI MUAJJAL (SALE ON DEFERRED PAYMENT): Sale on deferred payment means credit sales where goods are supplied on credit and payments are collected after a lapse of time either full at a time or in agreed instalments. Mudharabah, as discussed above also is a deferred sale in sense. However, these two deals have basic differences. In the Mudharabah IBs procure the items that are indicated by the prospective customers and sell that item after informing the client about its margin of profit. In Bai Muajjal goods are procured without specific indication by the clients and sales may be done keeping cost as a trade secret. Sharing cost may be a good practice, although not a precondition, in Bai Muajjal while it is a necessary in the case of Mudharabah.
It is debatable whether it is permissible in Islam to keep different prices for cash sale and credit sale. This debate is very much relevant for the business of an IB as more than 80% of their business is being done assuming permissibility of such differential pricing between cash sale and credit sale. Maliki, Shafii, Hanbali and Ahle-Hadees Schools of Jurisprudence (Mazahib) consider this differential as premium for the time lag in payment and hence consider it to be a form of Riba. Hanafi School of Jurisprudence (Mazhab) permits this difference of price on the logic that it is the prerogative of the seller to keep any price he likes. The seller may demand different prices from different customers. For example, he may keep higher price from a new client than from a client with better goodwill in market.
The Hanafi School, however, puts one condition; that the same customer cannot be offered both the options of lower price on cash-down-payment and higher price on deferred payment. Single price shall have to be offered to a customer after assessing whether the party will pay in cash or on credit.
IBs globally opt for the Hanafi logic!
BAI SALAM (FORWARD DELIVERY CONTRACT): It is the reverse of Bai Muajjal. Here goods are deferred in supply whereas price is paid in advance. Such advance payment for supply of goods at a later date in the case of production activity is called Bai Istisna (Contracted Production). These cases are not very much relevant for Islamic Banking business. However, in certain cases such contracts may have to be applied.


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