UNDERSTANDING ISLAMIC FINANCING
KHALID LATIF
It is important to note that Islam not only provides a complete code of ethical values but also covers the entire socio-economic spectrum of human life based on equity and justice. The recent resurgence of Islam symbolises, among other things, the disillusionment of the Muslim world with both the prevailing major economic systems, namely capitalism and socialism.
Muslims believe that the Islamic system, and the Islamic system alone, being divine in origin, holds the key to their socio-economic well-being and progress. Islam considers Riba, that is, interest in all its forms, as unjust and exploitative and forbids it in strong terms.
Consequently, a few decades ago, Muslims in several parts of the world decided to establish interest-free financial institutions. As a result, today mor e than one hundred financial institutions are practising interest-free modes of financing all over the world. Moreover, there are strong indications that the movement for interest-free financial institutions is poised to gain momentum, especially in the Muslim countries, leading to the establishment of many mor e such institutions.
The basis of its creation being the ideology of Islam, Pakistan decided to dispense with the interest-based banking system and introduce various mode s of Islamic financing in the country’s banking sector.
Background
The task was given to the Council of Islamic Ideology, constituted in 1962 under the constitutional provisions. Th e Council submitted its final recommendations to the federal government in 1980. Pursuant to the said report, profit-and-loss-sharing deposit accounts were introduced by banks in 1981.
The conversion of credit into Islamic modes of financing was, however, scheduled gradually and was commenced on 1st January, 1985 by eliminating Riba from the finances of the government, public sector corporations, government owned/managed companies and private sector joint stock companies, and finally culminated on 1st July, 1985 in the conversion of all deposits in all banks into profit-and-loss-sharing accounts and financing on a mark-up basis instead of interest.
At the outset, the State Bank of Pakistan had identified twelve modes of Islamic financing which could be broadly classified into five categories, depending upon the nature of the transactions involved:
a) Shared-risk financing
b) Selling on profit
c) Renting of assets
d) Renting of services
e) Qard-Al-Hasana
Shared-risk Financing
The arrangement under shared-risk financing is to share profit/loss among the investors, i.e., the bank on the one hand and the customer on the other, who may be natural or legal persons. The modes of financing under this class are as follows:
• Musharaka
• Equity participation and purchase of shares
• Participation Term Certificates, Term Finance Certificates and Mudaraba Certificates on a short-, medium- and long-term basis
• Development charges for financing the development of property
Musharaka is a purely Islamic nomenclature, which implies an arrangement of business or its financing based on the concept of profit-and-loss-sharing in which all parties contribute their money or efforts or skills or a combination of all three. Profit from the venture can be shared in any agreed proportion, but the loss, if any, is borne by the parties in strict proportion to the capital contributed by each.
Equity participation can be done by banks purchasing the shares in a business and earning the dividends declared by the company from time to time.
Participation Term Certificates/Term Finance Certificates and Transferable Finance Instruments attempt to replace the interest-based system of equity/debenture/bridge financing. The present mechanism adopted for sharing profit or loss on these financial instruments suffers from serious deficiencies in the light of the dictates of the Islamic Sharia. However, with the passage of time and experience, these are being replaced with financial instruments that are strictly in accordance with the Islamic concepts of business transactions.
Selling on Profit
• This system implies the purchase of goods by banks and their sale to clients at an appropriate mark-up in price on a deferred payment basis, without levy of mark-up on mark-up.
• Secondly, this system covers the purchase of bills on a mark-down basis.
• And thirdly, it encompasses the purchase of property by banks from their clients with a buy-back agreement or otherwise.
The assumptions made for financing on mark-up/mark-down mechanisms are:
• The ownership of the goods being sold to a customer at a mark-up price on a deferred payment basis belongs to the bank, as no one other than the owner can sell the goods.
• The possession of goods sold by the bank to its customers is not notional but properly documented.
• No mark-up is charged to the customer in the event of his failure to make a deferred payment on the due date.
• Mark-up in price can be charged only when goods are being sold, otherwise it will become interest, which is prohibited.
Similarly, in the case of purchase of movable/immovable property by the bank, the said property, goods or any other tangible item is owned by the client, and in order to meet with his liquidity requirements, he sells the same to the bank with a promise to buy it back at a future date. The bank agrees to resell the property, goods or other tangible items to its customer on a deferred payment basis, either in a lump sum or in instalments at a mark-up price. The difference between the purchase price and the subsequent sale price will be the income of the bank.
Renting of Assets
The renting of assets is a comparatively modern concept embraced by financial institutions all over the world. This category of finance has the following three modes, namely:
• Leasing
• Hire Purchasing
• Rent-Sharing
Under leasing, a lessee acquires the right of the use of the asset without becoming its owner. The lessor, for an agreed period of time, with or without the option of purchase of the leased asset by the lessee, agrees to accept rental and payment for the residual value of the asset. The terms and conditions of leasing can be tailored to suit the financing requirements of customers as regards the lease package, rental payments, tax accounting etc.
As for the mode of hire-purchase financing, equipment or vehicles or consumer durables are purchased by the bank at the specific request of the customer. The equipment is then hired out to the customer on payment of periodical instalments. The instalments are so arranged that the hire-purchase price is amortised during the useful life of the equipment.
The agreed hire-purchase price payable by the customer, in instalments, includes a fair return to banks in addition to the original price of the equipment. The ownership of the equipment remains with the bank until it is transferred to the hirer against payment of the specific nominal amount agreed to at the time of executing the hire purchase agreement.
As for the rent-sharing mode of financing, the bank may provide part of the finance to the customer required by him for the construction/purchase of a property. The return on such financing would be in the shape of a proportionate share in the property purchased by the customer by investing part of the funds borrowed from the bank.
Renting of Services
In the case of the renting of services, the following two modes have been prescribed:
• The financing to a customer can be made by banks without consideration of the cost of funds and/or return thereon. However, the bank may recover actual service charges involved in such financing.
• The bank may sell its services to a customer against charges where no financing is involved. Such charges are usually recovered from the customer by way of commission.
Qard-Al-Hasana
Qard-Al-Hasana is granted on compassionate grounds free of interest and/or sei-vice charge. It is repayable as and when the borrower is able to repay. Under this mode of financing, the banks are already providing Qard-Al-Hasana for education and medical treatment.
Although these modes of financing have evolved on a purely non-interest basis, the mechanism adopted by the banks for conducting the transactions has been subjected to various observations by scholars and even by the Federal Sharia Court.
They have observed that the banking system alone cannot be fully Islamised unless the related federal and provincial laws are also brought into conformity with the injunctions of Islam. So far as the present mechanism for conducting Islamic modes of financing is concerned, it is rightly said that the rate of mark-up, which is predetermined, is unislamic.
In the light of the Federal Sharia Court’s decision, and the requirements of the Sharia Act, the Permanent Commission on the Islamisation of the Economy has been constituted and has submitted proposals for the elimination of elements in the economy which are at variance with Sharia injunctions.
It should be appreciated that to bring all of the intricate credit systems – which have been in use for such a long time – fully in line with the Sharia, will take a great deal of time-consuming effort. There is no doubt that this goal will eventually be achieved, as a serious start has been made by teams of jurists, religious scholars, economists and bankers etc., in various countries of the world.
Edited By Asma Siddiqi
Institute Of Islamic Banking And Insurance London
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