in the name of allah, the beneficent, the...

Journal of Islamic Banking and Finance Oct. – Dec. 2011 1

IN THE NAME OF ALLAH, THE BENEFICENT,

THE MERCIFUL

O ye who believe Fear God and give up what remains of your demand for usury if ye are indeed believers.

If ye do not, take notice of war from God and His Apostle.But if ye turn back ye shall have your capital sums. Deal not

unjustly, And ye shall not be dealt with unjustly.

SURA AL BAQARA IIVERSE 278-279

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The articles published in this Journal contain references from the sacred verses of Holy Qur’an and Traditions of the prophet (p.b.u.h) printed for the understanding and the benefit of our readers. Please maintain their due sanctity and ensure that the pages on which these

are printed should be disposed of in the proper Islamic manner.

2 Journal of Islamic Banking and Finance Oct. – Dec. 2011

Journal Of Islamic Banking and Finance

The Quarterly Journal of Islamic Banking and Finance is an official publication of International Association of Islamic Banks Karachi, Pakistan. It is a refereed quarterly journal, as well as a pioneer for the studies in Islamic banking and finance being published since 1984. The journal has wide readership at home and abroad. Its clientele include IMF, World Bank, Central Commercial/Banks Universities, Educational Institutions, and Public Libraries in Pakistan/abroad. Etc

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Journal ofIslamic Banking and Finance

Volume 28 Oct. – Dec. 2011 No. 4

Founding ChairmanMuazzam Ali (Late)

Former Chairman* Pakistan Press Foundation (Pak)* Pakistan Press International (Pak)* Institute of Islamic Banking &

Insurance (UK)* Former Vice Chairman

DAR AL-MAAL AL-ISLAMI TRUST, GENEVA,SWITZERLAND

ChairmanBasheer Ahmed Chowdry

EditorAftab Ahmad Siddiqi

Associate EditorMazhar Ali

Co-ordinator Research & MarketingMohammad Farhan

Business ExecutiveA. N. Haqqani

Published byInternational Association ofIslamic BanksKarachi, Pakistan.Ph: 35837315Fax: 35837315Email: ia _ ib @ yahoo.com

Registration No. 0154Printed at M/S Maaz Prints,Karachi

Board of Editorial Advisors

S. A. Q. HaqqaniDr. Hasan uz ZamanDr. Mohammad UzairAltaf Noor Ali (ACA)

International Advisory Panel

Professor Dr. Md. Ma’sum BillahCorporate Advisor & Consultant to Global Islamic Banks & Financial Market. Malaysia.

Professor Dr. Rodney WilsonSchool of Government and International Affairs,Durham University, UK

Dr, R. Ibrahim AdebayoDepartment of Religions, University of Ilorin, Nigeria

Prof. Dr. Zubair HasanThe Global University of Islamic Finance, Kuala Lumpur, Malaysia

Dr. Waheed AkhtarAssistant Professor, Comsats Institute of Information Technology (CIIT), Lahore, Pakistan

Dr. Manzoor Ahmed Al-Azhari, PH.DLegal Policy (Shariah Law) Shariah Academy,International Islamic University, Islamabad,Pakistan.

Professor Dr. Khawaja Amjad Saeed FCA, FCMAHailey College of Banking & FinanceUniversity of Punjab, Lahore, Pakistan

Dr. Mehboob ul HassanForeign Professor, International Islamic University of Islamabad, Pakistan

Mr. Salman Ahmed SheikhExternal Reviewer Bankers Academy USA, Karachi, Pakistan

Prof/ Dr. Habib ur RahmanHead Business Administration DepttSarhad University of Science & Information Technology, Peshawar, Pakistan

Dr Muhammad Zubair UsmaniJamia Daraluloom Karachi


Journal of Islamic Banking and Finance

Volume 28 Oct. – Dec. 2011 No. 4

C O N T E N T S

1. Editorial ......................................................................................................13

2. Cultivating good prospectsBy Imran Hussain Minhas ..........................................................................17

3. The Analysis of Applications of Salam & Istisna’a in Islamic Financial IndustryBy Muhammad Zeeshan Farrukh ..............................................................22

4. Thesis of Religion: Normative Basis of Islamic EconomicsBy Salman Ahmed Sheikh..........................................................................27

5. Why Musharaka Mode of Finance is worth ConsideringBy Dr. Badr El Din A. Ibrahim and Mohammad Osman Khalifa ..............39

7. The Mega Islamic Bank: A ‘Silver Bullet’ SolutionBy Mughees Shaukat and Zamree Mohd Ishak..........................................54

8. Regulatory Response to the Impact of the Global Financial Meltdown on Islamic Finance in NigeriaBy Dr. Abdulqadir Ibrahim Abikan............................................................94

9. News Monitor .........................................................................................108

10. Glossary-Islamic Terminology .................................................................110

11. Note To Contributors of Articles..............................................................115

12. Order Form for Subscription/Ad to the Journal .............................................116


Editor’s NoteThe article “Cultivating good prospects” by Imran Hussain Minhas recalls the

chequered history of introduction of Islamic economic system in Pakistan. The Government initiated steps for this purpose in 1970. The Council of Islamic Ideology was set up which prepared a blue-print for interestless banking. A relevant law was enacted and an existing one was amended. After completion of all preliminaries, Islamic system was introduced in Pakistan and the first Islamic bank was licensed in 2002. The Islamic funds, Islamic pension fund and Sukuk appeared on the scene and have been progressing well. Modarabas initially developed at a fast pace but later on their growth was marred. To provide incentive, Government accorded them the facility of conditional tax exemption but in vain. It appears that the practitioners of Modaraba are unaware of this concession. Interest was banned and other Shariah restrictions were enforced. The Islamic financial system has been successfully operating in Pakistan. However there are some impediments in its way which, when removed, will open up a bright future for this system in Pakistan.

The article on “The Analysis of Applications of Salam & Istisna’a in Islamic Financial Industry” by Muhammad Zeeshan Farrukh discusses the use of Salam and Istisna’a in Islamic Financial industry. When a customer seeks financial facility for production/manufacture of some article, the subject article is not available which is a condition for a valid sale, and therefore other modes like Murabaha, Ijara etc can not be used. In such cases Salam and Istisna are utilized. The paper has detailed three alternatives which can be adopted so that no difficulty may arise in the use of these modes. In conclusion it has specified the choice alternative for adoption.

It is also stated that the mode is beset with risk of loss to the financier,therefore its use is limited to such customers who are considered trustworthy. Its use can be expanded but only if the society and corporate world show a healthy response.

The article “Thesis of Religion: Normative Basis of Islamic Economics” by Salman Ahmed Shaikh limelights the ills of the capitalism which is the predominant system of the present age. Its aim is to amass wealth by any means without the least consideration of the consequential visitation of sufferings and miseries upon other human beings. Naturally this exploitative system attracts severe criticism and is detested by all except the capitalists who are the sole beneficiaries of its unethical practices.


As opposed to this, Islamic economic system has the highest priority for human welfare and its operation is guided by Shariah principles based on the Commandments of God and sayings of the Holy Prophet (p.b.u.h). The paper therefore suggests that the deficiency of the capitalism should be remedied by incorporation of the religious regime but for the conviction of the practitioners of capitalism about the efficacy and rationality of the suggestion the paper has explained all the Islamic beliefs by adducing convincing reasons for their viability. As an illustration: when it is asserted that God is the Creator of this universe, it is asked as to who created God. The answer given is that God is not a Creature and hence needs no Creator. Similarly all beliefs regarding doomsday, Day of Judgment Prophethood, rewards for good deeds and punishment for evil deeds hereafter have been reasonably explained. These were preliminaries to be followed by Islamic version of economics which bans all factors that lead to exploitation through gambling, interest and a host of such evil practices. The paper then states the Islamic point of view regarding the consumer behavior which is poles apart from that of the mainstream economics. The later allows them full liberty to lead a luxurious life without the least care for have-nots, whereas the former enjoins its wealthy followers to seek the pleasure of Allah and not overlook the needy of the society.

Thus the paper has given the Islamic perspective in respect of host of other economic matters which differ from those of the mainstream economics and opines that the capitalism can be shorn of its evil side by incorporation of religion.

This article on “Why Musharaka Mode of Finance is worth considering” has been co-authored by Dr. Badr El Din A. Ibrahim and Mohammad Osman Khalifa. It discusses Musharaka mode of finance exhaustively. It further notes that this methodology in spite of its utility is not fully exploited owing to some misunderstandings about it. The article makes out a case for its practice and suggests ways and means for removing difficulties supposed to be strewn in its path which discourage its adoption.

To begin with; according to Islam God is the owner of every thing of this universe and man is only a steward who has to follow His Commandments which basically enjoin that the interest should be shunned in all dealings and no such action be undertaken which in any way even gives a semblance of interest. Besides this, stock in trade should comprise of Halal merchandise. All transactions should be based on profit and loss. The return on investment should not be fixed in advance but it has to be strictly based on actual profit earned by an enterprise. Additionally in Islamic banking the banks are not supposed only to earn profit but also to cater to the welfare of the community. The paper details the mode of operation of Musharaka followed by rules which apply to its working. It then recounts it advantages and enumerates its limitations which discourage its use.

The authors have concluded that for Musharaka to be fully exploited modification in PLS sharing formula is necessary to assure more incentives, the minimizing of under-reporting of profits, well-developed property rights to facilitate the application of PLS formula, and the discrimination between profit and interest in the matter of taxation should also be removed. The paper has also made some other suggestions which need to be considered. The paper also asserts that the Islamic


banking formulas are not prescribed in the Holy Quran and the Traditions of Holy Prophet (p.b.u.h) but are the products of the ideas of jurists. Therefore any modifications are acceptable if these are not against the basic rules. The authors have therefore suggested some modifications to be considered.

This article on “The Mega Islamic Bank: A ‘Silver Bullet’ Solution” is the co-production of two authors Mughees Shaukat and Zamree Mohd Ishak who propose that a Islamic Mega Bank should be set up. They have undertaken a study to ascertain its viability, advantages, disadvantages and also justification for the project. It says that the Islamic finance has made tremendous progress and has penetrated in a greater part of the world but the capital of none of the Islamic banks matches that ofa conventional bank. There is not a single Islamic bank which can be compared tosuch giants of the conventional banking as BNM or JP Morgan etc. In view of the fast growth of Islamic finance but meager amount of 25 Million being the paid up capital of the Islamic banks, the Idea of founding a Mega bank has cropped up. But as it will be a giant step forward involving huge capital and risk, its failure would be a great catastrophe, therefore sagacity demands thorough examination of its pros and cons before taking the leap. The present study has been undertaken to judge the viability of the project.

Ten Islamic and Ten conventional banks have been selected as samples for study and their profitability and performance have been compared. The methods adopted for research are Fixed and Random Panel Technique and Dynamic Heterogeneous Panel. The study has reviewed literature and also surveyed the researches made by others on this subject. It has also analyzed the present financial position of the Muslim world and the status of Islamic banking in the context of global banking. Considering these factors the formation of a Mega bank has been proposed and appears to be feasible. Besides the idea of Mega bank has created enthusiasm among the Islamic financial hubs in the world viz Saudi Arabia, Malaysia, Indonesia, Kuwait etc. some of them have indicated their interest to make a debut in this field.

The study has found this feasible but the path is beset with some difficulties as it may demand merger of some banks which the individual owners may not like or the Chief Executives of present banks are not likely to handover their power and take a secondary position.

The objectives of this article “Regulatory Response to the Impact of the Global Financial Meltdown on Islamic Finance in Nigeria” By Abdulqadir Ibrahim Abikan is to investigate the impact of the global financial meltdown on Islamic finance in Nigeria and also the law which enabled Islamic finance in the country.

Since independence from colonial rule in 1960 Nigerians have been waging a struggle for revival of Islamic way of life that prevailed in pre-colonial era.

These protracted efforts extending over a long period succeeded at last when Banks & Other Financial Institutions Act 1991 became the first law to give recognition to Islamic financing under the name of profit and loss banking. This was followed by issue of Regulating Framework in March 2009 by Central Bank of Nigeria for practice of Islamic Financial System in the country. The covering circular


is very comprehensive and covers all requirements of banking. The Draft Framework was meant to elicit comments and suggestions. The authors of this article and Albaraka Trust Fund submitted a memorandum containing eight suggestions and observations. The final framework which took cognizance of the above suggestionswas issued in January 2011 and was amended in June 2011 in response to some religious sensitivities.

To assess impact of the recession on Islamic banking, tests were proposed to be carried out on three firms JAIZ International, Lotus Capital and Habib Nigeria Bank (Now Platinum Bank). Former two did not qualify for the purpose and the test was therefore carried out on the third one which itself lost 20% of its investment in the meltdown but a comparison of the loss with its benchmark DSE – ASI shows that the firms was more resilient even in adversity.

The positive effect of recession was that it boosted public awareness about the Islamic banking, and resulted in increase in the number of Islamic cooperative societies. It also mounted further pressure on regulatory authorities to facilitate take-off of Islamic banking system. As a result the Framework was made which has set a stage for introduction of Islamic financial system in Nigeria.

Disclaimer

The authors themselves are responsible for the views and opinions expressed by them in their articles published in this Journal.

We invite our readers not to hesitate in communicating to us their opinion which will be welcomed. This will help us in improving the standard of the Journal.


Cultivating Good ProspectsBy

Imran Hussain Minhas*

Abstract

The Government of Pakistan took several steps to Islamize banking system in Pakistan. Despite a set back they continued to proceed further and ultimately they succeeded in setting up this system.

After Islamization of Banking Islamic products were introduced. Modaraba operated as a corporate entity under regulating framework of Security and Exchange Commission of Pakistan. The Modaraba initially made good progress but later on its growth was checked. Other Islamic products like Sukuk are also operating. Islamic funds and Islamic pension fund were also launched and are regulated by SECP.

The ingredients for success are available in Pakistan, but they have not been nurtured. For Islamic finance to thrive, there will need to be more focus on liquidity management, manpower and public awareness.

Key Words: Modaraba, Musharaka Sukuk, Awareness,

ISLAMIC FINANCE has proved to be a competitive and feasible substitute for the conventional banking system over the last three decades. Before 1980, Pakistan’s banking and finance system was entirely based on conventional banking practices, and the country began taking steps to Islamise the economy in the late 70s.

The local Council of Islamic Ideology, which comprised panelists of bankers and economists, was set up on 29 September 1977. They prepared the blueprint of an interest-tree economic system and submitted their report, highlighting details for eliminating interest from the economy, in February 1980.

The Modaraba Companies and Modaraba (Floatation and Control) Ordinance 1980 was passed, enabling business groups to set up SME modarabas in the country.

Amendments were made to the Banking Companies Ordinance 1962 so that conventional banking practices could be converted into interest free banking.

* Author: Imran Hassain Minhas is a joint Registrar Modarba Companies & Modarabas,

Securities & Exchange Commission of Pakistan: E-mail: [email protected]


Specialist financial institutions, such as House Building Finance Corporation, transformed their operations to conform with Islamic principles with effect from 1st July 1979.

In December 1899, the Shariat Appellate Bench of the Supreme Court of Pakistan declared efforts towards Islamic banking as un-Islamic. The government of Pakistan therefore formed a commission for transformation of financial system—its recommendations were adopted to reintroduce Islamic banking in Pakistan in line with best international practices.

Islamic products

In Pakistan, modarabas are allowed to operate as corporate entities under the regulatory framework of the Securities and Exchange Commission of Pakistan (SECF). Modaraba management companies operate as the modarib, managing the modarabas and contributing 10% towards total paid up funds of the venture. Certificate holders of the modaraba, or rab-ul-maal, provide 90% of the funds to the modaraba.

Modaraba growth

Year MMCs Modarabas Branches Total equity Total assets

2006 51 29 52 10,062 23,736

2007 51 29 52 10,821 26,009

2008 41 27 50 11,489 29,281

2009 40 26 49 10,839 23,087

2010 40 26 50 11,489 24,469

Source: SECP’s Annual reports/Modaraba Association of Pakistan annual report

The modarabas are allowed to offer any Shariah-compliant financial product, providing it is approved by the religious board, constituted by the Government of Pakistan for the purpose of modarabas.

Modarabas provide purely Islamic financial services and can invest in stock markets, trading of halal commodities, project financing activities and act as special purpose vehicles. The modaraba can raise deposits as certificates ofmodarab/musharakah and can also float musharaka-based term finance certificates (TFGS). To encourage Islamic finance, the Pakistan government exempted modarabas from income tax, as long as they distribute 90% of their profits to the shareholders.

Over the last 20 years, the modaraba sector has established a position in the financial intermediaries of Pakistan. It grew rapidly until 1995 but there has been no notable growth in the sector in the last five years (see Modaraba growth above).

In Pakistan, Islamic funds have a 15-year track record and are launched in three categories: equity funds; money market funds; and income funds. Islamic funds are


regulated by the SECP under the Non-Banking Financial Company (Establishment and Regulation) Rules 2003 and NBFC Entities Regulations 2007. There are six Islamic funds in Pakistan, with a total asset size of Rs. 34,080m, as at 30 June 2010.

Islamic pension funds (IPFS) have been around for four years in Pakistan. Each IPF comprises three sub funds: equity, debt and money market. The funds are managed by pension fund managers registered with SECP under Voluntary Pension System Rules 2005. Five IPFS are currently in operation, with a total asset size of Rs794m as at 31st December 2010.

In Pakistan, non-interest based redeemable capital and securities, or sukuk/TFCs, are issued under section 120 of the Companies Ordinance 1984, after completion of the formalities prescribed by the SECP. There were 56 outstanding issues of privately-placed sukuk amounting to Rs282bn as at 31 December 2010. The corporate sector is also allowed to issue TFCS to raise redeemable capital on the basis of musharakah. The payments of profit or sharing of loss with the TFC holders are linked to the operating profit and loss of the TFC issuing companies.

State Bank of Pakistan

On 1 January 1981, banks in Pakistan started separate interest-free counters, to mobilise deposits on a profit and loss sharing basis. From 1 July 1982, banks were allowed to provide finance for meeting the working capital needs of trade and industry on a selective basis under the musharakah. As from 1 July 1985, all commercial banking operations were made interest-free, apart from foreign currency deposits or loans.

Once the legal infrastructure was put in place to carry out, a phased conversion of the financial system to an Islamic one, separate Islamic banks were allowed to operate in parallel to conventional banks. A massive education and training program for bankers and their clients was launched.

Share of Islamic Banking Assets in Pakistan (Rupees/Million)

June 2010 Dec. 2009 June 2009 Dec. 2008 June 2008

Total assets 559,569 487,188 377,985 346,225 330,813

Share in total banking (%)

5.2 5.1 4.9 4.0 2.8

Financing & Investment

230,592 215,856 185,514 178,620 158,962

Share in total banking (%)

8.2 8.1 7.6 8.1 7.4

No of branches

583 561 441 433 320

Source: SBP’s annual reports

Existing prudential regulations were reviewed for Islamic banks and three institutional options were provided: setting up an independent and dedicated Islamicbank; setting up an Islamic banking subsidiary of a conventional bank; and setting up dedicated Islamic banking branches of a conventional bank.


In January 2002, the first fully fledged Islamic bank received license from the State Bank of Pakistan (SBP) and commenced operations on 20 March 2002. There are now six fully fledged Islamic banks and 12 conventional banks offering Islamic financial services.

Challenges

The Pakistani market lacks Islamic money market or liquidity instruments that could be used to cover liquidity shortages or to manage excess liquidity by Islamic banks. The development of instruments for liquidity management is the main challenge for regulators.

Banks and financial institutions have sizable investment in interest-bearing government securities. Therefore, the process of fully Islamising the financial system will depend on developing instruments for Shariah-compliant government securities and transactions based on real assets.

There is an absence of standard Islamic pricing benchmarks. When lending, most Islamic banks prefer to run on a guaranteed profit basis for which KIBOR is used as benchmark. Conventional economists and consumers therefore sometimes fail to understand the difference between Islamic and conventional banking.

Capacity building is another major challenge being faced by Islamic financial institutions. Islamic banks need professional staff. Bearing in mind the pace of growth in the sector, skilled human resource is inadequate. Efforts are being made through the National Institute of Banking and Finance and Institute of Bankers to overcome this problem.

Despite the growth of Islamic banking over the last 30 years, many people in the Muslim and non-Muslim world do not understand what Islamic finance actually is. Media campaigns, awareness programs, roadshows and seminars are required to educate business communities and the general public.

There are no proper research and development Institutes for Islamic finance. Islamic financial institutions need research and training forums to prompt entrepreneurship among their clients.

The central bank exercises authority over Islamic banks under laws and regulations engineered to control and supervise both conventional and Islamic banks. The operations of Islamic banks are on a profit and loss share basis, which does not come fully under the jurisdiction of existing civil laws. In the case of murabahah transactions, there is the problem of double taxation. Proper regulations should exist to address the problems faced by the Islamic financial institutions to financial agreements.

The regulatory financial reporting framework for Islamic banks consists of international financial reporting standards and reporting standards of the SBP and SECP. Murabahah and ijara standards have so far been notified and implemented by the SECP.

But Shariah-compliant standards for the distribution of profit to profit and loss sharing depositors, diminishing musharakah and musharakah and other interest-free modes of financing and investments need to be introduced.


As at the end of June 2010, there were only 583 licensed branches of Islamic banks and 50 modarabas compared with more than 9096 conventional banking branches. Islamic banking and modarabas have strong growth potential and an enhanced network can increase share of Islamic finance in the country.

Bright future

But the future of Islamic finance in Pakistan is bright. Despite slow economic activities and the global financial meltdown, the growth rate of Islamic finance was higher than the conventional alternative. The State Bank of Pakistan has projected that Islamic banking will grow by 15% over the next four years.

The Modaraba sector has great potential but its growth has remained stagnant in the last few years. Modarabas have not penetrated small cities and so far only exist in the three major cities of Pakistan—Karachi, Lahore and Islamabad. Around 70% of the country’s population resides in smaller cities, where individuals are generally more inclined towards Islamic than interest-based banking.

Business groups are not using the modaraba structure for their industry for tax exemptions, primarily owing to lack of awareness. The modaraba is the only business model under which the entrepreneur can avail 100% tax exemptions, subject to distribution of 90% of the profit among certificate holders, limited media campaigns and a lack of public education means that many people are not aware of Modaraba sector.

Islamic funds, Islamic pension funds and sukuk have shown steady growth and have grown from Rs108bn in 2008 to Rs317bn at the end of December 2010. The biggest issuers of sukuk are Pakistan Domestic Sukuk Company with a total size of Rsl75.7bn, WAPDA with Rs21bn. Liberty Power Tech with Rsl2.4bn, Maple Leaf Cement with Rs. 8bn and PIA with Rs. 6.8 bn. Sukuk and the Islamic fund market isexpected to grow at a much faster pace than Islamic pension funds.

Assets of Islamic banks increased from Rs330bn in June 2008 to Rs560bn in June 2010. There are now 583 Islamic banks in the total 9096 bank branches in the country. But the market share of Islamic banking is only 5.2% in total assets of scheduled banks, showing a gap of 94.8%. This remaining 95% share of conven-tional banking shows a portion of the cake yet to be shared.


The Analysis Of Application Of Salam & Istisna’a In Islamic Financial Industry

ByMuhammad Zeeshan Farrukh*

Abstract

The modes of Salam and Istisna’a are the exceptional sales that help Islamic Financial Institutions (IFIs) to cater to the needs of those customers who require working capital financing to produce or manufacture something.

Keeping in view the conditions and guidelines for execution of Salam and Istisna’a transactions; this article is based upon the evaluation of different ways and possibilities to find the best possible way, upon which the product might be structured by Islamic Financial Institutions to meet the financial requirements of the customer with the special consideration of coverage of unique risks in these transactions.

Key words: Evaluation, Ijarah, Murabaha, Manufacture, Devaluation, Agency Agreement

Introduction

Islamic Financial Institutions (IFIs) enter into Salam & Istisna'a transactions with the customers who require finance facilities to produce or manufacture something. Since in these cases; the subject matter is not available at the moment, which is the condition of a valid sale or rental transaction in Islam, the general practicing modes like Murabaha, Ijarah, and Diminishing Musharaka etc. cannot be used for this purpose. The permissible modes, in this respect, are Salam and Istisna’a which are being practiced in Islamic Financial Industry, in accordance with the guidelines as given by Shariah. These transactions are being executed at very small scale and with very reliable customers due to the high intensity of risk inherent in these transactions.

* Author – Muhammad Zeeshan Farrukh is working as Products Specialist with UBL

Ameen Islamic Banking, Karachi, Pakistan.


Evaluation Of The Financial Needs & Possible Solutions

For the purpose of production or manufacturing something, generally the customers require financing from financial institutions for two purposes:

1. The customer needs financing to produce or manufacture something for his personal use or expansion of business etc.

2. The customer needs financing to produce or manufacture something in order to sell in the market or meet the delivery orders and earn profit.

Possibility No. 1

The Islamic banks may enter into an arrangement of Parallel Salam/ Istisna’a contract in which the Islamic bank would be the seller in the first contract and become the buyer in the second contract. The Islamic bank may buy the commodity or asset from the one party and then sell it to the other party at the same date or period. The two contracts would be executed in a separate capacity and cannot be linked with each other. The difference in prices would be determined as income of the Islamic bank.

The analysis, in this context, is as under:

a. It is a fact that Islamic banks deal only with their customers and provide financing facilities to their customers after consideration and proper credit analysis of their customers. The Islamic bank would not like to enter into an agreement with any party other than the Islamic bank’s customer because Islamic bank is not the trader in actual and performs as financier in the market like conventional banks. Likewise, any third party other than the customer would also not like to execute an agreement with the bank. This is the general behavior of working of banks and corporate world in the present business scenario.

b. Apart from the above-mentioned hindrance of parallel contract aspect, if the parallel transaction would be executed, there is a delivery risk which might be faced by Islamic bank at the time of delivery. If the seller would not be able to deliver certain commodity or asset, the Islamic bank would be liable to deliver the certain commodity or asset to the customer. In this certain case, the Islamic bank might face difficulty.

c. The general phenomena regarding financing for banks is that banks disbursefinancing to their customers, to fulfill the certain need, and receive repayment as principal plus profit i.e. the amount over and above the principal. Therefore, it is an understood fact that banks disburse lower amount and receive higher amount. In Parallel Salam/Istisna’a arrangement, the Islamic bank would have the capacity of seller with the customer and having the capacity of buyer with the third party who is producing or manufacturing the certain item for the bank’s customer. In case of Salam, it is impossible for Islamic bank to choose parallel arrangement due to the condition of full payment in advance. In this way, the Islamic bank would make payment to the producer or simultaneously


receive payment from the customer. Why the customer would make higher payment to the bank as he would have already the requirement of capital? If he has the capital, he may directly go to the producer. While in Istisna’a, parallel istisna’a transaction might be executed in case of certain manufacturing or construction where the bank would make full or partial payments to the constructor or manufacturer and receive repayment, in installments (partial payments), from the customer higher than the disbursed amount and in this way, it may earn profit according to the pre-agreed benchmark.

d. In parallel arrangement, one problem may also arise an the part of the customer that if the customer requires prompt or immediate financing for any purpose like salaries payment, utility bills payment etc. while production or manufacturing something, the parallel salam/istisna’a contract would not be suitable.

Possibility No. 2The Islamic Bank may enter into Salam/Istisna’a contract with the customer

and sell the item in the market at the time of delivery. In this case; Promise to Purchase may be taken from the third party at the time of execution of salam/istisna’a agreement to sell the item at the time of delivery, without any delay.

The analysis, in this context is as under:

In both the above-mentioned general financial requirements of the customers, this option cannot work because as per salam/istisna’a agreement, the customer has to return the item to the bank which is not the desire of the customer in both the cases.

This option may be considered in those cases where the actual trading is being done for which the banks generally do not go.

Possibility No. 3The Islamic banks may execute Salam/Istisna’a agreement with the customer

and at the time of delivery, the customer becomes an agent of the bank to sell the commodities or asset on behalf of the bank.

The analysis, in this context, is as under:

This option might be considered when the customer needs financing to produce or manufacture certain items for further selling in the market to make profit thereon.

The bank will buy certain items from the customer either on Salam/Istisna’a basis. At the time of execution of salam/istisna’a agreement, the bank must ensure that the customer has certain delivery orders from the market.

At the time of delivery, the bank will execute Agency Agreement with the customer after taking constructive possession of certain goods/commodities. The Agency Fee or the formula of Agency Fee must be decided and mentioned in this agreement.

If the customer would sell certain quantity of commodity in the market above the certain price, the profit above the certain value would be considered as Agency


Fee of the customer but if the customer would sell the commodity equal or below the certain price, the agent would not be entitled for any Agency Fee. The agency fee or formula of agency fee might be determined on the basis of consideration of profit that the bank would have to earn on disbursed amount according to the certain benchmark.

The bank purchases a certain quantity of commodity/asset on discount keeping in view the expected market price at the time of delivery OR keeping in view the selling price upon which the customer has the commitment to sell the certain item to the buyer. At the time of completion or production of goods/commodity, the customer would sell the same to the third party being an agent of Islamic bank. The customer would make payment of principal (disbursed amount) and profit to the bank and get the remaining amount as an agency fee according to pre-agreed arrangement as per agency agreement. This remaining amount of selling price would be the profit for the customer that is intended by the customer while doing business.

This option is used widely by Islamic banks while executing salam/istisna’a transactions to meet the working capital needs of the corporate customers either to produce or manufacture something for further sale in the market.

The Unique Risks

It is a fact that Salam and Istisna’a transactions are very risky in nature as the customer has not any direct obligation of repayment in monetary terms but has an obligation to deliver certain commodity or asset at the specified time. Due to this reason, Islamic banks face some unique risks, not faced in other modes of Islamic banking, which are as under

1. To cover the risk of non-deliverance or non-performance by the producer or manufacturer, Islamic banks may obtain appropriate security in the form of guarantee, mortgage or hypothecation.

2. Islamic banks may face commodity or asset risk as between the period of delivery of the certain commodity or asset by the customer and selling the same to the final buyer, in case of any mishappening with the certain commodity or asset, the risk will be borne by the Islamic bank. To avoid the occurrence of any mishappening, the Islamic bank must obtain takaful coverage and the expense has to be borne by the Islamic bank in this respect.

While executing Istisna’a, the bank must avoid to make financing very specialized items, for example: specialized software for a certain firm, as in case of refusal to buy such item from the final buyer, the bank might face very much difficulty to sell it in the open market.

3. If the expected price of the commodity in the market decreases at the time of delivery, the bank may suffer loss or earn profit less than the expected profit. To mitigate price risk, bank must execute transactions with the customers having agreed delivery orders (as mentioned above in the option of agency arrangement) or in any other case like parallel salam/istisna’a, the selling price must be ensured at the time of disbursement. But, in case, where the situation


arises where the bank receives the delivery and it has to sell the goods in the market due to refusal to purchase from the other party or for any other reason, it might face the risk of devaluation of certain commodity or asset in the market. To cover this risk, the Islamic bank must buy the asset or commodity at the considerable discount rate to face such type of risk, if it arises.

Conclusion

The customers require financing either to produce or manufacture something for their personal use or expansion of business etc. OR to produce or manufacture something in order to sell in the market or meet the delivery orders and earn profit. From the above-mentioned evaluation of different possible options, it is clear that the option of Parallel Istisna’a might be chosen for construction or manufacturing purposes where the customer needs financing to make expansion of the business or for personal use while in the second case where the customer needs financing to meet the delivery orders, the option of Salam/Istisna’a agreement along with agency agreement (at the time of delivery either physical or constructive) might be chosen.

Due to unique risks, Islamic banks do not make these transactions on a very large scale and execute only in case of immense need where the execution of other modes are impossible. Furthermore, Islamic banks only execute these transactions with their very selective customers who have good creditworthy track record.

It is a fact that in the present scenario, the Islamic banks are not interested in trading of assets and commodities but to provide monetary facility to their customers. The transactions based upon the modes of Salam and Istisna’a might be increased if the Islamic Financial Institutions would start thinking beyond the boundaries and take out themselves from the conventional thinking structure. If IFIs come to actual trading and become ready to make hybrid arrangements with more than one party who need financing, the Salam and Istisna’a transactions might be enhanced or developed. But, it is also a fact that the society and corporate world must show a healthy response as IFIs could not do this as a sole activist in this respect.


Thesis of Religion: Normative Basis of Islamic Economics

BySalman Ahmed Sheikh*

Abstract

This paper discusses the ethical void in Capitalism which does not look prominent in welfare societies and states. But, its effects become more eminent in tough economic conditions. Unbridled pursuit of self interest, moral relativism, incentive-led economic choices and apathy to communal responsibilities would lead to a society where economic interests become the sole basis of maintaining and sustaining relationships. This inner void of identity and purpose at individual level and social void in the form of a stratified society bound together only for economic interests can be better filled with incorporating religion. Humans are much more than utility driven species, they are capable of using both instrumental and critical reasons to differentiate right from wrong and need reinforcement to adopt virtues influenced by an inner urge other than material interests as in Capitalism. This inner urge can be rekindled by looking beyond utility maximization to re-acknowledge the fundamental identity that humans are moral being than just an instrument for material advancement. Other sections of the paper provide an outline and salient features of Islamic Economics on different economic themes and perspectives for a comparative study. These provide a unique introduction to Islamic Economics in a mainstream framework.

Key words: Normative, Relativism, Stratified Society, Consumer, Evolution, Big Bang, Opportunity Cost & Time Value of Money

* The author Salman Ahmed Sheikh is a researcher in Islamic Economics and has written 14

research papers on Islamic economics. He is author of “Proposal for a New Economic Framework Based on Islamic Principles”. He is Faculty member at Szabist Pakistan.E-Mail: [email protected]


1. Introduction: The Thesis of Religion

Morality is very eloquently discussed by Kant (1889/1785). He said that intentions define actions and not the consequences and not even compassion. He said that because compassion is temporary, a particular state and is not absolute. However, intentions best define the existence of morality in actions.

But, Kant did not give the method by which we could prioritize Maxims. For instance, truth and justice both are important moral values. But, what should we do if there is a conflict between the two? For illustration, if a person is known to us as murderer, but if we do not have witnesses to prove him as murderer in the court of law, should we give false testimony to convict that person?

Islam helps us to prioritize Maxims. Islam shows us that this world is not fair in all respects. A morally upright man is not necessarily the most honorable man in the world. A morally upright trader is not necessarily the richest in the world. Not all murderers have been or will be convicted in this world. Even if all murderers could have been convicted, it will not be ‘naturally’ possible to give equitable punishment to the murderers who have killed more than one human being.

Even if it was possible, it will not be possible to reverse the immoral actions. What happened has happened and cannot be reversed. Death is the plainest truth and if justice cannot be provided in the life of a person; then, is it not rational to believe in life after death where everyone would be given equitable rewards and punishment for one’s acts and Allah by His infinite wisdom would be able to judge without any doubt the intentions behind the actions and justice will be provided to each and every one?

One can decide to do an act morally as an end in itself and not merely as means to a material end only with the knowledge of life after death and the belief in Allah. Moral act in Islam is also a means to an end i.e. to achieve eternal success and blessings of Allah. But, it is not a material end confined to this life only. In this way, the utilitarian mind is also satisfied as happiness is a relative term not achieved only by material things. The fact that moral actions even if they are not rewarded in this world will be rewarded in life hereafter satisfies the utilitarian mind.

We know what is right and what is wrong through our conscience. In matters where our conscience does not guide us, Allah intervenes and guides us through His prophets. Therefore, Prophets (peace be upon them) guide us in matters where we might not have reached the right decision about right and wrong through our conscience. For instance, interest, gambling, liquor etc. might seem useful and right; but, Allah tells us in Holy Quran that there is more harm in these things than good. (Al Baqarah: 219)

Today, we are seeing interest based system and gambling (speculative financial instruments) causing severe disorder in the economy. Similarly, the greatest asset of a human is his power to reason, his intellect, his use of wisdom and his ability to think. When we take liquor, we lose our greatest asset i.e. conscience and often do bad things which harm others also, besides us. For instance, we see people having accidents, people misbehaving with other women after taking liquor etc.


If one believes in this life only; then, that person will be more selfish to get everything in this life. If we restrict our existence confined to this world alone with no accountability in afterlife; then, I am "just" as long as I am "just" in front of the society even though there could be sins that society could have never seen me doing. Contrarily, I could be regarded as "unjust" by the society if it convicts me based on evidence which could have been untrue. Life hereafter gives all our actions the meaning by promising each and every soul the equal reward and punishment.

People can take justice in their own hands if they are allowed absolute freedom. We need institutions which can impose certain restrictions on all of us so that we can enjoy our freedom without denying freedom to others.

Islam is also such an institution which though put restrictions on one's absolute freedom (as do all other systems), but Islam not only safeguards the rights of the people, but, more importantly and fundamentally, gives meaning to the life and to our own existence.

We can use both reason and experience to believe in Allah. By way of reasoning, if we are creatures, then we are created by someone and that creator is Allah. The question that who created Allah is not valid as Allah is the creator and not the creature. Ultimate Creator needs not be created.

By way of experience, we can use empirical knowledge obtained from science to learn how the galaxies, planets, stars, rotation of the moon, rotation of the sun, rotation of the earth around sun works. How do millions of living beings sustain themselves in a universe in which even a tiny unusual interference can make life impossible on this earth? Why such a tiny interference does not happen and life continues to exist. All of this could not have been possible without accepting that this universe that is so perfect in its design was created and is being managed by Allah alone. Had there been more than one Allah, then there would not have been such ‘uniformity’ in the way we see universe and the way our planet earth works.

Furthermore, no meaning to life, world, man, his role and purpose can be explained without believing in Allah. Islam explains this by outlining our role that we have been created by Allah and sent in this world to be judged for our actions and will be rewarded in life hereafter if we follow the teachings of Allah i.e. to be just, kind, truthful, faithful, obedient and morally upright.

The fundamental value is freedom. Happiness results from it. Justice comes in to protect it. Humans, we see can become unjust using that freedom as speculated by Angels as well (Al Baqarah: 30). Can we provide justice and happiness in a paradigm of absolute freedom? Even when humans had little freedom in this world, we have seen them becoming unjust and then depriving the mission of providing maximum collective happiness for all.

The fundamental question is that can we provide perfect justice in this world. Can we have maximum happiness as we envision in this world. Are we or can we be absolutely free in this world?

What is of fundamental importance is the fact that this test has to be ‘just’. According to Islam, everyone would be judged based on his intentions, general


attitude, general behavior, and general tendencies and most importantly in matters in which one has choice clarifies that this test is just.

How can a creation like this universe, having millions of stars, reachable not within centuries even at the speed of light, all so perfectly interwoven to make life exist and that too for some time as we do not grow to be immortal by way of evolution, be explained? Not only us, none of the species can escape from natural constraints and become immortal.

Everything in this world has been created in pairs. If there is thirst, there is water. If there is moon, it needs a sun to have its light reach us. If there is man, then there is a woman. Each one alone cannot live in isolation. They are all interdependent. Similarly, this world is incomplete without a belief in life hereafter.

This world alone shows us that few people get rewards which they do not deserve, while few people do not get rewarded even when they deserve, some go through severe illness, while some live a very healthy life, while some are unjust and yet they are not given punishment, some are honest and they do not get rewarded. All these incomplete events suddenly end when we die. Then, if no one will get equitable reward and punishment, then there will be no reason why they should wait for an afterlife. They can do all the wrong things if they can avoid the law. But, even if they can, they do not always do that, they have the ability to differentiate between right and wrong inbuilt into their souls. They would like to do good acts and avoid wrong acts.

Are we our own creators? Millions of species cannot just exist in such beautiful contrast without someone responsible for it. For someone to be an ultimate creator, the Supreme Being, He has to be someone beyond the constraint of this world and nature. If the premise is that Allah created everything and nothing exists independent of His will. Then, logical conclusion would be that This Supreme Being, Allah, has to be an independent personality having no constraints of nature.

If Allah is powerful in one thing and not in another, then He is not a supreme being. If Allah is omnipotent, then, we as humans cannot predict the behavior of Allah using examples of ourselves because our frame of reference is limited and we are creatures and not ultimate creators and we have constraints.

The question arises, if Allah is omnipotent, can He be unjust. Allah knows everything, but it has nothing to do with us having a freedom to choose our way of action. A teacher sometimes knows the fate of the students, but it is the student who makes his destiny provided the teacher is just. Allah's knowledge about a person has nothing to do with the trial in question. I can, by way of my expertise, predict the result of a cricket match, but it was not me who decided the result of the cricketmatch in the end.

If someone is my teacher, he has the power to fail me for no reason. But, if he is just, he will do justice and will not fail me; however, it does not mean that he could not do so because of his inability, but it is because he can not contradict his own attributes and values if he was consistent (as Allah is).


Allah is just as He will only hold us accountable for our actions in which we have choice. We will not be held accountable for color, race, creed etc. Therefore, everyone has an equal chance to succeed in life hereafter.

Religion provides the answer that this universe was created by a supreme being Who created it for a purpose. Science also confirms that because it has not at all provided answers to "Why it is”. In fact, science has shown that life cannot mathematically and statistically exist by chance.

We, humans have not just come in this world today and are now looking for answers. We have history behind us that tells that the Prophets came with the message of Allah and the nations which were "direct recipients" who disbelieved were punished in this world. Christians, Muslims and Jews, all believe in that history and it is our common heritage.

Shops, factories, computer programs, machines etc, are systems and they run and are operated by someone. Universe is also a system and is the most complex and a grand system. How can it just be ‘the only system' that does not require a creator. All the systems mentioned above have some purpose. How can only this most grand system have no purpose?

Why there exists so much contrast in species? Why not some species just by way of chance found nothing that they could eat? Found to have body structure that is suitable in land, but they existed in sea or vice versa. The limited knowledge we have about each and every living thing and how they live and exist is just fascinating.

How could all species exist in circumstances which suit them with respect to geography, climate, body structure etc? Why then they still die and not evolve into immortality. We could not do it. None of the millions of species could do it. The extinction of species and our death signifies that someone who created us (humans) and took our lives will indeed be able to bring us to life again and that life would justify the purpose of existence and give meaning to this worldly existence.

Why none of the species became selfish enough to evolve differently so as to become a little bit superior to others etc. They would want to if they were all different kinds of animals because we as animals (if we take the evolutionists’ stance) know that we are selfish to some extent, and want freedom from natural constraints.

If humans were little smarter animals, then they would have at least made some progress to get out of the natural constraints and succeed in a millions of years of history of evolution that evolutionists support.

If I am standing close to another person and if I am hit with a stick, why would only I feel the stick and not the other person? If we cannot sense each other, cannotget through our independent existence (considering we are the same types of animals), how can distinct species, one existing and one not existing, make way for each other in such a magnificent and perfect way in every detail that life becomes possible without an ultimate creator?


Can we avoid the question ‘why’ in any other matter of life? If we think that evolution defines a why or even if does not define it, it defines the material dispensation in this world and the human struggle and evolution in this world intellectually and physically, then we ought to believe that all the bodies of knowledge are also one way or the other biological processes.

How do we differentiate between right and wrong? It has not gone through any evolution. Speaking truth is considered (I am not saying acted upon) a right thing throughout history.

If we are not creatures, just a manifestation of nature, then, there needs to be no reason to believe anything right or anything wrong, if we will just die without any accountability in life or hereafter for our actions, then, if we can avoid the court of law, we can kill, steal, hurt etc as long as no one can hold us accountable. But, we do not think and act like that. It is because we have conscience, ability to differentiate between right and wrong. Then, we have feelings and values, and in most cases, absolute feelings and values.

It makes this belief and argument very weak that this world and universe came out just other than by way of a creator creating it. Just like everything is created by a creator as we see it and observe it, this world and universe also has to be created.

It would be normal to believe like that as it will make us consistent. But, believing that every small thing, though insignificant, needs to be created by someone, but not applying this belief to the creation of the universe is erroneous. This universe could not have come about naturally. If species could co-exist naturally and fulfill their needs naturally, why they die?

A biological process cannot describe this complex set of choices we make through our conscience to uniformly identify right from wrong.

If we restrict the scope of evolution to some aspects; then, it cannot claim to take the place of religion which is a set of comprehensive doctrine i.e. a holistic system of beliefs and practices. If evolution is restricted in just describing how, then any description of 'how' (either correct or incorrect) does not in principle contradict with the thesis of religion. One cannot avoid the question ‘why’ though.

Social learning theory also cannot provide the wholesome answer because social learning requires for its acceptance and relevance, a history behind some of the values which gradually need to become sacred so that the society could force them on others to believe. In the start of life, nothing could be described as such.

Birds fly in winter to avoid cold. They have built-in map and take the best route to avoid flying over sea for most time. Birds few days old and doing it for the first time in life without access to books, journals and experience can never do that as perfectly as they do neither by way of evolution nor by way of social learning. Furthermore, the process, any process, may it be evolution or a sudden big bang, or whatever, does not give any answer to ‘why’.

A question arises as to why we cannot just be able to see Allah and avoid having to solve this puzzle. We cannot see Allah, because Allah has sent us here for a


purpose. That purpose would be meaningless if we could see Allah through our own eyes. But, we can observe, learn within ourselves and use our intellect to search for Allah and we will find the answer, but we have to be unbiased in our search.

2. Consumer Behavior Theory: Islamic Viewpoint

In the mainstream neo-classical economics, utility is assumed to be attained when the person himself/herself consumes the material goods which bring satisfaction, and not when he gives these goods to others. Mainstream economics allows people to have outright freedom in consuming whichever goods they like as long as they can afford them. Consumers seek maximum utility and do not have obligation to share their wealth with the poor masses apart from compulsory taxes.

This supposition has at least three problems when viewed from Islamic viewpoint.

First, with belief in Allah, a Muslim's scope of life and objective is different. His principal goal is to seek Allah's pleasure and succeed in the life hereafter. So; he is supposed to make every decision in a way to seek Allah's pleasure rather than pursuing self-pleasure and satisfaction.

Second, as per Islam, this world is a place for test and this test requires some people to be privileged and some to be deprived. The deprived and privileged are both tested for patience and thankfulness to Allah and how they take care of society and its needs. Hence, this worldview puts the focus of all human beings towards the fact that material resources they enjoy are all blessings of Allah and these are instruments for this test.

Third, as a corollary of point one, the focus of a Muslim shifts from materialism to fulfilling Allah’s commands of excelling in character wholesomely. Prophet Muhammad (PBUH) said: “Wealth is not in having vast riches, it is in contentment”.

An ideal Muslim will not indulge in lavish and conspicuous consumption due to prohibition of Israaf (extravagance even in lawful things), Tabzeer (consumption in unlawful things like liquor, free sex etc), Hasad (jealousy), and having to fulfill Allah’s commands and directive of Infaq (pay to charity), his independent and mutually exclusive choices in the wake of such controls will automatically bring about an optimal result for the society as well. Islam also creates a balance between seclusion/self-denial and lavishness. Prophet Muhammad (PBUH) taught that 'your body has rights over you'.

Diminishing Marginal Utility upon successive consumption of a commodity is a natural phenomenon and approves of the limitedness of this world and what’s in it. The fundamental value is freedom. Happiness results from it. Justice comes in to protect it. Humans, as we have seen, can become unjust using that freedom. Can we provide justice and happiness in a paradigm of absolute freedom? Even when humans had little freedom in this world, we have seen them becoming unjust and then depriving the mission of providing maximum collective happiness for all.


The fundamental question is that can we provide perfect justice in this world. Can we have maximum happiness as we envision in this world. Are we or can we be absolutely free in this world?

People can take justice in their own hands if they are allowed absolute freedom. We need institutions which can impose certain restrictions on all of us so that we can enjoy our freedom without denying freedom of others.

Islam is also such an institution which though put restrictions on one's absolute freedom (as do all other systems), but Islam not only safeguards the rights of the people, but, more importantly and fundamentally, gives meaning to the life and to our own existence.

Moral act in Islam is also a means to an end i.e. to achieve eternal success and blessings of Allah. But, it is not a material end confined to this life only. In this way, the utilitarian mind is also satisfied as happiness is a relative term not achieved only by material things. The fact that moral actions even if they are not rewarded in this world will be rewarded in life hereafter satisfies the utilitarian mind permanently and meaningfully.

3. Islamic Perspective on Factors of Production & Distribution

In an Islamic economy, we can classify factors of production as follows:

1. Land with natural resources.

2. Labor.

3. Physical Capital Stock.

4. Entrepreneur (Working as well as investing).

Below, we try to present details of our proposed classification.

Land with natural resources – It includes all things of value which are naturally occurring goods such as soil, minerals, land etc and that are used in the creation of products. The payment for the use of those resources in fixed supply is rent. When these are sold, their compensation is profit.

Labor – Providing physical or mental exertion by way of contract for consideration in the form of wage or salary. It does not include entrepreneurial labor as the compensation for entrepreneurial labor is the residual outcome of the productive activity and contains an element of risk and uncertainty.

Physical Capital Stock - It includes human-made goods or produced means of production. These are goods which are used in the production of other goods. These include machinery, tools and buildings. The payment for the use of those resources in fixed supply is rent. When these are sold, their compensation is profit.

Physical capital stock and the factor ‘land and natural resources’ are differentiated on the basis of their source of existence. Physical capital stock includes


human-made goods or produced means of production, whereas the factor ‘land with natural resources’ is not produced by humans. Both have the same compensation for their use. It is because while they are used, they do not lose their existence and hence they can be leased and traded.

One could argue that even when a production process hires a natural person providing labor, it does not consume that person and hence wage is basically the rent on human skills used. But, it is worthwhile to classify labor as a separate factor of production due to following reasons:

1) ‘Physical capital stock’ itself is dependent upon labor since it is man-made.

2) Termination of physical capital stock and labor from a production process could be different. When a person owning physical capital stock dies, rent will still accrue on assets in his/her ownership as long as the assets are in useful condition and as long as the contract of lease does not end. When a person providing labor dies, the factor payment ends instantly because the utility of labor or the capabilities of labor are intrinsic and are not detachable and transferable.

3) Physical capital stock is saleable and transfer of ownership is possible in them. But, in labor, transfer of ownership cannot happen. Since transfer of ownership is possible in physical stock, they can be recorded as assets.

4) Distinction has far reaching qualitative effects on behavior and management process. Expenditure on labor can only provide services or skills owned and possessed by labor which the labor willfully provides. He cannot be subjugated like physical capital stock or be traded. Only the skills are tradable and the supply of labor is much more in the hands of labor and consideration for the supply rests on factors much different from factors impacting supply of physical capital stock.

The classical economists also employed the word "capital" in reference to money. Classical economics includes money with physical human made assets/goods in Capital. Money itself has no intrinsic value and is neither a rentable asset nor a tradable commodity as per Islamic principles. If capital is combined with labor, it “could” produce profit, but if money alone is lent, the interest it earns is not permissible as per Islamic principles. Interest is neither a justifiable reward of money nor capital. Money holder/owner has to convert it in one of the four factors of production namely 1) land with natural resource, 2) labor, 3) physical capital stock and 4) or become an investing entrepreneur to have any justifiable compensation out of the production process.

It is necessary that we properly name this factor of production. Else, it could allow one to mix up physical assets and money in the general word ‘Capital’. In classical economics literature, Capital takes different forms. A firm’s assets are known as its capital, which may include fixed capital (machinery, buildings, and so on) and working capital (stocks of raw materials and part-finished products, as well as money, that are used up quickly in the production process). Financial capital includes money, bonds and shares. In classical economics, investment which


increases the capital stock is also priced the same way as capital stock. Hence, classical economics considers rent on machine and interest on money as one and the same thing and the classical economics only mentions ‘interest’ as compensation to capital generally.

Entrepreneur – It refers to an economic entity, natural person or corporation (juristic person), which undertakes the ultimate responsibility for the production process. It undertakes the responsibility to bear losses (if any) and is entitled to the entire residual positive economic outcome after rent on ‘physical capital stock’ and ‘land with natural resource’ and wages have been paid. Entrepreneur could be classified as Working Entrepreneur as well as Investing Entrepreneur. If entrepreneur is defined as an economic entity which is not entitled to a fixed compensation and that his/her compensation is based on the actual positive but residual economic outcome of the production process, then, we can introduce this classification. In Mudarabah, the Mudarib is the working entrepreneur and Rabb-ul-Maal is the investing entrepreneur. (Usmani, 2004)

By this definition and classification, we can avoid the very unnatural definition of land which also includes machines in traditional Income/Factor distribution literature in Islamic Economics. (Usmani, 2004)

By way of this classification, we are able to distinguish between assets which are natural resource and those that are human made. We are also able to distinguish between money and capital. Owner of money has to 1) buy land with natural resource and earn rent on it, or 2) need to buy physical capital stock and earn rent on it, or 3) need to become an investing entrepreneur in an Islamic economy to earn profits through enterprise. Money itself does not have any intrinsic value as per Islamic principles.

Furthermore, we are also able to include ‘human capital’ into the whole picture through our classification of ‘working entrepreneur’ and by separately including ‘labor’ as a distinct factor of production and qualifying ‘labor’ to also include ‘human mental exertion’.

4. Islamic Perspective on Opportunity Cost & Time Value of Money

Opportunity cost is a useful concept in Economics. Some Islamic Economists argue that Islamic Economics does not recognize or give consideration to opportunity cost. Below, we try to present why this is not an appropriate approach.

4.1 Explanation of Opportunity Cost

If I have a job paying me $1,000 and I decide to leave it and complete my PhD. Then, the opportunity cost of going to do PhD is $1,000 of job income forgone for me. When I am considering the option of doing PhD, I must also bear in mind this opportunity cost (implicit cost) along with fees and cost of books (out of pocket costs).

Opportunity cost of an activity is the cost of best alternative forgone in its place. (Parkin, 2003). If, for example, I had another job option paying $500, then, the


opportunity cost will remain to be $1,000. It is because by not doing PhD, I would have taken one of the two jobs and I will have taken the one that pays me $1,000 over the one that pays $500 if I am rational. Then, the opportunity cost of going to PhD is $1,000 of job (best alternative of the two jobs) income forgone.

Just like I cannot ask or force the university to pay me $1,000 each month for me to do PhD with the satisfaction that I have not made any ‘economic loss’, similarly, the owner of capital cannot ask or force the borrower to pay him/her any stipulated increase over the principal amount in a loan transaction.

4.2 Time Value of Money & Islamic Finance

In investment for trade (which Islam allows), the investment goes through the entire process of a commercial activity that involves risk taking at each stage and any compensation on investment is strictly dependent upon the outcome of the commercial activity. The profit for the businessperson strictly depends upon the actual profit realized after taking market risk including price risk. It does not depend upon time. (Islahi, 1998)

Time value of money is the basis of interest. Time value of money is the problem for the investor to avoid keeping his/her money idle and to avoid forgoing the use of money that may bring positive value to his/her investment. However, it does not mean that the investor can demand an arbitrary increase (or is given as the case may be) as the cost of using money without taking the market and price risk.

Yes, the investor could seek ways to avoid earning an ‘economic loss’, but, for that, the investor cannot demand an arbitrary increase over the principal amount lent.

In a model Islamic economy, with closure of interest based Savings, Fixed/Term deposit accounts, more money will come in stock market either directly or through mutual funds. Primary market activities will increase since companies will no longer be able to generate finance through debt. Therefore, increase in listed companies will expand the market and diversify trading opportunities for investors.

This leads us to face the problem of how to price capital in corporate finance,which we discuss briefly hereunder:

In corporate finance, Nominal GDP growth rate could be used in following valuation models:

1. It will replace RF in Capital Asset Pricing Model.

2. It will help in calculating “Ks” and “Capitalization rate” in dividenddiscount model.

3. Income Bonds could be valued using Discounted Cash Flow approach. The proposed benchmark rate i.e. Nominal GDP growth rate could be used as the discount rate.

4. Free Cash Flow could be calculated using this benchmark rate.

5. In project valuation, this benchmark rate could be used to find Present Value (Indicative) of Cash Flows. This would be appropriate due to the following:


i. It will not lead us into falling in time value of money as we are using an enterprise or output related benchmark rather than interest based benchmark.

ii. The Cash Flows will be themselves obtained using equity contractual modes like Mudarabah and Musharakah.

iii. We are calculating valuation models for the investor and not for the borrower. Borrower or financee will be in no obligation to provide the returns based on these valuations. But, the investor can use this “indicative valuation results” to rank investment alternatives.

iv. In actual distribution of income between financier and financee, profit sharing ratio would be used and applied to the gross profit earned by the financee.

Conclusion

This paper discussed the ethical void in Capitalism manifested in unbridled pursuit of self interest, moral relativism, inventive-led economic choices and apathy to communal responsibilities. This has led to a society where economic interests have become the sole basis of maintaining and sustaining relationships. Marcuse (1964) has described this phenomenon as ‘One Dimensional Man’ in his book. This inner void of identity and purpose at individual level and social void in the form of a stratified society bound together only for economic interests can be better filled with incorporating religion. The Islamic perspective on different important mainstream economics concepts provides the much needed addition to the literature on Islamic Economics.

References:

Islami, Amin Ahsan (1998). “Taddabbur-e-Quran”. Lahore: Faran Foundation

Kant’s Critique of Practical Reason and Other Works on the Theory of Ethics, trans. Thomas Kingsmill Abbott, B.D., Fellow and Tutor of Trinity College, Dublin, 4th revised ed. (London: Kongmans, Green and Co., 1889).

Marcuse, Herbert (1964). One Dimensional Man. Boston: Beacon.

Parkin, Michael (2003). “Economics”. USA: Pearson Education

Usmani, Muhammad Taqi (2004). “An Introduction to Islamic Finance.” Karachi: Maktaba ma’ariful Quran.

Yahya, Harun (2003).“Creation of the Universe.” Ankara: Harun Yahya International.


Why Musharaka Mode of Finance is Worth Considering?

ByDr. Badr-El-Din A. Ibrahim & Mohammed Osman Khalifa1

Abstract

The Musharaka Mode of Finance has many advantages but it is not fully utilized as it is not properly understood. However there are quite a few reservations in its application which discourage its use. The paper clarifies all misconception against Musharaka and suggests some modifications which will encourage the utilization of Musharaka.

Key Words: Musharaka, Mudaraba, Muzaraa, and Musaqaf, Constraints, Diminishing Musharaka, Diversification

1. Introduction

This paper argued that Musharaka mode of finance is neither understood properly as the core formula of Islamic financing, nor fully exploited, despite its many advantages. This paper maintained that Musharaka mode of finance has fulfilled some expectations, though some difficulties, which have faced its application, need to be properly addressed. Moreover, these constraints cannot undermine its usefulness or fairness. Application constraints can be surmounted either by more experience; via changes in acts, regulations and policies; and through modification of PLS sharing formulae to assure more incentives.

This paper is mainly intended to elucidate three issues: First: the representation of Musharaka, together with other sharing forms, as a core of the Islamic financing system, Second: identification of the many advantages of Musharaka as shown in the literature and using some case studies, and third: suggestion of some modifications to this integral Islamic formula.

The paper is divided into eight sections. Following this introduction section 2 attempts to illustrate the concept of Money in Islam and the sharing nature of Islamic 1 Dr. Badr EL Din A. Ibrahim is a Dean, Modern College of Business & Science and, Muscat,

Oman & Ex-Advisor to the General Manager Mohammed Osman Khalifa of the Sudanese Islamic Bank and Ex-Social Planning Minister, Sudan;


financing by reviewing the conceptual differences of assets and liability side of the balance sheet of Islamic banks (ISBs) and conventional banks (CBs). Section 3 illustrates the concept of Islamic Musharaka mode of finance. The advantages and reservations against Musharaka are enumerated in sections 4 and 5. Section 6 presents some cases for Musharaka. Some modifications to the applied Islamic partnership are suggested in section 8. The conclusion is provided in section 8 and thereafter references.

2. The Concept of Money in Islam & the Sharing Nature of Islamic Banking

Human experiences in economic sphere are characterized by two major forms of ownership: private and state ownership. In Islam Allah is the only owner of money and all other assets and human-beings are only trustees or stewards2 i.e. possess but not own. The stewards must act in accordance with the laws of God. The major difference between Islamic ownership and other conventional ownership of resources lies in that the steward in the Islamic system need to take his interest compatible with the interest of the community when he is investing. In this way Islam brings into existence the dimension of the social function of money, which characterised the concept of money in Islam (Khalifa, 2004)..

In providing investment avenues for individual resources, ISBs are mainly characterised by two features: the prohibition of interest and any receipt of fixed (or predetermined) rewards, and operation according to profit and loss sharing arrangements in which the rate of return is not predetermined but depends on the actual profit accrued from the investment operations. Moreover, in the investment side, ISBs operate through variety of modes of finance the most common among them are profit and loss sharing modes (Musharaka, Mudaraba, Muzaraa andMusaqat) and sales-based modes (mainly Murabaha, Ijara, Salam and Istisna) 3 (see for example, Iqbal and Mirakhor, 1987; Ibrahim, Badr El Din A., 2004b).

Despite the use of sales-based formulae, which exhibit some application (but not the conceptual nature) of conventional lending, Islamic banking operation is essentially of Mudaraba nature. This can be illustrated through the differences

2 Stewardship implies accountability to the owner.3 Musharaka — joint partnership, credit/partnership, where two or more persons

combine either their capital or labor together, to share the profits. Mudaraba — agency joint venture/limited partnership which involves two parties — the bank (which owns the money) and the partner/entrepreneur (who uses his/her skills to use it). In Muzar’aa and Musaqat (Musharaka contracts in agriculture) the bank provides finance and or land and share in investment. Sales-based Islamic formulae includes Murabaha - mark-up/deferred payment sales of a working capital or means of production — after adding a specific profit margin (Murabaha margin). ISBs also resort to other sales-based modes of finance on a deferred payment base leasing/ Ijara (Lease or pre-paid purchase of goods for a specified sum at a specified period of time, including purchases as a preparation towards the final purchases and transfer of ownership), Bai’muajjal (sellingin installments or in lump sum payments for an agreed fixed price), Bai’Salam ( the buyer pays the full negotiated price of the product that the seller promises to deliver at a future date) to name a few.


between Islamic and conventional banks (ISBs and CBs respectively). The following table (Table 1) summarizes the assets and liability components of a financial statement of a typical Islamic and conventional bank.

Table (1): Financial statements of a typical ISB & CB

ASSETS LIABILITIESDESCRIPTION CB ISB DESCRIPTION CB ISB1. Current Cash Balances 1. Shareholders EquityCash x x Shareholders Equity x xBalances with the Central Bank x x Paid Up Capital x xBalances with Banks x x Legal Reserve x x2. Portfolio of Securities Regular Reserve x xGovernment Bonds x n.a. General Reserve x xLoans, Advances & Discounted Commercial Papers

x n.a. Undistributed Profits x x

Investment in Securities x n.a. 2. LiabilitiesReal Estate Investment n.a. x Call (Current) Deposits x xRepaid Amount (expenses) & Other Assets

x x Time Deposits (with notification)

x n.a.

Financing & Investment Activities n.a. x Saving Deposits x xMudaraba n.a. xBalances due to Banks x-

Commercialx-Islamic

Source: Zuair, Mohammed (2002).

In the asset side cash or reserves are common in the two sets of banking, and so are balances with the Central Bank. In both cases reserves are part of deposits, but the concept of deposits is different. Both types of banks engage in exchanges in the form of cheques, money transfers, and export documents. ISBs’ credit balances with CBs (positive or negative balances) do not carry interest (balances are kept to the minimum and usually covered before maturity). Investment items which do not appear in the ISBs’ Financial Statement: Government Bond, Discounted Treasury Bill, Bonds, & (sometimes) companies’ shares. ISBs dealings with shares should conform to the Shariaa’ (form of profit and loss arrangements, and activities of the companies should be halal). Financing and investment activities in ISBs are different from CBs (include Musharaka, Murabaha and Mudarabah modes). Items such as fixed assets, overhead capital, and depreciation are valued/ calculated the same way in both types of banks.

In the liability side, the CBs deposits carry contractual agreement different from the ISBs. It is an equity-like contract between the bank and the shareholder who share in profit and loss, according to ratios stipulated in the contract and depends on the bank’s performance and profit from investment. Banks pool deposits’ fund to provide depositors with professional investment management. Depositors do not influence in the bank investment decision, as the relationship is regulated according to restricted Mudahraba. Deposits of CBs carry interest, whereas ISBs’ deposits are entitled for profit or liable for loss (deposits reward is related to profits and the volume of deposits). Deposits in Islamic banks is of a Mudaraba nature in which profit accrued from its investment is shared between the two partners. Moreover, ISBs have to obtain permission of the depositors to use these accounts


funds for financial investment. That is why deposits are guaranteed, but not the return on them. Nominal value of Demand deposits is guaranteed (except in the event of insolvency) – it is a pure debts contract with no returns. ( Errirco, L. and Farahbaksh, M. (1998), p. 10).

Investment deposits in ISBs are invested by the bank and share profit or loss. Investment deposits in ISBs can be for specific investment operation or it may be open. Saving deposits in ISBs exhibit the same conditions but withdrawal is made according to different sets of conditions. In the liability side of the balance sheet of an Islamic bank, there are three classes of accounts for deposits: Current account deposits, similar to demand deposits, are guaranteed in capital value. In the current account deposits the bank provides safe custody, amanat (or safekeeping), checks and other services such as drawing money on demand. Demand deposits are not entitled to any bank’s profit, and the bank uses demand deposits at its own risk, but they keep legal reserve at the central bank. Saving deposits can be withdrawn on demand. Some saving deposits may share profits on the basis of a minimum balance maintained within a specific period of time from time to time, and the provisions of maintaining legal reserves are sometimes applied to saving deposits. Investment deposit is based on the unrestricted Mudaraba contract between the depositor and the bank, in which the bank is authorized to use it for any investment project not prohibited by the Islamic principles. Investment deposit is not guaranteed in capital value, and do not yield fixed rate of return. Instead, profit or losses from the bank’s operations are distributed according to negotiated proportions. Profits are distributed either at maturity or sometimes advances are paid to depositors in regular intervals and adjustments are made at maturity. Legal reserves are not kept against investment deposits since the bank cannot guarantee them. Sometimes special purpose investment deposits, which operate on restricted Mudaraba (on specific investment operation), are managed by the bank. Profit and losses are distributed according to the agreed formula.

3. Musharaka Mode of Finance

Musharaka is an Arabic word means partnership. It is a joint business-capital-& profit-based sharing formula, allowing building new & particularly growing business without financing cost. Profit & loss sharing Musharaka & Mudarabaresemble the same features of conventional venture capital arrangements.

Musharaka (or Sharaka) can be defined as a “form of partnership where two or more persons combine their capital or labour together, to share the profits, enjoying similar rights and liabilities” (Al Harran, S. 1993, p. 74). It is a limited period contractual agreement between the Islamic bank and the investment partner, to use both human and financial resources and distribute whatever profit and loss they make in accordance with capital and human resources invested.

Islamic Musharaka is of two types: “Sharakat al-milk” and “Sharakat al-uqood”. The former is a joint-ownership of assets without having entered into a joint partnership (two persons receiving inheritance of a property). Sharakat al-uqood, on the other hand, involves two partners entering into a contractual agreement for investment to share profit. This contractual agreement might be in the authority and


obligations (Sharakat al-mufawadah), in labor skill and management (Sharakat al-abdan), in goodwill, credit-worthiness and contracts (Sharakat al-wujuh), and in restricted authority and obligation (Sharakat al-inan). It ought to have been mentioned that apart from the most popular Sharakat, Sharakat al-inan (which is our concern here) all other types of Musharaka are obsolete nowadays. Our concern here is with contractual Sharakat al-inan (not necessarily formal or written), in whichprofit or loss is shared in any equitably agreed proportions, and in which there is only restricted authority and obligation. In such a kind of Islamic partnership, partners need not have equal shares, or equitable responsibility for the management. Losses would be shared in accordance with capital contribution. It is not only the contribution of capital that governs Musharaka in Islam. In practice labour, skills, management, goodwill, credit-worthiness and contacts can also form the partners’ contribution.

Musharaka is governed by a contract signed by the two parties. The partnership contract is wide in coverage, accurate and flexible. It extends to include financing as well as the management of the project. The contract shows the financial shares and management obligations, distribution of expected profit or loss and other conditions, which govern the partnership relations. These conditions include the conduct of the partnership operations through a joint account opened in the name of the partnership, in which withdrawals and deposit of sales proceeds are made according to the contractual plan. Moreover, joint storage of raw materials subject to partnership is also specified in the contract, and an insurance cost added to the total cost. In the case of financial loss, the damages incurred shall be borne by the two parties in the same way, unless it is otherwise proved to be due to the neglect, abuse or violation of terms agreed upon by the party undertaking the management and operation of the venture, in which case such party shall bear the cost of all damages.

A Musharaka contract varies in accordance with the investment project and the contribution of the partner and the bank. It is subject to mutual agreement, but the main concept can be illustrated as follows: If we denote the amount of capital shared by the bank and the partner respectively by Kb and Kp ( Kb + Kp = K, total venture capital). If e denotes expected profit, and m denotes management profits (m < e). m could be distributed as follows: (Pm). (m) and (Bm). (m) for the partner and bank respectively, where (Pm) and (Bm) are the agreed share of the bank and the partner in management profit respectively (Pm + Bm = 1). The remaining profit s (equivalent to e

- m) is to be distributed according to the contribution of the two partners in total capital. Thus total profit of the partner and the bank is the addition of management profit and shared profit as follows: (Pm). (m) + (Kp/K). (s) and (Bm). (m) + (Kb/K). (s) respectively. Losses also are distributed according to the investment shares.

In any Musharaka contract the following rules are applied:

1. The capital is generally paid in cash. Payments in kind (non-monetary assets) are also acceptable. In the case of financing working capital, working capital ought to be associated with the asset of the business. The assets will be hired for a suitable period. The depreciation of the asset for the whole Musharaka period will be calculated, and added to capital share of the partner. The net income is distributed in accordance with the agreement of the contract.


2. Each partner enjoys a legal capacity to act for him and on behalf of other partner(s) in dealings with partnership matters.

3. Profit allocation must be stated in percentages and according to partners’ shares.

4. It is possible that if a partner exerts more effort, or has more experience, he or she can take an additional percentage of the profits in lieu of his labour/expertise.

5. Losses are calculated in proportion of the shares of each partner in capital.

6. A Musharaka contract is non-binding— each partner has a right to withdraw under certain conditions if it causes no loss or damage to other parties and after proper notice to the other parties (Abdullah, 1997, pp. 1-11).

Musharaka can take another form, in which the bank can enter into partnership with the client on the basis of diminishing Musharaka, through which the full ownership of the business assets passes to the partner after a certain period. Under this type of agreement, the client is given the right to gradually buy, as much as he can, from the bank’s shares until he/she becomes the sole owner of the asset — for example consider a project with a cost of 1000 currency units divided into 10 shares of 100 currency units each. A partner having 5 shares (50%) can buy the shares held by the bank at the end of each financial period, raising his share to 100%.

4. Advantages of Musharaka

The Islamic partnership is better suited for meeting the needs of enterprises. In most cases financing is granted without an obligation on the part of the partner to pay back whether he or she gains or loses. Moreover, no strict security is demanded, as Islamic investment arrangements put great emphasis on the transaction itself, rather than the creditworthiness of the partner (Ibrahim, 1997; Khalifa 2004). If the operation ends in a loss the partner does not bear this loss alone and if the project failed to generate profit partners cannot become indebted to the bank. If he or she is unable to settle his or her bills, a grace period is given without any additional fees. Musharaka does not require collateral and any advancement demanded is made to cover the share of the partner in the venture and not as a security against losses. Since the Islamic principle is basically based on profit and loss sharing arrangement then “any security demanded by the Islamic bank is against possible fraud or repayment-evasion, and not against the risk of losses“ (Awad, 1994; see also Khalifa, 2004 and Ibrahim, Badr El Din, 2004).

Partnership financing has many advantages to offer. Musharaka is fair and risk diversifying. Musharaka is also flexible, easily understandable form of financing. Musharaka accept different forms of capital such as physical efforts, technical expertise, management skills or any form of assets, thus leading to increased incomes for income groups who do not own capital. It is a suitable mode of financing for both working and fixed capital. In countries with high inflation, Musharaka preserves the real value of capital invested — that is, at the time of selling the two partners may decide to delay selling in anticipation of higher prices. Musharaka does not require


strict collateral guarantees and does not leave the partner with a heavy burden of debts, post-dated cheques or any other kind of obligations. Personal acquaintance with the client, and his behaviour, in addition to continual supervision and follow-up by the bank’s management, are necessary requirements in the absence of conventional guarantees. Sudanese Islamic banks, for example, usually use personal guarantees, storage of raw materials subject to partnership, and regular field visits, which limit the chances of dishonesty such as unrecorded sales of the product under partnership, or tampering with records. Another important advantage of Musharaka is that the client does not have to contribute large share of money in which case his/her share might be in kind (inputs such as labour, machine and so on). In Musharaka the bank may take an active role in marketing the product, thus reducing the marketing burden of the entrepreneurs. Musharaka also avoids repayments from entrepreneurs who have already lost their livelihood in the case of a total failure.

Besides providing finance to the already established enterprises, partnership modes of finance are likely to create new socially and economically viable investments, through the concentration of feasibility studies rather than the creditworthiness of entrepreneurs thus allow a great number of people to participate in productive activities and avoid wealth concentration in the hands of few. Moreover, Musharaka search for high profitability and sociably-oriented projects (Khalifa, 2004, p. 4). Wider branch networks and ranges of banking services are a prerequisite for banks in order to reach a large number of entrepreneurs, through partnership formulae. The partnership arrangements can also enhance the ability and incentives of banks to reach small entrepreneurs, thus overcoming the commercialbanks’ reluctance to lend to small producers. Using partnership arrangements, however, does not mean providing finance to small and micro-enterprises on concessional rates. PLS provides high rate of return on capital investment to both the bank and the partner.

Musharaka also contribute by generating valuable employment opportunities of professionals. Musharaka uses professional partners such as agriculturalists, veterinaries, engineers, or professional managers from outside the bank as genuine partners. Those contributors receive substantial salaries charged as an input cost to the Musharaka. In addition they receive up to 7% of operations' profits. Moreover, the employment of such partners in agricultural partnership to perform management services, for example, guarantee the availability of inputs at the right time, contributed to high yields,4 adds to the credibility of ventures amongst farmers and provide genuine extension work acceptable to farmers (for more details see, Khalifa, 2004).

5. Limitations of Musharaka

It is now well known that Individual Islamic banks have so far failed in widely adopting profit and loss sharing formulae. Equity-based PLS constitutes less than 20

4 A survey of Agricultural Musharaka of the Sudanese Islamic Bank by Khalifa and

Khalifa Consultants in Al-Shihinab and Al-Gezira Islang concluded that the presence of agriculturalists management contributed to producing high yields, as this leads farmers to exclusively devote their time to agricultural production.


percent of the total assets of Islamic banks of today (Chapra. 2001, p. 4; see also Dar and Presley, 2001; Ibrahim, Badr-EL-Din, 2006). This is because of some reservations against the use of this formula. One reservation is related to adequate experience in running PLS formulae. Chapra (2001, p. 4) asserts that Islamic Banks are hesitant to undertake PLS formulae in the initial phase, as they do not have adequate experience in managing them. Dar and Presley (2001), assigned different explanations. In PLS contracts, they argued, entrepreneurs have disincentives to put in effort and have incentives to report less profit. They added that this “is based on the idea that parties to a business transaction will shirk if they are compensated less than their marginal contribution in the production process and as this happens in the case of PLS”. As a result “The unwillingness to bear risk on the capitalists’ part and the entrepreneurs’ tendency to exclude others from sharing profits has resulted in a less favourable response to PLS from the financial and business community”.

Another limitation to apply PLS formulae was that PLS contracts require well-defined property rights to function efficiently, which was lacking in Muslim countries (Dar and Presley, 2001). Moreover, Islamic banks, in a mixed banking system, as well as investment companies need to offer relatively less risky modes of financing as compared to Mudaraba or Musharaka in the wake of severe competition from conventional banks and other financial institutions. Choudhury, 2001 also argued that the limited role of the bank in management leads to the parties sharing financial resources without participatory decision-making.

Another reservation against PLS is that equity financing is not feasible for funding short-term projects due to the high degree of risk. This led Islamic banks and other financial institutions to rely on some other debt-like modes instead, especially mark-up, to ensure a certain degree of liquidity.

Unfair treatment in taxation is also considered to be a major obstacle in the use of PLS. While profit is taxed, interest is exempted on the grounds that it constitutes a cost item. Hence PLS is less reliable as a tool for reward sharing. In fact in a country with high corporate tax incidence, this type of financing takes away the benefit of financial leverage, since no tax deduction can be availed on capital contribution. In some cases, financing by way of interest bearing loans will give some return than this system.

Another obstacle in the use of PLS is related to the way banks are looking at profit gain. Since profit is the main criterion to look into, banks will be tempted to finance high return projects, ignoring the socially beneficial projects. Hence Islamic banks lack a social orientation, which seems to be necessary in all developing countries. The social benefits of ISBs cannot be fully utilized without the substantial use of PLS mode of finance.

Most of the limitations outlined above are products of weak experience of ISBs in applying PLS formula. With more and fair application the under reporting of profits will be minimized. Moreover, the establishment of a well-designed property rights in Muslim countries and the already existing ones in advanced countries will facilitate the application of PLS formulae. The unequal treatment of profit and interest for tax is a policy gap rather than a weakness of the PLS formulae.


Nevertheless, commentators of the existing practice of PLS system made some suggestions to develop PLS (or venture capital) in an Islamic setting, via the provision of more incentives to all parties participating in PLS. Shapra (2001, p. 25), for example, called for ‘shared institutions’, which can perform other lending tasks for ISBs to be able to move to a more risky PLS modes. Dar and Presley (2001) argued that under PLS Islamic banks do not have any controlling rights, but they share financial risks with the borrowers. They called for reforms in banking regulations to balance the management and control rights between Islamic banks and managers of the companies they invest in. In this way shareholders are not just passive capitalists but share decision making in the running of the organization. Choudhury (2001) also argued for the use of Musharaka to realize the extensively relational perspectives of Islamic socio-economic co-operation with extensive participation across agents, firms and sectors, and to transform venture capital into a more integrated financial instrument. He pointed that resource mobilization in the economy-wide case through the extension of Musharaka from limited liability and partnership to extended form of economy-wide and intersectoral participation causes linkages between real and financial resources (See Choudhury, 2001).

In sum, Musharaka constraints cannot undermine its usefulness or fairness. These constraints can be overcome either by more experience; via changes in acts, regulations and policies; and through modification of PLS sharing formulae to assure more incentives. But the more important modification that needs to be looked at is how to use PLS as an integrated financial instrument capable of being an economy-wide equity participation formula. Choudhury, in his comments on the draft of this paper, argued for the economy-wide participation that can be afforded by Musharaka. This feature essentially, he argued, is the social and economic transforming property of Musharaka, if true risk-sharing, production diversification and fair distribution of resources over the economy are to take place. Writers on Musharaka, he added, forget that Musharaka is economy-wide equity participation under economic co-operation and participation.

6. Cases of Musharaka

Khalifa (2004) identified many uses of Musharaka in the Sudanese Islamic Bank during the 1990s. One type of Musharaka operation heavily used is the finance of agricultural grains using a formula in which the bank owns the machinery and contributes to capital by the running expenses of the machinery and other expenses of agricultural inputs. In this system no collateral is required as operations of this type do require neither advanced money nor machinery parted with.

In export Musharaka the bank normally contributed 75% of the total cost and the trader normally receives a profit equal to his share while the bank stores the products. Likewise in this operation no collateral is required as a trader hold no excess money in excess of his share. As for imports the bank also shares75% and the product is stored under a joint key and no single partner can get access to the product and hence no collateral is required. The same is applied to Musharaka in local trade.

The bank also engaged in the management of oil mills. Oil mill owner’s share in the depreciation of the machine and the bank contributes the value of the crop and


the cost of operation of oil mills. This type of Musharaka can be further extended to include storing and selling oil. The joint co-management of the project necessitates no use of collateral.

Musharaka can further be used as a mode of finance to run dentist surgery or x-ray unit. Here the bank purchases the equipment and the professionals contribute 25% of the value. The project is run by the professionals who reap a profit of not less than 60%. The remaining profit is distributed according to capital shares. This type of agreement is structured to let the professionals gradually buy out the stake of the bank.

The following is an example of Musharaka from the Sudanese Islamic Bank

A sample of Musharaka in agricultural marketing of the Sudanese Islamic bank in 1987 in Shihinab is displayed underneath. The farmer received a price of 45 Sudanese pounds per sack during the harvesting time. This price was considered very low. The bank entered into marketing partnership with farmers paying half of the prices of potatoes to the farmer. All products were refrigerated by hiring large fridges costing 35 pounds per sack for three months. The selling price per sack after three months was 140 pounds, making an overall profit of 60 pounds per sack. The sharing formula is such that the farmer got 75%, whereas the share of the bank in profit is 25%. The rate of returns for both the partner and the bank exceeded 100%.

Table (2) Musharaka in Potatoes RefrigerationDescription Farmer Bank totalValue of a sack 22.5 22.5 45Cost of refrigeration 0 35 35Percentages of shares 28% 72% 100%Total cost 22.5 57.5 80Total revenue 140Total profit (total revenue – total cost) 60Profit shares (value) 45 15 60Profit shares (%) 75% 25% 100%Rate of return (agricultural season) 200% 26% 75% *Annual rate of return 808% 104% 300% *

* Own calculation.Source: Khalifa, Mohammed Osman (2004)

Musharaka has also a distinctive feature which relates to size and profitability. The following Musharaka in three different project sizes by Sudanese Islamic bank during the 1990s shows interesting additional benefits of partnership financing related to project sizes and rates of returns.

The Table (3) below, which compares the rate of returns of different project sizes, shows additional advantages of Musharaka. Even when the partner’s financial contribution to the project is less than the bank, the rate of return on the partner’s capital is higher than it. This is due to the inclusion of management effort in Musharaka. Moreover, the rate of return on capital invested by the bank or the partner is unexpectedly, very high, reaching three digits per year in some cases. This


gives a clear indication that financing through Musharaka is financially profitable to both parties. It also indicates that financing through Musharaka does not expose the financial institution to any risk of lending. Another observation is that the bank’s profit share, although high, is not proportional to its capital contribution. It is clear from the table below that, the smaller the finance, the larger rate of return and vice versa. This indicates that small enterprises have a larger percentage of profit to each partner’s finance and to the total finance compared with medium and large enterprises.

Table 3: Rates of return on investment by sizes of enterprise (Sudanese Islamic Bank)

Description Project 1 Project2 Project 3 Project 4

Projects: Bread Making

Flower nursing

Coffee shop

Medical lab

Duration of Musharaka One week One week

Four months

One month

Date of MusharakaSeptember, 1995

January, 1996

December, 1995

1996

Volume of Musharaka 29,295 200,000 1,000,000 1,000,000

Bank contribution 75% 50% 50% 14%

Partner contribution 25% 50% 50% 86%

Bank’s share in management 0% 0% 1.20% 5%

Partner’s share in management 30% 60% 87.70% 25%

Bank’s share in total profit 52.50% 20% 6.75% 14.80%

Partner’s share in total profit 47.50% 80% 93.25% 85.20%

Monthly rates of return:

Bank 122% 20% 6%* 5.20%

Partner 325.30% 80% 84% * 6.80%

Total 223.60% 50% 45%* 6.60%

Annual rates of return:

Bank 1464% 240% 18% 62.40%

Partner 3904% 960% 252% 81.60%

Total 2803.20% 600% 135% 78.90%

* Period (four months)

Source: Ibrahim, Badr El Din (2004).

7. Some Modifications

First, let us ascertain the fact that Islamic banking formulae originated from ideas and judgements of ancient Islamic jurists hundreds of years ago, and are not


written in Qu’ran or Hadith. The latter gives general guidelines about how the system of Islamic financing should work. These formulae represent a judgement according to the times and circumstances prevailing when they were originally made. The Muslim schools of thought differ on details related to application but not the basic principle. Islamic banks of today have taken the ancient views as a base to build the system of financing that we now see today. This basic principle of the system is, no doubt, originated from basic Islamic rules, but there are some constraints in the application. Islamic banks, we argue, have to be built on solid intellectual foundations. For the Islamic system to gain more ground and acceptability internationally, experts are confronted with devising techniques of financing which are not only more operational, but in accordance with strict Islamic rules. Any modifications are accepted as far as they do not invalidate the basic rules. Here we suggest some modifications.

The application of Islamic partnerships has singled out the high costs of following up and monitoring of projects as major problems (Ibrahim, 1997; Ibrahim, Forthcoming in Choudhury M.; Harper, 1997, 1999). To reduce the administrative burden, branches have been created to serve limited geographical areas and located around the business (Ibrahim, 1997). A third party to follow up and share certain percentage in the total profit is also recommended (Ibrahim, 1997, p. 10). Group collateral which can serve a dual function of reducing the administrative costs and acts as a security against fraud and misuse of funds is recommended (Abdullah, 1997, p. 60). A group leader in collaboration with the bank’s staff should undertake the monitoring obligations.

Another problem noticed is getting a fair management share of the profit for the partner. In principle the determination of the management share is made through mutual agreement between the bank and the partner. In practice it is usually in the range of 20 to 30 per cent of the total expected profit. This flat rate may be unfair either to the bank or to the partner, as the management effort is project-specific. Here a more operational and fair methodology is required. The Residual Approach (RA) to calculate the management share in total profit is suggested as a solution (Ibrahim, 1995, pp. 29-31). To calculate the share of management in total profit Ibrahim proposed to deduct share profits from total expected profits and then divide the result by the total expected profit. To have the management profit as a residual requires knowledge of the rate of return on the capital invested in previous similar projects (the rate of return on each unit of capital). By multiplying the volume of capital invested by the rate of return on each unit of capital, we get an estimate of shared profit. To illustrate the RA in calculating the management share let us denote management profit by m, and expected profit by e. Let K denote capital investment, and rk denotes the rate of returns on capital, then m

= (e)-( K). (rk)/e.

Alternatively, m= 1 - (K).(rk

)/e. Additional incentive to the partner can be granted, thereby the bank can determine a maximum rate of return of total capital used in the project, above which the bank will be ready to sacrifice additional profit for the partner. In the current situation the partner sometimes gets this incentive through increased management share, over and above the limit determined by the contract. The modification outlined here is more operational and easier to calculate. Alternatively, we can use what we call the “Imputed Market Share Approach”


(IMSA). Here the value of the management efforts can be evaluated at the prevailing local market price and then divided by the total expected profit. To illustrate the approach, if Vm is the market value of the management effort, and e is expected profit, then IMSA gives a management share in profit of (Vm/e). A weighing system can be used for factors such as qualifications, experience, and volume of capital, sensitivity of the project and additional incentives for the management.

Evaluating the fixed assets in diminishing (self-liquidating) Musharaka also needs a modification. Banks do not usually re-evaluate the asset at different times when part of the repayment is made. Inflation is not taken into account, and hence diminishing Musharaka is at the disadvantage of the bank. Re-evaluation of the assets should be undertaken and the volume of payment can be considered as a ratio of the value at the time of payment. For full payment of the value of the asset, the addition of these ratios must equal to unity. If r1, r2, r3, r4 and so forth are payments in periods 1, 2, 3, 4, respectively, and v1, v2, v3, v4, and so forth are values of the asset in each payment period respectively, then at the time of full payment r1/v1+ r2/v2+r3/v3+r4/v4+ …= 1. Adjustment of the partners’ shares has to be modified each period in accordance with the changes that may have happened after each part payment.

8. Conclusion

Musharaka mode of finance is neither understood properly as the core formula of Islamic financing, nor fully exploited. Musharaka has many advantages, nevertheless it has not yet received wide acceptance. Experiences of Musharaka are rich and a lot can be learned from.

Using some real case studies as well as reviewing literature on the subject, this paper maintained that Musharaka mode of finance has fulfilled some expectations, though some difficulties, which have faced its application, need to be properly addressed. A great deal of research is needed in the application of the Islamic formulae if it is to become more widespread and successful.

In this paper we argued that Musharaka constraints cannot undermine its usefulness or fairness. Moreover, application constraints can be surmounted either by more experience; via changes in acts, regulations and policies; and through modification of PLS sharing formulae to assure more incentives. With more and fair application the under reporting of profits will be minimized. Moreover, the establishment of a well-designed property rights in Muslim countries will facilitate the application of PLS formulae. The unequal treatment of profit and interest for tax is a policy gap rather than a weakness of the PLS formulae. This paper also advanced some suggestions to reduce the cost of following-up, getting a fair management profit and clients' fixed assets of diminishing Musharaka and provision of more incentives.

References

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Al Harran, Saad. 1993. Islamic Finance: Partnership Finance. Malaysia: Pelanduck Publication.

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Awad, Mohammed. 1994. “Islamic Financing for Small Enterprise”. Industry and Development, No. 1. Nielien Industrial; development bank Group (NIDBG), Khartoum.

Chapra, M. 2001. “Strengthening Islamic Banks”, Paper presented to a seminar on Regulations and Supervision of Islamic Banks – Current Status and Prospective Development, Sudan). Islamic Research Institute, IDB and the High Institute for Banking and Financial Studied, 24th – 26th April, Khartoum, Sudan.

Choudhury, M. 2001. “Venture capital in Islam: a critical examination”, Journal of Economic Studies, 28:1.

Dar A. Humayon and Presley, J. 2001. “Lack of Profit Loss Sharing in Islamic Banking: Management and Control Imbalances”. International Journal of Islamic Financial Services, Vol. 2 No. 2.

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Ibrahim, Badr-El-Din. 1995. “Methods to Determine the Share of Management in the Islamic Musharaka Mode of Finance”. Industry and Development. No. 3. Nielien Industrial Development Bank Group (NIDBG), Khartoum, Sudan.

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Zuair, Mohammed, A., 2002, Islamic Economy, No. 235, Dubai Islamic Bank, UAE (in Arabic).


The Mega Islamic Bank: A ‘Silver Bullet’ Solution

ByMughees Shaukat* and Mohd. Zamree Mohd Ishak*

AbstractIslamic finance is fast becoming a major global force and its impact is only just beginning. However it still lacks well-capitalized institutions. About a quarter of the roughly 300 Islamic financial institutionsworldwide are reported to have less than US$25 million in paid-up capital. No wonder the idea of ‘Mega Islamic Bank’ has picked up pace, and so have these burning questions. For instance, is it viable to havesuch a bank or do we really need one? If so, then how? Who will take the lead? What could be the consequences? Are there more pros than cons to it? These are among the many pivotal IFs & BUTs. This study will attempt to address most of these issues, and finally would prove the viability of this idea and even come up with some policy implications to support its transformation from reasons to reality. Our findings and arguments are based on comparing the profitability and performance of a sample of 18 Islamic viz-a-viz 18 conventional banks globally. The techniques involved would be the Fixed and Random Panel Techniques and more advanced Dynamic Heterogeneous Panel, to make the comparisonmore rigorous. The findings provide a justification for further mergers and consolidation in the industry. Better capitalized, more profitable and robust banks are found to operate at higher efficiency levels in a politically

* The Author Mughees Shaukat is currently a PhD Researcher & Assistant Researcher in

Islamic banking and finance and is working alongside Distinguished Scholars and IDB Award winners, Prof. Dr. Abbas Mirakhor and Prof. Dr. Zubair Hasan (Professor of Islamic Economics- Dept of Economics and Governance-INCEIF): email: [email protected]; Phone:+60178726766

* Mohd Zamree Mohd Ishak [BSBA, MBA (Finance), CIFP] became the Chief Operations Officer of INCEIF- The Global University of Islamic Finance (established by the Central Bank of Malaysia) in July 2009. Prior to joining INCEIF, Zamree was an Executive Vice President in Malayan Banking Berhad (Maybank) where he started his 20 years banking career in July 1989. Zamree holds a Bachelors of Science in Business Administration from Saint Louis University, St. Louis, USA and an MBA (Finance) from University of Hull, UK as well as a Chartered Islamic Finance Professional (CIFP) qualification from INCEIF.e-mail: [email protected]; direct line:+60327814040


stable environment that fosters financial openness and this is exactly at the core of why we should have an Islamic Mega Bank.

Key Words: Mega Islamic Bank, Advanced Heterogeneous Panel,

1 Introduction:

Islamic finance has become an increasingly integral part of the global financial system. From being concentrated in Muslim populated regions, Islamic finance has drawn significant participation by non-Muslims.More recently, there have been increased initiatives to acquire strategic stakes in Islamic financial institutions in different parts of the world. With increased liberalization, the Islamic financial system has become more diversified and the Islamic financial markets have deepened. As a result, Islamic finance has now emerged as among the fastest growing segments in the international financial services industry.

How fast this infant industry is growing? What proportion of the global finance industry will be turning to Islamic instruments in the future? Where will the industry be in 2011 and beyond? The key to understanding where Islamic finance will be tomorrow is grasping where it is today; the resilience of the Islamic Financial Institutions (IFIs) during the recent crisis epitomizes the intrinsic strengths in Islamic finance, the purpose and objectives of which are guided by the Shariah principles.

A study on the performance of the top 10 conventional banks with the top 10 Islamic banks indicates the following, IFSB-IRTI, (2010) andErnst & Young, (2009):

The combined market capitalization of top 10 conventional banks suffered a decline of 42.8% vs. 8.5% decline in market capitalization by Islamic banks for the period between December 2006 and May 2009.

Between 2006 and 2008, total assets of conventional banks grew by 36% to USD17.4 trillion while assets of the Islamic banks grew by 55% from USD94 billion to USD147 billion. The growth in total equity during this period was 24% and 36% for conventional and Islamic banks, respectively.

Conventional banks’ leverage ratio (Assets/Equity) was 16.6 times in 2006 which increased further to 18.2 times in 2008. This was nearly three times the leverage ratio of Islamic banks, which was 5.8 times in 2006 and 6.6 times in 2008.

Five of the top 10 conventional banks received government financial assistance to the extent of USD163 billion in aggregate, or 26% of the affected banks’ combined equity. In contrast, only one Islamic financial institution required government assistance to restructure and trading of its shares was suspended. As at end 2009, none of the Islamic banks needed any government rescue scheme.

Chart 2(Appendix-II) compares the changes in market capitalization, net profit/ (loss), total assets and equity between conventional banks and Islamic banks pre and post crisis. The following charts3-6 (Appendix-II) show the performance of


individual banks with respect to market capitalization, profitability, assets and leverage.

It is important to note, however, that the above observations are subject to some important caveats:

The size of the Islamic banks is a small fraction of that of the conventional banks. The top 10 Islamic banks’ market capitalization was only 3.1% of the top 10 conventional banks’market capitalization in 2006. While this has improved to 4.8% in 2008, it remains small. The size of Islamic bank assets as a percentage of total bank assets was less than 1% in 2008. The universe of assets that has been used to create Sharia-compliant profit is still limited though there is great scope to expand it.

The Competition is fierce. Customer base is becoming more sophisticated and demanding. Innovation is now a major priority with the introduction of new methods, ideas and products. Innovation has to take into account the multiple dimensions surrounding the world of Islamic finance, from technology and distribution channels to product development and the regulatory framework, Mughees, (2010). Islamic banks are currently in an evolutionary and transitory phase where there is a concentration of their assets in a few products which have been carefully structured to largely replicate the risk and return characteristics of conventional financial products. To the extent that this is diluting the distinctiveness of Islamic finance, it could also expose the Islamic banks to the destabilizing forces inherent in the conventional financial system.

IFIs lack well-capitalized institutions. About a quarter of the roughly 300 Islamic Financial Institutions (IFIs) worldwide are reported to have less than US$25 million in paid-up capital.

The caveats are too tempting to resist and may force one to think and say that today’s Islamic banking though is booming, there is really an immense need of constant rethinking, re-strategizing and innovating to compete in this rapidly growing world. There is also perhaps a need to redefine the structure for success in future. Merger(s) of the Islamic banks may perhaps be a zealous way forward for survival in this era. There is need to increase the size, capital and ability to create assets,Kahf, M. (2002).The future glamour may seem a future glory, but it may also turn into future gloom, if eyes are kept completely shut and if realm is ever compromised.

No wonder the focus indeed is gearing more and more into the development of a comprehensive Islamic Financial Infrastructure.Several key institutions have been established to provide the infrastructure for the continuous growth of Islamic finance. Among the key institutions are the IFSB (Islamic Financial Services Board), AAOIFI (Accounting and Auditing Organization for Islamic Financial Institutions) and specialized institutions that provide Islamic financial services such as rating agencies, deposit insurance corporations and mortgage corporations. The latest feather in the hat has been the establishment of the International Islamic Liquidity Management Corp. last year, to better manage the excess liquidity often found in IFIs (Islamic Financial Institutions) Mughees, (2010).


All these steps seem to be in the right direction but it demands a whole lot more; that too at the rate which is abreast with the lightning speed of this dynamic world of financial architecture. The thrust of ‘Do More’ has now become the order of the day and so has this aboriginal idea of having a ‘Mega Islamic Bank’. Though not new in the conventional field of affairs, this idea of having an Islamic version of a mega bank has genuinely picked up pace. First mooted by the General Council for Islamic Banks and Financial Institutions (CIBAFI), it clearly has been on the minds of many industry players.

“We need big Islamic banks with the balance sheet and the muscle that can compete with the likes of BNP and JP Morgan,” said Mohamad Safri Shahul Hamid, deputy chief executive at Malaysia’s MIDF Amanah Investment Bank, a sukuk arranger.1

The idea has created such instant and powerful ripples among stakeholders of all kinds that potential Islamic financial hubs like Malaysia, Bahrain and Saudi Arabia have all tried to dive in and take the lead. Malaysia has already made her intentions clear and loud and is in process of issuing license for the creation of a Mega Islamic Bank sooner rather than later. This was evident when the governor of the Central Bank of Malaysia Tan Sri Dr. ZetiAkhtar Aziz announced such intentions. “A new Islamic bank that will be jointly established by institutions from Asia and the Middle East”.2

Bahrain has not been sitting quiet as well;chairman of Al Baraka Banking Group, Shaikh Saleh Abdullah Kamel also confirmed the plan to form the world's largest Sharia-compliant lender which is expected to be launched soonReuters,(2010).Islamic Development Bank, the Jeddah-based multilateral lender, said the Mega Islamic Bank will have an initial paid up capital of $1bn.Mega Islamic Bank shall provide “liquidity management solutions in an effort to create an Islamic interbank market,” The bank will also originate and finance large projects across Muslim countries, IDB said Bloomberg,(2010).

However the transformation of this idea from mere announcements to practicality comes along with a package of some burning questions. For instance, is itviable to have such a bank or do we really need one? If so then who will take the lead? What could be the consequences?Are there more pros than cons to it? These are among the many pivotal IFs & BUTs. This now lays the required platform for the objective of our study.

2 Objective of Study:

An idea as big as above, may provide a big leap in the world of Islamic finance, but so are big these IFs &BUTs that come along; therefore a thorough research is needed before transcending it from fantasy to realm. The core objective of this study is an attempt to address most of the above jigsaw puzzles, and finally an effort to prove the viability of this idea alongside coming up with some policy

1 Islamic Finance Asia. August/September 2009. [http://www.islamicfinanceasia.com].2 Business times. 23rd December, 2010 [http://www.btimes.com.my].


implications to support its diffusion from reasons to reality. Our findings and arguments would be based on comparing the profitability and performance of a sample of 18 Islamic viz-a-viz 18 conventional banks selected from all over the world. We can safely say that this study would be the first of its kind which will zoom in to this issue even though with old approach of cross comparison of profitability and performance between banks but what would make it even more novel, is not only the relation of these comparisons with the need satisfaction and viability of a mega bank but also the modeling techniques that we will be applying to come up with acute results as would be elucidated in the sections related to data &methodology and empirical findings; but first let us explore the past and see what extensions have already been made in this world of comparative analysis.The literature review will unfold the story.

3 Literature Review:

The study of bank profitability is an important tool to evaluate bank operations and to determine management planning and strategic analysis. It may also lead us to new dimensions of analyzing banking performance and may yield interesting conclusions. Banks contribute to economic growth, so if bank performance is outstanding, the overall economy will be strong. A number of researches have been conducted in the past on the profitability of banking. Recent papers on profitability have improved as they include more bank characteristics that either contributed or impacted performance. Previous studies on profitability published in the recent past Zakrajsek (2002), Bodla&Verma (2007), Shen & Chang (2006), Murthy (2004), DeYoung (2003), Seabright et.al. (2002) have identified the following determinants of bank profitability: bank size, spread (net interest margin), asset quality (loan loss provisions to total assets or NPL ratio), expense control, cost to income ratio (non-interest/interest expenses to net interest revenue plus other operating income), leverage (equity to total assets), liquidity (liquid asset to total liabilities), management efficiency (earning assets to total assets), operation efficiency ( loans to deposits), burden (non-interest expenses minus non-interest income to earning assets), business per employee, profit per employee vs. PBT per employee and PAT per employee, and credit to deposit ratio.

The study by Shen& Chang (2006) tries to explain bank performance by using not only bank specific determinants but also macro-environment and governance variables. However, it may be worth to note that many of the above studies did not specifically focus on managing and forecasting bank profitability, but on issues of bank performance under alternate circumstances. The latest paper on profitability was done on European banks by Goddard, Molyneux and Wilson (2009). This study investigated the profitability of European banks during the 2000s using cross sectional and dynamic panel analysis. Another paper by Ben Naceur(2007) studied banking profitability in Tunisia, Spathis, Kosmidou, and Doumpos (2007), studied the profitability of Greek banks using a unique approach by classifying banks according to assets size before they were studied. Portela and Thanassoulis (2009) analyzed profit efficiency on Portuguese’s banks.

A large number of empirical studies have been conducted about factors influencing bank’s profitability and determinants of bank performance. However,


most of these studies covered developed economies, whereas much less studies covered emerging economies. The following is a summary of the findings of some of these studies:

Delis and Papanikolaou, (2009) investigated the determinants of bank’s efficiency. They found that the banking sectors of almost all sample countries show a gradual improvement in their efficiency levels. The model used shows that a number of determinants like bank’s size, industry concentration and the investment environment have a positive impact on bank’s efficiency. The determinants of performance of Greek banks during the period of EU financial integration (1990-2002) has been examined by Kosmidou, (2008). He used an unbalanced pooled time series data set of 23 banks. For bank performance measure, he used the ratio of return on average equity (ROAE) and for the determinants he classified them into internal and external determinants. The internal set included: the cost-to-income ratio, the ratio of equity to total assets, the ratio of bank’s loans to customer and short-term funding, the ratio of loan loss reserves to gross loans and the bank’s total assets. The external set included: the annual change in GDP, inflation rate, the growth of money supply, the ratio of stock market capitalization to total assets, the ratio of total assets to GDP and concentration. The results showed that ROAE was found to be associated with well-capitalized banks and with lower cost to income ratios. The results also indicated that the impact of size and the growth of GDP was positive, while inflation had a significant negative impact.

Unal et al.,(2007) conducted a comparative performance analysis between the Turkish state-owned and private commercial banks during the period 1997-2006. They used net profit-loss, return on assets and return on equity as proxies to measure profitability. To measure operating efficiency they used net profit, net assets efficiencies relative to total employment and total number of branches. The findings suggested that state-owned banks are as efficient as private banks. Chirwa, (2003) investigated the relationship between market structure measured by concentration and profitability of commercial banks in Malawi using time series data between 1970 and 1994. He concluded that there was a positive relationship between concentration of banks and performance. Naceur and Goaied, (2001) examined the determinants ofthe Tunisian deposit during the period 1980-1995. The results indicated that the principal determinants of a bank’s performance were by order of importance: labor productivity, bank’s portfolio composition, capital productivity and bank capitalization.

However when it comes to Islamic banking literature, such research works are limited. In general, Islamic banking operations are characterised by risk or in simpler terms profit and loss sharing since the interest factor is absent. According to Dar and Presley, (2000). Islamic banks function on the basis of profit and loss sharing (PLS), so if the banks undertake risk then investors share part of the risk. The following is a discussion on some of the studies conducted on Islamic banking profitability:

First of all, Bashir (2000) assessed the performance of Islamic banks in eight Middle Eastern countries. He analyzed important bank characteristics that affect the performance of Islamic banks by controlling economic and financial structure measures. The paper studied fourteen Islamic banks from Bahrain, Egypt, Jordan,


Kuwait, Qatar, Sudan, Turkey, and United Arab Emirates between 1993 and 1998. To examine profitability, the paper used Non Interest Margin (NIM), Before Tax Profit (BTP), Return on Assets (ROA), and Return on Equity (ROE) as performance indicators. There were also internal and external variables:

Internal variables included in the regression were bank size, leverage, loans, short term funding, overhead, and ownership; external variables included macroeconomic environment, regulation, and financial market. In general, results from the study confirm previous findings and show that Islamic banks profitability is positively related to equity and loans. Consequently, if loans and equity are high, Islamic banks should be more profitable. If leverage is high and loan to assets is also large, Islamic banks will be more profitable. The results also indicate that favorable macro-economic conditions help profitability, Bashir(2000).

Secondly, Hassoune, (2002) examined Islamic bank profitability in an interest rate cycle. His findings states that Islamic banks operate on a profit and loss sharing basis compared to conventional banks operations which are based on interest. Hassoune also compared the ROE and ROA Volatility for both Islamic and conventional banks in three GCC countries: Kuwait, Saudi Arabia, and Qatar. He stated that since Islamic banking is based on profit and loss sharing, managements have to generate sufficient returns for investors given that they are not willing toaccept no returns;Hassoune,(2002).

Thirdly, Bashir and Hassan, (2004) which forms the basis for this dissertation as it is a comprehensive piece of literature covering every aspect of examining profitability in Islamic banks. Similar to Bashir (2000), Bashir and Hassan, (2004) studied the determinants of Islamic baking profitability between 1994 and 2001 for 21 countries. Their figures show Islamic banks to have a better capital asset ratio compared to commercial banks which means that Islamic banks are well capitalized. Furthermore, their paper used internal and external banks characteristics to determine profitability as well as economic measures, financial structure variables, and country variables. They used, Net Non Interest Margin (NNIM), which is non-interest income to the bank such as, bank fees, service charges and foreign exchange to identify profitability. Other profitability indicators adopted were Before Tax Profit divided by total assets (BTP/TA), Return on Assets (ROA), and Return on Equity (ROE).

They studied 43 Islamic banks. Results obtained by Bashir and Hassan, (2004), were similar to the Bashir (2000) results, which found a positive correlation between capital and profitability but a negative correlation between loans and profitability. Bashir and Hassan also found total assets to have a positive relationship with profitability which supports that bigger banks are more profitable. In addition, during an economic boom, bank’s profitability seems to improve because there are fewer non-performing loans. Finally, results also indicate that overhead expenses for Islamic banks have a positive relation with profitability which means if expenses increase, profitability also increases (Bashir and Hassan, 2004). While several good theoretical studies on Islamic banking are available, there is a serious shortage of empirical studies.


In summary it can be concluded that both ROA and ROE have been extensively used as measures ofbanks’ profitability and hence performance at times interchangeably. Whereas ROA shows the profit earned per dollar of assets, on the other hand ROE reflects how effectively a bank management is using shareholders’ funds. A bank’s ROE is affected by its ROA as well as by the bank’s degree of financial leverage (equity/ asset). Since returns on assets tend to be lower for financial intermediaries, most banks utilize financial leverage heavily to increase return on equity to a competitive level. Thus ROE could be considered that much more sensitive and hence a better profitability/performance measuring tool.

So based on the above literature, we feel no hesitation to join the band and use ROE as our dependent variable in our model in order to determine our results by using advanced dynamic panel modeling (which we believe that we are at the forefront to apply these techniques to Islamic finance to say the least), and then argue from there to uphold our stance of being‘Pro’ to Mega Islamic Bank. The coming sections will delineate our quest to sublimate our position. The section on Data and Methodology will further lay the foundations.

4 Data and Methodology:

Efficiency is a concept that is more close to profitability insofar as it involves the optimization of behavior which relates it. We have two perspectives. On one hand, the maximization of outputs produced from a combination of available inputs (output-oriented measure).Ang, Elaine, (2009). On the other hand, the use of minimum quantities of inputs to produce a given quantity of output (input-oriented measure)Aka, Jahangir, (2009).In both cases the idea of optimization comes from the desire to avoid waste and to be as efficient as possible in achieving the objectives which in turn derives more profitability. Measuring the efficiency/performance of banks leads to determine their level of profitability in terms of use and distribution of financial services, based on inputs they use Cihak, M. and Hesse H., (2008). Methods for efficiency in terms of profitability measurement used in the literature indicate this ability of banks, since they allow calculation of composite indices to take into account this capacity.

As the Islamic financial industry is an infant, so are the empirical studies on it. The most important reason for the lack of empirical studies on Islamic banking is the lack of a long and consistent time series for the Islamic banks. There are so many variations in practices of reporting financial statements and construction of a consistent time series is a project in itself. It is also widely known that tests based on individual time series have low statistical power, especially when the time series is short Campbell and Perron, (1991).To address the lack of adequate information, Panel based tests represent an improvement in this respect by exploiting additional information that results from the inclusion of the cross-sectional dimension. Based on this reason, time series cross-sectional/unbalanced panel data from 2005-2009 was collected for each conventional bank-C.Bs and Islamic bank-I.Bs in Bahrain, Bangladesh, Iran, Jordan, Kuwait, Malaysia, Pakistan, Saudi Arabia, Sudan, UAE and the U.K. The table below lists the banks that were used for our analysis.


Table 1: List of Banks

Islamic Banks Conventional Banks

GCC GCC

Al-Rajhi (Saudi Arabia) Riyad Bank (Saudi Arabia)

Dubai Islamic (UAE) National Bank of Bahrain (Bahrain)

Shamil Bank (Bahrain) Bank of Bahrain & Kuwait (Bahrain)

KFH (Kuwait) National Bank of Kuwait (Kuwait)

SOUTH ASIA SOUTH ASIA

Meezan Bank (Pakistan) Askari Bank (Pakistan)

Faysal Bank (Pakistan) Bank Alfalah (Pakistan)

Dubai Islamic (Pakistan) Habib Bank (Pakistan)

MelliBank (Iran) Sonali Bank (Bangladesh)

Bank Islami (Bangladesh) Dhaka Bank (Bangladesh)

EUROPE EUROPE

Islamic Bank of Britain (U.K) Barclay (U.K)

NORTH AFRICA NORTH AFRICA

Jordan Islamic Bank (Jordan) Jordan Commercial Bank (Jordan)

Sudanese Islamic Bank (Sudan) Byblos (Sudan)

SOUTH EAST ASIA SOUTH EAST ASIA

Bank Islam(Malaysia) HSBC (Malaysia)

CIMB Islamic (Malaysia) CIMB. Conventional (Malaysia)

Bank Muamalat (Malaysia) EON Bank (Malaysia)

Am.Islamic Bank (Malaysia) Am Bank. Conventional (Malaysia)

Hong Leong Islamic (Malaysia) HongLeong. Conventional(Malaysia)

RHB (Malaysia) Maybank (Malaysia)

It will an unbalanced panel data since it contains for some banks, years in which some information for certain variables was inconsistent, though such instances were on a minuscule. These countries were chosen because of the importance of IBs (Islamic Banks) in their banking systems and data availability. For comparative purposes, another sample of eighteen conventional banks was chosen. An attempt was also made to choose banks roughly of the same size as the Islamic banks. The number of banks for the total sample used in this study is 36, half of which are Islamic and the other half conventional. The main sources used in building the database include bank’s annual and interim reports, Zawya database, information from rating agencies and mainly BankScope.

Since the dataset includes cross sectional time series data, Panel Data Regression approach (sometimes called pooled or longitudinal or event-history) is appropriate. Fixed Effects Model (FEM) also called the LSDV (Least Squares


Dummy Variable) Model and the Random Effects Model (or Error Components Model) was considered appropriate3, Gujarati (2003) p.650 and Asteriou& Hull, (2007) and hence will be used first for the purpose of estimations. The primary difference between the various panel data estimators is the degree to which they impose homogeneity or equality restrictions across groups (or units or countries) with respect to:

(i) Intercepts

(ii) Error variances

(iii) Short run regression slope coefficients

(iv) Long run regression slope coefficients

We will see the effects on results by relaxing each assumption one by one inthe models we have used. The FE (Fixed Effects) estimator is the most restrictive of all. This estimator holds the first three assumptions, only intercepts are allowed to vary. Whereas, RE (Random Effects) is the less restrictive, this estimator holds thefirst two assumptions; however, error variance and intercepts are allowed to vary. The Hausman test at 5% significance level was used in selecting which model best fits for each group. It was seen that for the Islamic banks Fixed Effects model proved more meaningful unlike in the case of conventional where Random Effects model was more appropriate. The output of the Hausman tests given in the appendix will justify the selection of these modeling.

The basic framework for panel models is:

Ybt = αb + βbt + ebtWhere b = 1 …18 and t = 2005…2009

Our dependent variable is the ROE of each bank- Islamic or conventional and the independent variables will be: Total Assets (TA), Total Equity to Total Assets (TETA), Deposits to Total Assets (DETA), Net Loans to Total Assets (NLTA), Non-interest income to Average Assets (NIIAA) and Equity to Net Loans (EQLO). Our model is demonstrated as below.

ROEbt=α1 + β1log (TA)bt+ β2TETAbt + β3 DETAbt + β4NLTAbt + β5NIIAAbt+ β6 EQLObt+ebt

Where: the ‘bt’ suffix given with each variable stands for the respective bank and the given year. For example, ROEbtrepresents the Return on Equity for bank b in year t.

When it comes to the idea of having a mega bank, size is something that does matter. The variable of total Assets may give us a good picture. The estimations of size of equity could also yield synonymous results, however due to awfully inconsistent and missing figures available in the above samples related to equity particularly of Islamic banks; we were further pushed to use Total Assets as a

3 The FE estimator is the most restrictive of all. This estimator holds the first three

assumptions, only intercepts are allowed to vary, whereas, RE is the next less restrictive, this estimator holds the first two assumptions; however, error variance and intercepts are allowed to vary.


representative. Nevertheless we will still touch the parlance on size of equity and its importance whereever necessary. The financial structure is another most important aspect that affects growth, profitability and efficiency Mughees, (2010).Financial structure is always changing and requires careful management, especially in cases of rapid growth. Institutions that fund their assets primarily (70-80%)with member-client deposits are independent from the fluctuating price of external funds, Pearls, (2010).

The Effective Financial Structure would focus on an institution's sources of funds (deposits, shares, external credit and institutional capital) and its uses of funds (loans, liquid investments, financial investments and non-earning assets) Ahmad, Ziauddin (1995). An institution has an effective financial structure when assets, financed by deposits, generate sufficient income to pay market rates on them, cover operating costs and maintain capital adequacy. Thus the variable of Deposits to total assets rejuvenates its importance again here when talked in relation to the novel idea of an Islamic mega bank.

The Estimations will take a quantum leap and thus will get even more rigorous this time. This is where the 3rd and 4th assumptions given above would be relaxed. The estimations will be called PMG (Pooled Mean Group) and MG (Mean Group) panel techniques also known as the dynamic heterogeneous panel techniquesAsteriou& Hull, (2007). These techniques will be put into application first time ever in such empirical studies which are specially related to Islamic finance. Again Hausman test at 5% significance level will be used to select which model best fits each group.

It was found from the test that the PMG estimation was felicitous for both groups. Wewill use the results of fixed and random modeling from above to the extent of information given from them and would squeeze the sample now only to the best performers. We would analyze them this time in relation to their Total Assets and the Deposits to total Assets, in order to add more velour and refinement to our findings, to further strengthen our case as the next section on the empirical findings will manifest.

5 Empirical Findings:

As mentioned, the present study have used panel and advanced panel econometric methodologies to come up with the findings (summary statistics of the variables used are presented in appendix-I).When looking at the results for the fixed and random effects models, we have to take note of the shift in the value of the overall constant with respect to the individual values of the constant given for each bank. The more upward the shift in the value of the model’s overall constant, the better the bank has performed and hence the more efficient it has been in operations and managerial skill. So a more profitable bank is expected to have a bigger shift in the value of the overall constant term ‘α’ which in the results below is given by ‘C’.

We observed from our results of fixed effects for the Islamic group, the signs for each coefficient came as expected but not so for the C.Bs. (Conventional Banks) in the random model. The adjusted R2 is 55.4% and the F-statistic is also significant even at 1%.The sign for TA impact on profitability for Islamic banks is positive for


Islamic banks which prove a very important point that size does matter because by increasing the size of banking firm, cost can be reduced and therefore, performance can be improved. However it remained insignificant even at 10% level. The same variable in C.Bs model was found significant at 5% but indicating a negative relationship with profitability, surprisingly meaning that bigger conventional banks are less profitable and seem less efficient. The TETA got a negative significant relation with ROE/profitability. This may indicate that the more equity issued, the lower return on equity generated, which means less efficiency with shareholders investments in Islamic banks.

Table 2: Fixed Effects-Islamic

Variable Coefficient t-Statistic Prob.

C -171.1521 -1.822162 0.0732TA? 5.560271 -0.814547 0.4184

TETA? -7.152085 -4.273844 0.0001DETA? 1.811725 2.610144 0.0113NLTA? 2.261939 3.717697 0.0004NIIAA? 16.50397 7.420588 0.0000EQLO? 0.396215 3.882128 0.0003

Table 3: Random Effect-Conventional

Variable Coefficient t-Statistic Prob.

C 64.55711 3.187807 0.0020TA? -3.105348 -2.808859 0.0062

TETA? 0.108257 -0.257072 0.7978DETA? -0.070095 -0.537335 0.0025EQLO? 0.036269 -1.687351 0.0854

NLTA? -0.063997 -0.454570 0.6506

NIIAA? -3.455793 -2.971913 0.0039

This may also be because the amount of capital affects the rate of return to the bank equity holders. There is a trade-off between the return to the owners and the safety of the bank. Given the return on assets the smaller the bank capital, the higher the rate of return to the owners of the bank, therefore the owners of the bank have a natural tendency to keep lower capital/asset ratios. This may further explain why Islamic banking market is fragmented, however caution must be observed as the lower capital/asset ratios increase the risk of bank failures in I.Bs. Ang, Elaine, (2009). It is for this reason that regulatory agencies prescribe certain minimum capital/asset ratios.

This again indirectly fosters the need for a much more cohesive network of institutions linking the basis of a mega bank.The conventional side though the


coefficient was insignificant even at 10% was opposite and showed a positive effect and the explanation could be the other way round. However, the good old theory that well-capitalized banks remain profitable; or the view that well-capitalized banks enjoy access to cheaper (less risky) sources of funds with subsequent improvement in profit rates (see Bourke, (1989) may remain intact in C.Bs case.

DETA is not only significant but also shows a positive relation with ROE for Islamic banks revealing that it has a right impact on profitability. Deposits are a major source of funds for a bank. A higher percentage of Deposits usually means more customers, more non-interest income and a bigger pool to which loans or financing may be made. Institutions that fund their assets primarily (70-80%) Pearls, (2010) with member-client deposits are independent from the fluctuating price of external funds. DETA in case of conventional though significant but shows a negative relation with profitability, which again shows a superiority of Islamic banks in terms of generating and managing deposits, perhaps the recent financial crisis maybe one reason for it, swaying clients to Islamic versions.

The coefficients for NLTA, NIIAA and EQLO were all found to be positive and significant for the Islamic group but NLTA showed contrary results for their counterparts and was found insignificant even at 10%. Based on NLTA comparison Islamic banks seem to have a much effective financial structure. They maintain most (70-80%) of their total assets in the sale based or credit nature contracts portfolio which also means they have the greatest opportunity to maximize returns on these productive assets while providing their member-clients with the credit services Pearls, (2010). Perhaps this may also have more to do with excess liquidity in I.Bs than effective capital structure, implying that they do not have enough investment opportunities.

In order to prove this hypothesis, we need, first to determine what “excess liquidity” means. As mentioned earlier, unlike other firms, banks are legally required by the regulating agencies to keep a minimum amount of liquidity Ahmad, Ausaf (1987). These are known as 'legal reserve requirements'. The ratio of legal reserves varies from country to country. In the case of countries from where our sample is drawn, this ratio on average is around 10 percent of deposits. In addition, it is customary that all banks keep some liquid assets as 'prudent reserves'. Therefore, for the purposes of this study we can set the desired liquidity ratio at 12-15 percent depending upon the ratio of current deposits to total deposits. Within this range, the higher the ratio of current deposits to total deposits for a bank, the higher the desired liquidity ratio.

The industry average for Islamic banking during 2005-09 works out to be 17.6percent Bankers, (2010). That seems to lend some support to the excess liquidity hypothesis. Moreover, we also need to consider the fact that in the case of Islamic banks the possibilities of borrowing from the central bank in case of need are either not available or not desirable due to involvement of interest; it is prudent for them to remain relatively more liquid, El Said A., and Ziemba R., (2009).

The NIIAA or non-interest income to average assets, measures income realized from service fees, trading and other income, excluding gains/losses on securities


transactions FSA, (2009).The Non-Interest Income ratio measures the utilization of assets based on the Non-Interest Income revenue that they generate. Once again Islamic bank shows better performance as it has the maximum positive coefficient with significance at 1%. This is rightly so since bulk of the earnings of Islamic banks come from non-interest activities. The same variable though also shows significance at 1% has a negative bearing on profitability for the C.Bs.

EQLO ratio forms part of the Capital and Funding ratios of a bank, and measures a company's financial leverage by calculating the proportion of equity and debt the company is using to finance its assets. Once again I.Bs outperform C.Bs since the variable has a positive and significant impact on profitability. Again this may have less to do with higher leverage benefits but more to do with the smaller bank capital in the Islamic case making which eventually make them more risky. The impact of EQLO is not as positive to C.Bs profitability as in the I.Bs scenario with significance at 10%; this again may be due to the recent global credit crunch.

All in all it is clear from the above findings and analyses that I.Bs have shown better profitability and hence performance than their peers and have proved more resilient even in times of stress. The fixed effects model results above show that most of the variables showed a positive relation with profitability in Islamic banks andwhat it means is that the combination of all these variables, most of which were found significant other than the total assets, showed terrific effects on the ROE/ profitability of the banks. The shifts in the overall constant by taking into effect the individual constants of each bank have shown more upward movements than downward. The Islamic banks from the Gulf region have really shown some quantum shifts, evidencing as best performers in the sample. It may also be safe to say that the overall better profitability and performance of Islamic banks may owe a lot to these banks.

South Asian banks (Pakistan, Iran and Bangladesh) have shown an even performance. Same can be said about MENA (Jordan & Sudan) and Malaysia while the Islamic bank of Britain has really languished along as the intercept has descended further down.

The meager story in the C.Bs case is nothing to write much about. The Random Model results prove that the combination of all the significant variables, which are found to be three out of six, does not have an ideal bearing on the overall profitability of the banks. There have been half upward and half downward shifts in the value of the overall constant, depicting weak efficiency and hence lower profitability in the span of 2005-09. Most of the upward shifts came from South Asia and Europe (Britain). The weakest was the Jordan commercial bank whereas the best was HSBC Malaysia. The conventional banks from Gulf region had a mixed case. Banks from MENA were found below par.

6 From reasons to reality:

It is fulfilling to see that the above results manifest explicitly that Islamic banks proved to be more profitable and better performers than their conventional peers in the span of 2005-09. However, this where it all actually starts; now comes the real challenge: the challenge for institutions offering sharia-compliant services to sustain


this growth trend. Perhaps a reality check may give us some indication, and the reality is, that though IFIs are booming and out-performing conventional finance; it is still just a mere 1% of its counterparts despite being a $1trillion industry and the market is fragmented into mostly small players.

Size is something that really does matter a lot. These banks with an average capitalization of roughly $2million, IFSB-IRTI, (2010) are finding it harder and harder to compete with not only the ever pervasive conventional industry, but also with the Islamic divisions of larger conventional banks on mandates to syndicate loans, arrange Islamic bonds and undertake project finances. The lack of a lender of last resort is seen as one greatest weakness, as few central banks issue liquidity instruments compliant with Islamic law, forcing Islamic banks to place their liquidity with large conventional banks IFSB-IRTI, (2010).The above and the caveats pointed out earlier in the Introduction may make one to feel and perceive this as a comparison between apples and oranges and that the elating results shown above may not hold for long. Therefore perhaps the biggest questions facing the Islamic finance industry are: can the ever-increasing rate of growth be sustained? And will all sharia-compliant institutions be viable?

Unlike the complex nature of Islamic finance,we believe the answer to these questions is not as complex at all. The path to long-term viability and sustainability will come from increased inter-operation between sharia-compliant financial institutions throughout the world. To sustain the overall growth in the Islamic finance market in the long-term, regional co-dependency between national economies will increase the ability for regional businesses to conduct activities across borders, with a minimum of encumbrances. Central banks and political figures in various Islamic regions will need to achieve increasing levels of regulatory collaboration, which will be the key to regional competitiveness Chapra, M. U., (2008).

Creating a level playing field for Islamic finance is the key to sustainable growth whereby economic activity of nations with a dominant Muslim populations must seamlessly interact on par with the economic engines of the US, Europe and China. Facilitating the next level of growth in the industry will require Islamic nations to begin trans-national economic and monetary collaboration on a scale without precedent. This is where the answers come from. The answer is simple yet as big as the idea itself that is to have a ‘Mega Islamic Bank’.

It is this mega Islamic bank that may make these immiscible conditions turn into an ideal miscible solution. The idea of an Islamic mega bank has been going around for years, mostly as a sort of Middle Eastern fantasy that had very little in common with reality. People would talk wistfully about Islamic mega banks as they would about world peace. It sounds like a good idea, revolutionary even, but has not been given any practical attention, so if there was any time for this to happen, now is the time, but then comes the question how viable is it going to be and who will take the lead? This is where our Dynamic heterogeneous Panel techniques will help address this matter.

These advanced techniques will be based on PMG and MG modeling as decided by the good old Hussman test. The test proved the PMG as the right model


for this analysis. (Summary statistics of the results are presented in appendix-I).These results would be a value addition on the previous ones as they will go deeper by taking into consideration long-term scenarios and giving us more in-depth information to facilitate our views.

Since the idea is as big as its perceived impact, we squeeze the sample to a total of 6, this time to only those banks that are big enough and impactful enough to be tested on these bases. Fortunately from our Fixed and Random effects results above we were able to have at least one better performing bank from each region in the case of Islamic group enabling us again to take a holistic view from all over the world. Our results above proved that Islamic banks from the Gulf region had a huge role to play in making the overall profitability/performance results of I.Bs surpass those of C.Bs, therefore at least half of the samples here would contain I.Bs from Gulf i.e. Al Rajhi form Saudi Arabia, Shamil Bank from Bahrain and KFH, Kuwait.

The other banks would be Meezan representing South Asia, Jordan Islamic Bank from MENA and CIMB Islamic from Malaysia. Unfortunately nothing from Europe in the sample as the Islamic Bank of Britain could not be considered due to its relatively below par performance. The Variables here, as explained in the section of data and methodology, will be the Total Assets(TA) and Deposits to Total Assets(DETA). The dependent variable would be again the ROE.The analyses based on the above econometric methodology would be focused on to see the short term adjustment to long-term equilibrium of the TA and DETA with ROE/Profitability. This would give us a strong and much deeper indication of how size and even sizeable funding can play a huge role in both long term and short term progress of a bank and hence the industry as a whole.(All this would propel further in a big way the need for and advantages of having a Mega Islamic bank).

The adjustment would be interpreted by looking at the ‘Error Correction Term’ or ECT coefficient and the significance of it. The null for this would be that the ‘ECT is zero’ meaning to say that there would be no adjustment or no short termadjustment back to long-term equilibrium.4 In other words since there is a long runequilibrium relation between the total assets (TA) and Deposits to total equity (DETA) with ROE/profitability, any short run deviations from the equilibrium,will be adjusted back to equilibrium in the long run due to the impact of the long run relationship of TA and DETA with ROE and we would reject the null.

Below is the PMG output for ROE and total assets (TA). The coefficient of ECT tells us as to how long it will take for the adjustment to complete and the signs of it will point to an upward or downward movement towards the equilibrium.

4 In finance terms we can also say that in case we accept that the null of ECT is zero then it

means there is no deviation and it requires no adjustment hence no room for arbitrage.


Table 4: PMG DETAIL Total AssetPanel variable (1) : 1 dcode Number of obs = 24Time variable (t) : years Number of groups = 6

obs per group : min = 4avg = 4.0max = 4Log Likeihood = 1.724847

D.roe Coeff. Std. Err. z P>| z | [95% Conf. Interval]

Ectta 4.37345 7.79e07 5.6e+06 0.000 4.373449 4.373452

1dcode-1

ECT .2713096 .1845359 1.47 0.142 .6329934 .0903742

Tp

D1. 17.46749 22.0932 0.79 0.429 60.76936 25.83439

_cons 5.839809 4.06145 1.44 0.150 13.8001 2.120487

1dcode-2

ECT 3.849606 .3339471 11.53 0.000 3.195081 4.50413

Tp

D1. 172.0533 13.42553 12.82 0.000 198.3669 145.7398

_cons 100.5014 8.68746 11.57 0.000 83.47428 117.5285

idcode_3

ECT .3338862 .7564222 0.44 0.659 1.816446 1.148674

Tp

D1. 2.7768194 6.894069 0.40 0.088 10.74393 16.28032

_cons 11.56643 6.155065 1.88 0.060 23.63013 .4972784

idcode_4

ECT .293336 1.033299 0.28 0.777 1.731893 2.318565

ta

D1. 34.4369 53.31325 0.65 0.518 70.05515 138.929

_cons 2.743975 55.44368 0.05 0.961 111.4116 105.9236

1dcode_5

ECT 2.138903 .4228627 5.06 0.000 2.967698 1.310107

ta

D1. 32.5465 27.49393 1.18 0.237 21.34062 86.43362

_cons 35.44959 8.052801 4.40 0.000 51.23279 19.66639

1dcode_6

ECT 1.412559 1.63e07 8.7e+06 0.000 1.412559 1.412558

ta

D1. 7.548391 1.55e06 4.9e+06 0.000 7.548394 7.548388

_cons 33.77276 .0000126 2.7e+06 0.000 33.77279 33.77274


We observe clearly from the above findings that out of the total of six banks, there are half cases where the null is rejected and what it means is that there are three instances where the adjustment back to the equilibrium has taken place and the impact of the long-term relation of TA to ROE has had bearing on any short run deviations in banks profitability as ECT coefficient was found significant at 1%.Looking at the coefficients of ECTs, astoundingly the speed adjustment to complete is exceedingly fast in at least two of the three banks (if the ECT coefficient is 1 or closer to it, it points to a swift adjustment back to equilibrium condition) which further proves the strong long-term equilibrium relation of TA to profitability.

Two out of the three were downward adjustments. Least surprisingly, the banks which evidence such results are the banks which are big in size and two of the three are Middle Eastern banks i.e. AlRajhi, KFH and the other is CIMB Islamic from Malaysia. The rest of the three banks fail to capture any impact of short term adjustment due to the long-term equilibrium relation and any fluctuation will be adamant- Perhaps some other bearings may bring the required short term adjustment in deviations in profitability but not TA.However, it is important to see that the overall combined effect of this long-term TA and ROE relation for all 6 Islamic banks is facilitating adjustment to the overall short term fluctuations in profitability. The above analyses clearly substantiate again that size does matter which is the backbone for our notion of an Islamic mega bank.

The effect of long run equilibrium relation of DETA and Profitability show even more interesting results and here we see 100 percent cases where there has been an adjustment in the short run deviations in the profitability due to the impact of this long run relation. All the banks show significant ECT coefficient at 1% by looking atthe p-values. The period of adjustments was found to be reasonably swift and small in most cases by looking at the coefficients and bulk were downward movements back to equilibrium. This fast pace of adjustments in fluctuations in profitability by the DETA relation impact, reveals the importance of DETA hence the size of fundingto profitability like never before. Studies (Al-Kassim, 2005 &Iqbal, 2003) show that the total deposits during the mid-90 grew at an annual rate of 8.8 percent. This rate declined to 5.7 percent during early 2000.

Table 5: PMG Detail DepositPooled Mean Group Regression(Estimate results Saved as PMG)Panel variable (1) : 1dcode Number of obs = 24time variable (t) : years Number of groups = 6



ECTdeta 1.121051 3.08e07 3.6e+06 0.000 1.121051 1.12105

1dcode_1

ECT .3388115 .0390122 8.68 0.000 .4152739 .262349


deta

D1.1.614115 .1686738 9.57 0.000 1.944709 1.28352

_cons 32.48019 4.6191091 7.03 0.000 23.4269 41.53348

1dcode_2

ECT .3753361 .0813014 4.62 0.000 .2159882 .534684

deta

D1..2554921 .0669109 3.82 0.000 .1243491 .3866351

_cons 27.41344 5.585783 4.81 0.000 38.36138 16.46551

1dcode_3

ECT 1.99641 .0995379 20.06 0.000 2.1911501 1.801319

deta

D1.1.7-6367 .2225354 7.67 0.000 1.270205 2.142528

_cons 202.3973 10.11326 20.01 0.000 182.5757 222.219

1dcode_4

ECT -6.165225 -4667952 -13.21 0.000 -7.080126 -5.250323

deta

D1.-3.136823 -2952499 -10.62 0.000 -3.715502 -2.558144

_cons 444.0518 34.60353 12.83 0.000 376.2301 511.8735

1dcode_5

ECT -1.215164 -4719487 -2.57 0.010 -2.140167 -.2901616

deta

D1. -5591628 1.977888 0.52 0.604 -1.553459 2.671784

_cons 140.1451 54.63003 2.57 0.010 33.07221 2.7.218

1dcode_6

ECT -.4377146 4.49e-08 -9.7e+06 0.000 -.4377147 -.4377145

deta

D1. .2205799 4.19e-08 5.3e+06 0.000 .2205798 -22058

_cons 42.88884 6.59e-06 6.5e+05 0.000 42.88883 42.88885

Other studies Iqbal, (2008) have shown that deposits of Islamic banks are growing at least 10-11 percent lately. There are reasons for this and one fundamental reason could be that during the late 80s and early 90s there were a lot of immobilized funds due to the fact that many Muslim clients do not want to involve in any interest dealings. In the absence of a viable alternative, they were keeping their savings in private lockers and likes.

With the advent of Islamic banking in the late seventies, these people started dealing with these banks. A higher percentage of Deposits usually means more customers, more non-interest income and a bigger pool to which loans may be made. Institutions that fund their assets primarily (70-80%) Pearls, (2010) with member-client deposits are independent from the fluctuating price of external funds and hence profits as mentioned earlier. It may also be because the nature of Islamic banks


business is such where depositors are co-investors who share in the risks that they take on. In practice, like U.S. money-market funds, they strain every sinew to ensure they don’t “break the buck”, or give customers back less than they deposited. Thisfurther legitimates our finding of this long-run equilibrium relation and its adjustment impact. Having said all, an increasing number of conventional banks started offering Islamic products.

These banks offered a new kind of competition to existing Islamic banks hitherto unknown. Many of these Western multinational banks brought with them their marketing expertise, international connections, superior technology and better customer relations. Therefore, some of the deposits are now diverted to these banks. Due to the absence of any definite information, the extent of such diversion cannot be estimated though some indication can be obtained by comparing the growth rates of deposits of such banks with those of Islamic banks. This fragmented growth of Islamic deposit can cause further fragmented but not an integrated and a holistic growth. Again this provides a huge boost to our idea of a mega Islamic bank from the DETA angle because one of biggest achievements by the advent of a Mega Islamic Bank could be, is to bring this huge amount into the formal sector particularly from the HNWI or high net worth individuals.

7 Conclusion:

The growth of Islamic finance is nothing less than magnificent and it is outpacing almost every other business segment of the global banking system. The past five years have seen exponential growth of the business, as has been proven by our study. Just to elaborate further, in Saudi Arabia, at least 95% of all retail banking transactions are now done through Islamic banking institutions; Bankers, (2009).Other markets with a vast potential, such as Malaysia, Bahrain and even Indonesia, are moving dynamically through a development stage. The Malaysian and East Asian markets show a great deal of promise, as they tend to be highly sophisticated with a more developed infrastructure than the Middle East and a more liberal Shariah interpretation.

All in all the future seems full of glory but only if the challenges that have been pointed out in the study are to be addressed relatively quickly. Moving forward, three key areas of priority warrant greater policy attention to further strengthen and enhance the entire Islamic finance eco system:

Strengthening the infrastructural building blocks of the Islamic financial services industry to further enhance the industry’s resilience;

Accelerating the effective implementation of Shariah and prudential standards and rules to facilitate the creation of a more stable, efficient and internationally integrated Islamic financial services industry; Convergence of Shariah; and

Creating a common platform for the regulators of the Islamic financial services industry to enhance constructive dialogue.

The Industry has been talking up an Islamic mega bank for a few years from Sh. Saleh Kamal to Malaysia, but in an Islamic financial industry that is without a


lender of last resort and sporadic Islamic deposits insurance, the viability of this idea needed to be examined before adopting the proposed mega bank. Our study has both qualitatively and quantitatively tried to provide the decision makers, enough food for thought for this idea to be turned into from reasons to reality. The need and viability of this project could be further elaborated by taking into consideration the recent happenings across the wider financial spectrum. The price of oil more than doubled as war and surging Asian economies, notably those of China and India, created unprecedented demand and the countries that produced oil started seeing their budgets ballooning as the revenues kept coming in.

Mohammed Amin from PricewaterhouseCoopers put it in perspective when he said that "the reason why many conventional banks are very big is that you get economies of scale,but the theory is that as you get bigger, you are able to have lower costs of processing, in fact you are able to share information across countries, so that explains the rationale as to why many, many conventional banks have chosen to get big by a combination of expansion and acquisition. That same logic should apply to Islamic banking. So an Islamic mega bank could be the way to go”.

The talk of expansion or consolidation has been on everybody's lips for quite some time and it goes without saying that if the idea of an Islamic mega bank that could compete with the world's largest conventional banks was ever to be realized then now is the time. Competing with the world's largest conventional banks is not going to be easy, especially when you look at the hard facts. Tayyebi, Aziz, (2009).HSBC alone has total assets of around $2.42 trillion and it is 5th in the list of the biggest conventional banks5. In comparison, there were only one or two Islamic institutions that have upto about $2bn capital, while others had it in millions.The creation of a mega Islamic bank would not only have a larger capital base to finance large projects, but also offer competitive funds.

When we talk about mega projects (whose expenditure runs into billions of dollars), you can’t play that game with the existing capital base. You can do it with Gulf banks but doing it with Islamic banks is different and is challenging (due to lower capital base). The Gulf region has outlined more than $1tn capital expenditure and Qatar alone has more $130bn worth projects in both oil and non-oil sectors. If the sponsor did not have faith-based requirements to have some Islamic financing at least, then the conventional banks would win every time since funds from them were always cheaper. A majority of Islamic tranches were provided by conventional banks and that a majority of recent sukuk investors have been conventional institutions, while Islamic bank participation has been relatively small. Hasan Zubair, (2010).So in terms of capital size, it is hoped that Islamic mega bank will have at least $5-10bn capital. It is elating to observe that such signs are already beginning to be more apparent, but now comes in the question as to who will take the lead? And who

5 BNP Paribas leads the tally with an asset size of $3.21 trillion, followed by Royal

Bank of Scotland with $2.99 trillion. Barclay PLC and Deutsche Bank are at 3rd and 4th

in terms of size with $2.54 trillion and $2.43trillion respectively. The Wall Street Journal. 20th NOVEMBER, 2010 [http://online.wsj.com]


should take or be given the initiative. Luckily we have such candidates that can be considered as we will analyze below.

Saudi Arabia and Kuwait

Saudi Arabia, with 25 per cent of the world's oil reserves making up between 90 to 95 per cent of the country's revenues, and a population of around 27 million that has nearly tripled since 1980, is where a lot of attention was focused. The banks there started to capitalize on the oil boom, much as their neighbors had done around the Gulf and slowly the now plausible idea of an Islamic mega bank began to emerge. Saudi banks are easily amongst the most profitable in the GCC and from there came Al Rajhi bank. All Saudi banks are Islamic and Al Rajhi, with more than 500 branches across the kingdom is easily the biggest Islamic bank in the world. Its return on assets was 3.5 per cent and its return on equity was in excess of 26 per cent.

Kuwait had also been busy making the most of the windfall from yet another petrodollar driven boom and it was from there that Kuwait Finance House (KFH) materialized. KFH, which is the third oldest Islamic bank in the world, is that rare thing in Islamic banking. It has cleverly managed to second guess all the major market movements over the years and has an uncanny knack of being able to position itself where the consumer is at his most willing. KFH also recognized the impact of non-branch distribution of services, both in terms of customer service and reduced costs and the bank has become a leader in exploiting technology to serve business needs.

If one looks at conventional banks and global banks, one realizes that there is a difference in scale. We have been criticizing Islamic banks for being so fragmented in the sense of a limited scale and concentration of risk. The steps that we are seeing from the likes of Kuwait Finance House, Al Rajhi and Al Baraka, who are what might be considered large players, are quite positive in a sense that, on one hand they are diversifying their presence with an interest in gaining a foothold in the Asian markets where Islamic banking demand is high and they will have good opportunities to grow there. On the other hand they are putting more capital behind their institutions and as a consequence this is increasing the prospects of their becoming major regional players."

Al Rajhi Bank decided to make its presence felt when it decided to embark on an ambitious expansion programme and open 50 branches in Malaysia but Al Rajhi Bank officials were coy when they were asked what kind of retail and corporate products they planned to offer, although word started leaking out that they planned to offer products like car and real-estate financing as well as mutual funds. Al Rajhi is one of three foreign Islamic banks in Malaysia, which also includes KFH and HSBC Amanah.

Malaysia, Indonesia and China

There is a common perception that being established in Malaysia is all about clever positioning for greater things further down the road in South East Asia, especially in Indonesia; and Malaysia has been described as a good foundation for those with ambitions for moving into Indonesia. Malaysia has long been at the


forefront when it comes to the issuance of Sukuk, but it has sold many of them using the bitaminajil rule of deferred payment which some say effectively makes it a form of debt payment. However, a scarcity of capital will determine where they make their move. These cross border moves by Islamic banks will also highlight the need to come up with a uniform industry regulation. That is the other dimension to Islamic banking. There is not a lot of uniformity, so as you see banks hopping from country to country, it should become much more relevant for the Islamic banking community to solve.

China, which is well on its way to becoming the next superpower, could be where the contest is decided. If an Islamic bank is successful there, then that could be where the definition of what constitutes an Islamic mega bank is finally decided. Chinese government officials were recently in Jeddah, urging Saudi bankers to open branches there. "Chinese banks are willing to open branches here and we also invite Saudi banks to open branches in our country," Dr. Hu Wei former Chinese ambassador to Riyadh said. China has 23 million Muslims, mostly concentrated in the North-western province of Xingjian. Indonesia, another country that is also a natural next-step has a population of 250 million, most of them Muslims.

So while it is probably safe to say that the dream of an Islamic mega bank is now a little closer, much remains to be done. Whether one of these banks can ever hope to compete with the likes of Barclays or HSBC is probably a discussion for well into the future, but for now the next and more interesting step will be, from Malaysia to where? A mega Islamic bank - could be created by merging three or four large institutions, but the merger was possible only if the GCC and the other interested governments took it seriously.

Delightfully, this much desired seriousness is now surfacing. A long-touted Islamic mega bank has received approval from Bahrain and a preliminary green light from Malaysia to begin operations, and as was hinted earlier, Bank Negara Malaysia (BNM) expects the two entities given the provisional licenses to set up Islamic mega banks in the country to announce their investment plans this year. "We are giving them more time (to make the announcement) given the environment is more challenging," said its governor, Tan Sri Dr. Zeti Akhtar Aziz, adding that the investments would be huge. "As soon as they have made their final submissions that include business plans, their senior management and board members and the details surrounding their applications, then the announcement will be made,”6

On the other hand, the plan to form the world’s largest sharia-compliant lender is being promoted by the chairman of Al Baraka Banking Group Sheikh Saleh Abdulla Kamel said. “The key shareholders, I would say, are on board and we are looking for an imminent launch, within six months to a year,” Sameer Abdi, Head of Islamic Finance at Ernst & Young, told the Reuters Islamic Banking and Finance Summit in Bahrain.

Needless to say that such a bank alongside providing platform to resolve all the earlier discussed future challenges and caveats, must be structured in such a way that: 6 http://www.btimes.com.my/articles/ 3rd Feb 2011.


It is managed independently of the other state financial institutions.

It invests in a diverse array of financial asset classes in pursuit of commercial returns.

It has made significant proportions of its publically-reported investments internationally.

The ownership of such a bank should be an OIC member. Unilateral, bilateral or multilateral would not matter much.

Funding options could also include funding via commodities, trade surplus et cetera.

Since the objective has been both commercially oriented and long term passive investor, the mandate of the fund would be future generations, rainy day, Islamic lender of the last resort are among the much dire.

Finally, will this mega bank have an OIC or G-20 like impact? This is something that can only be answered in the post and not the pre phase of the creation of this much hyped institute. Megabank skeptics like to point out that ambitious, egotistical chief executives are unlikely to want to hand over power and take a lower position. Some Middle Eastern Islamic banks are owned by prominent families who may be unwilling to see their creation disappear into the arms of a more powerful neighbor. Regional and local rivalries are common. Arcane laws which impose limits on foreign ownership in Asia may trip up the unwary, not only this they indicated that big size does not necessarily guarantee lasting success, naming a number of global giant banks that once flourished but now do not exist or are struggling to survive.

If you look at history, the largest banks in the world changed a lot. In 1945, it was the Midland Bank from Britain. In the late 1970s, it was the Bank of America (BOA). Now Midland Bank no longer exists, while BOA has had its ups and downs (but is now quite strong again). So these increasing mergers and consolidations in to mega institutes often play spoils, but our answer to them is that looking at history again there have been countless banking and financial crises, but has the world stopped banking, on a different note, there has been an increase in divorce rates also with time but has the world stopped getting married? So rather than cursing the past and lamenting on it, it is better to go along with the tide and the above study has tried to show the direction of this tide. We do not write off the fears that are on the minds of some but our position is simple. It is not the institute but the running of it is what actually matters. One must also keep in mind that since this is an Islamic version of a mega bank, at the end of the day faith would really be the driver.

Islamic finance alongside all the Shariah rooted financing stipulations is based on risk sharing and not excessive risk taking which proved to be a doomsday recipe for many others. Therefore it would be expected that it offers a silver bullet solution by always considering the past mistakes of others and would learn to do what not to do, thereby increasing the chances of its much anticipated success while justifyingthe need, viability and the advantages of having such a bank, all of which we have rigorously proved in our study. Now it is just about transformation, and all it needs isa strong political will among the Muslims nations, since it is this very‘will’ (though often found missing) that has been, is, and will always be at the heart of real progress.


WA ALLAH A’LAM

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MugheesShaukat, (2010),“ The General preception of Fatwa and its role in Islamic Finance” . Published in the Global Islamic Finance Magazine- United Kingdom June-July 2010 issue- Also available at http://instituteofhalalinvesting.orgArticles/Mughees-Shaukat.html

MugheesShaukat, (2010), “A Model to gauge the performance of Islamic banks in Compliance to Maqasid Al-Shariah”. The Global Islamic Finance Magazine U.K. March 2010.

Tayyebi, Aziz (2009), “Eclipse by the Crescent Moon: Islamic Finance provides some light in the Global Financial Crisis”, Financial Services Review, ACCA Global, June.


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http://www.freepatentsonline.com/article/Journal-International-Business-Economics/178900124.html


Appendix-ITable 6: Hausman Output for Islamic

Correlated Random Effects - Hausman TestPool: PANELTest cross-section random effects

Test SummaryChi-Sq. Statistic Chi-Sq. d.f. Prob.

Cross-section random 36.087158 6 0.0000

Table 7: Individual Constants for Islamic banks

Fixed Effects (Cross)

1—C 43.588052—C 17.188213—C 136.18394—C 52.966545—C -27.983256—C -8.5298127—C -92.813068—C 92.642079—C -95.1004710—C -134.157011—C -9.72041212—C 26.3071713—C 35.0396414—C 28.2858615—C -32.7476016—C -42.1451517—C -4.73883218—C -5.600311

Table 8: Hausman Output for Conventional

Correlated Random Effects - Hausman TestPool: PANELTest cross-section random effects

Test SummaryChi-Sq. Statistic Chi-Sq. d.f. Prob.

Cross-section random 11.225283 6 0.0817


Table 9: Individual Constants for Conventional Banks

Random Effects (Cross)

1—C 4.989700

2—C -5.727562

3—C -5.214588

4—C 4.490645

5—C -0.786928

6—C -5.590514

7—C 7.480637

8—C 9.712122

9—C 0.606638

10—C 6.772763

11—C -7.007636

12—C -0.140447

13—C 1.110114

14—C 8.297039

15—C -4.450077

16—C -7.580341

17—C -7.894565

18—C 0.933000

Table 10: PMG TA

Table 10: PMG TAPooled Mean Group Regression(Estimate results Saved as pmg)

panel variable (1) : idcode Number of obs = 24time variable (t) : years Number of groups = 6


D.roe Coeff. Std. Err. z P>| z | [95% Conf. Interval]ECT

ta 4.37345 7.79e07 5.6r+06 0.000 4.33449 4.373452SR

ECt .002286 .8497214 0.00 0.998 1.667709 1.663137ta

D1. 21.2196 31.36646 0.68 0.499 82.69673 40.25753_Cons 1.854805 20.53661 0.09 0.928 38.39622 42.10583


Table 11: MG TA

Mean Group Estimation: Error correction Form(Estimate results saved as mg)

D.roe Coeff. Err. z P>| z | [95% Conf. Interval]ECT

ta 13.46575 7.753665 1.74 0.082 28.66266 1.731149SR

ECT 5.439941 4.0880884 1.33 0.183 13.45244 2.572555ta

D1. 11.05897 59.08459 0.19 0.852 126.8626 104.7447

Table 12:HAUSMAN TA

Coefficients (b) (B) (b – B) sqrt (diag (V_b_v_B))1 mg pmg Differece 5.E.

ta 13.46575 4.37345 17.83921 2.65e+15

b = consistent under Ho and Ha:obtained from xtpmg B = inconsistent under Ha, efficient under Ho; obtained from xtpmg

Test: Ho: diffrence in coefficients not systematic

chi 2(1) = (b – B) [ (V_b V_B) (1) ] (b B) = 0.00 Prob>chi2 = 1.0000

Table 13: PMG DETAPooled Mean Group Regression(Estimate results Saved as pmg)

panel variable (1) : idcode Number of obs = 24time variable (t) : years Number of groups = 6



ECT

deta 1.121051 3.08e07 3.6e+06 0.000 1.121051 1.12105

SR

ECT 1.629665 .9658276 1.69 0.092 3.522652 .2633227

deta

D1. .3388894 .7097042 0.47 0.637 1.725884 1.056105

_cons 139.0916 69.60707 2.00 0.046 2.664281 275.519


Table 14:MG DETA

Mean Group Estimation: Error Correction Form(Estimate results saved as mg)


ECT

deta 2.075022 2.298818 0.90 0.366 6.576703 2.42666

SR

ECT 2.421484 1.094097 2.21 0.027 4.565875 .2770928detaD1. 1.493249 1.265988 1.18 0.238 3.97454 .9880425

_cons 18.41887 176.4554 0.10 0.917 327.4273 364.2651

Table 15:HAUSMAN DETA

Coefficients (b) (B) (b – B) sqrt (diag (V_b_v_B)) mg pmg Differece 5.E.

deta 2.075022 1.121051 .9539707 8.79e+13

b = consistent under Ho and Ha:obtained from xtpmg B = inconsistent under Ha, efficient under Ho; obtained from xtpmg

Test: Ho: diffrence in coefficients not systematic

chi (1) = (b – B)` [ (V_b V_B) (1) ] (b B) = 0.00Prob>chi2 = 1.0000


Appendix-II

Chart 1: Muslim population, Islamic assets, revenues and profit pool breakdown by region, 2008 and Chart 2: shows Changes in market capitalization, net profit, assets and equity - pre and post crisis

Chart 2

Source: IFSB-IRTI, 2010.Source: Hasan&Dirdi, 2010


Chart 3: Market capitalization of top 10 conventional and Islamic banks – pre & post crisis.


Chart 4:Total assets of top 10 conventional and Islamic banks – pre & post crisis.


Chart 5: Total assets of top 10 conventional and Islamic banks – pre & post crisis.


Chart 6:Leverage ratios (Assets/Equity) of top 10 conventional and Islamic banks – pre & post crisis.

Sources:•IFSB-IRTI, (2010), Company annual reports and websites; financial database websites (Thomson Reuters etc.)• The Banker, November 2008 report on top 500 Islamic financial institutions• Ernst & Young AnalysisNote:• All financial figures have been converted to USD on current exchange rates.• The 2008 numbers for Investment Dar are for 9 months – up to 30 September 2008.• As of 1 April 2009, the Kuwait Stock Exchange suspended trading in Investment Dar’s shares until further notice as a result of the postponement of the release of its full year financial results for the year ended 31 December 2008.• The list of top 10 Islamic banks in terms of 2006 market cap does not include some large Iranian banks which claim to be Shari’ah compliant but their market data is not easily available.


Chart 7

Source: Standard & Poor’s, McKinsey Company, Euromoney, country wise central banks &Blominvest.

Chart 8

Source: IMF, Country wise Central Banks, country wise central banks &Blominvest(Saudi Arabia’s core Islamic banks accounts for 15% of total Banking assets).BHN: Bahrain, KWT: Kuwait, QTR: Qatar, OMN: Oman, SAR: Saudi Arabia,UAE: United Arab Emirates, EGT: Egypt, JRD: Jordan, LBN: Lebanon, MYA:Malaysia, INA: Indonesia, PKT: Pakistan and TKY: Turkey.


Table 12: Size of the Islamic financial services industry – 2010

(in USD billions)

Country 2007 2008 2009 2010

Iran 235 293 369 406

S.Arabia 92 128 161 177

Malaysia 67 87 109 120

UAE 49 84 106 116

Kuwait 63 68 85 94

Bahrin 37 46 58 64

Qatar 21 28 35 38

UK 18 19 24 27

Turkey 16 18 22 25

Bangladesh 6 8 9 10

Sudan 5 7 9 10

Egypt 6 6 8 9

Pakistan 6 5 6 7

Jordan 3 5 6 6

Syria 1 4 5 5

Iraq --- 4 5 5

Indonesia 3 3 4 5

Brunei 3 3 4 4

Other countries 7 7 9 10

Total 639 822 1.036 1.139 Source: Global islamic Finance Report (2011)

Appendix-III

PMG & MG

PMG and MG (dynamic and heteroscedasticity)

PMG holds only the first assumption of long-run regression slope coefficient, the rest of them are allowed to vary. Whereas, MG allows all assumptions can vary, in other words, this estimator does not hold any assumptions.

ROEit =μi + β1i TAit + εit………..(1)ROEit =μi + β1i DETAit + εit………..(2)

where all coefficients are allowed to vary across cross-sectional units. Consider now dynamic autoregressive distributed lag (ARDL (1,1,1)) model for basic equation.If the variables are I(1) and co-integrated, then the error term is I(0) for all i. A principal feature of co-integrated variables is their responsiveness to any deviation


from long-run equilibrium. This feature implies an error correction model in which the short-run dynamics of the variables in the system are influenced by the deviation from equilibrium. Thus it is common to re-parameterize equation (1) into the error correction equation, by modifying equation (1) such that:

θ1i andθ2iare the long-run coefficients of TAit andDETAitfor the ith cross-sectional unit. Then, we can rewrite the equation (1) as:

∆ROEit= – ( 1 – λi ) (ROEi,t-1 – θ0i – θ1i TAit) + β11i ∆TAit+ εit

∆ROEit= – ( 1 – λi ) (ROEi,t-1 – θ0i – θ1i DETAit) + β11i ∆DETAit+ εit

Then we substitute – ( 1 – λi ) with Φi:∆ROEit = Φi (ROEi,t-1 – θ0i – θ1i TAit) + β11i ∆TAit+ εit …..(3)

∆ROEit = Φi (ROEi,t-1 – θ0i – θ1i DETAit) + β11i ∆DETAit+ εit …..(4)Then, the mean of Mean Group estimate of error correction coefficient is:

With the variance:

The error-correction speed of adjustment parameter, Φi,, and the long-run coefficient,θ1i andθ2i, are of primary interest. With the inclusion ofθ0i , a non-zero mean of the co-integrating relationship is allowed. The parameter Φi is the error-correcting speed of adjustment term. If Φi = 0, then there would be no evidence for a long-run relationship. This parameter is expected to be significantly negative under the prior assumption that the variables show a return to a long-run equilibrium. Of particular importance are the vector θ1iandθ2i, which contains the long-run relationships between the variables.


Regulatory Response To The Impact Of The Global Financial Meltdown On

Islamic Finance In NigeriaBy

Abdulqadir Ibrahim Abikan (Ph. D)*

ABSTRACT

This research examines the impact of the Global Financial Meltdown (GFM) on Islamic finance in Nigeria. It examines the law which enabled Islamic finance in the country and the various efforts made to effectuate the law. It compares the performance of the Lotus Capital Halal Investment Fund with the Nigerian Stock Exchange All Shares Index (NSE-ASI). It also reviews the response of the regulatory authorities to the impacts. It finds that the crisis has both negative and positive impacts on Islamic finance in Nigeria. It concludes that while the negative impact is not adverse comparatively, the positive has set the stage for the takeoff of full-fledged Islamic financial system in the country.

Key word: Impact, Meltdown Full-fledged, Regulatory Authority.

Introduction

All through the period of the struggle for the official re-establishment of Islamic ways of life in Nigeria1 since attainment of independence in 1960 to 1986, demand for the establishment of Islamic Banking and financial system was not separated from the general demand for full application of Islamic law. The earliest

* The Author holds Degrees of LL.B, LL.M, B.L. Ph.D (IIUM), and is a Senior Lecturer,

Department of Islamic Law, Faculty of Law, University of Ilorin-Nigeria; Solicitor and Advocate, Supreme Court of Nigeria email: [email protected]

1 The word re-establishment is used here against the background of the fact that the present northern Nigeria and beyond was governed under Islamic system of government in the Sokoto Caliphate for a century (1804-1903) before the British colonial incursion into the territory in 1862, see Abdulqadir I. A., “Constitutionality of Islamic Banking in Nigeria”, in Ahmadu M. L., Mansur I. S. and Mohammed Isah (eds.) Contemporary Issues in Islamic Jurisprudence, (Benin: Rawel Printing Press, 2009), p. 94.


trace of the nations’ relationship with Islamic finance is its becoming a member of the Organization of the Islamic Conference in 1986. But events took a dramatic turn when in 1991, provisions for Profit and Loss Sharing (Islamic) banking reared its head into Banks and other Financial Institutions Act. However nothing serious was heard of it again until in 1999, when former Habib Nigerian Bank limited (now merged in Platinum Habib Bank) introduced its interest-free banking window.

By the close of 2003, Nigerian Muslims took real practical steps on the establishment of Islamic Banking and finance outfit by placing application with the Central Bank of Nigeria for operating license for a full-fledged Islamic bank under the auspices of Jaiz International2.

While the operating license was being awaited, some Muslim members of the National Assembly moved a motion in the House of Representative on Wednesday, 25 May, 2005 for a resolution of the House to urge the Federal government to effectuate the nation’s membership of Islamic Development Bank.3 This was to facilitate the Bank’s investment in the Islamic banking system in Nigeria.4 As the motion was undergoing a heated debate, hinged on religious bigotry, the federal government on June 8, 2005 endorsed the nation’s membership of the world financial institution, subscribing to 250 units of its shares.5

Unfortunately, issuance of the operating license was caught up in the Nigerian financial policy or politics of the Central Bank of Nigeria banking reform of 2006. The reform required banks to capitalize to N25 billion (165,947,567.29 USD) from N2 billion (13,275,805.38 USD)6 stipulated at the time of filing the application7. In the middle of the policy/political intrigues on the take-off of the Islamic financing in

2 Jaiz International plc was incorporated on 1st April 2003 as a public limited company

with an authorised share capital of =N= 2.5 Billion ( US $18.5 Million ) with main objective of being an investment holding company to set up non-interest institutions such as Islamic Bank, Takaful, Pension Fund Administration etc., see Jaiz International Plc at http://www.jaizinternationalplc.com/ accessed 13th November, 2010.

3 See Ibanga Isine, “Reps Suspend Debate on Nigeria’s Membership of Islamic Bank,” The Punch, Thursday, 26 May, 2005, 1-2.

4 One of the crucial responsibilities of IDB is to be closely associated with the establishment and development of Islamic banks by way of assistance in the mobilization of new and additional resources in member countries, see, Islamic Development Bank, 30th IDB Annual Report 1425H (2004-2005) 93.

5 See Kabiru, Y., “FEC approves Nigeria’s membership of IDB,” Daily Triumph,Thursday, 9 June, 2005, 1-2.

6 Conversion done on line at Xe Universal currency converter, www.xe.com at USD1 = N150.65k, live rates at 2010.14.11 04.48 local time (+1 GMT).

7 This author has criticized the policy, elsewhere, for contravention of the constitutional policy of categorization of the Nigerian banks and the Central Bank Governor’s arrogation of legislative powers to himself illegally, see Abdulqadir, I. A., (Il)Legality of the 2004 – 2005 Reform of the Nigerian Banking Sector, paper accepted for publication in the University of Maiduguri Law Journal, 2010 (in press), p. 14


Nigeria, Lotus Capital8 took the courageous step of floating a Halal Fund at the peak of the Global Economic Meltdown in July 2008. The fund is not only the first acclaimed Shariah compliant investment fund9 to be managed publicly in Nigeria but is also the only platform available for assessing the market impact of the global economic crisis on Islamic financing in the country10.

The economic meltdown has brought Islamic financing to the front burner of the Nigerian financial system as a desired alternative. Foreign investors have begun to take interest in Jaiz International and its capital requirement. Muslim groups have been forming themselves into cooperative societies and Islamic Micro Finance institutions. The Central Bank of Nigeria has thus risen to the occasion to regulate the growing interest in the emerging financial system by issuing a Draft Framework for the Regulation and Supervision of Non-Interest Banks in Nigeria in March 2009.

This paper therefore examines the impact of the economic crisis on Islamic financing (IF) in Nigeria and the response of the law thereto. It is presented in five parts starting with this introductory part. The second part examines the state of Islamic finance in Nigeria before the economic crisis. The impact of the crisis on the financial system is looked into in part three while part four deals with the legal response to it. It ends in part five with conclusion.

IF in Nigeria on the Eve on the Economic Crisis

The earliest interaction of the Nigerian financial system with Islamic financial system is the indirect consequence of the nation’s becoming a member, in 1986, of the OIC, which has Islamic Development Bank (IDB) as one of its specialized institutions11. However, like the requirement in all countries of the world, there was the need for legal backing for the emerging system to be integrated into the

8 Lotus Capital was established in June 2004 as a full-service, ethical investment

management boutique specializing in Shari'ah compliant Asset Management, Private Wealth Management and Financial Advisory Services, see http://www.lotuscapitallimited.com accessed 9th November, 2010.

9 The author has not been able to assess the level of Shariah compliance of the products of the company as discussion is still on to get data from its operators. Thus, reliance is only placed on the 1st Annual Report of the Fund which does not provide any evidence of the compliance, not even a certification by its Shariah Board, see Lotus Capital Limited, Lotus Capital Halal Investment Fund Annual Report and Accounts, 2009.

10 Although deposits were earlier taken and funds raised for investment by Habib Bank and Jaiz International, however, while the former could not show how it invested in Shariah compliant products, see Abdulqadir I. A., “Interest-free Window of the Defunct Habib Nigeria Bank: A Test-run for Islamic Banking System in Nigeria”, Confluence Journal of Jurisprudence and International Law, 3:1, 2010, pp. 144-148; the latter has been precluded from doing so by the Central Bank of Nigeria for reason of fear of depletion of the fund before the issuance of operating license, see Jaiz International, “Re: Update on the Proposed Jaiz Bank” issued on 16th November, 2006, available at http://www.jaizinternationalplc.com/capital_raising.html accessed 14th November, 2010.

11 See OIC, Specialized Institutions and Organs, at http://www.oic-oci.org/page_detail.asp?p_id=65 accessed on 14th November, 2010.


mainstream of the nation’s financial system. As will be shown later however, the legal instrument is not sufficient for a takeoff of the system without the people’s readiness and, to a great extent, political will of the government.

The Enabling Law

Banks and other Financial Institutions Act 199112 became the first law to give recognition to the Islamic financing in the name of Profit and Loss Sharing (PLS) Banks. While Section 9 (2) of the principal Act recognized PLS banks as one of the categories of the Nigeria Banks, Section 66 of the amended Act13 defined PLS bank as a bank which transacts investment or commercial banking business and maintains profit and loss sharing account.

In recognition of the peculiarities of this new banking system, the law made provisions for a number of exceptions to facilitate its smooth operations. Chief among these exceptions is the non-applicability of the need to display the interest rate in the banking premises of a PLS bank. The law provides:

Every bank shall display at its offices its lending and deposit interest rates and shall render to the Bank information on such rates as may be specified, from time to time, by the Bank, provided that the provisions of this subsection shall not apply to Profit and Loss sharing banks.14

This provision presumes the payment or taking of interest on deposits or loans as a necessary practice of banks and thus mandated the display of the interest rates. Its exemption of PLS banks from the practice therefore sets a solid foundation for Islamic banking system. Similar provisions of the Decree empowered the Central Bank Governor to further exempt PLS banks from the provisions of the Decree as he may think fit.15

Efforts to Effectuate the Law

Habib Nigeria bank Interest-free window

Former Habib Nigeria Bank attempted to take advantage of the Islamic banking enabling law by applying for provisional operating license in 1992 to operate profit and loss sharing banking. However, due to what one of its former Managing Director described as lack of commitment on the part of the wealthy members of the Nigerian Muslim Community it was only able to secure approval from the Central Bank to operate interest-free banking window in 1997.16 It 12 Cap. B3, Laws of the Federation of Nigeria (LFN), 2004.13 Decree No. 38, 1988.14 S. 23(1) BOFID, 1991 Cap. B3, LFN, 2004; emphasis mine and reference to “Bank” as

opposed to “bank” in the law relates to the Central Bank of Nigeria and any other bank respectively, see S. 61 thereof.

15 See S. 52 BOFID, 1991 as amended.16 See Bello, F., “Emerging opportunities for Divine Banking in Nigeria,” paper presented at

the first orientation seminar on Islamic Banking and Finance in Nigeria, held on 25 November, 2000 in Kano-Nigeria, p. 15.


eventually operated the window between October, 1998 and December, 2005 when it merged to become Platinum Habib Bank.

Throughout that period, there was no evidence of the bank’s investment of the deposits received in any Shariah compliant investment product. This is aside the fact that a number of the terms and conditions published in the window’s operation manual17 offend Shariah principles18. Furthermore, the window has not enjoyed the prominence it enjoyed before the merger. Thus, it cannot be used to test the impact of the GFM.

Jaiz International Plc.

Jaiz International Plc. was incorporated on 1st April 2003 as a public limited company with an authorized share capital of 2.5 billion naira (16,594,756.73 USD)19. It is an investment holding company proposing to set up non-interest institutions such as Islamic Bank, Takaful, Pension Fund Administration. It raised N2.5 billion through Initial Public Offer of its shares which was oversubscribed by 120%20 and deposited N2 billion with the Central Bank in December, 2003, as was then required, in support of its application for operating license for full-fledgedIslamic bank21.

As mentioned above, Jaiz’s application was caught-up by banking reform which requires N25 Billion capital for all banks. While it is taking steps to meet up with the new requirement22 it has been precluded by the CBN from investing the existing fund in Shariah compliant products. The reason according to the Managing Director of the company is the CBN’s fear of depletion of the fund before the issuance of operating license23. Only in June 2011 was the bank granted approval in principle (AIP) by the CBN and for this reasons too, the fund with Jaiz International cannot be used to run market impact test of the GFM.

Lotus Capital Limited

Lotus Capital was founded in June 2004 as a full-service, ethical investment management company specializing in Shari'ah compliant Asset Management, Private

17 See Habib Nigeria Bank Ltd., Non-interest Based Banking- Guide to Participation, (Kaduna: HNB, 1999).

18 See Abdulqadir I. A., Interest-free window, p. 150.19 Compare the current USD equivalent with $18.5million it was in 2006.20 See Jaiz International Plc., Capital Raising at

http://www.jaizinternationalplc.com/capital_raising.html accessed on 14th November, 2010.

21 See Jaiz International Plc. Annual Report and Accounts, 2004, p. 422 Including attraction of foreign investment, Private Placement of =N=10 Billion (US $

75 Million) and making another Public Offer of =N=13 Billion (US $ 96.2 Million), see n.20.

23 See Jaiz International, “Re: Update on the Proposed Jaiz Bank” issued on 16th November, 2006, available at http://www.jaizinternationalplc.com/capital_raising.html accessed 14th November, 2010.


Wealth Management and Financial Advisory Services. It is duly registered with the Securities and Exchange Commission (SEC) as Fund Managers, Corporate Investment Advisers and Issuing House. Its products include Lotus Capital Halal Investment fund (medium to long term Unit Trust Scheme), Lotus Hisab (Short term investment and savings account builder), Lotus Capital Hajj Investment (Hajjii) and Lotus Ta’alim, (long term plan for future education of children or wards). It invests in screened stock, real estate and asset backed investment.24

Lotus Capital Halal Investment Fund was launched for business in the middle of the storm of the Global Financial Meltdown on July 1, 2008. The performance of this product within eighteen months of operation, i.e. between the above date and the financial year ended December 31, 2009 provides the platform for assessing the impact of the financial crisis on Islamic finance in Nigeria.

Islamic Cooperative Societies

In the last one decade, a shortcut adopted by the Nigerian Muslims for accessing credit facilities in Shariah compliant manner is through setting up of Islamic Multipurpose Cooperative Societies (IMCS). The societies offer products like qard hasanah (interest free housing and emergency loan), Murabahah (commodity sales), Mudarabah (entrepreneurial financing) and Musharakah (Business partnership) amongst others. In Kwara State alone, not less than twenty (20) Islamic Cooperative Societies have registered with the Ministry of Commerce and Industry. The growth in number of the societies leading to creation of union of the societies, increase in their membership strength and transformation of some of them to become Microfinance banks particularly within the last two years is traceable to the impact of GFM.

The Impact of GFM on Islamic Financing in Nigeria

GFM impacted both positively and negatively on Islamic financing in Nigeria. The Market Impact Assessment (MIA) conducted through the Lotus Capital Halal Investment Fund revealed a negative Impact. On the other hand the increase in the popularity of the financial system and the resultant growth in its demand are seen as positive index. But before we examine the impact on IF, a general outlook of how the Meltdown affects the entire Nigerian economy will be relevant.

Impact on Nigerian Economy

GFM impacted negatively on the Nigerian economy through the following indirect factors:

24 See Lotus Capital Limited, at

http://www.lotuscapitallimited.com/index.php?option=com_content&view=article&id=38&Itemid=32


1. Reduction in foreign direct investment as a result of withdrawals and withholding of foreign portfolio investments (in order to service financial

problems at home)25.

2. In the first half of the year 2009 the size of non-performing assets on the balance sheets of the deposit taking banks resulting from their exposure to the capital market and oil and gas sector through marginal borrowing/lending (Nigeria's own "sub-prime" lending) from previous years was significant26.

3. Decline in demand for petroleum product and consequently, reduction in earnings from the oil sector on which the nation’s export is significantly dependent: 99% of FX and 85% of local revenues are directly derived from activities related to export of oil which was at the center of the financial crises27. For instance, the price of Nigeria's light sweet crude appreciated to as high as $147 in mid- 2008, it subsequently declined sharply and ended 2008 below $45 per barrel28. This forced the Federal Government of Nigeria to reduce the 2009 budget revenue estimate to $45 per barrel from over $60 per barrel.

The Nigerian Capital Market was worse hit by the Meltdown. Nigeria's stock market index is the Nigerian Stock Exchange's All-Share Index (NSE-ASI), which provides a picture of the financial health of 233 listed equities. It started the year 2008 at 58,580 (with a market capitalization of N10.284 trillion), and went on to achieve its highest value ever of 66,371 on March 5, 2008, with a market capitalization of about N12.640 trillion29.

25 Mtango, E. E. E. (2008) “African Growth, Financial Crisis and Implications for TICAD

IV” GRIPSODI-JICA joint seminar: African Growth In The Changing Global Economy paper presented by Ambassador of Tanzania and Dean of the African Diplomatic Corps in Japan retrieved from www.google.com on 24/11/08; see also Mobolaji E. Aluko, The Global Financial Meltdown: Impact on Nigeria's Capital Market and Foreign Reserves, Nigerian Village Squire October 24, 2008 at http://www.nigeriavillagesquare.com/articles/mobolaji-aluko/the-global-financial-meltdown-impact-on-nigerias-capital-market-and-foreign-reserves.html accessed 14/11/10

26 See Lotus Capital Limited, Lotus Capital Halal Investment Fund Annual Report and Accounts, 2009, p.11.

27 See Abdul Adamu, The Effects of Global Financial Crisis on Nigerian Economy, Social Science Research Network, retrieved from http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1397232&http://www.google.ca/url?sa=t&source=web&cd=1&ved=0CBUQFjAA&url=http%3A%2F%2Fpapers.ssrn.com%2Fsol3%2FDelivery.cfm%2FSSRN_ID1397232_code515373.pdf%3Fabstractid%3D1397232%26mirid%3D1&rct=j&q=Abdul%20Adamu&ei=uK3gTPf6KMfMhAfiwuj7DA&usg=AFQjCNFgYQnBkZU60LZMgzSIZ50t1Tcm3Q


29 See Mobolaji E. Aluko, The Global Financial Meltdown, n. 25.


Equity market performance in the 18 month period from July 2008 to December 2009 was abysmal. The NSE-ASI declined inexorably by about 70% over the period from 57,047.27 points as at July 1, 2008 to close at 20,561.15 as at December 31, 2009. In terms of capital decline, the Nigerian capital market lost about N3.38 trillion, or about 26.7% between March 5 and October 24 2008 alone30. The poor performance of the market is graphically represented below:

Source: Nigerian Stock Exchange

Three key factors have been identified as being responsible for the poor performance of the market. First, as at early 2008, the intrinsic values of most stocks in the capital market (even with optimistic assumptions) were far below their market prices. Secondly, concerns about the economy as a result of the financial meltdown had overtaken the positive outlook and investor confidence, which underpinned the sustained rally in previous periods. Lastly, the excessive liquidity from bank margin loans that had driven demand for and prices of stock, was no longer available.

Impact on Lotus Capital Halal Investment Fund

The composite benchmark of the Halal Fund is the NSE-ASI which, as shown above, declined by 63.96% over the 18 month period from 57,047.27 points in July 1, 2008 to 20,561.15 in December 31, 2009. This translated into decline in the value of the Halal Fund by 20%. The Fund opened at N1.00 and closed at N0.80 over the same period31. Despite this decline, however, the Fund was rated to have out-performed its benchmark by almost 45%.

30 See Sanusi Lamido Sanusi, The Nigerian Banking Industry: What Went Wrong and the

Way Forward, Convocation Lecture delivered at the Convocation Square, Bayero University, Kano, on Friday 26 February, 2010, p.2.



The graph below shows the value, as at December 31, 2009, of a N20,000 investment made on July 1, 2008 in the Lotus Capital Halal Fund. The performance of the Fund’s benchmark, NSE-ASI, assuming the same minimum investment of N20,000, is shown on the same graph for comparative purposes.

Source: Lotus Capital Limited.

In the above graph, the NSE-ASI investment of N20,000 continued on a straight steep decline from July 2006 to as low as less than N8,000 (>40%) by January 2009. It steeped to its lowest in April 2009 to about N7,000 (65%) and flip-flopped between that period to appreciate to a little above N10,000 (50%) in June 2009. It then embarked on steeping down digressively to close at a little above N7,000 by December, 2009.

On the other hand, the Halal Investment Fund of the same amount at the same period showed more resilience even in its decline. It steeped to its lowest in January 2008 to close at a little below N16,000 (80%) as against NSE-ASI’s N8,000 (40%) in the same month. It then picked up progressively to reach N18,000 (90%) in September 2009 before going down again to close at N16,000 (80%) in December 2009.

Bearing in mind that there is hardly any domestic mortgage market for there to be a sub-prime mortgage portfolios that were spun off into securitized instruments and subsequently offered as investments and set off the global financial crisis in the UK and the USA it is difficult to attribute the above scenario to direct impact of GFM. The impact could at best qualify as what The Economist32 and El-Said and Ziemba33 referred to as second round effect.

32 The Economist, “Middle East finance: Shine comes off Islamic banks”, September 24,

2009.33 El Said A., and Ziemba R., “Stress-testing Islamic Finance”, Roubini Global

Economics, May 10, 2009.


Lotus Capital maintains that its investment philosophy is to optimize total returns of investors by seeking high quality investments whilst adhering to the strictest code of ethics in line with our Islamic finance investment philosophy. Yet it was difficult to ascertain the level of its investments’ Shariah compliance, especially as there was nothing on the face of its annual report to show certification of its Shariah Board.

The reason for the marginal loss of Lotus Capital in the period under review, which is an ‘impressive performance’ when compared with other public managedfunds and the NSE-ASI, may not be unconnected with the position of Umer Chapra’s view on the operations of Islamic Financial System. According to the scholar, the way the Islamic financial system has progressed so far is only partly, but not fully, in harmony with the Islamic vision. It has not been able to fully come out of the straitjacket of conventional finance34. He asserted that the use of equity and PLS modes has been insignificant, while that of the debt-creating sales and lease-based modes has been predominant. As at December 31 2009, the Halal Fund of Lotus Capital was 34% invested in equities, 14% in Asset-Backed Investments and 52% in cash and other liquid assets35.

Moreover, even in the case of debt-creating modes, all Islamic banks and branches or windows of conventional banks do not necessarily fulfill the conditions laid down by the Shari‘ah. They try to adopt different legal stratagems (hiyal) to transfer the entire risk to the purchasers (debtors) or the lessees36. The two leading English cases of Islamic Investment Company of the Gulf (Bahamas) Ltd v. Symphony Gems NV & Ors37 and Beximco Pharmaceuticals Ltd. & Ors v. Shamil Bank of Bahrain EC38 are unequivocal evidences of how murabahah was used just as hiyal for an illegal contract of loan at interest and further testimony to the assertion.39

34 See Chapra, M. U., The Global Financial Crisis: Can Islamic Finance Help Minimize

the Severity and Frequency of Such a Crisis in the Future?,” Paper presented at the Forum on the Global Financial Crisis. Jeddah: Islamic Development Bank on October 21, 2008, p. 17.

35 Lotus Capital Limited, Annual Report 2009, p. 12.36 Chapra, M. U., The Global Financial Crisis, p. 1737 (2002) WL 346969 (QB Comm. Ct 13 February 2002).38 [2004] EWCA Civ 19 (Court of Appeal, Civil Division); [2004] All ER (D) 280 (Jan);

for a detailed critique of this case, see Abdulqadir I. A. and Zainudin Bin Jaffar, “Islamic Financial Services: The Way Forward for the Financial Regulatory Authorities”, University of Ilorin Law Journal, 2006:1, pp. 156 – 162 and Engku Rabiah Adawiah bt Engku Ali, “Constraints and Opportunities in Harmonization of Civil Law and Shariah in the Islamic Financial Services Industry”, [2008] 4 MLJ i at p. xxix.

39 See Abdulqadir I. A., “Islamic Banking Dispute: Between Judicial Pluralism and ADR”, paper presented at the International Conference on Islamic Banking and Finance: Cross Border Practices and Litigation, Organised by the International Islamic


This result of the assessment of the impact of GFM on Lotus Capital is comparable, in a way, with the comparative survey conducted by Maher and Jemma on the impact of the crisis on Islamic and conventional banks in eight countries.40

The two results confirm the resilience of Islamic finance and its profitability throughout the period of the crisis. However, unlike the case in the survey, no data is available in case of Lotus Capital to examine its credit and asset growth and its external rating. In the former, Islamic Banks‘ credit and asset growth were at least twice higher than that of Conventional Banks during the crisis, suggesting a growing market share going forward and larger supervisory responsibility. External rating agencies‘ re-assessment of Islamic Banks‘ risk was also generally more favorable or similar to that of Conventional Banks41.

Positive impact of the GFMThe most important impact the GFM had on Islamic finance in Nigeria is the

greater awareness it has brought to the alternative financial system. The financial system has become more popularized and this has, in effect, put more pressure on the financial regulatory authorities to facilitate the take-off of full-fledge Islamic banking and financing in the country. Recently the governor of the CBN expressed the readiness of the Bank to the development of an Islamic bank in Nigeria particularly in response to the current global financial crisis which had exposed the deficiencies in the conventional banking system42.

While the take-off of the full-fledge bank is being awaited, several Muslim organizations have found a middle course in Islamic cooperative societies. The number of such societies has grown significantly within the period of the GFM. Forinstance a total number of twenty Islamic cooperative societies was registered with the Kwara State Ministry of Commerce and Industry between 2004 and 2009 and twelve (12) i.e. 60% of them were registered between 2008 and 2009 alone43. Also Al-Burhan Cooperative society of the University of Ilorin-Nigeria which registered in 2004 has membership strength of 165 members with 102 members (%) joining between 2007 and 2010.

University Malaysia (IIUM) and University of Wisconsin, USA, held at IIUM on 15-16 June, 2010, p. 15

40 Including Saudi Arabia, Bahrain Kuwait UAE, Qatar, Jordan, Turkey and Malaysia, see Maher Hasan and Jemma Dridi, “The Effect of the Global Crisis on the Islamic and Conventional Banks: A Comparative Study”, IMF Working Paper WP/10/201,September, 2010.

41 Ibid., at p. 33.42 See Sanusi Lamido Sanusi, “Islamic Solution to the Global Economic Meltdown”,

paper presented at Ramadan Seminar organized by Movement for Islamic Culture and Awareness (MICA) on 29 August, 2009

43 Al-Halal Muslim Workers MCS (2008), At-Taqwa MCS, Kwara Polytechnic (2008), Al-Barka MCS, Okekura, (2008), Al-Amanah MCS, Ilorin-South (2008), An-Nur MCS, Egba/Otte (2009), Halal MCS, Idofian (2009), Iman MCS, Ministry of Health (2009), Al-Amanah MCS, CAILS Ilorin (2009), NATAIS MCS, Ilorin-West (2009), Fithat MCS, Ode Alausa (2009), Al-Barka MCS, Oko Erin (2009) and Iwajowa MCS, Ilorin East (2009); source: Al-Barka Trust Fund, in charge of coordinating the registered Islamic Cooperative Societies in Kwara state towards formation of Islamic microfinance bank, www.albarkatrustfund.org


In April 2010, Al-Barka Cooperative Society belonging to The Muslim Congress (TMC) in Lagos State became Al-Barka (Islamic) Microfinance Bank. According to its chairman, the bank was set up in response to the increasing demand for alternative micro credit products by the less privileged members of the society against the conventional banking practices.

The number of seminars, workshops and conferences both national and international on Islamic banking and finance related themes has also increased significantly. While such conferences are held in the average of one in a year since around 200044, not less than ten (10) of them have been held between 2009 and 201045. These are aside from Radio and television sponsored by Muslim Organizations and corporate bodies on the subject matter. However, with these positive impacts come a greater regulatory responsibility and legal response.

Legal and Regulatory Response to the Impact

In response to the above mentioned impact of GFM on Islamic finance in Nigeria both on the existing products and the growing demand, the CBN on March 2009, acting under its statutory powers, issued a Regulatory framework for the practice of Islamic financial system in the country46. The enabling statute provides in part that “In addition to any of its power under this Act, the Bank may: …. (b) issue guidelines to any person and any institution under its supervision”47.

The covering circular to the framework is self explanatory:

In response to the increasing number of investors, banks and other financial institutions desiring to offer Non-interest products and services, the CBN has developed the attached draft framework for the regulation and supervision of Non-interest banks in Nigeria48.

44 IIBI, “4th Annual Islamic banking and Insurance Conference in Nigeria” New Horizon,

June/July, 2004.45 These include International conference on Islamic banking and finance organized by

the Department of Islamic law and Islamic Research and Training Institute 6-8 October, 2009, a workshop organized by Lotus Capital on December, 2009? Another one was organised by Crescent University Abeokuta on April, 2010 and that of the Muslim Lawyers’ Association of Nigeria on September, 2010 amongst others.

46 See CBN, “Draft Framework for the Regulation and Supervision of Non-Interest Banking in Nigeria”, Circular No.: BSD/Dir/Gen/NIB/01/008 published on 4 March, 2009 available at<www.cenbank.org/document/bsdcirculars.asp?beginrec=21&endrec=40> (accessed: 12 March, 2009).

47 See S. 33 (1) (b), CBN Act, 2007; see also Sections 57 (2), 61 (1) (a), 66 and 23 91) Banks and other Financial Institutions Act, 1991 as amended (Cap. B3, Laws of the Federation of Nigeria (LFN) 2004) for similar powers.

48 See CBN, Draft Framework for the Regulation and Supervision of Non-Interest Banks in Nigeria, circular No.: BSD/DIR/GEN/NIB/01/008 issued on March 4, 2009.


The sixteen paragraphs document covers areas including licensing requirements, the proposed banking models, the financial instruments, corporate governance, Shariah supervision, business standards, Audit and Accounting and Prudential requirements, risk management and combating of money laundering and financial terrorism. It also acknowledged the need for Shariah compliant investment outlets like Islamic Capital Market for the effectiveness of the prospective system and words were given to facilitate same49.

The draft framework was meant to be an exposure draft to elicit comments, suggestions and inputs from the stakeholders. To that effect, the author and some other individuals, under the auspices of Al-Barka Trust Fund submitted a memorandum containing our observations and suggestions including the following:

1. The need to require the Memorandum and Articles of Association of the Non-Interest banks to establish the office of Shariah Advisory/Supervisory Committee.

2. Undesirability of issuing license for non-interest banking window of conventional banks in Nigeria until such window or full-fledged Islamic bank has been operated as a pilot project. This position was based on research findings of the authors of the memorandum on earlier licensed window.

3. Guide to Bank Charges issued by Bankers’ committee should be scrutinized by the CBN Shariah Council to avoid the current unfair charges of the conventional banks.

4. Appointment of members of Shariah supervisory committee should be subjected to the approval of the CBN through its own Shariah Council. Mechanism should also be put in place to ensure that the activities of the committee are periodically subjected to the CBN and other regulatory bodies’ examinations.

5. The need to have the Shariah Council of the CBN as an in-house unit within the CBN and not outsourced.

6. The need to correct the impression created in the draft framework that the use of the word “Islamic” as part of the registered or licensed name of a non-interest bank is totally prohibited when Section 34 (1) (a) of BOFIA 1991 (as amended) only subjects its use to prior approval of the CBN governor.

7. The need to facilitate Shariah Compliant investment instruments proposed to be floated as liquidity assets to meet the CBN liquidity ratio and make it prerequisite to the take-off of the Islamic banking operations in the country.

49 see Abdulqadir I. A., Islamic Banks’ Participation in Deposit Insurance Scheme: A Legal Appraisal, paper accepted for publication in the Nigeria Deposit Insurance Corporation Quarterly, February, 2010, p. 17.


8. The need to rework profit equalization reserve in a way that injustice against the bank partners who cease to be partners but part of whose profit share has been contributed to the reserve50.

The CBN Governor, Sanusi Lamido Sanusi is of the view that the crisis has provided scholars, lawmakers and bankers opportunities to re-assess Islamic finance. CBN has, thus, embarked on extensive capacity building through collaboration amongst various stakeholders to develop cognate expertise in non-interest banking51. The final Framework, which took cognizance of the above suggestions, was issued in January 2011 and was amended in June 2011 in response to religious sensitivity of some of its provisions.

Conclusion

Since Nigeria became a member of OIC and the subsequent recognition given to PLS (Islamic) banking by BOFIA in 1991 none of the various efforts made to operate the financial system provides a platform for market impact assessment of GFM except the Lotus Capital Halal Investment Fund. Although the fund lost 20% of its investment during the crisis, yet a comparison of the loss with that of its benchmark NSE-ASI shows that the fund is more resilient even in adversity. Aside from this negative impact, GFM brought a number of positive impacts on Islamic finance in Nigeria including improved awareness of the financial system, increase in the number and membership of Islamic cooperative societies and growing pressure on the regulatory authorities to facilitate the take-off of the banking system. The pressure has also elicited legal and regulatory framework from the authorities which has been appropriately reacted to by the stakeholders. The eventual issuance of the framework thus becomes a major response to the impact of GFM in Nigeria and the CBN has, through it, set the stage for Islamic financial system in the Nigeria.

50 Al-Barka Trust Fund, Re: Draft Framework for the Regulation and Supervision of Non-

Interest Banks In Nigeria, Memorandum Reference No.: ATF/IL/COOP/006/1430 dated 22/03/1430AH (18/03/2009)

51 One of such capacity building workshop was organized by the CBN for its staff on 18-19 October, 2010 in collaboration with Islamic Financial Services Board of Malaysia at Sheraton Hotels Abuja.


News MonitorMalaysia

Islamic dual currency investment-Malaysia

Bank Muamalat Malaysia has launched its foreign exchange-based structured investment product under the Wakalah bil istithmar concept, the Islamic dual currency investment. The product initially will be offered in ringgit, euro or US Dollars to its wholesale customers.

Bahrain

Albaraka Banking Group acquires Al-Tawfeek shares-Bahrain

Al-Baraka Banking Group BSC plans to acquires 60% of issued shares of Al-Tawafeek Financial Group through its subsidiary in Baraka Islamic Bank. Al-Tawfeek Financial Group Company is closed joint stock company registered in Saudi Arabia and licensed by the Capital Market Authority. The Company engages in asset and portfolio management, custody, debt and equity arranging, as well as research and advisory services. According to Adnan Ahmed Yousif President & CEO the procedures for consummating the acquisition of shares are currently being finalized.

He added that this acquisition endorses our strong commitment to the region despite the economic and political developments regionally and globally, and proves our financial soundness and successful strategy.

Turkey

Noor Islamic Bank leads US $ 1.4 bn Islamic Finance mandates in Turkey

Noor Islamic Bank has been assigned to put in order and lead manage more than US $ 1.4 billion Islamic finance capital market deals in Turkey in the last 18 months, making it the most active UAE bank in the republic.

The bank revealed details of its financial dealings in Turkey on the eve of Islamic investment and Finance Forum, scheduled to take place in the Turkish capital Istanbul, from October 24-27., where it will be the Sukuk partner for the event.

During the four-day Islamic Investment and Finance Forum, leading regional and international Islamic finance experts will talk about a range of key topics for the Islamic Finance industry including how to animate the global Sukuk markets, following the financial crisis; kick starting sukuk market in frontier economies; new


business opportunities for Islamic syndicated finance and the future of participation (Islamic) banking in Turkey.

Pakistan

Current Swap Agreement

State Bank of Pakistan signs bilateral currency swap arrangement with the Central Bank of Republic of Turkey (CBRT). The CSA has been concluded in Pakistan Rupee/Turkish Lira with size amounting to $ 1 billion in equivalent local currency, agreement tenor will be for 3 years, core objective of the currency swap agreement is to finance bilateral trade in respective local currency of the twocountries.

Qatar

Islamic banks’ assets in Qatar crosses QR100bn mark

According to Sheikh Mohammad bin Hamid bin Jassim Ali Thani Chairman of Barwa Bank State the Islamic banks’ assets in Qatar exceeded QR 100 bn mark. Islamic banks have proved their QR 100 bn mark ability after standing firm against the Global Financial crisis. Taking cue form this, many of European Banks and international institutions have decided to open Islamic banking to reap the benefits and the advantages of Islamic banking system.

UK

Abu Dhabi Islamic bank has plans to set up its first branch in London, in November 2011 after it obtains its banking license. The bank also plans, to offer mortgages, once there is significant demand, stated Phillip Manning CEO of its UK branch.

UAE

Abu Dhabi Islamic Bank Posts Dh 319m profit.

Abu Dhabi Islamic Bank earned a record net profit of Dh 319.1 (M) for the quarter ended 30 Sept 2011, an increase of 3.2% over the corresponding period on higher income, in spite of difficult market condition & continued global financial crisis. The performance of the Bank’s core banking business was strong proof of the fact that its profit grew by 127% year on year to DH 1.086 Billion in period of nine months.

. Source: Electronic Media


Glossary: Islamic TerminologyfatwaA ruling made by a competent a Shariah scholar on a particular issue, where fiqh (Islamic jurisprudence) is unclear. It is an opinion, and is not legally binding.

fiqhIslamic jurisprudence. The science of the Shari’ah. This is an important source of Islamic economics.

ghararLit: uncertainty, hazard, chance or risk. Technically, sale of a thing which is not present at hand; or the sale of a thing whose consequence or outcome is not known; or a sale involving risk or hazard in which one does not know whether it will come to be or not.

halalActivities; which are permissible according to Shari’ah.

HaramActivities, which are prohibited according to Shari’ah.

ijaraA leasing contract under which a bank purchases and leases out a building or equipment or any other facility required by its client for a rental fee. The duration of the lease and rental fees are agreed in advance. Ownership of the equipment remains in the hands of the bank.

ijara sukukA sukuk having ijara as an underlying structure.

ijara wa iqtinaThe same as ijara except the business owner is committed to buying the building or equipment or facility at the end of the lease period. Fees previously paid constitute part of the purchase price. It is commonly used for home and commercial equipment financing.

istihsanIn Islamic jurisprudence, it refers to departure from the application of a ruling on an exceptional basis by taking a lenient view of an act that may otherwise cause unfairness or distress.


istisnaA Contract of acquisition of goods by specification or order, where the price is fixed in advance, but the goods are manufactured and delivered at a later date. Normally, the price is paid progressively in accordance with the progress of the job.

maysirGambling – a prohibited activity, as it is a zero-sum game just transferring the wealth not creating new wealth.

mudarabahA form of business contract in which one party brings capital and he other personal effort. The proportionate share in profit is determined by mutual agreement at the start. But the loss, if any, is borne only by the owner of the capital, in which case the entrepreneur gets nothing for his labour.

mudarabah sukukA sukuk having mudarabah as an underlying structure.

mudaribIn a mudarabah contract, the person or party who acts as entrepreneur.

murabahaA contract of sale between the bank and its client for the sale of goods at a price plus an agreed profit margin for the bank. The contract involves the purchase of goods by the bank which then sells them to the client at an agreed mark-up. Repayment is usually in instalments.

musharakahAn agreement under which the Islamic bank provides funds which are mingled with the funds of the business enterprise and others. All providers of capital are entitled to participate in the management but not necessarily required to do so. The profit is distributed among the partners in predetermined ratios, while the loss is borne by each partner in proportion to his contribution.

Rab-al-maalIn a mudarabah contract the person who invests the capital.

RetakafulReinsureance based on Islamic principles. It is a mechanism used by direct insurance companies to protect their retained business by achieving geographic spread and obtaining protection, above certain threshold values, from larger, specialist reinsurance companies and pools.

RibaLit: increase or addition. Technically it denotes any increase or addition to capital obtained by the lender as a condition of the loan. Any risk-free or “guaranteed’ rate of return on a loan or investment is riba. Riba, in all forms, is prohibited in Islam. Usually, riba and interest are used interchangeably.

sadaqahCharitable giving.


salamSalam means a contract in which advance payment is made for goods to be delivered later on.

Shari’ahRefers to the laws contained in or derived from the Holy Quran and the Sunnah (practice and traditions of the Prophet Muhammad (PBUH).

Shari’ah boardAn authority appointed by an Islamic financial institution, which supervises and ensures the Shari’ah compliance of new product development as well as existing operations.

shirkatulmilkPartnership by ownership, which could be automatic as in the case of inheritance by two brothers, or optional such as two persons purchasing a property jointly (not for a commercial purpose).

shirkatulaqdA contract between two or more persons who launch a business or financial enterprise to make profit, Generally it is termed as ‘shirkah’. Specifically, it has to be distinguished from shirkatulmilk, in which two or more persons become partners in the ownership of an asset not for business.

sukukSimilar characteristics to that of a conventional bond with the key difference being that they are asset backed; a sukuk represents proportionate beneficial ownership in the underlying asset. The asset will lie leased to the client to yield the return on the sukuk.

ta’awuniA principle of mutual assistance.

takafulA form of Islamic insurance based on the Quranic principle of mutual assistance (ta’awuni). It provides mutual protection of assets and property and offers joint risk sharing in the event of a loss by one of its members.

WakalaA Contract of agency in which one person appoints someone else to perform a certain task on his behalf, usually against a certain fee.

Waqf

An appropriation or tying-up of a property in perpetuity so that no propriety rights can be exercised over the usufruct. The waqf property can neither be sold nor inherited nor donated to any one.

ZakatAn obligation on Muslims to pay a prescribed percentage of their wealth to specified categories in the society, when their wealth exceeds a certain limit. Zakat purifies


wealth. The objective is to take away a part of the wealth of the well-to-do todistribute it among the poor and the needy.

arbounAn Islamic version of option, a deposit for the delivery of specified quantity of a commodity on a predetermined date.

bai al-inaThis refers to the selling of an asset by the bank to the customer on a deferred payments basis, then buying back the asset at a lower price, and paying the customer in cash terms.

bai bithaman ajilSale of goods on a deferred payment basis credit sale, another term used for such sales is bai muajjal. Equipment or goods requested by the client are bought by the bank which subsequently sells the goods to the client at an agreed price which includes the bank’s mark-up (profit).

HajjPilgrimage to Mecca. Hajj is a duty on every Muslim who is financially and physically able to carry it out, at least once in his lifetime, Hajj is performed in the month of Zulhajjah the last month of the Islamic calendar.

ibahaLit: permissibility. Ibaha refers to the rule that every economics transaction is mubah (permissible) unless expressly and specifically forbidden by shari’ah.

KafalahLit: responsibility or suretyship. In kafalah, a third party becomes surety for the payment of debt. It is a covenant/pledge given to the creditor that the debtor will pay the debt or any other liability.

qard hasanaAn interest-free loan given either for welfare purpose or for fulfilling short-term funding requirements. The borrower is only obligated to pay back the principal amount of the loan.

qimarLit: gambling. Technically, an agreement in which possession of a property is contingent upon the occurrence of an uncertain event.

RahanCollateral; technically, it means to pledge or lodge a real or corporeal property of material value as security for a debt or pecuniary obligation so as to make it possible for the creditor to recover the debt, in case of non-payment, by selling the pledged property.

RamadanIt is the ninth month of Islamic calendar, during which Muslims fast; it is also a time for reflection, intensive prayer and self-restraint.

tabarruA donation covenant in which the participants agree to mutually help each other by contributing financially.


TawaruqA sale of a commodity to the customer by a bank on deferred payment at cost plus, profit. The customer then sells the commodities to a third party on spot basis and gets instant cash.

UmraLit: visiting or attending. It is a mini-pilgrimage to Mecca which is not compulsory, but highly recommended, and can be performed at any time of the year.

Musharakah, diminishingAn agreement which allows equity participation and sharing of profit on a pro rata basis, but also provides a method through which the bank keeps on reducing its equity in the project and ultimately transfers the ownership of the asset to the participants.

AmanahLit: reliability, trustworthiness, loyalty, honesty, Technically, it describes a business deal where one party keeps another`s funds or property in trust.

UsufructA legal right to use and derive profit from property belonging to someone else provided that the property itself is not damaged.

Wa’adA promise to buy or sell certain goods in a certain quantity at a certain time in future at a certain price. It is not a legally binding agreement.

muftiAn Islamic scholar, who interprets or expounds Islamic law and gives fatwa.

WakilIn a wakala contract, a representative (agent) who acts on behalf of the principal/investor.

SunnahIt refers to the sayings and actions attributed to Prophet Muhammad (PBUH).


Note to contributors

Journal of Islamic Banking and Finance is an official publication of International Association of Islamic Banks Karachi, Pakistan and carries articles in area of Islamic economics covering theoretical and applied aspects of economics, finance and banking.

The Journal is being published for the last 27 years and its clientele include officials of Govt. of Pakistan, Central Banks, Banks & Financial Institutions, Universities/Educational National & Foreign Institutions, IMF, World Bank etc.

The articles of our esteemed writers will reach the tables of concerned authorities, experts, interested personalities and policy makers.

Articles Submission:The contributors are requested to observe the following rules. Articles should be typed in M.S. Word and restricted to 10 to 15 pages of A-4 size

paper. We accept original contributions only and if the material is taken from some book or any other source, the source may be mentioned. The editorial teamdoes not assume any liability for the views of the writers expressed in their articles nor may necessarily agree with their views.

The articles should be submitted before start of the first month of each quarter, beginning from January, April, July & October enabling review and approval of the material by the editorial board for publication in the issue in hand.

If the editorial Board is of the opinion that the article provisionally accepted for publication needs to be revised, shortened, or the particular expressions therein need to be deleted or rephrased, such opinions will be communicated to the author for appropriate action. The author may also be requested to recast any article in response to the comments made thereon by the reviewers.

The numbering of footnotes will be consecutive, and the footnotes themselves will be placed at the end of the article. For referencing Havard referencing or APA Method should be used.

The author (s) of articles published will receive 2 complimentary copies of the Journal of Islamic Banking & Finance and the IAIB reserves all rights in the material published in the Journal.

Abstract:The articles should contain well summarized abstracts between 100 to 200

words, covering the subject matter of the article, its conclusion and the result arrived at.Tables and Figures:

Figures, tables and boxes should be numbered consecutively in Arabic numerals (i.e figure 1, figure 2 and Table 1 & Table 2)

Book Review:New books (on Islamic economics, finance and banking, as well as on issues

and problems of economic development) will be reviewed in the Journal on request. Authors/publishers may send two copies of each book to the editor for purpose of review.

All communications should be addressed to the editor.


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Main Clifton Road, Karachi (Pakistan)Phone: 92(021) 35837315 E-Mail [email protected]

Quarterly Journal of Islamic Banking and Finance

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