wiley islamic finance e book sampler

INTRODUCTION

Islamic fi nance is growing as a source of fi nance for investors, Islamic

or otherwise around the world. With growing awareness of and

demand for Islamic products, along with supportive government

policies and growing sophistication of fi nancial institutions, the

industry has been growing rapidly. Keep up with this growth with

the latest resources from Wiley.

The Wiley Islamic Finance e-book Sampler includes select material

from Wiley’s leading titles on Islamic Business & Finance. The

material that is included for each selection is the book’s full Table of

Contents as well as a full sample chapter. To read more, please click

on the links below.

Frequently Asked Questions on Islamic

An Introduction to Islamic Finance: Theory & Practice, 2nd

Edition

Fundamentals of Islamic Money and Capital Markets

Introduction to Islamic Banking and Finance

Investing in Islamic Funds: A Practitioner’s Perspective

Islamic Banking in Indonesia: New Perspective on Monetary

and Financial Issues

Islamic Finance: The New Regulatory Challenge, 2nd Edition

http://www.wiley.com/buy/9780470748602







Takaful Investment Portfolios: A Study of Composition of

Takaful Funds in the GCC and Malaysia

Contemporary Islamic Finance: Innovations, Applications and

Best Practices

Strategic Management from an Islamic Perspective: Text and

Cases

For more information about Wiley’s Islamic Finance publication, please log on to www.wiley.com/go/islamicfi nance




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Contents

Preface xiii

Introduction xvii

1 The Islamic Banking Timeline (1890–2010) 1

2 Frequently Asked Questions 9

3 Why is Interest (Riba) Forbidden to Muslims? 99

4 Derivatives and Islamic Finance 113

5 How do you Establish an Islamic Bank? 123

6 Islamic Banking and Finance Qualifi cations 157

7 How Much Arabic do you Need to Know to Work in the Industry? 221

8 Test Your Knowledge 261

9 Further Reading 269

Crossword 289

Appendix Answers to Chapter 8 Test Your Knowledge 291

Index 299

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Chapter 1

TheIslamicBanking Timeline(1890–2010)

2 Frequently Asked Questions in Islamic Finance

I slamic finance has grown to be a US$1 trillion industry, after taking off in the private sector in Gulf States, such

as Dubai, in the 1970s.

The Sharia’a-law compliant system, which prohibits interest, is the national norm in Sudan and Iran, and in a parallel banking system in Malaysia, Bahrain and a few other Gulf States.

The landmark events in the industry’s evolution are summarised here chronologically.

Founding of Perbadanan Wang

Simpanan Bakal-Bakal Haji (PBSBH) in Malaysia

1950 1960

Founding of Dubai Islamic Bank, Kuwait Finance House, First Gulf Bank

1970 1980

Conventional banks open Islamic branches

Islamic accounting standards organisation (forms) (AAOIFI)

1990 2000 2010

First attempts to form Islamic banks

1890s

1900–1930

1930–1950

Bank Misr opens Islamic branches

Founding of Mit Islamisation of Number of banks Ghamr Savings banking in Pakistan, offering Islamic Bank in Egypt Iran, Sudan products expands

Barclays Bank opens its Cairo branch to process the financial transactions related to the construction of the Suez Canal. This is understood to be the first commercial bank established in the Muslim world. As soon as the bank’s branch was opened, Islamic scholars initiated a critique of bank interest as being the prohibited riba.

The critique also spreads to other Arab regions, and to the Indian subcontinent. In this debate, a majority of scholars subscribed to the position that interest in all its forms constitutes the prohibited riba.

Islamic economists also initiate the first critique of interest from the Islamic economic perspective and attempt to outline Sharia’a-compliant alternatives in the form of partnerships.

Chapter 1: The Islamic Banking Timeline (1890–2010) 3

1950s Islamic scholars and economists start to offer theoretical models of banking and finance as a substitute for interest-based banking. By 1953, Islamic economists offered the first description of an interest-free bank based on two-tier Mudaraba (both collection of funds and extension of financing on a Mudaraba basis). Later they showed that financial intermediation can also be organised on a Wakala basis.

1950s–1960s First experimental Islamic banks develop interest-free savings and loans societies in Pakistan and the Indian subcontinent. Egypt and Malaysia experiment with pioneering ventures in the 1960s. New banks develop during the 1970s as oil money pours into the Gulf states.

1960s Banking applications and practices in finance based on Islamic principles begin in Egypt and Malaysia. The landmark events include the rise and fall of Mit Ghamr (Egypt) Saving Associations during the period 1961–1964 and the establishment of Malaysia’s Tabung Haji in 1962. Tabung Haji has since flourished and has become the oldest Islamic financial institution in modern times.

Operational mechanisms for institutions offering Islamic financial services (IFS) began to be proposed and a number of books on Islamic banking based on profit and loss sharing/bearing and leasing were published.

1970s Islamic banks emerge with the establishment, in 1975, of the Dubai Islamic Bank and the Islamic Development Bank (IDB). Also in 1975, fuqaha (Muslim jurists) objections to conventional insurance became pronounced, laying the ground for an alternative structure, takaful. Murabaha was developed as the core mechanism for the investment of Islamic banks’ funds.

Academic activities were launched with the first International Conference on Islamic Economics, held in Mecca in 1976. The first specialised research institution – the Centre for Research in


1979

1980s

July 1983

September 1983

Islamic Economics – was established by the King Abdul Aziz University in Jeddah in 1978. The first takaful company was established in 1979.

Pakistan becomes the first nation to ‘Islamise’ banking practices at state level. The process continued until 1985.

More Islamic banks and academic institutions emerge in several countries. Pakistan, Iran and Sudan announce their intention to transform their overall financial systems so as to be in compliance with Sharia’a rules and principles. The governors of central banks and monetary authorities of the Organisation of Islamic Conference (OIC) member countries, in their Fourth Meeting held in Khartoum on the 7th and 8th of March 1981, called jointly, for the first time, for strengthened regulation and supervision of Islamic financial institutions. The Islamic Research and Training Institute (IRTI) was established by the IDB in 1981.

In 1980, Pakistan passed legislation to establish Mudaraba companies. Other countries such as Malaysia and Bahrain initiated Islamic banking within the framework of the existing system. The International Monetary Fund (IMF) published working papers and articles on Islamic banking, while Ph D research and other publications on Islamic banking were on the increase in the West.

The OIC Fiqh Academy and other Fiqh boards engaged in discussions as to how to apply Sharia’a principles to Islamic banks.

Islamic mutual funds and other non-banking financial institutions emerged towards the middle of the 1980s.

Malaysia opens its first official Sharia’a-compliant bank, Bank Islam Malaysia.

Sudan reforms its banking system on Islamic principles after President Jaafar al-Numeiri establishes Sharia’a law. Dual banking system develops; Islamic in the north and conventional in the south.


March 1984 Iran switches to interest-free banking at the national level after passing a 1983 Islamic Banking law that was promised in the 1979 Islamic revolution.

By 1985 Islamic financial products are offered by more than 50 conventional banks around the globe. Other major banks followed by the 1990s.

February 26, International Islamic accounting standards 1990 organisation, the Accounting and Auditing

Organisation for Islamic Financial Institutions (AAOIFI), is established in Bahrain by the IDB.

1990s Public policy interest in the Islamic financial system grows in several countries.

The first AAOIFI standards were issued. The development of Islamic banking products intensified. Interest in Islamic finance increased in Western academic circles, and the Harvard Islamic Finance Forum was established. Large international conventional banks started operating Islamic windows. The Dow Jones and Financial Times Islamic indexes were launched. Systemic concerns and regulation, supervision and risk management issues gathered momentum. Several countries introduced legislation to facilitate Islamic banking and its regulation and supervision.

Commercial event organisers discovered Islamic banking and finance conferences as a source of lucrative business.

1991 Indonesia’s first officially sponsored Islamic bank, Bank Muamalat, is established.

2000s Sovereign and corporate sukuk as alternatives to conventional bonds emerge and increase rapidly in volume. Bahrain issues Financial Trust Laws.

International Islamic financial infrastructure institutions such as the Islamic Financial Services Board (IFSB), International Islamic Financial Market (IIFM), General Council for Islamic Banks and Financial Institutions (GCIBFI) and the Arbitration and Reconciliation Centre for Islamic Financial Institutions (ARCIFI), as well as other commercial support institutions such as the International


By 2000

2001

2002

2004–2008

2004

2006

2008

Islamic Rating Agency (IIRA) and the Liquidity Management Centre (LMC), were established. The systemic importance of Islamic banks and financial institutions has been recognised in several jurisdictions.

The governments of United Kingdom and Singapore extended tax neutrality to Islamic financial services.

About 200 Islamic financial institutions have over US$8 billion in capital, over US$100 billion in deposits and manage assets worth more than US$160 billion.

About 40% are in the Middle East, another 40% in South and Southeast Asia and the remaining 20% are split between Africa, and Europe and the Americas.

Malaysia’s Financial Sector Master plan sets a target for Islamic finance to make up 20% of the finance sector by 2010. By 2009, its share of financial assets was about 17%.

International standard setting organisation, the Islamic Financial Services Board, is established in Kuala Lumpur, Malaysia.

Investor interest in Islamic finance products grows strongly amid steady rise in oil prices and petrodollars flowing through oil-producing states. World oil prices peaked at over US$147 per barrel in mid-2008 before sliding sharply.

Islamic Bank of Britain, the European Union’s first Sharia’a-compliant high street bank, opens in the United Kingdom.

Dubai’s main stock exchange, the Dubai Financial Market, announces that it is restructuring itself into the world’s first Islamic bourse.

Global credit crisis and economic slowdown send conventional financial markets into steep tailspin. New Islamic bond issuance falls two-thirds to a three-year low of US$15.77 billion.


January 2009 Singapore launches the first Islamic bond programme as it vies with Malaysia.

February 2009 Indonesia, the world’s most populous Muslim country, sells its first retail Sharia’a-compliant bonds, or sukuk.

October 2009 The IFC, a member of the World Bank Group, announced it would be the first non-Islamic financial institution to issue sukuk.

Late 2009 fears of the first major sukuk default emerge but the fears later subside.

Contents

Glossary ix

CHAPTER 1

Introduction 1

CHAPTER 2

The Economic System 29

CHAPTER 3

Riba vs. Rate of Return 57

CHAPTER 4

Financial Instruments 75

CHAPTER 5

Risk Sharing as an Alternative to Debt 99

CHAPTER 6

The Islamic Financial System 113

CHAPTER 7

The Stability of the Islamic Financial System 137

CHAPTER 8

Islamic Financial Intermediation and Banking 151

CHAPTER 9

Capital Markets 173

CHAPTER 10

Non-bank Financial Intermediation 207

CHAPTER 11

Performance of Islamic Financial Services 225


CHAPTER 12

Financial Engineering 245

CHAPTER 13

Risk Management 275

CHAPTER 14

Regulation of Islamic Financial Institutions 299

CHAPTER 15

Corporate Governance 323

CHAPTER 16

Globalization and its Challenges 351

CHAPTER 17

Issues and Challenges 365

Bibliography 393

Index 399

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1

CHAPTER 1Introduction

I slam propounds the guiding principles, and prescribes a set of rules, for all aspects of human life, including the economic aspect. How, and to what

degree, would an economic and fi nancial system designed in conformity with the principles of Islam be different from a modern, conventional, non-Islamic system? How would such a system deal with the questions of the allocation, production, exchange, and distribution of economic resources? How can some of its fundamental principles be explained with due analytical rigor? Researchers interested in contemplating or devising a social, economic, and fi nancial system based on the tenets of Islam are familiar with these and many other such questions.

It is only in the past few decades that efforts have been made to explain Islamic fi nancial and economic principles and rules in modern analytical terms and, despite considerable published research, there is still some con-fusion in regard to applying a precise defi nition to various social sciences prefi xed with the term “Islamic,” such as “Islamic economics” or “Islamic fi nance.” One of the main reasons for this confusion is the tendency to view different aspects of such a system in isolation, without looking at it in its totality. For example, the term “Islamic fi nance” is often deemed to denote a system that prohibits “interest.” However, this simple description is not only inaccurate but is itself a source of further confusion. Unfortunately, too, a number of writers have taken the liberty of expressing opinions on these issues without suffi cient knowledge of Islam, its primary sources, its history and often without even a working knowledge of Arabic—the lan-guage of Islam.1 Against the backdrop of a politicized atmosphere, such attempts render an understanding of these issues even more diffi cult.

Systematic thinking by professional economists about Islam and eco-nomics has had a short history compared to both the remarkable earlier period of vibrant scholarship in the sciences and humanities in the Muslim world and to the long “hibernation”2 that followed it. This earlier period witnessed major achievements in all areas of Muslim scholarship and gave rise to dynamic economic growth in Muslim societies. History has recorded how these contributions, discoveries and intermediation by Islamic sciences

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2 AN INTRODUCTION TO ISLAMIC FINANCE

actually helped facilitate the development and growth of Western societies and economies. When measured against the last three decades of research and development in other disciplines, it is clear that this hibernation is now over and the published writings on Islamic economics in various languages are testimony to a return of vibrancy and energy in the discipline. These efforts are directed toward the development of a coherent and rigorous expla-nation of how Islam proposes to organize an economic system by answering the fundamental questions of what should be produced, how and for whom; how decisions should be made and by whom; and, fi nally, how Islamic insti-tutions could be revived to address the problems of modern societies.

FOUNDATIONAL CONCEPTS

Islam postulates a unique nexus of contracts among the Creator, man and society on the basis of the Divine Law that directly affects the workings of the various social, political, economic, and fi nancial systems. Therefore, to understand the way in which economic affairs are to be organized in an Islamic system, it is fi rst necessary to comprehend the nature of this relation-ship. What differentiates Islam from other systems of thought is its unitary perspective, which refuses to distinguish between the sacred and the profane and which insists that all of its elements must constitute an organic whole. Consequently, one cannot study a particular aspect or part of an Islamic system—its economic system, say—in isolation, without an understanding of the conceptual framework that gives rise to that part or aspect, any more than one can study a part of a circle without conceptualizing the circle itself.

The economist Douglas North contends that what distinguishes one economic system from another is the “institutional scaffolding”—the col-lection of rules and norms along with their enforcement characteristics—in that system. He defi nes institutions as rules of behavior designed to impose constraints on human interaction. These institutions “structure human interaction by providing an incentive structure to guide human behavior. But an incentive structure requires a theory of the way the mind perceives the world and its functioning so that institutions provide those incentives” (North 2005: 66). It is at this point that paradigms become relevant because paradigms in economics do have conceptions of man, society and their inter-relationships. A paradigm can be defi ned as a conception of reality composed of a theoretical and empirical structure in a given fi eld. When a critical mass of practitioners accepts that structure, that conception of reality becomes a para-digm. Such conceptions are themselves products of a meta-framework lurking in the background whose elements may or may not be explicitly specifi ed but which, nevertheless, exist in the mind of the designer prior to the construction and presentation of a paradigm. For example, the meta-framework of neo-classical economics is classical economics, as the name implies.

There are basically two meta-frameworks that underlie all economic par-adigms: Creator-centered or man-centered. The former derives its economic

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Introduction 3

analysis from rules of behavior (institutions) prescribed by the Creator for individuals and societies. Examples are economic paradigms that are based on Abrahamic traditions, Judaism (see, for example, Tamari 1987), Christianity (see, for example, Long 2000) and Islam. The latter, the secular tradition, takes as given, or derives, rules of behavior (institutions) that are designed by humans and approved by society.

The meta-framework for Islam specifi es these rules of behavior within the context of its fundamental principles. The core and fundamental axioms of Islamic ideology are the belief in (1) the Unity and Oneness of the Creator (tawhid), (2) the prophethood (Nubuwwa), and (3) the ultimate return of everything to the Creator for the fi nal accountability and judgment (Ma’aad).

The fi rst and most important of these principles is the Oneness and Uniqueness of the Creator, a corollary of which is the unity of the creation, particularly the unity of mankind. The axiom of Unity and Oneness of the Creator requires the belief that all creation has one omniscient and omni-present Creator—Allah (swt)—who has placed humans on this earth to pursue their own felicity and perfection.3 Further, it requires that the orbit of man’s life is seen to be much longer, broader and deeper than the material dimension of life in this world.

A corollary of the axiom of the Unity of the Creator is that all His cre-ation constitutes a unity as well. The Qur’an (31:28) calls attention to the fact that despite all apparent multiplicity, human beings are fundamentally of one kind; they were created as one being (nafs) and will ultimately return to Allah (swt) as one as well.

In a series of verses, the Qur’an exhorts people to take collective and unifi ed social action to protect the collectivity from all elements of disunity.4 These and many other verses order human beings to work hard toward social unity and cohesion in constructing their societies, and preserve and defend that unity. Unity and social cohesion are so central among the Divine objectives set out for mankind in the Qur’an that it can be argued that all conduct prohibited by Islam is that which ultimately leads to disunity and social disintegration. Conversely, all righteous conduct prescribed by Islam is that which leads to social integration, cohesiveness and unity. As a result, Islam is a call both to the individual and to the collective and has given the latter an independent personality and identity, which will be judged on its own merits or demerits separately from the individuals that constitute the collectivity. The fi nal judgment on individual actions will have two dimen-sions: one as the individual and the other as a member of the collectivity.

The second fundamental principle is the belief in the Creator’s appoint-ment of individuals to serve as His messengers and prophets to others of their kind. These are very select among humans. Every messenger and prophet affi rmed and confi rmed the messages revealed before them and invited the people of their time and place to remind people of the rules of behavior contained in the revelation and to apply those rules in accordance with the added complexity of human life and the growth of human consciousness at

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specifi c points in time. The fi nal, universal, perfect message was then deliv-ered by the last of the messengers, Muhammad (pbuh).5

At some point in the cycle of life, each individual will be called to account to Allah (swt) for his/her actions and will be judged accordingly in the “life hereafter.”

These three axioms are comprehensive and govern all of man’s actions and decisions, and constitute an integrated, consistent and unifi ed whole; compliance with these rules leads, in turn, to the unity of human society.

The meta-framework envisions an ideal society as one composed of believ-ers committed to complying with the Creator’s rules. The individual members are aware of their “oneness” and conscious of the fact that self-interest is best served by seeing “others as themselves.” Such a society is one of the “golden mean” that avoids extremes, and a society that is so rule compliant that it serves as a benchmark for and a witness to humanity (Qur’an 2:143). This is a society which actively encourages cooperation in socially benefi cial activi-ties and prohibits cooperation in harmful ones (Qur’an 3:104, 110, 114; 9: 71). Moreover, in this society, consultation, at both individual and collective levels, is institutionalized in accordance with the rule prescribed by Allah (swt) (Qur’an 3:159; 42:38; 2:233). Similarly, all other rules of behavior pre-scribed in the Qur’an are institutionalized with a suffi ciently strong incentive structure to enforce rule compliance; the objective being the establishment of social justice. The internalization of the rules of behavior by individuals and their institutionalization, along with the incentive structure and enforcement mechanism, reduces uncertainty and ambiguity in decision–action choices confronting the individual and the society.

The structure of such a paradigm can be described as being composed of a meta-framework and an archetype model. The former specifi es rules (insti-tutions) that are, to a degree, abstract and immutable. The archetype model articulates the operational form of these rules in a human community. The meta-framework specifi es the immutable, abstract rules. The archetype model demonstrates how these rules are operationalized in a human community. The meta-framework specifi es general universal laws, rules of behavior. The arche-type model provides specifi c universal rules of behavior and the institutional structures needed for organizing a human society based on the immutable rules of the meta-framework (Mirakhor and Hamid 2009).

The abstract became operational in the hands of the one human being who was the one and only direct recipient of the source of the meta-frame-work; that is, the Qur’an. Through the words and actions of this perfect human, the meta-framework given by the Creator in the Qur’an was inter-preted, articulated and applied to the immediate human community of his time. As the spiritual authority for his followers, he expounded, interpreted, and explained the content of the Qur’an. In his capacity as the temporal authority the messenger operationalized the rules (institutions) specifi ed in the Qur’an in Medina. The economic system established in Medina is the archetype of Islamic economic systems and provides a core institutional structure which is immutable.

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Introduction 5

ISLAM’S CONCEPT OF JUSTICE

As mentioned earlier, a central aim of Islam is to establish a just and moral social order through human agency. This all-embracing desideratum of the Islamic system is the ruling principle from which human thought and behav-ior, the substantive and regulative rules of the Shari’ah, the formation of the community and the behavior of polity and of political authority derive their meaning and legitimacy. It is this emphasis on justice that distinguishes the Islamic system from all other systems. It is via the concept of justice that the raison d’etre of the rules governing the economic behavior of the indi-vidual and economic institutions in Islam can be understood. What gives the behavior of a believer its orientation, meaning, and effectiveness is acting with the knowledge that justice evokes Allah’s (swt) pleasure; and injustice, His displeasure. Whereas justice in Western thought is a quality of the behavior of one individual in relation to another and his actions can be perceived as unjust only in relation to the “other,” in Islam it has implications and conse-quences for the fi rst individual as well. That is, even when one does injustice to someone else, there is always reciprocity, in that through injustice to others, ultimately, one also does injustice to oneself and receives its results both here and in the hereafter.

Justice in Islam is a multifaceted concept, and several words or terms exist for each aspect. The most common word in use, which refers to the overall concept of justice, is the word adl. This word and its many synonyms imply the concepts of “right,” as an equivalent of “fairness,” “putting things in their right place,” “equality,” “equalizing,” “balance,” “temperance,”

WHY IDEOLOGY MATTERS

The strength of ideology determines the strength of rule compliance, and therefore the strength of institutions, which, together with tech-nology, determine the performance and effi ciency of an economic system. Effi ciency is measured by the cost of a given level of eco-nomic performance. The stronger the ideology, the less the divergence between the choices individuals make and those expected of them by the objectives of institutions, and, consequently, the lower the cost of enforcement of contracts and rules of conduct. By implication, in an ideal situation, with a strong ideology, in which all rules of con-duct are complied with and are universally enforced, there will be no divergence between what institutions expect of individual choices and the actual choices. Therefore, in the ideal situation, asymmetry and moral hazard are minimized since a large part of uncertainty will be eliminated with rule compliance. The remaining risks will become insurable.

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and “moderation.” These last few concepts are more precisely expressed as the principle of the “golden mean,” according to which believers are not only individually urged to act in conformity with this principle, but also the community is called upon, by the Qur’an, to be a “nation in the middle.”6

Thus, justice in Islam is the conceptualization of an aggregation of

moral and social values, which denotes fairness, balance, and temperance. Its implication for individual behavior is, fi rst of all, that the individual should not transgress his bounds and, secondly, that one should give others, as well as oneself, what is due.

In practice, justice is operationally defi ned as acting in accordance with the Law, which, in turn, contains both substantive and procedural justice. Substantive justice consists of elements of justice contained in the substance of the Law, while procedural justice consists of rules of procedure assur-ing the attainment of justice contained in the substance of the Law. The underlying principles which govern the distinction between just and unjust acts determine the ultimate purpose of the Islamic path, the Shari’ah, which includes: the establishment of the “general good” of society (considered to be the intent of the Qur’an for human collectivity and the Shari’ah is the path by which it is achieved); building the moral character of individuals; and, fi nally, the promotion of freedom, equality, and tolerance, which are often stated as important goals of the Shari’ah. Of these, protecting the interests of society is accorded the greatest importance. Although there can be no con-tradiction between justice for the community as a whole and justice for the individual, the interest of the individual is protected so long as such interest does not come into confl ict with the general interest of the community.

SHARI’AH—THE LAW

Islam legislates for man according to his real nature and the possibilities inherent in the human state. Without overlooking the limited and the weak aspects of human nature in any way, Islam envisages man in light of his pri-mordial nature as a theophany of Allah’s attributes, with all the possibilities that this implies. It considers the human as having the possibility of being perfect, but with a tendency to neglect potentialities of the human state by remaining only at a level of sense perception. It asks, therefore, that in exchange for all the blessings provided by their Supreme Creator, humans seek to realize the full potential of their being, and remove all the obstacles which bar the right functioning of their intelligence. To order human life into a pattern intended for it by its Creator, humans are provided with a network of injunctions and rules, which represent the concrete embodiment of the Divine Will in terms of specifi c codes of behavior, by virtue of accep-tance of which—through the exercise of his free choice—a person becomes a Muslim and according to which the individual lives both his private and social life. This network of rules—called the Shari’ah, which is etymologi-cally derived from a root meaning “the road”—leads man to a harmonious life here and felicity hereafter.

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Introduction 7

The emphasis on the axiomatic principle of Unity forms the basis for the fundamental belief that Islam recognizes no distinction between the spiri-tual and the temporal, between the sacred and the profane, or between the religious and the secular realms. Islam seeks to integrate all human needs, inclinations, and desires through the all-embracing authority of the Shari’ah. Life is considered as one and indivisible. Therefore, the rules of the Shari’ah hold sway over economic life no less than over social, political, and cultural life; they persuade, determine, and order the whole of life. It is through the acceptance of and compliance with the rules of the Shari’ah that individu-als integrate themselves not only into the community, but also into a higher order of reality and the spiritual center. Violations of these rules will have a disintegrative effect upon the life of the individual and that of the community.

The Shari’ah rules are derived, based on the Qur’an and its operation-alization by the Prophet (pbuh), through a rigorous process of investigation and thinking across time and geographical regions. The expansion of the rules of Law and their extension to new situations, resulting from the growth and progress of the Islamic community, is accomplished with the help of consensus in the community, analogical reasoning—which derives rules by discerning an analogy between new problems and those existing in the primary sources—and through the independent human reasoning of those specialized in the Law. As a result, Shari’ah is invested with great fl exibility in handling problems in diverse situations, customs, and societies and therefore has a wide range of solutions and precedents, depending on different circumstances.

History has not recorded instances when Muslim jurists were unable to provide Islamic solutions to new problems. Their opinions covered all aspects of life. They laid down brilliant theories, exemplary rules and solu-tions. Unfortunately, however, with the decline of Islamic rule in Muslim countries, the signifi cance of the Shari’ah in running day-to-day life also declined and development of the Shari’ah remained dormant. In the last few decades, however, the reawakening among Muslims has generated enor-mous demand for the development of Shari’ah-based rules that address the problems of modern society.

BASICS OF THE SHARI’AH

The life of a Muslim at the individual and the societal levels is governed by different sets of rules. The fi rst set, known as aqidah (faith), con-cerns the core relationship between people and the Creator and deals with all matters pertaining to a Muslim’s faith and beliefs. The second set deals with transforming and manifesting the faith and beliefs into action and daily practices and is formally known as Shari’ah (Law). Finally, the third set is akhlaq, which cover the behavior, attitude, and work ethics according to which a Muslim lives in society. Shari’ah

(Continued)

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ISLAMIC ECONOMIC AND FINANCIAL SYSTEMS

Given our understanding of the role of institutions, rules, Law (Shari’ah) and the ideology of Islam, we can make the following propositions regarding an Islamic economic system (the core principles of which will be discussed in detail in Chapter 2):

■ Islam has a view on how to organize political, social, and economic systems based on a set of ontological and epistemological propositions regarding individuals and their collectivities.

■ Defi ning an economic system as a collection of institutions dealing with production, exchange, distribution and redistribution, and defi ning insti-tutions as rules and norms, Islam proposes a distinct economic system

is further divided into two components: ibadat (rituals) focuses on the rites and rituals through which each individual comes to an inner understanding of their relationship with Allah (swt); muamalat, on the other hand, defi nes the rules governing social, political, and economic life. Indeed, a signifi cant subset of muamalat defi nes the conduct of economic activities within the economic system, which ultimately lays down the rules for commercial, fi nancial and banking systems.

Ijtihad (from the root jahd, meaning “struggle”) plays a critical role in deriving rules for resolving issues arising from time-dependent challenges. Ijtihad refers to the efforts of individual jurists and scholars to fi nd solutions to problems that arise in the course of the evolution of human societies and that are not addressed specifi cally in the primary sources. Ijtihad is based on the earlier consensus of jurists (ijma’), anal-ogy (qiyas), judicial preference (istihsan), public interest (maslahah) and customs (urf). Secondary sources of the Shari’ah must not intro-duce any rules that are in confl ict with the main tenets of Islam.

Over the course of history, different methods of exercising ijtihad have evolved depending upon the historical circumstances and the different schools of thought (madhahib) that prevailed at different times. The most commonly practiced methods are Hanafi , Maliki, Shafi ’i, Hanbali and Jafari, which each assign different weights in decision-making to each source of Law; that is, the Qur’an, the Sunnah, ijma’ and qiyas. For example, the Jafari school does not accept analogical reasoning in its entirety as a legitimate method to derive rules of Shari’ah, favoring instead the expert investigation and provision of solutions to new problems by jurists.

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Introduction 9

that differs in many important respects from those recommended by other schools of thought regarding how an economy is to be organized. To the extent that such an economy can be defi ned by its distinctive “institutional scaffolding,” it can also be defi ned as an Islamic economy to distinguish it from other types of economy.

■ The behavioral rules and norms of an Islamic system—once clearly, rig-orously, and analytically articulated—could yield empirically testable propositions that, in turn, could lead to policy analysis and recommen-dation on solutions to the problems of modern societies. To the extent that the emergence of a discipline devoted to studying and extracting eco-nomic rules of behavior in an Islamic economy is possible, analyzing the actual (as opposed to the ideal) performance of economies, devising incentive structures that promote rule compliance to allow convergence of actual and ideal, and recommending policy actions to accomplish such objectives, that discipline could be called “Islamic economics.” While an ideal Islamic economy is defi ned by the meta-framework and the archetypal model, Islamic economics would employ the accumulated store of human knowledge, including methods of analysis developed in the fi eld of economics, to fi nd ways and means of stimulating convergence between the actual and the ideal.

Since this book is about Islamic fi nance, a digression on the relevant basic principles may be helpful. Islam’s unconditional prohibition of riba (discussed in detail in Chapter 3) changes the landscape of a fi nancial sys-tem. This prohibition implies the prohibition of pure debt security and ulti-mately of leverage through debt. It is important to note that debts based on a predetermined rate tied to the principal are prohibited. Other modes of fi nancing based on the principle of the sharing of risk and reward are rec-ommended. The elimination of interest and the promotion of risk-sharing modes of fi nancing are the rationale behind Islamic fi nance practiced today. While acknowledging the expressions of skepticism, and even cynicism, regarding the present practices of Islamic fi nance, it appears that there is a consensus among an overwhelming majority of scholars on two fundamen-tal propositions: (i) interest is riba, and (ii) risk-and-reward sharing is an Islamic alternative to a system based on interest-rate debt.

The notion of having a system that operated without interest and debt came under immediate challenge, with analysts suggesting the folly of adopt-ing such a system. The prohibition of interest would, they argued, result in infi nite demand for loanable funds and zero supply. A zero-interest system would be incapable of equilibrating demand for and supply of loanable funds. Such a system would mean that there would be no savings and, thus, no investment and no growth. There could be no monetary policy, they said, since no instruments of liquidity management could exist without a fi xed, predetermined rate of interest. Any country adopting such a system could almost guarantee that there would be a one-way capital fl ight.

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BASIC PRINCIPLES OF AN ISLAMIC FINANCIAL SYSTEM

Prohibition of interest: Prohibition of riba, a term literally meaning “an excess” and interpreted as “any unjustifi able increase of capital, whether in loans or sales,” is the central tenet of the system. More precisely, any positive, fi xed, predetermined rate tied to the maturity and the amount of principal (that is, guaranteed regardless of the per-formance of the investment) is considered riba and is prohibited. The general consensus among Islamic scholars is that riba covers not only usury but also the charging of “interest” as widely practiced. A direct implication of the prohibition of interest is that pure debt securities with predetermined interest rates are also prohibited.

This prohibition is based on arguments of social justice, equality, and property rights. Islam encourages the earning of profi ts but forbids the charging of interest because profi ts, determined ex post, symbolize successful entrepreneurship and the creation of additional wealth. By contrast, interest, determined ex ante, is a cost that is accrued irrespec-tive of the outcome of business operations and may not create wealth if there are business losses. Social justice demands that borrowers and lenders share rewards as well as losses in an equitable fashion and that the process of wealth accumulation and distribution in the economy be fair and representative of true productivity.

Risk sharing: Because interest is prohibited, pure debt security is eliminated from the system and therefore suppliers of funds become investors, rather than creditors. The provider of fi nancial capital and the entrepreneur share business risks in return for shares of the profi ts and losses.

Asset-based: The prohibition of debt and the encouragement of risk sharing suggest a fi nancial system where there is a direct link between the real and the fi nancial sector. As a result, the system introduces a “materiality” aspect that links fi nancing directly with the underlying asset so that the fi nancing activity is clearly and closely identifi ed with the real-sector activity. There is a strong link between the performance of the asset and the return on the capital used to fi nance it.

Money as “potential” capital: Money is treated as “potential” capital—that is, it becomes actual capital only when it is combined with other resources to undertake a productive activity. Islam recog-nizes the time value of money, but only when it acts as capital, not when it is “potential” capital.

Prohibition of speculative behavior: An Islamic fi nancial system discourages hoarding and prohibits transactions featuring extreme uncertainty, gambling, and risk.

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Introduction 11

By 1988, this challenge was met when academic research, using modern analytical fi nancial and economic theory, showed that:

■ A modern fi nancial system can be designed without the need for an ex ante, determined, positive, nominal fi xed-interest rate. Indeed, it was shown that there was no satisfactory explanation for the existence of such a rate.

■ Moreover, it was shown that not having such an interest rate (that is, the absence of a debt contract) did not necessarily mean that there would be zero return on capital.

■ The basic proposition of Islamic fi nance was that the return on capital would be determined ex post, and that the magnitude of that return was determined on the basis of the return to the economic activity in which the funds were employed.

■ It was the expected return that determined investment. ■ It was also the expected rate of return, and income, which determined

savings. Therefore, there was no justifi cation for assuming that in such a system there would be no savings and investment.

■ It was shown that in such a system there would be positive growth. ■ Monetary policy in such a system would function as in the conven-

tional system, its effi cacy depending on the availability of instruments designed to manage liquidity.

■ Finally, it was shown that, in an open-economy macroeconomic model without an ex ante fi xed-interest rate, but with returns to investment determined ex post, there was no justifi cation to assume that there would be a one-way capital fl ight.

Therefore, the system which prohibited a fi xed ex ante interest rate and allowed the rate of return on capital to be determined ex post, based on the returns to the economic activity in which the funds were employed, was theoretically viable.

In demonstrating the analytical viability of such a system, the research also clearly differentiated it from the conventional system in which, based on debt contracts, risks and rewards were shared asymmetrically, with the

Sanctity of contracts and the preservation of property rights: Islam upholds contractual obligations and the disclosure of information as a sacred duty. This feature is intended to reduce the risk of asymmetric information and moral hazard. Islam places great importance on the preservation of property rights, defi nes a balance between the rights of individuals, society and the state, and strongly prohibits encroach-ment on anyone’s property rights.

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debtor carrying the greatest part of the risk, and with governments enforc-ing the contract. Such a system had a built-in incentive structure that pro-moted a moral hazard and asymmetric information and thus required close monitoring. The costs could be managed if monitoring could be delegated to an institution that could act on behalf of the collectivity of depositors/investors; hence the existence of banking institutions.

In the late 1970s–early 1980s, Minsky and others demonstrated that such a system was inherently prone to instability because there would always be a maturity mismatch between liabilities (short-term deposits) and assets (long-term investments). Because the nominal values of liabilities were guaranteed, but the nominal values of assets were not, when the maturity mismatch became a problem, banks would attempt to manage their liabilities by offering higher interest rates to attract more deposits. There was always the possibility that this process would not be sustainable, resulting in an erosion in confi dence and runs on banks. Such a system, therefore, needed a lender of last resort and bankruptcy procedures, restructuring processes, and debt-workout procedures to mitigate the contagion.

During the 1950s–60s, Lloyd Metzler of the University of Chicago had proposed an alternative system in which contracts were based on equity rather than debt, and in which there was no guarantee of nominal values of liabilities since these were tied to the nominal values of assets. Metzler showed that such a system did not have the instability characteristic of the conventional banking system. In his now-classic article, Mohsin Khan (1987) showed the affi nity of Metzler’s model with Islamic fi nance. Using Metzler’s basic model, Khan demonstrated that this system produces a saddle point and is, therefore, more stable than the conventional system.

By the early 1990s, it was clear that an Islamic fi nancial system was not only theoretically viable, but also had desirable characteristics that rendered it superior to a debt-based conventional system. The phenomenal growth of Islamic fi nance during the decade of the 1990s demonstrated the empirical and practical viability of the system.

The crises we have been witnessing in the international fi nancial system since 1997 have set the stage for Islamic fi nance to demonstrate its viabil-ity as potentially a genuine alternative global fi nancial system. The present international system is defi cient in many ways, of which the two most impor-tant are:

■ A debt-based system needs an effective lender of last resort, and the present international fi nancial system does not have one and it is not likely that one will emerge anytime soon; and

■ A debt-based system needs bankruptcy proceedings, debt restructur-ing, and workout mechanisms and processes that the present interna-tional fi nancial system lacks. There are preliminary discussions under way for an international sovereign-debt restructuring mechanism to be established, but there are many complications. While such a mechanism,

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Introduction 13

if and when it comes into being, will help reduce the risk of moral hazard and lead to a better distribution of risk, it will not address the inherent and fundamental fragility of a system based largely on debt contracts.

The fi nancial crisis of 2007–2009 reinforced and exposed many of the inherent vulnerabilities of a debt-based system: excessive leverage, failure of market discipline, complex derivatives remote from real economic transac-tions, and lapses of corporate governance. Askari et al. (2010) examined the crisis and have argued that an Islamic fi nancial system would be more stable when followed in its essence.

MODERN HISTORY OF ISLAMIC BANKING AND FINANCIAL SERVICES

Although Islam has provided a blueprint of how a society is to be organized and how the affairs of its members are to be conducted in accordance with its prescriptions, with the exception of a brief period following its incep-tion the system itself has not been applied in its entirety. The economy at that time was, of course, much less complex than the economies of mod-ern times. The business practices of the day conformed to the principles of Islam and the element of “interest” was minimized. Indeed, the practice of interest was also condemned by other major religions and the institution of interest had yet to be developed. It is only in recent decades, when the element of interest became an integral part of economic life, that Muslims have been forced to become more conscious of its existence at a time of growing interest in the wider implementation of Islamic teachings.

It is for this reason that our discussion on the history of Islamic eco-nomics and fi nance is limited to developments since the nineteenth century. These developments towards implementing a Shari’ah-compliant economic, fi nancial, and banking system can be divided into three phases.

Phase I: Pre-1960

Throughout the nineteenth century and through a good part of the twenti-eth century, several Muslim countries were under colonial rule. During the colonial period, these Muslim societies to varying degrees lost touch with their old traditions, values and cultural heritage. Although there is evidence of resistance to the imposition of colonial values and a desire to return to the Islamic tradition, such efforts were not widespread. It was only after the end of the colonial period that Muslims began to re-discover their identities and manifested the desire to regain the lost values in all aspects of life, especially in the economic sphere.

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Siddiqi (2006: 2) recalls conducting a survey of writings on Islamic eco-nomics and banking in English, Arabic, and Urdu languages in the early 1970s, and makes the following observations:

Out of the items included in the bibliography only eight date before 1920. Out of these, only two deal with the subject of interest, the remaining dealing with distribution of wealth (2) history (2) trade (1) and waqf (1). Of the 14 entries in the following decade only one deals with interest, the remaining are spread over other sub-jects. The fi rst writings on interest-free banking appear in the nine-teen forties. Out of a total of 28 writings on Islamic economics during this period, three are on interest-free banking. Among the remaining, zakat and the Islamic economic system in general has the largest number of writings. Though the writers in this period include Ulema [scholars] trained in traditional schools, the writings on interest-free institutions are not by them. We have 156 entries for the nineteen-fi fties which include several writings on interest and interest-free institutions but the writings on socialism, capital-ism and on some other aspects of Islamic economy far outnumber these.

A formal critique and opposition to the element of interest started in Egypt in the late nineteenth century when Barclays Bank was established in Cairo to raise funds for the construction of the Suez Canal. The establish-ment of such an interest-based bank in a Muslim country attracted opposi-tion from its inception. Further, a formal opposition to the institution of interest can be found as early as 1903 when the payment of interest on post offi ce savings funds was declared contrary to Islamic values, and there-fore illegal, by Shari’ah scholars in Egypt. In India, a minority community of Muslims in southern India took the fi rst step toward their desire to pursue an Islamic mode of economic activities by establishing interest-free loans as early as the 1890s. This was mainly a welfare association collecting dona-tions and animal skins from the public to provide interest-free loans to the poor. An interest-free credit society was also established in Hyderabad in 1923.

During the fi rst half of the twentieth century, there were several attempts to highlight the areas in which the emerging conventional economic system confl icted with Islamic values. The need for an alternative economic sys-tem conforming to the principles of Islam soon came to the fore and econ-omists began to explore Shari’ah-compliant contracts, especially equity partnerships. Some of the early Muslim intellectuals and jurists (fuqaha) who made signifi cant contributions in developing alternatives based on the tenets of Islam include Maulana Syed Abul Ala Maudoodi (Pakistan), Imam Muhammad Baqir al-Sadr (Iraq), Anwar Iqbal Qureshi (Pakistan), Mohammad Nejatullah Siddiqi (India), Muhammad Uzair (Saudi Arabia), Umer Chapra

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Introduction 15

(Saudi Arabia), and Ahmad al-Najjar (Egypt).7 By 1953, Islamic economists had offered the fi rst description of an interest-free bank on a two-tier muda-rabah and wakala (agency) basis. By the end of the 1950s, Islamic scholars and economists had begun to offer theoretical models of fi nancial intermediation as a substitute to interest-based banking.

Phase II: 1960s–1980s

By the start of the 1960s, the demand for Shari’ah-compliant banking was such that it resulted in the establishment of the Mit Ghamr Local Savings Bank in Egypt in 1963 by the noted social activist Ahmad al-Najjar. This is widely considered to be the fi rst modern Islamic bank.

It is worth noting that Dr. Najjar chose to promote this institution as a social welfare institution rather than as an Islamic bank.8 His bank, based on the principle of rural banking within the general framework of Islamic values, borrowed some ideas from German savings banks. Unfortunately, this experiment lasted just four years. Around the same time, there were parallel efforts in Malaysia to develop a scheme that would enable Muslims to save money to perform the Pilgrimage without the contamination of interest that regular commercial banks were charging. The Pilgrims’ Savings Corporation was established in 1963 and was later incorporated into the Pilgrims’ Management and Fund Board (popularly known as Tabung Haji) in 1969.

The Nasir Social Bank in Egypt, established by presidential decree in 1971, was the fi rst state-sponsored interest-free institution. The establish-ment of the Dubai Islamic Bank in the UAE in 1975 is considered to be one of the earliest private initiatives. The rapid accumulation of revenues (“petro-dollars”) in several oil-rich Muslim countries in the Middle East in the 1970s offered strong incentives for creating suitable investment outlets for Muslims wanting to comply with the Shari’ah. This business opportu-nity was exploited by both domestic and international bankers, including some of the leading conventional banks.

In 1975, the Islamic Development Bank (IDB) was established on the lines of regional development institutions with the objective of promoting economic development in Muslim countries as well as offering Shari’ah-compliant development fi nance. The Jeddah-based IDB has played a key role in expanding Islamic modes of fi nancing and in undertaking valuable research in the area of Islamic economics, fi nance and banking. During the 1970s, the concept of a fi nancial murabahah (trust fi nancing) was devel-oped as the core mechanism for the placement of Islamic banks’ funds. Academic and research activities were launched with the First International Conference on Islamic Economics, held in Mecca, Saudi Arabia, in 1976. The fi rst specialized research institution, the Centre for Research in Islamic Economics, was established at the King Abdul Aziz University of Jeddah, Saudi Arabia, in 1978.

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The 1980s marked the beginning of a trend of rapid growth and expansion for the emerging Islamic fi nancial services industry that contin-ued through the 1990s. During that period, the Islamic Republics of Iran, Pakistan and Sudan announced their intentions to transform their overall fi nancial systems to make them compliant with the Shari’ah. Other coun-tries such as Malaysia and Bahrain instituted Islamic banking within the frame-work of their existing systems. The International Monetary Fund (IMF) initiated research in the macroeconomic implications of an economic system operating without the basis of interest. Similar research was conducted into the fi nancial stability of a system based on the sharing of profi t and loss. The signifi cance and contribution of this research was recognized in 2004 when two IMF economists were awarded IDB’s highest prize in Islamic economics.9 The Organization of Islamic Countries (OIC) Fiqh Academy and other Shari’ah scholars became engaged in the discussions for reviewing fi nancial transactions.

During the early stages of the Islamic fi nancial market, Islamic banks faced a dearth of quality investment opportunities, which created business opportunities for the conventional Western banks to act as intermediar-ies to deploy Islamic banks’ funds in accordance with guidelines provided by the Islamic banks. Western banks helped Islamic banks place funds in commerce and trade-related activities by arranging a trader to buy goods on behalf of the Islamic bank and to resell them at a mark-up. Gradually, Western banks realized the importance of the emerging Islamic fi nancial markets and began to offer their own Islamic products through “Islamic windows” in an attempt to attract the clients directly. Islamic windows are not independent fi nancial institutions, but are specialized set-ups within conventional fi nancial institutions that offer Shari’ah-compliant products for their clients. Meanwhile, driven by the growing demand for Shari’ah-compliant products and fear of losing depositors, non-Western conventional banks also started to offer Islamic windows. In general, these windows are targeted at high-net-worth individuals who want to practice Islamic banking—that is, approximately 1–2 percent of the world’s Muslims.

Phase III: 1990s–Present

By the early 1990s, the market had gained enough momentum to attract the attention of policymakers and institutions interested in introducing innova-tive products. Recognizing the need for standards, a self-regulatory agency—the Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI)—was established. This was instrumental in highlighting the special regulatory needs of Islamic fi nancial institutions and in defi ning account-ing and Shari’ah standards, which were adopted or recognized by several countries. However, with the growth of the market, the regulatory and supervisory authorities, with the help of the IMF, established a dedicated regulatory agency, the Islamic Financial Services Board (IFSB) in the early

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Introduction 17

2000s to address systemic stability and various governance and regulatory issues relating to the industry.

Further progress was made in developing capital markets. Islamic asset-backed certifi cates, sukuks, were launched successfully in Bahrain, Malaysia and other fi nancial centers. Among the issuers were corporations, multi-laterals and sovereign entities such as the Islamic Development Bank, the International Bank for Reconstruction and Development and the Governments of Bahrain, Qatar and the Islamic Republic of Pakistan. During the equities market boom of the 1990s, several equity funds based on Shari’ah-compatible stocks emerged. The Dow Jones and Financial Times launched Islamic indices to track the performance of Islamic equity funds.

The number of conventional banks offering Islamic windows grew. Citibank was one of the early Western banks to establish a separate Islamic bank—Citi Islamic Investment Bank (Bahrain) in 1996—and the Hong Kong and Shanghai Banking Corporation (HSBC) now has a well-established network of banks in the Muslim world. With the objective of promot-ing Islamic asset securitization and private equity and banking in OECD countries, HSBC Global Islamic Finance (GIF) was launched in 1998. The list of Western banks keeping Islamic windows includes the American Express Bank Ltd., ANZ Grindlays, BNP-Paribas, Deutsche Bank UBS, and Kleinwort Benson. The leading non-Western banks with signifi cant Islamic windows are National Commercial Bank of Saudi Arabia, United Bank of Kuwait, and Riyadh Bank.

Several institutions were established to create and support a robust fi nancial system. These institutions include the International Islamic Financial Market (IIFM), the International Islamic Rating Agency (IIRA), the General Council of Islamic Banks and Financial Institutions (CIBAFI) and the Arbitration and Reconciliation Centre for Islamic Financial Institutions (ARCIFI).

Islamic fi nance has begun to go global. Although Western fi nancial centers and fi nancial intermediaries have always played an important part in executing and innovating Islamic transactions, such activities have been mostly carried in the private sector and in a discreet fashion. By early 2000, this trend had begun to change, with several non-Muslim countries taking an interest in this emerging fi nancial market. This can be attributed to sev-eral factors such as booming oil revenues leading to accumulation of invest-ible funds looking for attractive investment opportunities; an increased awareness of regulatory issues relating to Islamic fi nancial intermediaries; and the desire to tap into alternative funding resources by sovereign and corporate entities.

Islamic fi nance has had a long, if silent, presence in Europe. A major early development was the establishment in 1981 of the Dar al Maal al Islami Trust in Geneva, an investment company that held stakes in several Islamic banks.10 Many high-net-worth clients demanding Shari’ah-compliant invest-ments deal directly with European banks, notably with UBS of Switzerland, the leading provider of Shari’ah-compliant wealth-management services.

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The German Federal State of Saxony-Anhalt pioneered the sukuk in Europe with a fi ve-year offering which raised €100 million (US$120 million) in July 2004.11 Although London has been active in the market, the idea of Islamic fi nance has yet to attract attention on a large scale elsewhere in Europe. In France, for example, where the Muslim population of six million is three times that of the UK, the authorities and regulators have been slow to realize the potential of this market.12

During the period 2005–2008, there was another wave of interest in Islamic fi nance, again prompted by increased oil revenues in the Middle East. However, unlike the surge in the 1970s which was limited to the high-net-worth class, the current growth is the result of demand from a much wider group that includes small investors and retail consumers. Several countries where Islamic fi nance was dormant are experiencing a sudden surge in demand for Shari’ah-compliant products. In Saudi Arabia, for example, such has been the public pressure to embrace Islamic fi nance that the country’s largest bank, the National Commercial Bank, has converted its entire branch network to Shari’ah principles.13 Bahrain and Malaysia have also taken an active role in the development of Islamic fi nance and have made serious efforts to establish world-class fi nancial centers to promote Islamic fi nance.

London’s historical reputation and signifi cance as a fi nancial center, coupled with its attractiveness as a time-zone with respect to the Middle East, has made it a popular choice for Islamic fi nancial transactions. It is said that more money from the most widely used Islamic fi nancial instrument, the commodity murabahah, fl ows through London fi nancial center than in any other center.14 With a Muslim population of almost two million in the UK, there was suffi cient demand to establish the Islamic Bank of Britain in September 2004. By the end of 2006, this had attracted deposits worth £83 million (US$165 million) from 30,000 customers and its assets stood at £120 million (US$240 million).15 Similarly, the European Islamic Investment Bank (EIIB) began its operations in April 2006 with the objective of promot-ing Shari’ah-compliant investment banking. In 2008, the European Finance House (EFH), a unit of Qatar Islamic Bank, was awarded a banking license in the UK to provide Shari’ah-compliant banking. EFH plans to target the European Union’s 14 million Muslims who will have access to Islamic fi nancial products.16

Realizing the signifi cance and potential for Islamic fi nance domestically and internationally, the UK government has taken steps to make its markets “Islamic Finance Friendly.” In 2007, for example, it began to explore the possibilities for launching a sovereign sukuk designed to encourage the domestic Islamic fi nancial market and develop a global benchmark. In the budget that year, sukuk were accorded the same tax status as con-ventional debt instruments and the income to sukuk investors was treated as interest income. These measures were introduced to send positive sig-nals to potential sukuk investors and to ensure a level playing fi eld with

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Introduction 19

conventional securities. As more steps are taken to develop London as a hub for Islamic fi nance, it poses serious threats for regional fi nancial cen-ters such as Bahrain and Malaysia. Some argue that this may lead to capital fl ight, which can hamper the development of the regional centers. However, others argue that London can play a complementary and enhancing role through providing fi nancial innovations, cost-effective execution and access to other markets.

The presence of Islamic fi nance is beginning to be felt all over the globe and multilateral institutions are also engaging with the market. The World Bank and the IMF have made contributions to this fi eld through research, and other institutions are also getting involved. The International Finance Corporation (IFC)—the private-sector arm of the World Bank—has exe-cuted several Shari’ah-compliant transactions. In 2009, IFC issued sukuk to the value of US$100 million for funding Islamic fi nance projects in key sectors such as health, education, and infrastructure in the Middle East. In 2007, the World Bank-affi liated Multilateral Investment Guarantee Agency (MIGA) provided its fi rst-ever guarantee for Shari’ah-compliant project fi nancing, worth US$427 million.17

The major developments in modern Islamic economics and fi nance are summarized in Table 1.1.

Institutional Development

The private sector has been much more active than the public sector in the growth of this market. Governments such as those of Bahrain and Malaysia have made serious efforts to establish centers for Islamic fi nancial institutions and the institutional infrastructure to support development of the fi nancial sector is slowly emerging. This includes institutions to deal with accounting and regulatory standards, corporate governance, credit ratings, and capital markets. These efforts to develop institutions are also supported by several stakeholders such as the IMF, central banks of lead-ing Muslim countries, international standard-setting bodies, and fi nancial centers.

As mentioned earlier, the IDB was established in 1975 as a regional development institution to promote economic development in Muslim countries through Islamic fi nance. Since then, it has established several sis-ter institutions to develop the private sector, insurance facilities, and trade and export fi nancing.18

The Islamic Research and Training Institute (IRTI)—the IDB’s research arm—was established in 1981 to undertake research and training in a range of economic, fi nancial and banking issues. It has become a rich resource center for, and has played a critical role in, developing a 10-year master plan for the Islamic fi nancial industry.

The Islamic Corporation for the Insurance of Investment and Export Credit (ICIEC), another of the IDB’s sister organizations, was established in

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TABLE 1.1 Developments in modern Islamic economics and fi nance

Pre-1950s Barclays Bank opens its Cairo branch in the 1890s to process the fi nancial transactions related to the construction of the Suez Canal. Islamic scholars challenge the operations of the bank, considering its dealings to involve interest. This critique also spreads to other Arab regions, and to the Indian sub-continent where there was a sizeable Muslim community.

Majority of Shari’ah scholars declare that interest in all its forms amounts to the prohibited element of riba.

1950s–60s Initial theoretical work in Islamic economics begins. In 1953, Islamic economists offer the fi rst description of an interest-free bank based either on two-tier mudaraba or wakala.

Mit Ghamr Bank in Egypt and Pilgrimage Fund in Malaysia start.

1970s First Islamic commercial bank, Dubai Islamic Bank, opens in 1974.Islamic Development Bank (IDB) is established in 1975.Accumulation of oil revenues and petro-dollars increases demand

for Shari’ah-compliant products.

The 1980s Islamization of economies in Islamic Republics of Iran, Pakistan and Sudan, which introduce interest-free banking systems.

Increased demand attracts Western intermediation and institutions.The IDB establishes the Islamic Research and Training Institute

(IRTI) in 1981.Countries like Bahrain and Malaysia promote Islamic banking

parallel to the conventional banking system.

The 1990s Attention is paid to the need for accounting standards and regulatory framework. The Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI) is established.

Islamic insurance (takaful) is introduced.Islamic Equity Funds are established.Dow Jones Islamic Index and FTSE Index of Shari’ah-compatible

stocks are developed.

2000–Present The Islamic Financial Services Board (IFSB) is established to deal with regulatory, supervisory and corporate-governance issues.

Sukuks (Islamic bonds) are launched.Globalization of Islamic fi nance as Shari’ah-compliant transaction

starts to appear in Europe, Asia and North America.Growth of academic interest and research followed by offering of

organized programs at reputable Western universities.Limited application of fi nancial engineering through introduction

of profi t-rate swaps.Legal issues are raised in cross-border jurisdictions after defaults

on Shari’ah-compliant transactions during and after the fi nancial crisis.

Sources: Khan (1996), IDB (2005), and Iqbal and Mirakhor (2007).

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Introduction 21

1994 with the objective of enlarging the scope of trade transactions and the fl ow of investments among member countries. The ICIEC’s main objectives are to provide Shari’ah-compliant export credit insurance and reinsurance to cover the non-payment of export receivables resulting from commer-cial (buyer) and non-commercial (country) risks and to provide investment insurance and reinsurance against country risk, emanating mainly from foreign-exchange transfer restrictions, expropriation, war and civil disturbance, and breach of contract by the host government. The Islamic Corporation for the Development of the Private Sector (ICD) was established in 1999 to promote the development of the private sector in member countries. Its objectives are to (i) identify opportunities in the private sector that could function as engines of growth; (ii) provide a wide range of productive fi nan-cial products and services; (iii) mobilize additional resources for the private sector in member countries, and (iv) encourage the development of Islamic fi nancial and capital markets.

In 2006, the IDB established the International Islamic Trade Finance Corporation (ITFC) to promote trade among OIC countries by providing Shari’ah-compliant trade fi nance, promoting trade among member coun-tries, enhancing their export capabilities and increasing the developmental impact of trade fi nancing in those countries. That same year, IDB members also established a special “solidarity” fund for reducing poverty, eliminating illiteracy, eradicating major communicable diseases and building the human and productive capacities, particularly in the least-developed OIC countries. This fund is organized as an endowment (waqf ) fund, with targeted capital of US$10 billion.

The AAOIFI was established as a self-regulatory agency to tackle the problem of Shari’ah compliance and gaps in applying conventional fi nancial reporting standards to Islamic banks. Its membership consists of some 97 institutions spanning more than 24 countries and its Shari’ah Board is pav-ing the way towards harmonizing Islamic banking practices throughout the world.19 A number of countries, including Bahrain and Sudan, either require Islamic banks to comply with AAOIFI standards or, as in the case of Qatar and Saudi Arabia, are specifying AAOIFI standards as guidelines.

The AAOIFI was successful in defi ning accounting and Shari’ah stan-dards, which were adopted or recognized by several countries. However, with the growth of the market, in 2000 the regulatory and supervisory authorities established, with the help of the IMF, a dedicated regulatory agency, the Islamic Financial Services Board (IFSB), to address systemic sta-bility and various governance and regulatory issues relating to the Islamic fi nancial services industry. The IFSB took on the challenge and started work-ing in the areas of regulation, risk management and corporate governance, which are discussed in more detail later.

Table 1.2 sets out the functions of many of the key organizations now operating in the fi eld of international Islamic fi nance.

The General Council of Islamic Banks and Financial Institutions (GCIBFI) focuses on the media and awareness, information and research, policies

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TABLE 1.2 Key institutions in the Islamic fi nancial industry

Acronym Organization Function

IDB Islamic Development Bank Development institution developed in 1975 to promote Islamic fi nance and economic development

Member/Sister OrganizationsICD: Islamic Corporation for the

Development of the Private SectorICIEC: Islamic Insurance Company,

providing insurance products for investments and export credits

IRTI: Research and training arm of IDB

ITFC: International Islamic Trade Finance Corporation

Solidarity Fund: To reduce poverty in OIC countries

ARCIFI: Arbitration and Reconciliation Center for Islamic Financial Institutions

AAOIFI Accounting and Auditing Organization for Islamic Financial Institutions

Accounting and Shari’ah standard-setting body

IFSB Islamic Financial Services Board

Standard-setting institution to ensure best practices and help member countries with regulating Islamic fi nancial institutions

IIFM International Islamic Financial Markets

Trade association to promote capital markets

IIRA Islamic International Rating Agency

Rating agency

LMC Liquidity Management Center

Institution to provide liquidity enhancement to the fi nancial system

CIBAFI General Council of Islamic Banks and Financial Institutions

Trade association of Islamic banks to enhance member institutions’ ability to better serve customers around the world through transparent banking practices

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Introduction 23

and strategic planning, and Islamic fi nancial products. The Arbitration and Reconciliation Centre for Islamic Financial Institutions (ARCIFI) aims to settle, through reconciliation and arbitration, fi nancial and commercial dis-putes involving institutions that have chosen to comply with the Shari’ah to settle disputes.

The major objectives of the Bahrain-based IIFM are (a) to enhance cooperation among regulatory authorities of Islamic banks, (b) to address the liquidity problem by expanding the maturity structure of instruments, and (c) to explore the possibility of sovereign asset-backed securities. The IIFM is currently working with the International Capital Markets Association (ICMA) on the further development of primary and secondary markets for Islamic bonds (sukuk). The two groups are work-ing together to develop a repurchase (repo) master agreement to help central banks manage liquidity in the sukuk market; as well as a mas-ter agreement for murabahah commodities contracts, which are used in interbank transactions between Islamic banks and between Islamic and conventional banks.20

The IIRA aims to assist in the development of regional fi nancial mar-kets by providing an assessment of the risk profi le of entities and instru-ments that can be used for investment decisions. The IIRA is sponsored by multilateral fi nance institutions, several leading banks and other fi nancial institutions, and rating agencies from different countries. The organization has a board of directors and an independent rating committee as well as a Shari’ah board. The IIRA also provides a unique service of rating the level of compliance fi nancial institutions have with the stipulations adopted by their Shari’ah committee in good faith, both in letter and in spirit. They also examine whether there is a mechanism within the institution to evaluate its compliance with the Shari’ah and whether the Shari’ah committee has enough authority, information, and resources to perform the examination and evaluation.

The Liquidity Management Center (LMC) was established to facili-tate investment of the surplus funds of Islamic banks and fi nancial institu-tions into quality short- and medium-term fi nancial instruments structured in accordance with Shari’ah principles. Its shareholders include Bahrain Islamic Bank, Dubai Islamic Bank, Islamic Development Bank, and Kuwait Finance House. The LMC assists Islamic fi nancial institutions in managing their short-term liquidity and supports the interbank market. In addition, the center attracts assets from governments, fi nancial institutions, and cor-porations in both the private and public sectors in many countries. The assets are securitized into readily transferable securities or structured into other innovative investment instruments. The Center also provides short-term liquid, tradable, asset-backed treasury instruments (sukuk) in which fi nancial institutions can invest their surplus liquidity and offers advisory services dealing with structured, project, and corporate fi nance as well as equity fl oatation.

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RECENT TRENDS IN ISLAMIC FINANCIAL MARKETS

There is no formal or systematic source of statistics on Islamic fi nance but sev-eral estimates are often quoted by different commercial and non-commercial sources.21 According to the 10-Year Master Plan for Islamic Financial Industry prepared by the IDB and IFSB, by the end of 2005, more than 300 institutions in over 65 jurisdictions were engaged in Islamic fi nance. In a broad sense, the Islamic fi nancial industry consists of a number of com-ponents such as Islamic banks, Islamic windows, capital markets, Islamic insurance (takaful) and other non-bank fi nancial institutions. Islamic bank-ing usually refers to offshore and onshore deposit-taking commercial and investment banking and is the most dominant sector of the market. Islamic windows are specialized windows available through conventional banks catering to the demands of Islamic products. Historically, Islamic banking and windows have been the most active sector but in the last decade other forms of fi nancial products and services have been gaining momentum. Activities in the capital markets in the form of Islamic funds or Islamic bonds (sukuk) are increasing and there are institutions specializing in asset management, mutual funds, and brokerage houses. Islamic non-bank fi nan-cial institutions, which include specialized institutions offering fi nancial services through leasing (ijarah) or partnership (mudarabah), perform a similar function to conventional fund-management companies. There is a limited but growing number of institutions engaged in micro-fi nance, venture capital and private equity fi nancing.

Table 1.3 shows the total size of different segments of the market, compiled from different sources. Given the lack of transparency in fi nancial disclo-sure by fi nancial institutions in developing countries, these estimates are, if anything, on the conservative side, and the actual size of assets under manage-ment is likely to be signifi cantly higher.

Islamic banks have experienced high growth, as shown in Table 1.4 which lists growth rates of assets and deposits in selected countries in the Middle East and North Africa (MENA) region. From this, it is clear that

TABLE 1.3 Total assets under management as of 2010

Sector Amount (US$ billion)

Islamic banks 400

Islamic windows 250

Sukuk 120

Islamic funds 45

Takaful 5

Total 820

Source: IFIS and other estimates

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Introduction 25

the growth rate was high during the 2006–2007 and 2007–2008 period but there were signs of a slowdown after that. This can be attributed to economic slowdown after the fi nancial crisis.

In general, the trend is that competition is increasing for Islamic banks, as conventional banks are also pursuing this business aggressively. Several Islamic banks that once enjoyed a virtual monopoly in the market are now threatened by conventional banks that may have better marketing networks, name recognition, and economies of scale. For example, according to some estimates, Islamic banks accounted for 71 percent of Islamic assets in 2008 as compared with the almost-100 percent share recorded in 2003.22

During the subprime fi nancial crisis, Islamic banks were largely immune because they did not have any investments in toxic debt-based assets. However, Islamic banks were not insulated from the regional economic slowdown arising from the global economic recession. It was observed that, during the fi rst half of 2009, banking assets in the GCC countries declined by 1.1 percent, while assets of the fi ve largest Islamic banks increased by 1.3 percent. This compares with a rise of 17 percent and 21.5 percent, respec-tively, in 2008.23

With the economic recession, concerns have grown with respect to the quality of assets of Islamic fi nancial institutions for several reasons. First,

TABLE 1.4 Growth rates of assets and deposits across countries

CountryBanks in Sample Assets Customer Deposits

Growth Rate (%) Growth Rate (%)

2006–07 2007–08 2006–07 2007–08

Bahrain 12 48.54 39.00 58.33 32.07

Egypt 2 21.27 10.53 22.89 9.54

Jordan 2 (9.30) 25.86 (8.59) 16.34

Kuwait 2 47.04 19.33 51.05 24.94

Lebanon 1 362.09 145.54 (3.02) 21.43

Qatar 2 34.64 47.94 26.63 31.98

Saudi Arabia 3 23.16 27.94 28.65 22.32

UAE 5 40.28 17.07 46.16 19.56

Yemen 1 7.29 20.08 6.13 18.73

MENA Region 30 34.50 24.50 37.47 22.28

Source: Ali, Syed Salman (2011), Islamic Banking in the MENA Region, Washington, DC, USA. http://siteresources.worldbank.org/INTMNAREGTOPPOVRED/Resources/MENAFlagshipIslamicFinance2_24_11.pdf

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Islamic banks had considerable investments in the real-estate sector and as result of the decline in property prices and values the market value of assets has deteriorated. Second, Islamic banks tend to have geographical and sectoral concentrations, which has exposed them to additional risk. It is expected that because of prudent practices such as holding excessive liquid-ity and adequate equity capital, Islamic banks will weather this storm and will continue to grow their assets and deposits base.

Islamic capital markets which grew rapidly were also impacted by the fi nancial crisis. This is evident from the drop in the issuance of Islamic bonds (sukuk) in the post-crisis period. There were also several cases of legal dis-putes concerning sukuk which sent negative signals in the market and put downward pressure on demand. However, as legal issues were sorted out in orderly fashion, the market has seen a rebound in demand. For example, the sukuk issued by the IDB in 2010 was well received in the market and its demand exceeded the amount offered.

Finally, in another positive move, several central banks signed an agreement in October 2010 to establish a liquidity facility for Islamic fi nan-cial institutions with the objective of providing liquidity-enhancing products in the market and to offer liquidity through trading short-term fi nancial instruments.

ENDNOTES

1. For example, see Kuran (1995). 2. Chapra (2000). 3. The term (swt) is an abbreviation of subhana-wa-ta’ala, meaning “The Exalted

One.” 4. The verses emphasizing the principle of unity include: “And indeed this is my

straight path therefore follow it—and do not follow other ways because that will lead to disunity amongst you” (6:153) “Grab hold of the rope of Allah collectively and do not disunite” (3:103) “Cooperate with one another unto righteousness and piety and do not cooperate with one another unto unrigh-teousness and enmity” (5:2).

5. The abbreviation “pbuh” (“peace be upon him”) invokes the peace and bless-ings of Allah (swt) on the Prophet, and is a sign of respect.

6. Qur’an 2:143. 7. Khurshid (2009). 8. Martin (2007). 9. The IDB award for distinguished achievement in Islamic economics was awarded

to Dr. Mohsin Khan and Dr. Abbas Mirakhor.10. Wilson (2007).11. Ibid.12. Oakley, David, ‘‘Capital Takes a Leading Role,’’ FT Report—Islamic Finance,

May 23, 2007, Financial Times (London, UK).13. RedMoney 2007.

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Introduction 27

14. Oakley, David, ‘‘Capital Takes a Leading Role,’’ FT Report—Islamic Finance, May 23, 2007, Financial Times (London, UK).

15. Martin, op. cit.16. Financial Times, February 5, 2008.17. http://www.miga.org/news/index_sv.cfm?aid=169618. For further details, see IDB (2005).19. Alchaar (2006).20. Kerr, Simon, Financial Times reports: Islamic Finance, May 24, 2007.21. CIBAFI is making efforts to maintain statistics on Islamic fi nancial institutions.22. S&P Outlook (2010).23. Ibid.

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Contents

Preface xiii

Acknowledgments xv

1 An Introduction to Conventional and Islamic Financial Systems 1

Learning Outcomes 1

Introduction 2

The Roles and Functions of Financial Markets 4

Structures of Financial Markets 6

Based on the Instrument 6

Based on the Issuance of Securities 8

Methods Used in Secondary Markets 8

Based on the Maturity 9

Classifi cation of Financial Markets 9

The Money Market 10

The Capital Market 12

Types of Financial Intermediaries 13

Depository Institutions 14

Contractual Institutions 15

Investments and Finance Institutions 17

A Brief Overview of the Islamic Financial System 17

Evolution of Islamic Finance 18

Chapter Summary 20

Chapter Questions 21

Notes 22

References 22

2 Development of Islamic Capital and Money Markets in Malaysia 23

Learning Outcomes 23

Introduction 24

Development of Islamic Financial Institutions in Malaysia 24


1960 to 1990: Establishment of Islamic Financial Institutions 24

1990 to 2000: Conventional Banks Allowed to Offer Islamic

Financial Products and Services 26

2000 to 2010: Islamic Subsidiaries and the International

Integration of the Islamic Banking System 27

Islamic Capital Markets in Malaysia 29

Sukuk 30

Islamic Collective Investments 31

Islamic Stock Broking 32

Malaysia International Islamic Financial Centre (MIFC) 33

Chapter Summary 34


Notes 36

References 36

3 Regulators and Transactions Platform for Capital and Money Markets 37


Introduction 38

Bank Negara Malaysia (BNM) 38

Role and Functions 39

BNM Administered Legislation 40

Role of BNM on ICM Development 42

The Securities Commission (SC) 42

Role of SC on ICM Development 42

Bursa Malaysia (BM) 45

Role of BM on ICM Development 45

Shariah-Compliant Stocks and ETF 46

Islamic Equity Indices 46

Islamic REITs and Sukuk Market 47

Chapter Summary 47


Notes 48

References 48

Websites 48


4 Islamic Money Market 49


Introduction 50

Money Market Participants 50

Functions of the Islamic Money Market 51

Differences between Islamic and Conventional Money Markets 52

Components of the Malaysian Islamic Money Market 53

Islamic Interbank Market 53

Mudarabah Interbank Investment 54

Profi t Calculation for Mudarabah Interbank Investment 55

Example: Mudarabah Interbank Investment (MII) 56

Commodity Murabahah 56

Example: Commodity Murabahah Interbank Investment 58

Wakalah Investment 58

Trading of Islamic Money Market Instruments 59

Government Investment Issue (GII) 60

Example: Calculation of GII price 61

Malaysian Islamic Treasury Bills (MITB) 61

Example: Calculation of Proceeds on MITB 62

Bank Negara Monetary Notes (BNMN) 62

Sukuk Bank Negara Malaysia Ijarah (SBNMI) 63

Islamic Negotiable Instruments (INI) 63

Negotiable Islamic Debt Certifi cate (NIDC) 63

Example: Calculation of Price of NIDC of Less Than One Year 64

Example: Calculation of Price NIDC with Maturity of More Than One Year 65

Islamic Negotiable Instruments of Deposit (INID) 66

Example: Calculation of Proceeds for an INID 66

Islamic Accepted Bill (IAB) 67

Import and Local Purchases 67

Export/ Local Trade 67

Example: Price Calculation of IAB under Bai al-Dayn 68

Sell and Buy Back Agreement (SBBA) 68

Example: Sell and Buy Back Agreement 69


Cagamas Sukuk 70

Sanadat Mudarabah Cagamas (SMC) 70

Example: Sanadat Mudarabah Cagamas (SMC) Calculation 71

Sanadat Cagamas 71

Islamic Corporate Sukuk 72

Chapter Summary 72


Notes 73

References 74

5 An Overview of Sukuk 77


Introduction 78

Comparing Sukuk, Bonds, and Shares 79

Sukuk Types 81

Sukuk Structures 81

Sukuk al-Ijarah 82

Sukuk al-Musharakah 88

Sukuk al-Mudarabah 94

Sukuk al-Salam 99

Sukuk al-Istisna 102

Sukuk al-Murabahah 106

Sukuk al-Istithmar 110

Sukuk al-Wakala 114

Chapter Summary 117


Notes 118

References 119

6 Shariah-Compliant Equity 121


Introduction 122

The Structure of Equity Markets 124

Shariah-Compliant Equity Securities 125


Differences between Shariah and Non–Shariah-Compliant Equity Markets 128

Shariah-Compliant Stocks Screening 130

Malaysia Securities Commission 130

S&P Shariah Indices 131

Pakistan Meezan Islamic Fund 133

Global GCC Islamic Fund Screening 134

Jakarta Islamic Index 135

Chapter Summary 136


Note 136

References 136

7 Islamic Mutual Funds 139


Introduction 140

Closed and Open-Ended Funds 140

Conventional Mutual Funds 141

Active and Passive Management 143

Advantages of Mutual Funds 143

Disadvantages of Mutual Funds 144

Fees and Expenses 145

Islamic Mutual Funds 146

Basic Concept of Islamic Mutual Funds 147

Shariah Stock Screening 147

Purifi cation of Income 148

Types of Islamic Mutual Funds 149

The Role of the Shariah Advisory Board in Islamic Mutual Funds 151

Calculating NAV in the Islamic Mutual Funds 151

Organisation of Islamic Mutual Funds 153

The Process of Investing in Islamic Mutual Funds 154

Islamic Ethical Investment and Ethical Investment 156


Notes 158

References 158


8 Islamic Real Estate Investment Trusts (I-REITs) 161


Introduction 162

Islamic Real Estate Investment Trusts (I-REITs) 165

Shariah-Permissible Investments for I-REITs 166

I-REITs Structure 169

Case Study: Al-’Aqar KPJ REIT 171

Case Study: Al-Hadharah Bousted REIT 174

Difference between Conventional and Islamic REITs 176

Chapter Summary 177


Notes 178

References 178

9 Islamic Exchange-Traded Funds 179


Introduction 180

Open- and Closed-End Funds, and Unit Trust Funds 180

Open-End Funds 180

Closed-End Funds 181

Unit Trust 181

Exchange-Traded Funds (ETFs) 181

Islamic Exchange Trade Funds (I-ETFs) 185

Security Borrowing and Lending in Malaysia 190

Islamic ETFs in Other Countries 195

Challenges in Promoting I-ETFs 195

Chapter Summary 196


Notes 197

References 197

10 Islamic Derivatives Market 199


Introduction 200

Derivative Securities in the Conventional Market 200

Risk Profi le 202


Main Players in the Derivative Markets 203

Hedging with a Forward Contract 204

Hedging with Future Contracts 205

Hedging with Swap Contracts 206

Derivative Securities in the Islamic Perspective 211

Islamic Forward and Future Contract 213

Islamic Option Contract 216

Islamic Cross-Currency Swap 218

Islamic Profi t Rate Swap 220

Islamic Structured Product 222

Chapter Summary 225


Notes 226

References 227

Bibliography 229

About the Authors 233

Index 235

Buy This Book



CHAPTER

1

An Introduction to Conventionaland Islamic Financial Systems

Learning outcomes

At the end of this chapter, you should be able to:

1 Define a financial system.

2 List the functions and roles of the financial market.

3 Distinguish between debt instruments and equity instruments.

4 Classify financial markets.

5 Distinguish between financial instruments in financial markets.

6 Distinguish between financial intermediaries in the financial system.

7 Identify characteristics of the Islamic financial system and the conventionalfinancial system.

8 List the salient features of the Islamic financial system.

IntroductionHasan, a researcher in a Halal food technology unit at an Islamic university in Malaysia, hasinvented a machine to detect whether a chicken has been properly slaughtered or beaten todeath. He and his team are interested in selling their machine. Unfortunately, they do not havesufficient funds to produce the machine. Tuan Bakri, on the other hand, has plenty of savings,which he and his wife have accumulated over the years. If they could meet, do you thinksomething could happen? If Tuan Bakri could provide funds to Hasan, the future of Hasan’shalal detector machine would be brighter and the ummah, the Islamic society, would benefitfrom this machine.

However, before we conclude Hasan’s story, one might have to ask the followingquestions:

� Do they know each other before they engage in the contract?� How do Hasan and Tuan Bakri meet?� Who will control the transfer of funds from Tuan Bakri to Hasan?� Who will control the repayment process from Hasan to Tuan Bakri?� And so forth . . .

To answer these questions, we need to first understand the financial system and what isincluded within it. A financial system is the collection of markets, institutions, laws, regula-tions, and techniques that operate to enable the transfer of money from the surplus side,or savers, to the deficit side, or borrowers. It seeks the efficient allocation of resources betweensavers and borrowers. A healthy financial system requires, among other things, efficient andsolvent financial intermediaries, efficient and deep markets, and a legal framework that definesclearly the rights and obligations of all agents involved. In order to foster the sound devel-opment of the financial system and protect the public interest, the central bank permanentlymonitors the institutions that comprise this system, proposes reforms to the legislation inforce, and issues regulations in the areas under its authority.

Financial markets (sukuk, bond, and stock markets) and financial intermediary insti-tutions (banks, insurance companies, pension funds) have the basic function of bringingtogether people like Hasan and Tuan Bakri by moving funds from those who have a surplus(Tuan Bakri) to those who have a shortage (Hasan). Another example is that when theMalaysian government needs to build a road connecting Peninsular and Penang Islands, it mayneed more funds than local property taxes can provide. Therefore, the government must go tofinancial markets and ask for some funds by agreeing with the rules implemented in thatparticular market.

So, basically what could fulfil the needs of people like Hasan and Tuan Bakri is afinancial system that provides them facilities to lend and borrow money. Many scholars offinance and economics say that financial development is very important to boost the economic

2 / FUNDAMENTALS OF ISLAMIC MONEY AND CAPITAL MARKETS

growth of a country. Therefore, well-functioning financial markets and financial intermediaryinstitutions are crucial to economic wealth.

The flow of funds in a financial system is shown schematically in Figure 1.1. Those whohave surplus funds and become lenders are shown on the left-hand side and those who needfunds and become borrowers are on the right-hand side. The households are basically theprincipal lenders through financial intermediary institutions, but sometimes business enter-prises, local as well as federal government, foreigners, and foreign governments experienceexcess funds and therefore lend them out through financial markets. The borrowers also comefrom households, for example, homeowners; from governments, to build a road or a bridge, orto finance the annual budget; and from business enterprises, to finance their productionactivities.

Funds flow from lenders to borrowers via two routes. In direct or market-based finance,debtors borrow funds directly from lenders in financial markets by selling them financialinstruments, also called securities (such as debt securities and shares), which are claims onthe borrower’s future income or assets. If financial intermediaries play an additional role in thechanneling of funds, one refers to indirect finance. Financial intermediaries can be classified intocredit institutions, other monetary financial institutions, and other financial intermediaries.

FIGURE 1.1 Flows of Funds through the Financial System

Savers/Lenders:• Households• Firms• Governments• Foreigner

Borrowers:• Households• Firms• Governments• Foreigner

FinancialIntermediaries: • Banks• Credit institutions, etc.

FinancialMarkets: • Money Market• Capital Market

FUNDS

FUNDS

FUNDS

FUNDS

FUNDS

FUNDS

INDIRECT FINANCE

DIRECT FINANCE

CHAPTER 1: An Introduction to Conventional and Islamic Financial Systems / 3

Financial markets and financial intermediaries are not separate entities but are strongly inter-linked. We will discuss this relationship between financial markets and financial intermediariesfurther in the next section.

One might ask again, why is this channeling of funds so crucial to the economy? Theanswer is that people who save their money are frequently not the same people who haveprofitable investment opportunities, the entrepreneurs. Therefore, through this system,people can help each other through the mu’amalah (transactions). There is nothing wrongabout this from an Islamic point of view, as long as they do not cheat others or follow otherpractices or management methods that do not comply with Shariah principles.

The Roles and Functionsof Financial Markets

After we discuss the meanings and importance of financial markets to the country’s economy,we first discuss the roles and functions of financial markets toward the economy. There are atleast two views regarding the links and importance of financial markets’ development andgrowth to a country’s economy. The former view says that the development of financialmarkets and financial intermediaries will stimulate a country’s economy and thereforeincrease production and growth. This strategy seeks to allocate capital more efficiently and toprovide incentives for growth through the financial system, and this is recognized more asSchumpeter’s supply-leading view. A demand-following relationship, on the other hand, is aconsequence of the development of the real sector. This implies a continuous widening ofmarkets and a growing product differentiation, which makes necessary more efficient riskdiversification, as well as better control of transaction costs. The latter is known as Robinson’sdemand-following view. However, we will not discuss the pros and cons regarding which viewis right. The most important information that could be derived from these is that the financialmarket development is significantly higher than the economic growth of a country, andtherefore has an important role in a country’s economic performance.1

From a micro-perspective, examples of the roles of financial markets are enablinguniversity students to obtain loans, families to obtain mortgages for their homes, businesses tofinance their growth, and governments to finance their expenditures. Without financial markets,some young men and women cannot go to school, some families are homeless, some businessesare facing bankruptcy, and governments cannot provide sufficient public services. So, thegeneral function of financial markets is to provide a system that will allow people who havesurplus capital to finance people who experience deficits in capital.

However, other than that general function of financial markets and institutions, thereare some specific functions of financial markets and institutions (as shown in Figure 1.2):2

� Savings. Financial markets provide an avenue for the public’s savings. Bonds, stocks, and otherfinancial claims sold in the money and capital markets provide accessible liquid investments,


a relatively low-risk outlet for public savings, which flow through the financial markets intoinvestments, so that more goods and services can be produced (productivity increases).

� Wealth. The capital market provides an excellent avenue to store wealth (preserve thevalue of assets we hold) until funds are needed for spending. This use of funds is moreproductive than storing wealth in the form of tangible assets, such as automobiles oritems that are subject to depreciation and often carry a great risk of loss. Moreover,bonds, stocks, and other financial instruments do not wear out over time and usuallygenerate income.

FIGURE 1.2 Specific Functions of Financial Markets

“The global systemsof financial markets andinstitutions provides aconduit for the public’s

savings.”

Savings functions:

Wealth functions:

Liquidity functions:

Credit functions:Payment functions:

Risk protectionfunctions:

Policy functions:

“The financial marketsare a channel through

which governments mayattempt to stabilize the

economy and avoidinflation.”

“The financial marketsoffer protection againstlife, health property, and

income risks, bypermitting individuals

and institutions to engagein both risk-sharing and

risk reduction.”

“The global financialsystem provides a

mechanism for makingpayments for goods andservices, in the form of

currency, checkingaccounts, etc.”

“Global financial marketsfurnish credit to finance

consumption andinvestment spending.”

“Financial marketsprovide liquidity for

savers who hold financialinstruments but are in

need of money.”

“The financialinstrumets sold in the

money and capitalmarkets provide an

excellent way to storewealth.”

Functions of FinancialMarkets


� Liquidity. The capital market provides a means of converting financial instruments intocash, with little risk of loss. The capital market provides liquidity (immediately spendablecash) for savers who hold financial instruments, but are in need of cash.

� Credit. In addition to providing liquidity and facilitating the flow of savings intoinvestments to build wealth, the financial market furnishes credit to finance consumptionand investment spending. In this regard, individuals can borrow money to buy propertiesor a company can get financing to expand their businesses.

� Payments. The financial markets also provide a mechanism for making payments for thepurchase of goods and services. Certain financial assets, including currency, non-interest-bearing checking accounts (demand deposits), and interest-bearing checking accountsserve as a popular medium of exchange in making payments all over the globe.

� Risk protection. Financial markets offer businesses, consumers, and government pro-tection against life, health, property, and income risks. This is accomplished by allowingparticipants to engage in both risk-sharing and risk-reduction approaches. Risk sharingoccurs when an individual or an institution transfers their risk exposure to someonewilling to accept that risk (such as an insurance company), while risk reduction usuallytakes place when we diversify our wealth across a wide variety of different assets, so thatour overall losses are likely to be limited.

� Policy. Governments, particularly the central bank, use financial markets as one of thetools to manage monetary stability of the country. Through financial markets,governments could manage some economic parameters, such as money supply, inflation,exchange rate, and other relevant factors of the economy.

Structures of Financial MarketsAfter understanding the definiton, functions, and roles of the financial market, the next dis-cussion concerns the structure of financial markets. Financial markets are essentially dividedinto four types based on the instrument, the issues of the security, the trading methods insecondary markets, and the maturity (see Figure 1.3).

Based on the Instrument

We can divide financial market structures based on their instruments into debt markets andequity markets. Debt instruments, which are sold in debt markets, such as bonds, sukuk,and mortgages, are the most common method by which firms or governments obtain funds. Itis a contractual agreement by the borrower to pay the holder of the instruments a fixed amountof money at regular intervals, including principal and interest or profit margin, until a specifieddate as the final payment. The specified date for the final payment is the maturity date. A debtinstrument is called short-term if its maturity is less than a year, while it is called long-term if itsmaturity is 10 years or longer. In between are the intermediate-term instruments.


The other instruments that can be used for raising funds are equity instruments. Whilebonds, sukuk, or other debt instruments have maturity dates, equities do not and so thereforeare considered long-term securities. People or firms who are holding common stock, as anexample of equity instruments, obtain their shares from the net income and the assets of abusiness. Therefore, shareholders are sometimes called residual claimants, which means that theycan only get their shares after the stock-issuer company pays all its debts and taxes. Table 1.1depicts the main advantage(s) of debt and equity instruments from the investor’s point of view.

From the perspective of a company that wants to acquire funds, debt and equityinstruments are the two ways of getting those funds. It is said that the company acquires debtfunds when it takes a loan or sells bonds, while equity funds are raised when the companyissues shares to the public, who are keen on the company’s progress and growth rather than onearning interest on debt.

Table 1.1 shows the different advantages of debt and equity instruments from thesurplus side or lender’s side. However, there are also some differences between debt and equityinstruments from the deficit side, or the borrower’s side:

1. Issuing equity instruments means buying capital, while taking debt instruments meansborrowing capital.

2. The company shares its profits and gains with the holders of equity instruments, while itmust pay back the principal loan plus its interest to the holders of debt instruments.

3. The company should go to credit markets in order to obtain the loan, while it should goto capital markets to issue its shares as equity instruments.

FIGURE 1.3 Structure of Financial Markets

Structureof

FinancialMarkets

Based onthe

maturity

Based ontrading

methods insecondarymarkets

Based onthe issuesof security

Based onthe

instrument

DebtMarkets

EquityMarkets

PrimaryMarkets

SecondaryMarkets

ExchangesMarkets

Over-the-CounterMarkets

MoneyMarkets

CapitalMarkets


Based on the Issuance of Securities

People or firms in financial markets can sell new securities and resell old securities issued bythem or others. A primary market is a market where new issues of securities such as bondsand stocks are sold by the initial issuer, such as firms or the government selling to the firstbuyer or creditor who wishes to buy. However, primary markets are not as well-known assecondary markets, and in fact most trades are not done in primary markets. Why? Becausemost of the trades in primary markets are done behind closed doors. Investment banks are themain players in primary markets through underwriting securities, by which the bank guaranteesa price for a firm’s securities and then sells the securities to the public.

After those securities are traded in a primary market, the current owner may want to sellit again due to liquidity problems or to take profit. He or she can now sell those securities in asecondary market. So, a secondary market is a market where securities are traded after theyare initially offered in the primary market. Although the person who has sold the security in asecondary market receives money in exchange for the security, the company that issued thesecurity acquires no new funds. The company receives funds only when the security is first soldin the primary market.

Brokers and dealers are very important to the funcioning of the secondary market.Brokers are agents of investors who match buyers with sellers of securities, while dealers linkbuyers and sellers by buying and selling securities at a stated price. Kuala Lumpur StockExchange (KLSE) of Bursa Malaysia is the best-known example of a secondary market. It alsoincludes futures markets and options markets.

Methods Used in Secondary Markets

There are two methods by which secondary markets are conducted: exchange markets andover-the-counter (OTC) markets. An OTC is a decentralized market of securities not listed

TABLE 1.1 Instruments in Financial Markets

Type of Instruments Advantage(s)

Debt instruments 1. Fixed returns.

2. Can choose short-term, intermediate-term, or long-terminvestments.

3. If the company faces bankruptcy, lenders can still have theirprincipal money back plus interest or profit-sharing, whererelevant.

Equity instruments 1. Equity holders benefit directly from any increases in thecorporation’s profitability and asset value.

2. Owning stocks means also owning a portion of the firm and thushaving the right to vote on issues important to the firm and toelect its directors.


on an exchange where market participants trade over the telephone, facsimile machines,or electronic networks instead of on a physical trading floor. There is no central exchange ormeeting place for this market. In the OTC market, trading occurs via a network of middlemen,called dealers, who carry inventories of securities to facilitate the buy and sell orders ofinvestors, rather than providing the order matchmaking service seen in specialist exchangessuch as the KLSE.

An exchangesmarket, on the other hand, is where buyers and sellers of securities or theiragents meet in one central location to conduct trades either physically or through an electronictrading platform. The quoted prices of the various securities listed on the exchange represent theonly prices that are available to investors seeking to buy or sell the specific assets. A good exampleof this is the New York Stock Exchange, and Bursa Malaysia is an example for exchanges marketwhere trades are conducted via an electronic trading platform. The New York Stock Exchange isconsidered a centralized market because orders are routed to the exchange and are then matchedwith an offsetting order. However, the foreign exchange market is not deemed to be centralizedbecause there is no one location where currencies are traded and it is possible for traders tofind competing rates from various dealers from around the world.

Based on the Maturity

The last method in structuring the financial market is based on the basis of maturity of thesecurities traded in each market. The money market is a segment of the financial market inwhich financial instruments with high liquidity and very short maturities are traded. The moneymarket is used by participants as a means for borrowing and lending in the short term, fromseveral days to just under a year. Money-market securities consist of negotiable certificates ofdeposit (CDs) or Islamic negotiable instruments of deposits3 (INIDs), bank acceptances,Treasury bills, or Islamic accepted bills, commercial papers, municipal notes, repurchaseagreements (repos) and short-term sukuk. The money market is used by a wide array of par-ticipants, from a company raising money by selling commercial paper into the market to aninvestor purchasing CDs as a safe place to park money in the short term. The money market istypically seen as a safe place to put money due to the highly liquid nature of the securities andshortmaturities, but there are risks in themarket that any investor needs to be aware of, includingthe risk of default on securities such as commercial paper. The capital market, on the otherhand, is the market in which longer-term debt (one year or greater) and equity instruments aretraded. More details about money and capital markets are discussed in the following section.

Classification of Financial MarketsIn today’s financial world, one of the renowned classifications of financial markets is the moneymarket and capital market (see Figure 1.4). As we have discussed in the previous sections, this


classification is based on the maturity of the securities traded in a financial market. Now, weshall discuss the money market and the capital market.

The Money Market

In spite of its name, money markets are not used for trading currencies but rather for liquiditypurposes, such as to obtain or place out short-term funds. Currencies or M1 definition ofmoney (currency in the hands of the public, checkable deposits, and traveler’s checks) aretraded on the foreign exchange market. However, money in forms other than M1 are tradedhere (we call them as instruments), such as money market mutual fund shares, negotiablecertificates of deposit, repurchase agreements (repos), and government Treasury bills.

Although there are as many different types of money markets as there are instruments,people normally refer to these markets in the singular, as a money market. This is due to the factthat money market instruments share many characteristics.4 First, they are issued in largedenominations, usually of RM100,000 or more. This feature, along with the absence of reserverequirements and lower regulatory burdens when compared to depository institutions, makemoney markets an efficient means of raising and storing short-term funds. Second, moneymarket instruments have short maturities, ranging from one day to one year. Third, due to short

FIGURE 1.4 Classification of Financial Markets and Its Instruments

Financialmarket

instruments

Moneymarket

instruments

Capitalmarket

instruments

Stocks MortgagesCorporate

Bonds/Sukuks

Centaral BankFunds

RepurchaseAgreements

BankersAcceptances

CommercialPapers

Consumerand Bank

CommercialLaw

NegotiableBank

Certificatesof Deposit

GovernmentTreasury

Bills

GovernmentSecurities

GovernmentAgency

Securities

State andLocal

GovernmentBonds


maturities and active resale markets for most instruments, money market instruments arecharacterized by low liquidity risk as well as low default risk. Finally, the fourth characteristic ofmoney market instruments is that unlike commodities or stocks, which often trade on specificexchanges, the money market does not occupy any one particular geographic location or tradingfloor. Hence, although the market tends to be centered in Kuala Lumpur, for example, itconsists of borrowers and lenders as well as brokers and dealers linked by online computersthroughout the states and the world.

As all players in the economy, such as financial and nonfinancial businesses as well asgovernmental entities, generally experience flows of receipts and expenditures at differenttimes and sometime experience mismatch between them, they need to balance them. Theyneed to borrow in a period when they experience a shortage of funds and to lend their surplusfunds in other periods. One way they can get fresh funds to promote their businesses isborrowing from the money market.

Money Market ParticipantsThere are at least seven categories of participants in money markets, such as commercialbanks, governmental entities, central banks, corporations and finance companies, pensionfunds and insurance companies, brokers and dealers, and money market mutual funds andindividuals. Commercial banks participate in the money market by borrowing the centralbank funds and repurchase agreement market when they need to meet their reserverequirement and issue certificates of deposits (CDs) to raise funds. The government issuesTreasury bills (T-bills) to finance its expenditures. Central banks use these securities tomanage the banking system’s reserve level and interest rates. Government-linked companies(GLCs) issue commercial paper to fund expenses related to housing, agriculture, and otherloans. Corporations and finance companies assist consumers in buying automobiles and realestate investments by issuing commercial paper and lending these funds to their customers.Pension funds, insurance companies, other businesses, and individuals use the money marketand money market mutual funds for cash management purposes.

Money Market InstrumentsCommercial papers, central bank funds,5 and repurchase agreements (repos) are the threemost frequently used types of money market instruments. Commercial paper refers to short-term, large denomination, unsecured promissory notes issued by the most creditworthycorporations as an alternative to bank borrowing. Central bank funds and repurchase agree-ments are used primarily by depository institutions to meet their reserve requirements. Unlikethe central bank funds, repos are also used by securities dealers, money market mutual funds,pension funds, nonfinancial corporations, and state and local governments. Central bank fundsconsist primarily of overnight loans of reserves between banks. Repos are short-term agree-ments in which a seller simultaneously agrees to sell government securities now and also tobuy them back in the future at a higher price. In effect, repos look like collateralized loanssecured with government securities.


Negotiable CDs and INIDs are debt instruments issued by commercial banks. Theytypically have fixed interest or profit rates, maturities of 1 to 3 months, and denominations of$1 million. Government Treasury bills (T-bills) are regularly auctioned by the government tofinance the national debt and to manage the mismatch between government revenue andexpenditures. They are characterized by typical maturities of 4, 13, or 26 weeks, denomi-nations as low as $1,000 an absence of default risk, high liquidity, and preferential taxtreatment. Bankers’ acceptances facilitate international trade by allowing a bank to guaranteethe payments of its customers engaged in importing goods from abroad. Money-marketmutual funds pool the funds of their shareholders and use them to purchase a variety ofmoney market instruments. This has brought the safety and high yields of the money marketto individual investors.

The Capital Market

As explained in the previous section, the capital market is extremely important because itraises the funds needed by the deficit spending units to carry out their spending andinvestment plans. It facilitates the transfer of funds from economic agents in financial surplusunits to those requiring funds through selling-buying activities of securities, such as shares andbonds. The deficit spending units will issue securities and sell them to the surplus spendingunits. The major difference between capital market and money market is the maturity of thesecurities. Capital market instruments are debt and equity instruments with maturities ofgreater than one year.

The major capital market instruments are stocks, mortgages, corporate bonds, gov-ernment securities, sukuk, and municipals. Stocks represent partial ownership in the cor-porations that issued them. They are classified as capital market securities because they haveno maturity and therefore serve as a long-term source of funds. The income received by thestockholders due to their ownership is called dividends, which are distributed to the stock-holders periodically; and the other earnings for the investors are capital gains, which areobtained when they sell their shares in secondary markets.

Mortgages are long-term debt obligations created to finance the purchase of realestate. In the event the borrower fails to make the scheduled payments, the lender canrepossess the property. Lenders try to assess the likelihood of loan repayment using variouscriteria such as the borrower’s income level relative to the value of the home. They offerprime mortgages to borrowers who qualify based on these criteria. Mortgages are usuallymade for up to 30 years. Savings and loan associations and mutual savings banks are theprimary lenders in the residential mortgage market, although commercial banks are now alsoactive lenders in this market.

Sukuk6 and bonds are long-term debt securities issued by corporations and govern-ment agencies to support their operations. They are usually issued by corporations that haveexcellent credit ratings and the maturity is from 2 to 30 years. Similar to stockholders, sukukholders and bond holders receive two types of earnings, which are fixed-interest income or


coupon payments twice a year and the principal at maturity. The principal buyers of cor-porate or government agencies’ bonds are insurance companies, pension funds, banks, andforeign investors.

Types of Financial IntermediariesFinancial intermediaries possess many common traits. In general, they are regulated, profit-seeking firms that provide the public with a wide range of financial services. These services helpto reduce the risks associated with channeling funds from surplus spending units to deficitspending units. The services provided include the appraisal and diversification of risk, thepooling of funds, and the provision of a menu of claims, including contingent claims, tailoredto the needs of customers.

Now how do we classify the financial intermediaries? The most common method is bylooking at their balance sheet. A balance sheet is an accounting statement showing themonetary value of an economic unit’s assets, liabilities, and net worth at a specific point intime. By examining the balance sheets of the major financial intermediaries, it will be helpful togroup them according to the nature of their liabilities or the major financial service theyprovide. In general, types of financial intermediaries (see Figure 1.5) consist of depositoryinstitutions, contractual institutions, and investment-intermediaries institutions.

With regard to the flow of funds in financial intermediaries (see Figure 1.6), a bankinginstitution mostly receives deposits from depositors as its sources of funds and uses them as a

FIGURE 1.5 Types of Financial Intermediaries

DepositoryInstitutions

Types of FinancialIntermediaries

ContractualInstitutions

CommercialBanks

Development FinancialInstitutions (DFIs)

CreditUnions

Pension Funds &Government

Fire and CasualtyInsurance Companies

Life InsuranceCompanies

Investment Intermediariesand Finance Companies

FinanceCompanies

MutualFunds

Money MarketMutual Funds

InvestmentBanks


source of financing to businesses. Meanwhile, insurance institutions obtain their funds frompremiums paid by policyholders and invest the funds in shares and securities. Last, the mutualfunds companies collect the funds from the public pooled funds before they invest them inshares and securities.

Depository Institutions

A large portion of the liabilities of depository institutions are deposits and these institutionsinclude commercial banks, developmental financial institutions, savings banks, and creditunions. The major sources of funds for commercial banks are checking savings, and timedeposits plus nondeposit liabilities. Bank’s major uses of funds are financing or loans, gov-ernment securities, and reserves. Banks have also been authorized to underwrite and deal inmunicipal revenue bonds. Depository institutions are more popular compared to otherfinancial institutions due to the following reasons:7

� They offer deposit accounts that accommodate the amount and liquidity characteristicsdesired by most of the surplus units.

� They repackage funds received from deposits to provide financing or loans of the size andmaturity desired by deficit units.

� They have more expertise than individual surplus units in evaluating the creditworthinessof deficit units.

Now, in this modern era, imagine what surplus units will do to meet and evaluate thecredithworthiness of deficit units and how deficit units can meet their desired funds in order toexpand their business if depository institutions such as banks do not exist. It is not impossible,but it is very difficult.

FIGURE 1.6 Input-Output Flow of Funds in Financial Intermediaries

Deposits

INPUTS Sources of funds

Liabilities

Type of FinancialIntermediaries

OUTPUTSUses of funds

Assets

Premium payments

Public Pooled Funds Mutual funds

Insurance Companies

Banks Loans and Securities

Loans and Securities

Loans and Securities


In Malaysia, they have Development Financial Institutions (DFIs), which are specializedfinancial institutions established by the government with a specific mandate to develop andpromote key sectors that are considered of strategic importance to the overall socioeconomicdevelopment objectives of the country. These strategic sectors include agriculture, small andmedium-size enterprises (SMEs), infrastructure, maritime, export-oriented sectors as well ascapital-intensive and high-technology industries.

As defined by Bank Negara Malaysia, DFIs provide a range of specialized financialproducts and services to suit the specific needs of the targeted strategic sectors. Ancillaryservices in the form of consultation and advisory services are provided by DFIs to nurture anddevelop the identified sectors. DFIs therefore complement the banking institutions and act as astrategic conduit to bridge the gaps in the supply of financial products and services to theidentified strategic areas for the purpose of long-term economic development. The DFIs, to agreat extent, have contributed to the development and growth of the targeted sectors.

Currently, the members of the Development Financial Institutions are:

Malaysian Industrial Development Finance BerhadBank Pembangunan Malaysia BerhadSME BankBank Pertanian Malaysia BerhadSabah Credit CorporationSabah Development Bank BerhadBank Kerjasama Rakyat Malaysia BerhadBorneo Development Corporation (Sarawak) Sdn BhdBorneo Development Corporation (Sabah) Sdn BhdPerbadanan Usahawan Nasional BerhadPerbadanan Nasional BerhadJohor CorporationBank Simpanan NasionalCredit Guarantee Corporation Malaysia BerhadMajlis Amanah RakyatExport-Import Bank of Malaysia BerhadTekun NasionalAmanah Ikhtiar MalaysiaCradle Fund Sdn Bhd

Contractual Institutions

Contractual intermediary institutions offer contingency claims in return for regular payments.They include insurance companies takafuls, and pension funds. Based on its name, a contractualinstitution has liabilities defined by contract. These contracts generally call for regular paymentsunder specified conditions. Takafuls and insurance companies, for example, offer the public


protection against the financial costs, losses, and reduction in income associated with death,disability, old age, and other health problems, or even automobile accidents. The public makespayments (premium) in exchange for the protection. The funds collected afterward, are lent outto other households, business units, and governments. A part of the incomes and interestreceived are used to pay benefits to policyholders as they come due. These institutions use fairlylarge portions of funds to invest in longer-term assets of financial investment. These are because(a) the payment of premiums is relatively steady and predictable, and (b) the probability ofpolicyholders to become disabled, die, or injured in a given year is also predictable.

However, there are some differences between takaful8 and conventional insurance, inboth philosophical and technical aspects. Table 1.2 highlights those differences.

TABLE 1.2 Differences between Takaful and Conventional Insurance

No. Takaful Conventional Insurance

1 Takaful is based on mutual cooperation. Conventional insurance is based solely oncommercial factors.

2 Takaful is free from interest (riba),gambling (al-Maisir), and uncertainty (al-Gharar).

Conventional insurance is not free frominterest, gambling, and uncertainty.

3 The contribution paid by the participant isunder tabarru’ contract (donation) to theTakaful Fund, which helps otherparticipants by providing protectionagainst potential risks.

The premium paid by the participant tothe conventional insurance companies isowned by the companies in exchange forbearing all expected risks of theparticipant.

4 Every takaful company has a ShariaSupervisory Board; however, it is stillsubject to the governing law as well.

Conventional companies are onlysubject to the governing laws without anyrequirement to have a Sharia SupervisoryBoard.

5 As a consequence from characteristicnumber 3 above, the participants TakafulFund account is fully segregated from theshareholders’ accounts.

Premium paid by the policyholder isconsidered as income to the company,belonging to the shareholders.

6 Any surplus in the Takaful Fund is sharedamong participants only, and theinvestment profits are distributed amongparticipants and shareholders on the basisof mudarabah or wakala models.

All surpluses and profits belong to theshareholders only.

7 All funds are invested in Sharia-compliantinvestment funds

All funds are invested in any type ofinvestment funds, regardless of Shariah-compliant issues

8 Takaful companies have re-insurance withre-takaful companies.

Conventional insurance companies mayhave re-insurance with any re-insurancecompanies.

Source: Adapted from Tazur Company B.S.C. (c). (www.tazur.com/takaful-vs-conventional.html).


http://www.tazur.com/takaful-vs-conventional.html

Pension funds, as another contractual agreement, also provide an alternative and efficientway for individuals to save for their retirement. The money received from individual retirementaccounts is invested in stocks or bonds of companies or governments by the pension funds. Thepension funds will manage the money until the individuals retire or withdraw their money.

Investments and FinanceInstitutions

Collective investment-type intermediaries pool funds from the public, invest the funds, andreturn the income received—after deducting management fees—to the investors. Some fundsinvest in particular types of securities, such as corporate stocks and bonds, while others havebroader asset portfolios that include stocks, bonds, mortgages, gold, and so on. A number ofdepositors who seek higher returns than the rates offered by depository institutions preferinvestment institutions or mutual funds to banks.

Finance companies, on the other hand, lend money to households to purchase con-sumer durables such as automobiles, appliances, and furniture, and to businesses to financeinventories and the purchase or leasing of equipment.

A Brief Overview of theIslamic Financial System

The term Islamic financial system was not introduced until the mid-1980s. The proponents ofIslamic economics and finance say that the philosophical foundation of an Islamic financialsystem goes beyond the interaction of factors of production and economic behavior. Whereasthe conventional financial system focuses primarily on the economic and financial aspects oftransactions, the Islamic system places equal emphasis on the ethical, moral, social, and reli-gious dimensions, to enhance equality and fairness for the good of society as a whole. Thesystem can be fully appreciated only in the context of Islamic teachings on the work ethics,wealth distribution, social and economic justice, and the role of the state. It is obviously achallenge for the Islamic system to be implemented in the current economic environment.

The Islamic financial system is a system in a country’s economy consisting of financialmarkets, financial institutions, financial instruments, and market participants that operate alongwith Islamic principles and are aimed at meeting the Maqasid (objectives) of Shariah. Ingeneral, all Islamic financial instruments and institutions must comply with Shariah principles,namely:

� Prohibition of riba� Application of al-bay’ (trade and commerce)� Avoidence of gharar (ambiguity) in contractual agreement


� Prohibition of maisir (gambling)� Disengagement from production of prohibited commodities, such as pork, liquor, tobacco,

and so forth.

In addition, many Islamic finance scholars assert that although Islamic finance insti-tutions perform mostly the same functions as conventional ones, they do this in distinctlydifferent ways. Some of the salient features of Islamic banking and finance which make itdistinct and unique from its conventional counterparts include:9

� Islamic finance promotes a just, fair, and balanced society. Therefore, the many prohibi-tions are to provide social harmony and to protect the interests and benefits of all partiesinvolved in the market. For example, the practice of a conventional financial system inimposing interest causes injustice to the borrowers since the interest has to be paidregardless of the outcomes of their business.

� Islamic finance is structured on the principle of brotherhood and cooperation, whichstands for a system of equity-sharing, risk-sharing, and stake-taking between the surplusspending units and deficit spending units.

� As a system grounded on the ethical and moral framework of Shariah, Islamic finance isalso characterized by ethical norms and social commitments. Verses from the Qur’an andtraditions from As-sunnah are two divine guidances that provide halal (permissible) andharam (prohibited) filters to control these norms in the Islamic financial system.

� The Islamic financial institution is community-oriented and entrepreneur-friendly,emphasizing productivity and physical expansion of economic production and services.

� The Islamic financial institution operates within the limits that ensure stability in the valueof money and curtail destabilizing speculation. This is due to the monetary flows throughIslamic financial modes that are always tied directly to the flow of goods and services.

Evolution of Islamic Finance

The creation of modern Islamic finance (see Figure 1.7) began with the establishment ofIslamic banks. The landmark events include the rise and fall of Mitghamr Savings Associationin Egypt during the 1961 to 1964 periods and the establishment of Tabung Haji in Malaysia in1962. Although it is not considered an Islamic commercial bank, Tabung Haji has sinceflourished and become the oldest Islamic financial institution of modern times.

The first Islamic bank emerged in 1975with the establishment of theDubai Islamic Bank andthe Islamic Development Bank (IDB). These emergences were facilitated by at least two events:

1. Third Islamic Conference of Foreign Ministers in 1972, held in Jeddah, resulted inabolishing interest from Islamic financial institutions. A comprehensive plan to reform themonetary and financial systems of the Islamic communities according to Shariah princi-ples was laid out concurrently.


2. There was a change in the political climate in many Muslim countries that was induced bythe energy price rise in 1973 and 1974 and increased Arab oil wealth. The oil-rich countriesenabled a wide range of institutions to participate in the social and economic developmentof Muslim countries, while facilitating resurgence in self-confidence in the cultures of theMiddle East. Most of the major Islamic banks and banking groups formed in the 1970swere funded by oil-linked wealth.

One of the important outcomes from the conference held in Jeddah in 1972 was thatmany Muslim countries started to show their commitment by initiating various efforts toIslamize their financial system, particularly in the banking industry. In general, the Islamizationprocess of the financial system in the Muslim countries can be divided into two differentapproaches or settings:

1. Full Islamization. This approach was aimed at economy-wide elimination of interest. Thecountries that pioneered the full Islamization process were Pakistan, Iran, and Sudan.

2. Promotion and adoption of Islamic banking practices side by side with conventional banking.The majority of Muslim countries adopted this approach whereby Islamic banks coexist withconventional banks. These countries are Malaysia, Indonesia, Turkey, Bahrain, and others.

FIGURE 1.7 Timeline of Evolution of Islamic Finance

1. Sukuk as alternatives toconventional bonds emerged and israpidly increasing in volume.

2. Establishment of many Islamicfinance intemational infrastructureinstitutions such as IslamicFinancial Services Board (IFSB),International Islamic FinancialMarkets (IIFM), Council forIslamic Banks and FinancialInstitutions (CIBAFI),International Islamic RatingAgency (IIRA), LiquidityManagement Centre (LMC), andet cetera.

1. Applications and practices of Islamic principles infinance began in Egypt and Malaysia through theestablishment of Mitghamr Saving Associations (1961-1964) and Tabung Haji Malaysia (1962-present).

5. Non-banking financlal institutions emerged in themid-1980s.

2. A number of books on Islamlc banking based on profit-and-loss-sharing and leasing were published.

1. Pakistan, Iran, and Sudan announced their intentionto transform overall financial systems so as to be incompliance with shariah principles.

2.1981, establishment of IRTI.

3. Malaysia and Bahrain initiated Islamic bankingwithin the framework of existing system.

4. IMF published Working Papers on Islamic Banking.

1. 1975, emergence of first Islamiccommercial bank, Dubai IslamicBank, and Islamic DevelopmentBank.

2. 1975, Fiqhi objections toconventional insurance becomepronounced.

3. 1976, first InternationalConference on Islamic Economicsin Makkah.

4. 1978, establishment of Centrefor Research in IslamicEconomics, first specializedresearch institutions, in KingAbdul Aziz University, KSA.

5. 1979, establishment of firstTakaful company.

1. Public policy interest in the Islamicfinancial system grew in severalcountries.

2. The AAOIFI was established.

3 The Harvard Islamic Finance Forumwas established.

2000s

1990s1980s

1970s

1960s

4. The Dow Jones and Financial TimesIslamic Index was established.

5. Large international conventionalbanks started operating Islamicwindows.


In 1981, the governors of central banks and monetary authorities of the Organizationof Islamic Conference (OIC) member countries were called upon jointly to strengthenregulation and supervision of Islamic financial institutions, followed by the establishment ofThe Islamic Research and Training Institute of IDB in the same year. In the middle of the1980s, Islamic mutual funds and other nonbanking financial institutions emerged. The periodof the 1990s onward was the era of rapid development in every angle of Islamic finance. TheAccounting and Auditing Organization for Islamic Financial Institutions (AAOIFI) wasestablished in the early 1990s and the development of Islamic banking products intensifiedafterward. The interest in Islamic finance increased in western academic and business circles.The Harvard Islamic Finance Forum was established in 1998 and large internationalconventional banks started operating Islamic windows and the Dow Jones and FinancialTimes Islamic indexes were launched during that time.

At the end of the 1990s, several countries introduced legislation to facilitate Islamicbanking and its regulation and supervision. In other words, systemic concerns and regulation,supervision, and risk management issues gained momentum. Early in the 2000s, sovereign andcorporate sukuk as alternatives to conventional bonds emerged and its practice increasedrapidly in many countries. In order to have a conducive environment, international infra-structure institutions were established. These institutions include Islamic Financial ServicesBoard (IFSB), International Islamic Financial Market (IIFM), Council for Islamic Banks andFinancial Institutions (CIBAFI), International Islamic Rating Agency (IIRA), and LiquidityManagement Centre (LMC).

The Islamic capital market, as an integral part of the Islamic financial system, plays animportant role in complementing the investment role of the Islamic banking sector. Althoughits functions are similar with conventional capital markets, the way it is structured may bedifferent from conventional ones

Chapter Summary� The financial system is the collection of markets, institutions, laws, regulations, and

techniques to transfer money from the surplus side, or savers, to the deficit side, orborrowers.

� Specific functions of financial markets and institutions are: savings function, wealthfunction, liquidity function, credit function, payments function, risk protection function,and policy functions.

� Structure of financial markets can be categorized by (a) instruments, (b) issuance ofsecurities, (c) methods used in secondary markets, and (d) maturity date.

� Debt instrument is a contractual agreement by the borrower to pay the holder of theinstruments a fixed amount of money at regular intervals, including principal and interestor profit margin, until a specified date as the final payment.


� A debt instrument is called short-term if its maturity is less than a year, while it is calledlong-term if its maturity is 10 years or longer.

� Equity instruments do not have a maturity date and so are considered as long-termsecurities.

� A primary market is a market where new issues of securities are sold by the initial issuer tothe first buyer.

� A secondary market is a market where securities are traded after they are initially offered inthe primary market.

� There are two methods by which secondary markets are categorized: exchanges marketand over-the-counter (OTC) markets.

� An OTC is a decentralized market of securities not listed on an exchange where marketparticipants trade over the telephone, facsimile machines, or electronic networks instead ofon a physical trading floor.

� An exchanges market, on the other hand, is where buyers and sellers of securities or theiragents meet in one central location to conduct trades either physically or through elec-tronic trading platforms.

� The money market is a segment of the financial market in which financial instruments withhigh liquidity and very short maturities are traded.

� The capital market is the market in which longer-term debt (one year or greater) andequity instruments are traded. More details about money and capital markets are discussedin the following section.

� The Islamic financial system is a system in a country’s economy consisting of finan-cial markets, financial institutions, financial instruments, and market participants thatoperate with Islamic principles and are aimed at meeting the Maqasid (objectives) ofShariah.

� There are two layers of Shariah-compliance in Islamic financial principles. The first is incontracts and the second is in practices and management.

Chapter Questions1. Discuss briefly the differences between Islamic and conventional financial systems.2. What are the functions of developmental financial institutions?3. What are the differences between money and capital markets?4. What are the salient features of Islamic banking and finance?5. Islamic financial systems and markets are said to perform similar functions as conventional

financial systems and markets. Such functions include savings, wealth, liquidity, credit,payments, risk protection, and policy. Is this statement true, false, or uncertain? Explainyour answer.


Notes1. For further discussion about causal relationships between financial development and

economic growth, the following article is very useful: Ross Levine, Norman Loayza, andThorsten Beck, “Financial Intermediation and Growth: Causality and Causes,” Journal ofMonetary Economics 46 (2000): 31–77.

2. Securities Commission Malaysia, 2009, 6–7.3. It refers to a sum of money deposited with the Islamic banking institutions and repayable

to the bearer at a specified future date at the nominal value of INID plus declared dividend.4. Burton et al., 2003, 179.5. For example, in Malaysia it is known as Bank Negara Monetary Notes.6. Sukuk need not be only debt instruments, as they can also be issued on the basis of profit-

and-loss sharing contracts. For further information, see Chapter 5.7. Madura, 2010, 14.8. Takaful is an Islamic insurance that has started its operation for the first time in Sudan,

1968. Nowadays, takaful is one of the rising industries in the world.9. Securities Commission Malaysia, 28.

ReferencesBurton, M., R. Nesiba, and R. Lombra. 2003. An Introduction to Financial Markets and Insti-tutions. Mason, OH: South-Western.

Fabozzi, F. J., F. Modigliani, and F. J. Jones. 2010. Foundations of Financial Markets andInstitutions, 4th ed. Upper Saddle River, NJ: Prentice-Hall.

Iqbal, Z., and A. Mirakhor. 2007. An Introduction to Islamic Finance Theory and Practice.Hoboken, NJ: John Wiley & Sons.

Madura, J. 2010. Financial Institutions and Markets, 9th ed. Mason, OH: South-Western.

Securities Commission Malaysia. 2009. Introduction to Islamic Capital Market. Kuala Lumpur:Securities Commission Malaysia. LexisNexis Malaysia.


Contents

Preface xiii

About the Author xvii

1 Muslim Beliefs 1

1.1 Five Pillars of Faith 1

1.1.1 Profession of Faith 2

1.1.2 Five Daily Prayers 2

1.1.3 Almsgiving 3

1.1.4 Fasting 3

1.1.5 Pilgrimage to Mecca 3

1.2 Six Islamic Creeds 4

1.2.1 Defi nition of Iman 4

1.2.2 Iman as Basis of Righteous Deeds 5

1.3 Belief in Allah and His Attributes 5

1.4 Belief in Destiny 6

1.5 Belief in Angels 7

1.6 Belief in Apostles 7

1.7 Belief in the Revealed Books 8

1.8 Belief in the Hereafter 9

2 Sharia’a Law and Sharia’a Boards: Roles, Responsibility and Membership 13

2.1 Defi nition of the Sharia’a 13

2.2 Allah is the Law Giver 13

2.3 Objectives of the Sharia’a 14

2.3.1 Sharia’a: The Framework of Islamic Banking 14

2.4 Sources of the Sharia’a 16


2.4.1 Qur’an: The Primary Source of the Sharia’a 17

2.4.2 Sunnah: The Second Primary Source of the Sharia’a 18

2.4.3 Ijma (Consensus): The First Secondary Source of the Sharia’a 20

2.4.4 Qiyas (Analogical Reasoning): The Second Secondary Source of the Sharia’a 20

2.4.5 Ijtihad 21

2.4.6 Compliance with the Scheme of Sharia’a Laws 22

2.5 Sharia’a Islamic Investment Principles 22

2.6 Conditions for Investment in Shares 23

2.7 Sharia’a Supervisory Board (SSB) 23

2.7.1 Function and Responsibilities 24

2.7.2 Sharia’a Boards: Roles and Scope of Responsibilities 24

2.7.3 Dubai Islamic Bank (DIB) 26

2.8 Sharia’a Board Scholar Qualifi cations 27

2.8.1 Dr Hussain Hamid Hassan 27

2.8.2 Dr Ali AlQaradaghi 27

2.8.3 Dr Mohamed Elgari 27

2.8.4 Dr Mohd. Daud Bakar 28

2.8.5 Sheikh Nizam M.S. Yaquby 28

2.8.6 Sheikh Muhammed Taqi Usmani 28

2.8.7 Sheikh Abdullah Bin Suleiman Al-Maniya 29

2.8.8 Sheikh Dr Abdullah bin Abdulaziz Al Musleh 29

2.8.9 Sheikh Dr Muhammad Al-Ali Al Qari bin Eid 29

2.9 State Bank of Pakistan (SBP): Proper Criteria for Appointment of Sharia’a Advisors 29

2.9.1 Solvency and Financial Integrity 30

2.9.2 Personal Integrity, Honesty and Reputation 30

3 Definition of Islamic Banking 31

3.1 Conventional Bankers and Islamic Banking 31

3.2 Six Key Islamic Banking Principles 33

3.2.1 Predetermined Payments are Prohibited 33

3.2.2 Profi t and Loss Sharing 33

3.2.3 Making Money Out of Money is Not Acceptable 34

3.2.4 Uncertainty is Prohibited 35

3.2.5 Only Sharia’a-Approved Contracts are Acceptable 35

3.2.6 Sanctity of Contract 35

3.3 Defi nition of Asymmetric Information 36


3.3.1 Adverse Selection 36

3.3.2 Moral Hazard 36

3.4 Origins of Asymmetric Risk within Islamic Banking 37

3.5 Riba in the Qur’an and Sunnah or Hadith 37

3.5.1 Textual Evidence for the Ban on Interest 38

3.5.2 Islamic Rationale for Banning Interest (Riba) 39

3.6 Five Reasons for the Prohibition of Riba 39

3.6.1 Interest is Unjust 40

3.6.2 Interest Corrupts Society 41

3.6.3 Interest Implies Unlawful Appropriation of Other People’s Property 41

3.6.4 Interest-Based Systems Result in Negative Growth 41

3.6.5 Interest Demeans and Diminishes Human Personality 42

4 Murabaha as a Mode of Islamic Finance 43

4.1 Murabaha Transactions 43

4.1.1 Defi nition of Musawama 44

4.1.2 Some Terminological Issues 44

4.2 What Makes Murabaha Sharia’a Compliant? 45

4.3 Islam Treats Money and Commodities Differently 46

4.3.1 Commodity Transactions with Credit can Involve an Excess 46

4.4 Murabaha and the Sharia’a 47

4.5 Practicalities of Implementing Murabaha 47

4.6 Sharia’a Rules Concerning Murabaha 48

4.7 Reasoning Behind Sharia’a Rules 49

4.7.1 Important Exceptions to Sharia’a Rules 50

4.8 Practical Examples of the Application of Murabaha 50

4.8.1 Mortgages 50

4.8.2 Working Capital 50

4.8.3 Syndicated Credits 50

4.8.4 Financing of GSM Licences 51

4.8.5 Letters of Credit 51

4.8.6 Car and House Purchase 52

4.9 Key Issues Associated with Murabaha 52

4.9.1 Use of an Interest Rate as a Benchmark 52

4.9.2 Gharar Issues 54

4.9.3 Collateral Provisions Against the Murabaha Payment 55


4.9.4 Guaranteeing the Murabaha 55

4.9.5 Penalty of Default 56

4.9.6 No Roll-Over in Murabaha 57

4.9.7 Rebate on Earlier Payment 57

4.9.8 Subject Matter of Murabaha 57

4.9.9 Rescheduling of the Payments in Murabaha 58

4.9.10 Securitisation of Murabaha 58

4.10 Comparison of Murabaha with Interest-Based Finance 58

4.11 Murabaha Differences from the other Islamic Financing Techniques 58

4.11.1 Islamically Permissible Deferred Sales Contracts 59

4.11.2 Profi t and Loss Share (PLS) Contracts 60

4.12 Summary 60

Reference 61

5 Mudaraba as a Mode of Islamic Finance 63

5.1 Defi nition of Mudaraba 63

5.1.1 Types of Mudaraba 64

5.1.2 Two-tier Mudaraba and the Asset and Liability Structure

of an Islamic Bank 64

5.1.3 Sources of Finance for an Islamic Bank 66

5.1.4 Mudaraba as Limited Recourse Debt Finance 67

5.2 What makes Mudaraba Sharia’a Compliant? 67

5.2.1 Origin of the Term Mudaraba 67

5.3 Practicalities of Implementing Mudaraba 68

5.4 Sharia’a Rules Concerning Mudaraba 68

5.5 Practical Examples of Mudaraba 69

5.5.1 Target Profi t Rates and Mudaraba 71

5.6 Key Issues Associated with Mudaraba 72

5.7 Comparison of Mudaraba with the Conventional Banking Equivalent 72

5.8 Mudaraba: Differences from the other Islamic Financing Techniques 73



5.9 Summary 75

Reference 76


6 Musharaka as a Mode of Islamic Finance 77

6.1 Defi nition of Musharaka 77

6.2 What makes Musharaka Sharia’a Compliant? 78

6.3 Practicalities of Implementing Musharaka 79

6.4 Sharia’a Rules Concerning Musharaka 79

6.5 Practical Examples of Musharaka 80

6.5.1 Application of Diminishing Musharaka 80

6.5.2 Application of Musharaka in Domestic Trade 82

6.5.3 Application of Musharaka for the Import of Goods 82

6.5.4 Letters of Credit on a Musharaka Basis 82

6.5.5 Application of Musharaka in Agriculture 83

6.5.6 Securitisation of Musharaka: Musharaka Sukuk 83

6.6 Problems Associated with Musharaka 84

6.6.1 Confi dence of Depositors 84

6.6.2 Dishonesty: Asymmetric Risk 84

6.6.3 Secrecy of the Business 85

6.7 Comparison of Musharaka with the Conventional Banking Equivalent 85



6.8 Summary 87

Reference 88

7 Ijara as a Mode of Islamic Finance 89

7.1 Defi nition of Ijara 89

7.1.1 Defi nition of Usufruct 90

7.1.2 Ijara and Ijara wa Iqtina 90

7.1.3 Defi nition of Ijara wa Iqtina 91

7.1.4 Leasing as a Mode of Financing 91

7.2 What makes Ijara Sharia’a Compliant? 91

7.3 Practicalities of Implementing Ijara 91

7.4 Sharia’a Rules Concerning Ijara 92

7.5 Basic Rules of Islamic Leasing 93

7.5.1 Benchmarking Against LIBOR is Permitted with Ijara 94

7.6 Practical Examples of Ijara 95

7.6.1 Lease Purchase Transactions 96


7.7 Key Differences between an Ijara Contract and a Conventional Lease 97

7.7.1 Rental Payments Based on Interest 97

7.7.2 Penalty Interest with a Default 97

7.7.3 Insurance and Maintenance Issues 97

7.7.4 Sharia’a Board Issues 98

7.8 Comparison of Ijara with the Conventional Banking Equivalent 98

7.9 Ijara: Differences from the other Islamic Financing Techniques 98



7.10 Summary 101

Reference 101

8 Istisna’a as a Mode of Islamic Finance 103

8.1 Defi nition of Istisna’a 103

8.1.1 Istisna’a and Parallel Istisna’a 104

8.2 What makes Istisna’a Sharia’a Compliant? 105

8.3 Practicalities of Implementing Istisna’a 105

8.4 Sharia’a Rules Concerning Istisna’a 106

8.5 Practical Examples of Istisna’a 107

8.6 Key Issues Associated with Istisna’a 108

8.6.1 Guarantees 109

8.6.2 Other Issues Relating to Istisna’a 110

8.7 Comparison of Istisna’a with the Conventional Banking Equivalent 111

8.8 Istisna’a: Differences from the other Islamic Financing Techniques 111



8.8.3 Differences Between Istisna’a and Salam 113

8.8.4 Differences between Istisna’a and Ijara 114

8.9 Summary 114

Reference 115

9 Salam as a Mode of Islamic Finance 117

9.1 Defi nition of Salam 117

9.2 What makes Salam Sharia’a Compliant? 118

9.3 Practicalities of Implementing Salam 118


9.4 Sharia’a Rules Concerning Salam 119

9.5 Sharia’a Rules Concerning Parallel Salam 120

9.6 Practical Examples of Salam 121

9.7 Benefi ts of the Salam Contract 121

9.8 Problems Associated with Salam 121

9.9 Comparison of Salam with the Conventional Banking Equivalent 122

9.10 Salam: Differences from the other Islamic Financing Techniques 122



9.10.3 Differences between Salam and Istisna’a 124

9.11 Summary 124

Reference 126

10 Takaful: Islamic Insurance 127

10.1 Case for Islamic Insurance 127

10.2 Islamic Issues with Conventional Insurance 127

10.2.1 Issues in Conventional Insurance 127

10.3 Defi nition and Concept of Takaful 128

10.3.1 How Tabarru’ Eliminates the Problems of Conventional Insurance 128

10.3.2 Derivation of the Term Takaful 128

10.4 Islamic Origins of Takaful 129

10.5 Where Insurance Fits within Islam 129

10.6 Defi nition of the Parties to a Takaful 129

10.7 Takaful in Practice 130

10.8 Takaful and Conventional Insurance 130

10.9 Alternative Models of Takaful 130

10.9.1 Ta’awun Model 130

10.9.2 Nonprofi t Model 131

10.9.3 Mudaraba Model 132

10.9.4 Wakala Model 132

10.9.5 Applying the Relevant Model 132

10.10 Sharia’a Law as Applied by Takaful Operators 132

10.10.1 Principles of Contract 132

10.10.2 Principles of Liability 133

10.10.3 Principle of Utmost Good Faith 133


10.10.4 Principles of Mirath and Wasiyah 134

10.10.5 Principles of Wakala (Agency) 134

10.10.6 Principles of Dhaman (Guarantee) 134

10.10.7 Principles of Mudaraba and Musharaka 134

10.10.8 Principles of Rights and Obligations 134

10.10.9 Principles of Humanitarian Law 135

10.10.10 Principles of Mutual Cooperation 135

10.11 Takaful Operators 135

10.12 Defi nition of ReTakaful (Reinsurance) 136

10.13 Retakaful 136

10.14 Role of the Sharia’a Board in Takaful 137

10.14.1 Legal Basis for Assigning the Sharia’a Board 138

10.14.2 Nature of the Sharia’a Board’s Decisions 138

10.14.3 Sharia’a Board’s General Duties 138

10.14.4 Sharia’a Board’s Detailed Duties 138

Appendix 1. Comparative Features of Islamic Financing Techniques 141

A.1 Nature of the Financing 141

A.2 Role of the Finance Provider in the Management/Use of Funds 141

A.3 Risk Bearing by the Finance Provider 142

A.4 Uncertainty of the Rate of Return on Capital for the Finance Provider 142

A.5 Cost of Capital for the Finance User 144

A.6 Relationship Between the Cost of Capital and the Rate of Return on Capital 144

Appendix 2. Top 500 Islamic Institutions 1–73 145

Glossary 151

Bibliography 157

Index 165

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1

Muslim Beliefs

Islam is the name of the religion transmitted by the Prophet Mohammed as revealed tohim by God (Allah). Central to Islamic beliefs is The Qur’an, which can be defined as‘the book containing the speech of God revealed to the Prophet Mohammed in Arabic andtransmitted to us by continuous testimony’. The Qur’an is deemed to be a proof of theprophecy of Mohammed, is the most authoritative guide for Muslims and is the first sourceof the Sharia’a. The Ulema (religious scholars) are unanimous on this point, and some evensay that it is the only source and that all other sources are explanatory of the Qur’an. Thesalient attributes of the Qur’an, which are indicated in this definition, can be summarisedin five points:

• It was revealed exclusively to the Prophet Mohammed.• It was put into writing.• It is all mutawatir (universally accurately reported).• It is the inimitable speech of God.• It is recited in salah (ritual prayer).

1.1 FIVE PILLARS OF FAITH

The structure of Islam is founded on pillars. Just as the strength and stability of any structuredepends on the supporting pillars, the strength and stability of Islam depends on its pillars.Muslims are duty-bound to acquaint themselves with the nature of Islam’s pillars.

During the 10 years between his arrival in Medina and his death in AD 632, Mohammed laidthe foundation for the ideal Islamic state. A core of committed Muslims was established, anda community life was ordered according to the requirements of the new religion. In additionto general moral injunctions, the requirements of the religion came to include a number ofinstitutions that continue to characterise Islamic religious practice today.

Foremost among these institutions are the five pillars of Islam. These are the essentialreligious duties required of every mentally able, adult Muslim. The five pillars are eachdescribed in some part of the Qur’an and were already being practised during Mohammed’slifetime. They are:

• the profession of faith (Shahada);• daily prayer (Salat);• almsgiving (zakat);• fasting (sawm);• pilgrimage (hajj).

Although some of these practices had precedents in Jewish, Christian and other MiddleEastern religious traditions, taken together they distinguish Islamic religious practices from

1


2 Introduction to Islamic Banking & Finance

those of other religions. The five pillars are thus the most central rituals of Islam and constitutethe core practices of the Islamic faith.

1.1.1 Profession of Faith

The absolute focus of Islamic piety is Allah, the supreme, all knowing, all-powerful, God. TheArabic word Allah means ‘the God’, and this God is understood to be the God who broughtthe world into being and sustains it to its end. By obeying God’s commands, human beingsexpress their recognition of and gratitude for the wisdom of creation, and live in harmony withthe universe.

The profession of faith, or witness to faith (Shahada), is therefore the prerequisite formembership in the Muslim community. On several occasions during a typical day, and in thesaying of daily prayers, a Muslim repeats the profession ‘I bear witness that there is no Godbut Allah and that Mohammed is his prophet’. There are no formal restrictions on when andwhere these words can be repeated.

To become a member of the Muslim community, a person has to profess and act uponthis belief in the Oneness of God (Tawhid) and the prophethood of Mohammed. To be a trueprofession of faith, which represents a relationship between the speaker and God, the verbalutterance must express genuine knowledge of its meaning as well as sincere belief. A person’sdeeds can be subjected to scrutiny by other Muslims, but a person’s utterance of the professionof faith is sufficient evidence of membership of the Muslim community.

1.1.2 Five Daily Prayers

The second pillar of Islam is the religious duty to perform five prescribed daily prayers(Salat). All adult Muslims are obliged to perform five prayers, preceded by ritual cleansing orpurification of the body at different intervals of the day. The Qur’anic references also mentionthe acts of standing, bowing and prostrating during prayers and facing a set direction, knownas qibla. Muslims were first required to face Jerusalem during prayer, but already duringMohammed’s lifetime they were commanded to face the Kaaba, an ancient shrine in the cityof Mecca.

The most detailed descriptions of the rituals for prayer derive from the example set by theprophet Mohammed and are preserved in later Islamic traditions (Ahadith). Some details ofthese rituals vary. However all Muslims agree that there are five required daily prayers to beperformed at certain times of day:

• dawn (fajr or subh);• noon (zuhr);• mid-afternoon (asr);• sunset (maghrib);• evening (isha).

The dawn, noon and sunset prayers do not start exactly at dawn, noon and sunset; in-stead, they begin just after, to distinguish the Islamic ritual from earlier pagan practices ofworshipping the sun when it rises or sets.

A prayer is made up of a sequence of units called bowings (rak’as). During each of theseunits, the worshipper stands, bows, kneels and prostrates while reciting verses from the Qur’an.


Muslim Beliefs 3

Wherever Muslims live in substantial numbers throughout the world, the call to prayer (adhan)is repeated five times a day by a muezzin (crier) from a mosque, the Muslim place of worship.

The Friday noon prayer is led by an imam, who is a prayer leader in the Sunni divisionof Islam. This prayer differs from the usual noon prayers of the other days of the week. Asa required part of the ritual at this congregational meeting, two sermons precede the prayer.On other days, Muslims can pray anywhere they wish, either individually or in groups. Theymust, however, observe the rituals of praying at certain times of day, facing in the directionof Mecca, observing the proper order of prayers and preparing for prayer through symbolicpurification.

1.1.3 Almsgiving

The third pillar of Islam is almsgiving (zakat). A religious obligation, zakat is considered anexpression of devotion to Allah. It represents the attempt to provide for the poorer sectorsof society, and it offers a means for Muslims to purify their wealth and attain salvation. TheQur’an, together with other Islamic traditions, strongly encourages charity and constantlyreminds Muslims of their moral obligation to the poor, orphans and widows. However itdistinguishes between general, voluntary charity (sadaqah) and zakat, the latter being anobligatory charge on the money or produce of Muslims.

1.1.4 Fasting

The fourth pillar of Islam is fasting (sawm). Clear Qur’anic references to fasting account forthe early introduction of this ritual practice. The Qur’an prescribes fasting during the monthof Ramadan, the ninth month of the 12-month Islamic lunar year. The month of Ramadan issacred because the first revelation of the Qur’an is said to have occurred during this month.By tradition the month starts with the sighting of the new moon by at least two Muslims. Forthe entire month, Muslims must fast from daybreak to sunset and refrain from eating, drinkingand sexual intercourse. Menstruating women, travellers and sick people are exempted fromfasting, but have to make up the days they miss at a later date.

According to various traditional interpretations, the fast introduces physical and spiritualdiscipline, serves to remind the rich of the misfortunes of the poor and fosters, through thisrigorous act of worship, a sense of solidarity and mutual care among Muslims of all socialbackgrounds.

1.1.5 Pilgrimage to Mecca

The fifth pillar requires that Muslims who have the physical and financial ability shouldperform the pilgrimage, or hajj, to Mecca at least once in a lifetime. Arabs before the rise ofIslam practised the pilgrimage and the ritual continues from the early days of Islam.

The hajj is distinct from other pilgrimages. It must take place during the 12th lunar monthof the year, known as Dhu al-Hijja, and it involves a set and detailed sequence of rituals thatare practised over the span of several days. All pilgrimage rituals take place in the city ofMecca and its surroundings, and the primary focus of these rituals is a cubical structure calledthe Kaaba.

According to Islamic tradition (Hadith), the Kaaba, also referred to as the House of God,was built at God’s command by the prophet Ibrahim (Abraham of the Hebrew and Christian



Bibles) and his son Ismail (Ishmael). The Qur’an provides detailed descriptions of variousparts of the ritual, and it portrays many of these rituals as re-enactments of the activities thatIbrahim and Ismail undertook in the course of building the Kaaba. Set into one corner of theKaaba is the sacred Black Stone, which according to one Islamic tradition (Hadith) was givento Ibrahim by the angel Gabriel.

Once pilgrims arrive in Mecca, ritual purification is performed. Many men shave their heads,and men and women put on seamless white sheets. This simple and common dress symbolisesthe equality of all Muslims before God, a status further reinforced by the prohibition ofjewellery, perfumes and sexual intercourse. After this ritual purification, Muslims circle theKaaba seven times, run between al-Safa and al-Marwa, two hills overlooking the Kaaba, seventimes, and perform several prayers and invocations.

After these opening rituals, the hajj proper commences on the seventh day and continuesfor the next three days. Again, it starts with the performance of ritual purification followedby a prayer at the Kaaba mosque. The pilgrims then assemble at Mina, a hill outside Mecca,where they spend the night. The next morning they go to the nearby plain of Arafat, wherethey stand from noon to sunset and perform a series of prayers and rituals. The pilgrims thenhead to Muzdalifa, a location halfway between Arafat and Mina, to spend the night. The nextmorning, the pilgrims head back to Mina, on the way stopping at stone pillars symbolisingSatan, at which they throw seven pebbles.

The final ritual is the slaughter of an animal (sheep, goat, cow or camel). This is a symbolicre-enactment of God’s command to Ibrahim to sacrifice his son Ismail, which Ibrahim andIsmail duly accepted and were about to execute when God allowed Ibrahim to slaughter a ramin place of his son. (In the Hebrew and Christian Bibles, Abraham is called to sacrifice his sonIsaac rather than Ishmael.)

Most of the meat of the slaughtered animals is to be distributed to poor Muslims. Theritual sacrifice ends the hajj and starts the festival of the sacrifice, ‘id al-adha. The festivalsof breaking fast (‘id al-fitr) at the end of Ramadan and ‘id al-adha are the two major Islamicfestivals celebrated by Muslims all over the world.

During the pilgrimage most Muslims visit Medina, where the tomb of the Prophet is located,before returning to their homes. If the pilgrimage rituals are performed at any time of the yearother than the designated time for hajj, the ritual is called umra. Although umra is considereda virtuous act, it does not absolve the person from the obligation of hajj.

1.2 SIX ISLAMIC CREEDS

The Shahada is the Muslim declaration of belief in the oneness of Allah and acceptance ofMohammed as God’s prophet. The declaration reads: ‘There is no God but Allah; Mohammedis the messenger of Allah’. The complete Shahada cannot be found in the Qur’an but comesfrom the Ahadith. The application of these principles is known, to Muslims, as Iman.

1.2.1 Definition of Iman

Iman (faith) is to proclaim the Kalimah and affirm its truth. By proclaiming the Kalimah,Muslims express their beliefs in the following Articles of Faith:

• existence and Attributes of Allah;• destiny (Qada’ar);


Muslim Beliefs 5

• angels;• prophets;• revealed Books;• The Hereafter.

Belief in these six Articles together forms the Creed of Islam. Belief in any one of theseimplies belief in the others as well, and rejection of one implies rejection of all.

1.2.2 Iman as Basis of Righteous Deeds

Iman is the basis of acts of worship and righteous deeds in Islam. Without the firm foundationof Iman, Muslims believe that no act of worship and no deed, however sincerely and devotedlyperformed, will be acceptable to Allah.

1.3 BELIEF IN ALLAH AND HIS ATTRIBUTES

The Islamic reasoning behind the first Article of Faith is as follows:

1. The unimaginably vast universe around us, which contains millions of stars and planetsand galactic systems, cannot have come about by mere chance, by material and physicalaccident or by a chain of accidents, but has been created by Allah in accordance with Hiswill and design.

2. Allah is the creator of each and every thing in the universe. Nothing has come into beingof its own accord; and everything depends on Allah for its existence and survival.

3. Allah is eternal: He is ever-living and will never cease to be.4. Allah is one: everything depends on Him, but He depends on none. He is All-powerful,

and none has the power to change or evade His will or verdict. He has neither parents, noroffspring, nor clan.

5. Allah is unique both in His essence and attributes. He exists by Himself and is Self-sufficient, and does not stand in need of anybody else’s aid to establish His rights andpowers.

6. Nothing is beyond Him: nothing conceivable is beyond His control and power. He is aboveevery conceivable defect, weakness or fault.

7. Allah is the real sovereign of the whole universe: He is the source of all sovereignty:everything is functioning according to His will.

8. Allah is the real source and centre of all power: no power exists besides His.9. Allah is omnipresent: He watches over everything: nothing is hidden from Him either in

the depths of the earth or in the limitless vastnesses of the heavens. He is the knower ofthe unseen and is fully aware of man’s intentions, thoughts, feelings, even hidden motives.He possesses full and exact knowledge of what has happened in the past, or will happenin the future.

10. Life and death are completely under His control: He grants life to whomsoever He willsand brings death to whomsoever He wills.

11. The treasure houses of everything are with Allah: none can bestow anything on anyonewhom He wills to deprive, and none can withstand anything from anybody whom He willsto favour.



12. Bestowing of gains or inflicting of losses is entirely in Allah’s hands: none can ward off amisfortune that He wills one to suffer, and none can stop a good life that He wills one toenjoy.

13. Allah is the provider of every creature: all provisions of life are under His control. He isfully aware of the needs of His creations and provides them accordingly. He restricts Hisprovisions or gives generously to whomsoever He wills.

14. Allah is just, all-knowing, all-wise: His decrees are just. He does not deprive anyone of hisdue. For Him good and evil are not equal: He will reward and punish everyone accordingto his deeds. He will neither punish a sinner unduly nor deprive a righteous worker of hisrewards.

15. Allah has great love for His creatures: He forgives their sins, accepts their repentancesand is ever merciful to them. A believer should never lose hope of His mercy and grace.

16. Allah alone deserves to be loved: one should seek only His pleasure and approval.17. Allah alone deserves to be thanked, worshipped, adored and none else.18. Allah alone has the right to be worshipped and His law obeyed unconditionally.19. Allah alone deserves to be feared: He alone can fulfil hopes and grant prayers and give

help and succour in difficulties and hardships.20. Allah alone can show guidance: none can misguide the one whom Allah wills to guide,

and none can show guidance to the one whom He has deprived of guidance.

Muslims would further reason that the worst people on the earth are those who disbelievein Allah, reject His guidance, make others His associates and worship their own selves anddesires instead of Him. As it says in the Qur’an:

Those who disbelieve, and die while they are disbelievers; on them is the curse of Allah and ofangels and of men combined.They ever dwell in it. The doom will not be lightened for them, neither will they be reprieved.

(S2: 161–162)

Holding others as partners in Allah’s Godhead is a falsehood and a most heinous sin. Thisis known as shirk (blasphemy). Allah will forgive all other sins but not the sin of shirk. As itsays in the Qur’an:

Shirk is the only sin that Allah does not forgive. He may forgive whosoever He will, other thanthis sin, for whose associate’s partners with Allah does, in fact, go far astray into deviation.

(S4: 116)

1.4 BELIEF IN DESTINY

The second Islamic Article of Faith is the belief in one’s destiny as an integral part of one’sbelief in Allah’s existence and His Attributes, and the Qur’an mentions it as such. The traditions(Hadith) of the Holy Prophet mention destiny as a separate and independent article of the faith.

Belief in destiny implies that all good and evil that takes place in the world, or will takeplace in future, is from Allah and in His knowledge. His knowledge is all-comprehensive andnothing of good or evil is outside it. Allah’s knowledge comprehends all the good or evil deedsthat humans will commit after their birth. Not a single particle moves anywhere in the universeunless its movement is within Allah’s knowledge and in accordance with His will. No powercan deprive or withhold from a creature anything that has been pre-ordained for it by Allah,


Muslim Beliefs 7

and none can provide a creature with anything of which Allah has deprived it. Allah is theMaker of all destinies, good or otherwise.

In this regard, the teaching of Islam is that one should continue doing as much good as onecan. One should avoid violating or neglecting religious commands and injunctions.

1.5 BELIEF IN ANGELS

The Islamic reasoning behind the third Article of Faith is as follows:

1. Angels have been created from light and are invisible, are of neither sex and have beenappointed by Allah to carry out His Commands.

2. Angels are helpless creatures and cannot do anything out of their own will. They carry out,without question, all the Commands of Allah and dare not oppose or neglect them in anyway.

3. They are engaged day and night in praising and glorifying Allah and are never tired ofdoing so.

4. They remain in awe of Him and can never so much as think of disobeying or revoltingagainst Him.

5. They carry out their respective functions honestly, efficiently and responsibly, and are neverguilty of shirking work.

6. The number of angels is only known to Allah Himself; four of them, however, are well-known, being nearest to Him in status and position. They are:Gabriel: whose duty has been to convey Allah’s revelations and messages to the Prophets.

He no longer performs this duty given that the institution of Prophet has come to an endwith the arrival of The Holy Prophet Mohammed.

Israfil: who by Allah’s Command will blow into the trumpet on the Day of Judgement andbring the present system and order of the world to an end.

Michael: whose duty is to arrange for rainfall and supply provisions to the creations ofAllah, with His Command.

Izra’il: who has been appointed to take the people’s souls.7. Two angels have been attached to every human being: one to record his good deeds and the

other his bad deeds. They are called Kiraman Katibin.8. Two angels, called Munkar and Nakir, are sent to the grave to question a person after his

death.

1.6 BELIEF IN APOSTLES

The Islamic reasoning behind the fourth Article of Faith is as follows:

1. The arrangement made by Allah to convey His messages and commands for the guidanceof mankind is called Apostleship, and those chosen for the mission are known as Apostles,Messengers or Prophets.

2. The Apostles have been conveying the Divine messages most scrupulously without tam-pering with them in any way.

3. Apostleship is God-given and cannot be acquired by effort and will.4. All the Apostles have been men, and none of them was an angel, or jinn (evil spirit), or any

other creature. Their only distinction was that God had chosen them as His Messengersand sent down His revelations to them.



5. The Apostles have faithfully practised what they presented and preached. They have beena perfect and true practical model of their teachings.

6. The Apostles were sent in every age and to every community and country. Muslims mustbelieve in all the Apostles and reject none. They have to express complete faith in thoseof them who have been mentioned in the Qur’an and Hadith and hold them in the highestesteem.

7. All the Prophets gave the same message and invitation. Therefore rejection of one Prophetwill indeed be rejection of all.

8. Belief in a Prophet implies that one should follow him in life faithfully and completely.9. The institution of prophethood came to an end with the arrival of The Prophet

Mohammed. He was the Last of the chain of Prophets. No Prophet is to appear afterhim. His prophethood, therefore, will last and remain effective until the Day of Judge-ment.

10. The personal example set by the Prophet Mohammed is the most perfect model for all hisfollowers in all spheres of life. His verdict is decisive in all religious matters. A Muslimhas to follow faithfully and sincerely all that he has enjoined and to avoid all that he hasforbidden.

11. Obedience to the Prophet is obedience to Allah and disobedience of the Prophet is dis-obedience of Allah. Love of Allah, therefore, demands that one should obey the Prophetfor that alone is the test of one’s firmness in the faith.

12. Another proof of one’s faith is the extent of honour and esteem in which one holdsthe Prophet generally. Any insolence or impudence shown with regard to the Prophet isdestructive of all one’s works of the lifetime. As it says in the Qur’an:

O you who believe! Do not raise your voices above the Prophet’s voice, nor speak loudly tohim as you speak loudly to one another, lest your deeds become null, while you know not.

(S.49: 2)

Muslims are honour-bound to regard the Holy Prophet dearer than their own parents,children and near and dear ones, even oneself. The Qur’an is explicit on this point:

The Prophet is closer to the Believers than their own selves.(S.33: 6)

13. The belief in prophethood demands that Muslims should invoke Allah for His mercy andblessings on the Holy Prophet:

O believers! Call for blessings on him and salute him with a (becoming) salutation.(S.33: 56)

1.7 BELIEF IN THE REVEALED BOOKS

The Islamic reasoning behind the fifth Article of Faith is as follows:

1. Allah sent down Scriptures for the guidance of humans to teach them how to live life inthe right way. The Prophets demonstrated, by personal example, the meanings of theseScriptures.

2. Belief in all the revealed Books is necessary, for basically they all taught one and the samecreed: to worship and serve Allah alone and to avoid blasphemy (shirk).

3. Five of the Scriptures revealed to five of the well-known Prophets are as follows:Sahifah Ibrahim: revealed to Prophet Abraham;


Muslim Beliefs 9

The Torah: revealed to Prophet Moses;The Psalms: revealed to Prophet David;The Gospel: revealed to Prophet Jesus;The Qur’an: revealed to Prophet Mohammed.

4. Out of these revealed Books, Muslims believe that only the Qur’an is intact, exists in itsoriginal form and will remain so until the Last Day. Muslims believe that Allah has takenit on Himself to preserve it. As it says in the Qur’an:

Surely We have sent down the Qur’an, and surely We are its Preserver.(S.15: 9)

5. The other four revealed Books have, Muslims reason, been irrevocably tampered with andnone exist in their original form today. These Books were compiled long after the passingaway of the Prophets and, Muslims reason, people inserted many things into them, whichwere opposed to their actual teachings. Thus the Qur’an is the only authentic and safe guidetoday in order to know and understand the practice of the original guidance sent down byAllah.

6. No one has the authority to effect any alteration in the Qur’an in any way. The Prophethimself was not authorised to do so; his only mission was to follow and practise it faithfully.To interpret the Qur’an according to one’s personal whims and reading one’s own meaninginto its verses is highly sinful.

7. The Qur’an gives clear guidance for the solution of all human problems, personal andcollective. Muslims believe that ignoring its guidance in any sphere of life or adopting andfollowing other laws in preference to the Qur’anic Laws is sinful.

1.8 BELIEF IN THE HEREAFTER

The Islamic reasoning behind the sixth Article of Faith is as follows:

1. Life is not only this worldly life, but the real and eternal life is the life of the Hereafter thatstarts after death. The next worldly life will be blissful or painful and grievous dependingon what one has earned and done in this worldly life. Belief in such a life is called beliefin the Hereafter.

2. Every person is visited after death in the grave by two angels, called Munkar and Nakir,who put to the deceased the following questions:Who is your Lord?What is your religion?What do you say about this man (pointing to the Holy Prophet Mohammed)?

This is the first of the tests in the accountability of the Hereafter.3. On the first blowing of the Trumpet, the event which Muslims believe precedes the Day

of Judgement, the present system and order of the universe will be upset and brought toan end. The earth will be shaken by a terrible earthquake, the mountains will be uprootedand shattered, the sun and the moon will collide, the stars will lose their brightness, andall living creatures will cease to live and the universe will be totally destroyed.

The Day of Judgement, Muslims believe, is the final day of life on earth and for theuniverse. At the same time it is the beginning of the eternal life in the Hereafter.

4. On the second blowing of the Trumpet, all the dead will be brought back to life by Allah’sCommand. This is the Day of Resurrection. A new order will be created in which allhuman beings will have eternal life and there will be no death. This will be a terrible and



dreadful Day. People will be in awe with downcast heads and eyes, awaiting the Divineverdict.

5. All humans will be gathered together before their Lord, Who will be the sole Judge andRuler on that Day. As it says in the Qur’an:

The day when all people will rise up (from their graves), nothing about them will remainhidden from Allah. (It will be asked): To whom belongs the sovereignty on this Day? (Thewhole world will cry out): To Allah, the One, the Almighty.

(S.40: 16)

The sovereignty on that Day rightly belongs to the Beneficent, and it will be a hard Day forthe disbelievers.

(S.25: 26)

No one will have the heart to utter a word except with Allah’s permission. He will callupon each individual separately to account for all his deeds. Then Allah will deliver Hisverdict in full knowledge, justice and wisdom. Each individual will be recompensed justlyand equitably for all his deeds and no one will be done any injustice whatever.

6. The righteous will be handed their life-scrolls in their right hand, and the sinners will behanded their life-scrolls in their left hand. The former will attain true success and the lattermeet with failure. The former will exult in their success with bright and shining faces,while the latter will be burning inwardly with gloomy and dark faces. The righteous willbe admitted to Paradise where they will enjoy Allah’s favours and life of eternal bliss andpeace. The criminals will be cast into Hell to suffer Allah’s wrath and displeasure.

7. The Divine verdict on that Day will be final. None will be able to escape it by any trick,device or design; nor will any saint or prophet intercede for anyone, because intercessionwill not be possible except by Allah’s leave and permission. Nor will it be possible foranyone to return to the world so as to work again to earn one’s salvation.

8. All one’s deeds and actions, verbal and practical, are being recorded by the angels of Allahin a manner so that nothing escapes their notice.

9. None of anyone’s doings, big or small, remains hidden from Allah’s sight.10. The Believers will be blessed with such favours and bliss in Paradise that the like of these

will never have been conceived by any eye, ear or mind.11. The rebels of Allah will be cast into the blazing Hell from where they will have no escape.

They will neither die to get rid of the everlasting torment nor live to enjoy the good thingsof life. They will desire death but death will disappoint them. The blaze of Hell will beever brightening and unquenched. The dwellers will cry with thirst and be given moltenmetals for drink, which will scald their mouths and throats. They will have heavy collarsaround their necks and dresses of tar and fire on their bodies. They will be served withthorny bushes for food and will face Allah’s wrath at every moment.

12. Who will be admitted to Paradise and who will suffer in Hell is known only to Allah.The Prophets of Allah, however, have clearly indicated and pointed out the works anddeeds that enable one to deserve Paradise and the works that will lead one to Hell. It is,therefore, not possible in this world to predict with certainty as to who will be admitted toParadise, except those who were given the good news of admission into Paradise by theHoly Prophet himself. One may, however, expect this from Allah: that He will admit oneto Paradise on the basis of the good works that one is performing in this world.

13. Allah in His mercy will forgive any sin that He pleases, but, according to the Qur’an, Hewill not forgive the sin of shirk and outright rejection of the Truth.


Muslim Beliefs 11

14. A person may believe and repent of sins any time in life; Allah is Gracious and Com-passionate to His creatures and accepts their repentance most mercifully. No belief orrepentance, however, is acceptable at the time one has reached the point of death anddiscerned, unmistakably, one’s approaching end.

Given this background to Islam, the next chapter turns to the legal principles underlyingIslamic banking and financial relationships: the Sharia’a.

Contents

List of Tables and Charts xvii

Foreword xxi

by Larry Zimpleman

Preface xxv

by Tan Sri Zarinah Anwar

Preface xxix

by Mohammad Faiz Azmi

Acknowledgments xxxi

Introduction 1

CHAPTER 1

The Growth of Shariah Investments: Preparing the Next Generation 13

Introduction 15

The Global Islamic Funds Industry: Where Is It Now? 16

Global Product Innovation of Islamic Investment Products 21

Prognosis for Islamic Financial Markets: Where Are They Going? 23

Conclusion 27

Notes 28

Helpful Hints 29

CHAPTER 2

Fund Management within Shariah-Compliant Investment

Guidelines: Is There More Reward? 31

Introduction 33


The Application of Islamic Ethics to Asset Management 35

Benefi ts of Shariah vis-à-vis Conventional Investing 38

Conclusion 44

Notes 44

Helpful Hints 46

CHAPTER 3

Uncovering the Driving Principles of Islamic Finance: A Journey to

Accumulate Wealth Responsibly 47

Introduction 49

The Five Basic Principles of Islamic Finance 50

Conclusion 59

Notes 60

Helpful Hints 62

CHAPTER 4

Investing Responsibly: The Search for Similar Benefi ts for Ethical and

Shariah Forms of Investing 63

Introduction 65

Screening Criteria 68

Screening Process for Ethical Form of Investing 72

Socially Responsible Investment versus Shariah-Compliant Investment 74

A Similar Approach to Your Investment? 77

Availability of Choice for Investors 79

Broader Portfolio Diversifi cation 80

Conclusion 81

Notes 82

Helpful Hints 83

Appendix: Ethical Investment Screening Based on Negative Screening 85

CHAPTER 5

Broad Choices of Islamic Investment Funds: Can They Become Mainstream? 89

Introduction 91

Equity Funds 93

Sukuk Funds 94

Exchange-Traded Funds (ETFs) 95


Money Market Funds 96

Alternative Funds 97

Real Estate Investment Trust Funds (REITs) 97

Private Equity Funds 98

Hedge Funds 99

Lease Funds 100

Conclusion 101

Notes 102

Helpful Hints 104

CHAPTER 6

Mitigating the Myths: The Benefi ts of Islamic Funds for the Broader Investor Base 105

Introduction 107

Islamic Principles Come with Built-in Financial Ethics 108

The Myths of Shariah Investing 109

Benefi ts of Shariah Investing 116

Conclusion 119

Notes 120

Helpful Hints 122

CHAPTER 7

Comparative Analysis with Conventional Investing: Shariah-Compliant Investing is

Resilient, while Conventional Investing Has to Recover from Financial Crisis 125

Introduction 127

Islamic Indices Outperformed Conventional Indices 128

Qualitative Comparison of Islamic Index Screening Processes 129

Performance Analysis of Three Dow Jones Shariah Indices and Their Counterparts 131

Value-Added Optimization for Shariah Performance 139

Conclusion 140

Notes 140

Helpful Hints 142

CHAPTER 8

Using Performance Characteristics to Build Wealth: Empirical

Evidence, Proven and Tested 143


Introduction 145

The Impact of Black Swan Events 146

Why Shariah Investing Is Resilient 147

Conclusion 152

Notes 152

Helpful Hints 154

CHAPTER 9

The Sukuk Portfolio: A Broader Investment Universe for Mainstream Investors 155

Introduction 157

Emergence of Different Sukuk Structures 158

Examining Sukuk Investment Results 161

Case Study: Sukuk Investing as a Diversifi cation Strategy 166

Conclusion 167

Notes 168

Helpful Hints 170

CHAPTER 10

Shariah-Compliant UCITS Funds: Satisfying the Appetite of International Investors 173

Introduction 175

Solution at Your Doorstep 176

Providing Ease of Transaction to International Investors 177

Bringing Shariah Investment to a Global Audience 178

Notes 181

Helpful Hints 183

CHAPTER 11

Legal, Regulatory, Risk, and Operational Framework: Building Investors’ Confi dence 185

Introduction 187

The Islamic Financial Institutions’ Regulatory Framework 188

Country Examples 192

Conclusion 198

Notes 199

Helpful Hints 200


Epilogue 203

About the Author 205

About the Contributors 207

Glossary to the Quotations 209

Glossary of Islamic Finance 215

Global Islamic Finance Education Centers 235

Global Islamic Finance Conferences/Summits/Seminars 239

Islamic Investment and Finance Readings: Guide to Research Materials 243

Recommended Reading 245

Index 249

Buy This Book



13

CHAPTER

1The Growth of

Shariah InvestmentsPreparing the Next Generation

Permissibility is the original state.(Islamic legal maxim)*†

* For further explanations please refer to the Glossary of Quotations.† The legal maxim indicates that everything is permissible unless it is proven otherwise by Shariah; hence it is permissible to grow business and expand Islamic asset management provided that the motivating factors for the growth are Shariah compliant and driven by values and principles of Shariah.

INTRODUCTION

When I was a speaker at the Islamic Finance News (IFN) Europe Con-ference in London in June 2011, a young European participant asked, “Why would Japan join the bandwagon and issue Sukuk when it does not have a sizable Muslim population?” I explained that whilst Japan itself has ample liquidity, its involvement in Islamic fi nance is to show the world that the Japanese remain relevant and innovative and are able to grant value to investors with the latest investment trend. We have seen AEON Credit Services and Nomura Holdings issue Sukuk (Islamic bond) in 2007 and 2010, respectively, and Daiwa Asset listed its fi rst Islamic ETF in Singapore in 2008.

What is being done by Japan is refl ective of active market players envisioning that over the next 10 years, the landscape of institutions offering Islamic fi nancial services, including banks, nonbanks and microfi nance institutions, Takaful (insurance), Re-Takaful operators, and capital market players, will evolve into a full-fl edged system of Islamic fi nancial services that coexist effectively and effi ciently with conventional fi nancial institutions.

The rapid pace of economic growth and the accumulation of wealth in the Middle East and among the Muslim populations of the Far East are the catalysts that have driven and stimulated the develop-ments in Islamic asset and wealth management. I have observed that the second and third generation of Muslim immigrants in the United States, the United Kingdom, and Europe care deeply about practicing Islam in all aspects of their lives, including their investments. In addi-tion to Shariah compliance, this emerging demographic also demands similar investment performance to that of conventional investing. This growing group also wants the option of choosing from a wide range of Islamic investment solutions.

15

16 INVESTING IN ISLAMIC FUNDS

The idea of Islamic investing is gaining popularity as it also offers distinct risk management advantages. For example, several years ago Islamic funds were little affected by the scandal-affl icted companies such as Enron and WorldCom, as Shariah-compliant investment funds were prohibited under Shariah investing principles from holding these stocks given these companies’ highly leveraged balance sheets. The creation and improvement of international Islamic capital markets’ regulatory frame-works have contributed to an improvement of governance, which has increased international investors’ confi dence.

In the wake of the 2007 U.S. credit crisis and subsequent global fi nancial crisis in 2008, the Islamic fi nancial system not only survived; it has also grown. The size of the Islamic fi nancial services industry was USD1.14 trillion of banking assets as of 2010, a 78 percent increase over 2007.1 What helped Islamic banking and fi nance during the fi nancial crisis was the absence of exposure of derivatives, which ruined the balance sheets of most conventional banks. A situation like American Insurance Group (AIG), which had an unsustainably highly leveraged balance sheet due to high-risk debt instruments, is not likely to occur in Islamic fi nance. While many hedge funds and other fi nancial in-struments took signifi cant risks and fell hard in the late 2000s, the Islamic fi nance, in many cases, remained conservative and generic in its product offerings and investments and as a result, became one of the fastest-growing segments in the global fi nancial service sector.

The viability of Islamic fi nance is derived from its capability to meet the changing demand of the capital market. It is worth noting that the McKinsey Islamic World Conference 2008–2009 report highlighted that among the high-net-worth individuals, between 10 and 20 percent were ready to sacrifi ce investment return for Shariah compliance, thus providing a reasonable market demand to drive the development and expansion of Shariah-compliant investment products and solutions.

THE GLOBAL ISLAMIC FUNDS INDUSTRY: WHERE IS IT NOW?

Islamic fi nance is gaining importance in asset and wealth management. As of 2011, according to the data from the Global Islamic Finance Forum magazine, there are more than 700 Islamic investment funds

The Growth of Shariah Investments 17

managing total assets under management of USD60 billion to USD65 billion.2 These funds are dominated by equity funds, followed by money market funds.

Islamic investment funds are being offered by emerging asset management companies to meet the changing appetite of the inves-tors. While equity funds remain most popular, Sukuk, money market, commodities trading, and real estate are also catching up. The avail-able selection of Islamic funds has evolved from being domestically invested to being diversifi ed regionally and internationally. Investors’ growing interest, added to the availability of diversifi ed offerings across various asset classes, are no doubt creating choices for all inves-tors, Muslim and non-Muslim. Currently, a broad spectrum of asset classes—including equity, Sukuk, real estate, commodities, leasing, trade fi nance, private equity, and hedge funds—are available. The number of global asset management companies offering a broad range of Shariah-compliant investment funds across the world demonstrates the increasing diversity of players. These companies are headquar-tered in the strategic Islamic fi nance hubs of Malaysia, Saudi Arabia, Kuwait, United Arab Emirates, Bahrain, and United Kingdom.

During its infancy stage from 2003 to 2009, the global Islamic funds industry produced a commendable annualized growth rate of 25 percent.

Examining the trend of new launches over the last 10 years, there are two key infl ection points. The fi rst infl ection point in 2002 saw the beginning of a fi ve-year growth trend in the number of new fund launches which peaked in 2007. In 2008, the trend reversed sharply, with investors prioritizing capital preservation and fl eeing the markets, bringing demand for new funds to a halt. There was healthy industry attrition and consolidation as asset management companies had to ra-tionalize their range of offerings with the impact of the global fi nancial crisis. Therefore, the year 2010 saw 23 fund closures, followed by 46 fund launches.3 Slow growth of 3.5 percent in 2011 has not deterred the establishment of new asset classes.4

A decade ago, investors who wanted to invest in Islamic funds had to turn to established markets with strong domestic market demand for Islamic investments, like Saudi Arabia and Malaysia. In 2011, Saudi Arabia led with a 33.2 percent market share of funds offered, followed


by Malaysia, which domiciled 21.8 percent of funds (see Table 1.1). However, there is more asset class diversity in Malaysia versus other countries. Observing the rapid growth of new funds from 2002 to 2006, new market participants from different countries rallied to enter the industry to drive the establishment of the 180 new funds in 2007.

Malaysia and Saudi Arabia were pioneers in the development of Islamic funds. The world’s fi rst Islamic fund, LembagaTabung Haji or The Pilgrims Fund, was created in 1963 by the Malaysian govern-ment to help Muslims save for their pilgrimage to Mecca. The fi rst designated Shariah-compliant fund in Saudi Arabia was the Al-Ahli International Trade Fund, launched by National Commercial Bank in 1987. At their inception, the primary goal of these funds was to provide equities that comply with Shariah principles.

Since then, Shariah-complaint funds have demonstrated their per-severance by diversifying into various asset classes. In 2011, Malaysia and Saudi Arabia had a combined 55 percent market share, totaling USD26.8 billion out of almost USD60 billion in assets under manage-ment (see Table 1.1), but Islamic funds are also available on global

TABLE 1.1 Islamic Funds by Country (2011)

Fund Manager Country Percentage (%)

Saudi Arabia 33.2

Malaysia 21.8

Kuwait 7.1

United States 6.4

Cayman Islands 5.5

Luxembourg 3.5

Ireland 3.3

Jersey 2.9

Bahrain 2.6

Indonesia 2.4

Others 11.3

100.00

Source: Global Islamic Finance Forum magazine (2012)


platforms like Luxembourg, Ireland, and the Cayman Islands. Al-though funds registered in the Cayman Islands are largely distributed in the Middle East through Bahrain, funds registered in Luxembourg and Dublin are largely distributed by global banks in the respective jurisdictions, and they are also in compliance with Undertakings for Collective Investment in Transferable Securities (UCITS). This dem-onstrates that Shariah-complaint funds have evolved to meet the de-mands of sophisticated international investors, especially those from the United Kingdom and other parts of Europe. Due to these plat-forms’ robust risk framework, investors have a “window” with which to monitor the track records of these funds in Luxembourg and Dub-lin before deciding to invest.

As of 2011, the Cayman Islands offered 5.5 percent of the to-tal universe of Islamic funds, and Luxembourg offered 3.5 percent, followed by 3.3 percent in Dublin, Ireland. The popularity of these Islamic investment funds in Luxembourg and Dublin has been spurred by sophisticated global investment managers who already have a suf-fi cient track record on specifi c asset class capabilities in the conven-tional space.

UCITS are synonymous with strong capability and wider scope. Any Islamic investment fund established as a UCITS vehicle would have adhered to two of its important guidelines: namely, risk diver-sifi cation and liquidity. UCITS funds are heavily regulated, ensuring effective and uniform investor protection. Global UCITS fund plat-forms are structured to appeal to international investors, given the robust risk framework and strict governance. The UCITS structure is fl exible enough that it can be offered in multiple asset classes and multiple currencies to a broader investor base. As such, it can more easily build scale internationally and not be limited to the domestic sandbox. Such platforms are popular in the conventional space, and Shariah asset managers would do well to take full advantage to struc-ture these types of funds and utilize them to service the integrated world.

In essence, an UCITS-compliant fund is regarded as a European passport whereby if a fund is authorized in one European Union (EU) member state, the fund can be distributed in any other EU member state without any additional authorization.5


Table 1.2 above shows that equity Islamic funds lead in terms of as-sets under management, contributing to 46.9 percent of the total Islamic funds universe. Over the years, investors’ appetites have tended to fa-vor Islamic equity funds when compared to the rest of the asset classes launched. This might be related to the fact that investors know that equity investing potentially generates higher return than fi xed income. It is worth noting that Islamic equity investing avoids indulging in exces-sively risky and high-debt company stocks, leading to reduced volatility. Since money market and commodities fund are generally more stable in an uncertain market, there has been an increase in the number of funds launched since 2007. It must also be noted here that although the Sukuk market represents 5.8 percent of the funds asset class, it is currently the most visible Islamic fi nance instrument to various global investors.

Analysis of these global developments of Islamic funds industry and fund managers showed that 67 percent of the funds are invested in Asia Pacifi c and Middle East/Africa. Considering that investors were initially based in Asia-Pacifi c, the Middle East, and Africa, it makes commercial sense that these funds are invested in their backyards, the markets they are most familiar with.

Figure 1.1 shows where the funds were geographically invested. Global funds contributed a maximum weightage of 26.3 percent.

TABLE 1.2 Funds by Asset Class

MANDATE

Percentage

Contribution

Amount USD

(Billion)

Equity 46.9 28.14

Money markets 22.2 13.3

Mixed assets 11.8 7.0

Real estate 9.0 5.4

Sukuk 5.8 3.4

Commodities 3.4 2.04

Others 0.9 0.54

Trade fi nance 0.1 0.060

Structured products/ Hedge funds

0.1 0.060

TOTAL 100 60

Source: Global Islamic Finance Forum magazine (2012)


Saudi Arabia is second with 21.8 percent, followed by 19.2 percent concentration in Malaysia; almost a majority of the funds raised in these two regions are distributed locally.

FIGURE 1.1 Funds by investment geography (2011)Source: Global Islamic Finance Forum magazine (2012)

GlobalSaudi Arabia

MalaysiaUnited States

KuwaitMENA

UAEIndonesia

India

Asia Pacific ex JapanGCC

Others

%

0.0 5.0 10.0 15.0 20.0 25.0 30.0

Generally, the popularity of the investment locations has to do with where the funds were launched. For instance, Malaysia launched numerous Asia-Pacifi c investment funds because Malaysia is part of the Asia-Pacifi c region, and the fund managers and investors there were more familiar with the investments. Likewise, Saudi Arabia and Kuwait were more likely to have launched Middle East funds as they are more comfortable with investing close to where they are.

There is a gradual growth trend in the emerging market invest-ment. Emerging market strategy fi rst appeared in 2006, and two funds were each launched in 2006 and 2007. One of the notable emerging market products is the iShares UCITS-compliant MSCI emerging mar-ket Islamic ETF. It was listed in December 2007. The existing net total assets are a respectable USD28.8 million as of November 2012.6

GLOBAL PRODUCT INNOVATION OF ISLAMIC INVESTMENT PRODUCTS

Islamic investment funds started much later, in the early 1990s. Al-though the evolution of Islamic fi nancial markets started 30 years ear-lier, Islamic investment funds growth has been phenomenal since 2000.


The evolution was infl uenced by investors from Europe and the United States, as well as the global offshore market. Sophisticated products—namely, private equity and Islamic REITs, hedge funds, derivatives, Is-lamic asset-backed securities, and global Islamic bonds—are all being added. As a result, new institutions such as Islamic investment banks have joined the club in offering Islamic funds.7

Islamic funds have evolved into the wealth management space to cater to investors who want market exposure in conjunction with ethical, responsible investing. Investors can obviously benefi t from the broad spectrum of Islamic funds.

Islamic investment products have progressed over the period from 1990 to 2005. Beginning in 1990, investment products were largely equity and Murabaha funds. Islamic investment products now in-clude a wide spectrum of funds, ranging from generic funds to even hedge funds. There was an infl ection point from year 2005 onward where there was an active infl ux of new funds (see Table 1.3).

TABLE 1.3 Range of Global Islamic Investment Products

2005 and Onward

Equity funds

Murabaha funds

Ijarah funds

Lifestyle funds

Balanced funds

Sukuk funds

Private equity funds

Real estate funds

Commodity funds

Funds of funds

Hedge funds

Index funds

Structured products

Listed REITs

Exchange-traded funds (ETFs)

Source: International Organization of Securities Commission (IOSCO)’s Islamic Capital Market Task Force Report 2004 and CIMB Islamic Research


PROGNOSIS FOR ISLAMIC FINANCIAL MARKETS: WHERE ARE THEY GOING?

The global market for Islamic banking assets was valued at USD1.357 tril-lion at the end of 2011. That year also saw tremendous growth in one of the asset classes, which contributed to further progress in the Islamic banking and fi nancial services in an otherwise depressed environment for fi nancial services. Sukuk saw a 77 percent growth totaling USD85.0 bil-lion in issuance. The growth in global Islamic banking and services in-dustry was 16.04 percent. One potential scenario shows global Islamic banking assets with commercial banks to reach USD1.8 trillion in 2013, representing an average annual growth of 17 percent.8

It is believed that Malaysia not only continues to dominate the Sukuk market but also intends to lead the internalization of Islamic fi -nance so that it can grow into the largest marketplace. Malaysia’s pro-claimed vision and facilitative legal framework has attracted companies from countries that are assessing the viability of Islamic fi nance. It has continued to raise the bar with landmark issuances and developments over the last three years. To achieve its aspiration to be a hub for global Islamic fi nance, Malaysia has established a comprehensive value chain of market players supported by services providers in a comprehensive legal and regulatory framework, as shown by Figure 1.2.

As the previous framework lays out, there is no doubt that Malaysia is at the forefront of the industry and continues to raise the bar with landmark issuances and developments taking place the last three years. It is an industry leader in structuring Islamic funds when compared to other countries.

Other key clusters of countries—namely, the Middle East and South East Asia—are actively developing the Islamic investment funds business as one of their organizational goals. Other jurisdictions are clearly joining the bandwagon to take advantage of their bene-fi ts. Islamic funds will be a fundamental tool to capture the wealth of opportunity. Rampant development of knowledge and soft skills will be optimized. Talents will be deployed to ensure that the back-room, system integration, prime broker, custodian, and trustees are aligned to Islamic principles. Progress of product development will deepen into Islamic ETFs, structured products, and hedge funds. Asset

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24


securitization is promising because current market operations are re-stricted by the dearth of liquidity in enhancing products—hence, the small Islamic secondary markets currently lack depth and breadth. A favorable tax regime will be introduced to address this.

Islamic investment funds are expected to grow at a considerable rate due to the fact that global middle-class investors are looking for alternatives to generate higher return combined with responsible in-vestment. The Islamic banking sector is projected to grow at a com-pound annual growth rate (CAGR) of 21.1 percent until 2020. This was the same projection used from 2007 to 2011.9 Figure 1.3 illus-trates the projected global Islamic banking assets growth until 2020.

FIGURE 1.3 Global Islamic banking assets growth trendsSource: Global Islamic Finance Forum magazine (2012)

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In a dynamic industry, the global Islamic funds market is trending upward. It is notable that this is spanning beyond the “captive” market of the sizable global Muslim population. Others are being drawn to the ethics and principles that form the basis of these funds.

The conducive regulatory environment and the size of market in the Middle East/North Africa is expected to support the rapid growth. New investment fi rms are established each year, and the funds in this re-gion have increased fi vefold in less than 10 years. Although most man-agers handle few mutual funds, some institutional mandates and some discretionary portfolios, banks in Abu Dhabi, Kuwait, and Saudi have


started to separate their investment banking from commercial banking. From the standpoint of progress in distributing investment products, the international fund managers offer offshore funds in the Middle East by using Bahrain, UAE, and Qatar as a distribution platform.

Today, there is greater focus on Saudi Arabia, which has the longest-standing record of foreign–local teamwork, than in previous years. New licenses have allowed more foreign banks to tie with local Saudi fi nancial institutions, notably Morgan Stanley Saudi Arabia and Credit Suisse/Saudi Swiss Securities, Merrill Lynch Saudi Arabia, HSBC-Saudi British Bank/Al Amana, and Citibank-Saudi American Bank. JP Morgan is licensed in Saudi Arabia under its own name. Deutsche Bank has both a local venture and a license under its own name.

The market players are keen to squash the feeling that Shariah is a retail story and that petrodollars do not care about whether a fund is Shariah compliant. They are intent on meeting investor demand and providing the requested diversity. Many international institutions already provide distinct Shariah-compliant businesses (e.g., HSBC Amanah, Citi Islamic and BNP Paribas Investment Partners).

There is growing interest in Asia’s growth potential. Middle Eastern investors are eyeing opportunities in emerging markets, particularly India, China, and Pakistan. Despite being perceived as “new kids on the block,” most experts believe it wouldn’t be too diffi cult for both Singapore and Hong Kong to establish themselves as Islamic wealth centers due to their long association as fi nancial hubs in Asia. All they need to do right now is to get the necessary infrastructure and regulation, followed by a jump start into the sector, and then build critical mass based on their Islamic fi nance expertise. Case-in-point: Hong Kong Airport Authority has expressed an interest in taking the lead in issuing its fi rst Islamic bonds of up to USD1.0 billion in 2013.10 Hong Kong can even provide a getaway for inves-tors interested in mainland China (especially Gulf Cooperation Council investors) by constructing Shariah-compliant products with underlying Chinese assets. While Indonesia and Japan are not forgotten, Malaysia is still most favored.

The United Kingdom is now the leading center for Islamic fi nance outside the Gulf Confederation Council and Malaysia. The United Kingdom seems poised to establish and maintain London as Europe’s gateway to international Islamic fi nance.


CONCLUSION

Saudi Arabia and Malaysia have been quick to capitalize on the emerg-ing sector of Islamic fi nancial instruments, and are now jointly recog-nized as world leaders in Islamic fi nance development. These countries played a crucial role in upgrading awareness, fi rst on Islamic fi nance itself and consequently on Islamic asset management. While these two nations have led the charge toward the growth of the sector, other countries are following suit.

Today in the Asia Pacifi c, the Islamic asset management industry has grown immensely in many countries, including Malaysia, Brunei, Singapore, Japan, South Korea, China, and Indonesia.

Demand-driven results speak for themselves. Global investment houses today continue to aggressively develop products to provide for investors of all levels with varying needs. Boutique investment com-panies are also becoming an increasingly popular business model for global houses, to capture their share of the market in different countries.

Demand for product diversifi cation has never been stronger, as in-stitutional fund managers are heeding the call from clients to provide new investment exposures in their portfolios. As such, the number of Islamic asset managers and the amount of total assets under manage-ment has multiplied tremendously. This is most welcome in the in-dustry, as it helps to promote new talent, better product quality, and greater competition.

As Islamic asset management continues to spread over multiple ge-ographical regions and across new customer classes, it is only a matter of time before Islamic asset management stands head-to-head with con-ventional investing. In the Asia Pacifi c ex-Japan region, the industry is burgeoning in a dynamic, prohibited manner, with growing awareness and investor acceptance around the world. This is also the region with the greatest number of Shariah-compliant investment opportunities.

The amount of products and instruments available in the mar-ket makes the investor spoilt for choice. The future development of Islamic asset management in the region is supported by various fac-tors—an overall positive growth in its component economies, growing population, and increasing wealth and increasing government support for the industry.


The Shariah-compliant investing approach has been proven to investors. This approach is able to form a balanced portfolio while reducing disparities and offering a socially and morally conscious al-ternative—thereby making it a valid and irresistible investment choice.

NOTES

1. “The Global Islamic Financial Services Industry,” in Global Islamic Finance Report 2011, 35.

2. KFH Research Ltd. and the Global Islamic Finance Forum (GIFF). “Global Islamic Finance Forum (GIFF).” Kuala Lumpur, Malaysia: Sep-tember 18–20, 2012.

3. Ernst & Young, 5th Edition Islamic Funds and Investment Report (IFIR 2011): Achieving Growth in Challenging Times, 2011.

4. KFH Research Ltd. and the Global Islamic Finance Forum (GIFF). “Global Islamic Finance Forum (GIFF).” Kuala Lumpur, Malaysia: Sep-tember 18–20, 2012.

5. Tony Goh. “The Next Frontier” Smart Investor, 264 (April 2012): 14–17. 6. “iShares MSCI Emerging Markets Islamic” Factsheet. iShares by Black-

rock, November 2012. 7. International Organization of Securities Commission (IOSCO) Islamic

Capital Market Task Force Report 2004. 8. IMF, The Banker, Central Bank Reports, and EY Universe, The World

Islamic Banking Competitiveness Report 2012–2013. 9. KFH Research Ltd. and the Global Islamic Finance Forum (GIFF). “Glob-

al Islamic Finance Forum (GIFF).” Kuala Lumpur, Malaysia: September 18–20, 2012.

10. Bernardo Vizcaino. “Hong Kong’s sukuk bill on track but local interest dim.” Reuters, 2012. http://www.reuters.com/article/2012/11/14/islamic-fi nance-sukuk-idUSL5E8LU7Y920121114

General Reading

Ernst & Young. The World Islamic Banking Competitiveness Report, Grow-ing Beyond: DNA of Successful Transformation (Report 2012–2013), December 2012.

Jaffer, Sohail. Islamic Asset Management: Forming the Future of Shariah Complaint Investment Strategies. Euromoney Books, 2004.

Jaffer, Sohail. Islamic Wealth Management: A Catalyst for Global Change and Innovation. Euromoney Books, 2009.

http://www.reuters.com/article/2012/11/14/islamic-finance-sukuk-idUSL5E8LU7Y920121114



29

■ A matured and fully functioning Islamic fi nancial market must contain asset management to complement the demand side of the value chain.

■ Islamic investment funds are no longer seen as an alternative investment but regarded as competitive to conventional.

■ As of October 2012, there are around 750 funds with assets under management totaling USD60 billion to USD65 billion. About 55 percent are dominated by Malaysia and Saudi Arabia.

■ 12 percent of funds are available in Luxembourg, Dublin, and the Cayman Islands, demonstrating global standard and cred-ibility.

■ Bahrain is a good platform for investors in Middle East/Africa to source foreign funds.

■ Financial centers mapped from Malaysia, Singapore, Hong Kong, Bahrain, Dubai, and London are now leading the global initiatives.

Helpful Hints

Contents

Foreword xvii

Preface xix

Acknowledgments xxi

CHAPTER 1

Classic Arab Financial Contracts in Modern Financial Institutions 1

Introduction 1

Economic Conditions in the Prophet Muhammad’s (pbuh) Era 1

Development of Classic Economic Contracts 6

Conclusion 12

Notes 13

References 13

CHAPTER 2

Program to Develop Indonesian Islamic Banking 15

Introduction 15

The Indonesian Islamic Banking Industry 15

A Program to Improve the Performance of the Islamic Banking Industry 26

Conclusion 27

References 27

CHAPTER 3

Understanding Characteristics of Depositors 29

Introduction 29

Studies on the Output of Empirical Surveys 30

Segmentations of Banking Depositors 33


Investment Behavior of Banking Depositors 35

An Integrated Program to Develop the Industry 41

Conclusion 43

References 44

CHAPTER 4

Liquidity Risk Management in Banks: The Conventional Perspective 45

Introduction 45

Liquidity Risk in Banking Institutions 45

Process of Liquidity Risk Management 49

Asset-Liability Imbalance and Maturity Mismatch Risks 52

Techniques to Mitigate Liquidity Risk 55

Financial Instruments as Sources of Banks Liquidity 58

Conclusion 60

Note 61

References 61

CHAPTER 5

Liquidity Risk Management in Banks: The Sharia Perspective 63

Introduction 63

Liquidity Risk Issues in Islamic Banking 63

Characteristics of Islamic Banks Facing Liquidity Risk 64

Sharia Issues in Liquidity Risk Management 67

Approaches to Manage Liquidity Risk Based on Sharia 71

Techniques to Mitigate Liquidity Risk Based on Sharia 75

Conclusion 80

Notes 81

References 81

CHAPTER 6

Islamic Banking Characteristics, Economic Conditions, and Liquidity Risk Problem 83

Introduction 83

Supporting Factors of Development 83

Characteristics of the Industry in Relation to Liquidity Problems 85

Investment Behavior of Depositors and Economic Conditions 88


Ideas for Improvements 94

Conclusion 95

References 95

CHAPTER 7

Performance of the Islamic Banking Industry 97

Introduction 97

Background of the Indonesian Islamic Banking Industry 98

Organizational Approach to Managing Liquidity 99

Liquidity Risk Management Related to the Liability Side 102

Instruments to Manage the Demand for Liquidity 120

Conclusion 124

Notes 125

References 125

CHAPTER 8

Growth of the Islamic Banking Industry 127

Introduction 127

Islamic Banking Industry and Its Development Programs 128

Literature Reviews 129

Construction and Output of the Models 133

ARIMA Models 134

Conclusion 143

References 144

CHAPTER 9

The Optimal and Decreasing Growth Rate of the Islamic Banking Industry 145

Introduction 145

Conditions Leading to the Optimal and Decreasing Growth Rate 146

Papers Analyzing Growth and Development of the Islamic Banking Industry 146

Construction of the ARIMA Models and Estimations 147

Findings and Strategic Policy Recommendations 154

Conclusion 155

References 155


CHAPTER 10

Liquidity Management Index 157

Introduction 157

Liquidity Risk Problem in Sharia Perspective 157

Construction of Liquidity Risk Management Index 158

Assessing the Indonesian Islamic Banking Industry 160

Overall Assessments of the Islamic Banking Industry 163

Conclusion 164

Appendix 10A: Liquidity Risk Management (Survey Manuals) 165

Appendix 10B: Bank X Survey Results 171

Appendix 10C: Bank Y Survey Results 177

Appendix 10D: Bank Z Survey Results 183

Note 189

References 189

CHAPTER 11

An Empirical Survey on Liquidity Risk Management 191

Introduction 191

Depositors Understanding of Islamic Banking 192

Investment Behavior of Depositors 193

Liquidity Behavior of Depositors 198

Risk Management Committee in Islamic Banks 205

Sources of Liquidity Risk Problem and Liquid Instruments 212

Conclusion 214

Notes 214

References 215

CHAPTER 12

Islamic Banking Behavior Model of Indonesia (ISLAMI) 217

Introduction 217

Framework of ISLAMI 217

Model Review and Justifi cation 219

Asset Liability Balance Models: Theoretical Background 221

Liquidity Reserves Model: Theoretical Background 227

Model of Islamic Monetary Operation: Theoretical Background 231


Econometric Analysis 236

Interpretation of the Models 250

Long-Run Causality and Dynamic Responses of Variables 253

Findings and Recommendations 261

Conclusion 262

Notes 263

References 263

Appendix 12A: Proofi ng Formula 265

Appendix 12B: Proofi ng Formula 266

Appendix 12C: Proofi ng Formula 266

Appendix 12D: Proofi ng Formula 266

CHAPTER 13

Strengthening and Improving Liquidity Management 267

Introduction 267

Organizational Structures 268

Integrated Output of the Previous Chapters 269

Discussion of the Depositors’ Side 270

Discussion of the Islamic Banking Side 273

Liquidity Problems and Islamic Liquid Instruments 274

A Proposed Program to Manage Liquidity Risk 275

Conclusion 280

References 281

CHAPTER 14

Demand and Supply of Liquidity in Islamic Banks 283

Introduction 283

Short-Term Demand for Liquidity 284

Short-Term Suppliers of Liquidity 285

Historical Performance of Short-Term Liquidity Management 287

Future Performance of Short-Term Liquidity Management 289

Findings and Suggestions 299

Conclusion 301

References 301


CHAPTER 15

An Empirical Survey on Depositors’ Withdrawal Behavior 303

Introduction 303

Potential Problems of Withdrawals Risk in Islamic Banks 304

Depositors’ Behavior in Withdrawing Funds 304

Empirical Survey on Deposit Withdrawal Behavior 308

Policy Recommendation 315

Conclusion 316

Notes 316

References 316

CHAPTER 16

An Econometric Model of Depositors’ Withdrawal Behavior 319

Introduction 319

Flow of Funds in Islamic Banking 320

Model of the Liability Side in the Competitive Banking Sector 321

Econometric Analysis 323

Findings from Models and Suggestions 329

Limitation of the Models 331

Conclusion 331

References 331

CHAPTER 17

Formulating Withdrawal Risk and Bankruptcy Risk 333

Introduction 333

Characteristics of Islamic Banking Industry 334

Assumptions and Risk Formulas 335

Withdrawal Risk Scenarios 336

Bankruptcy Scenarios 338

Soundness and Failure of Islamic Banks 339

Revenue-Sharing Equilibrium Ratio 340

Conclusion 342

Notes 342

References 343


Appendix 17A: Proofi ng Formula of the Invulnerable and Vulnerable Condition 343

Appendix 17B: Proofi ng Formula of Solvency and Bankruptcy Condition 344

Appendix 17C: Proofi ng Formula of Combination of Scenarios 345

CHAPTER 18

An Optimal Risk-Return Portfolio of Islamic Banks 347

Introduction 347

The Dominant Islamic Financing Instruments 348

Risk-Return Portfolio Theory 348

Effi cient Portfolio Theory 350

Risk-Return Analysis of Islamic Financing Instrument 351

An Effi cient Portfolio Financing Frontier 360

Conclusion 362

References 362

Appendix 18: Derivation of Variances of 1–4 Financing Instruments 363

CHAPTER 19

Volatility of the Returns and Expected Losses of Islamic Bank Financing 365

Introduction 365

Islamic Financing Instruments 366

Value at Risk Approach 367

Value at Risk (VAR) Analysis for the Indonesian Islamic Banks 369

Value at Risk Result 372

Recommendations 376

Conclusion 377

References 377

CHAPTER 20

The Moral Hazard Problem in Murabahah Financing 379

Introduction 379

Murabahah Financing 380

Moral Hazard in Murabahah Financing 382

Minimizing Moral Hazard in Murabahah Financing 386

Conclusion 388

Note 389

References 389


CHAPTER 21

Central Bank Islamic Monetary Instruments: A Theoretical Approach 391

Introduction 391

General Assumptions 392

Islamic Monetary Instruments 393

Utility of Islamic Monetary Instruments 402

Conclusion 403

Notes 405

References 405

Appendix 21A: Derivation of Central Bank Wakalah wa Ijarah Certifi cate 406

Appendix 21B: Derivation of Central Bank Wakalah wa Ijarah Muntahia

Bitamlik Certifi cate 407

Appendix 21C: Derivation of Central Bank Islamic Securitization Wa Ijarah

Certifi cate—Ijarah Rental Rate 407

Appendix 21D: Derivation of Central Bank Islamic Securitization wa Ijarah

Certifi cate—Investors Investment Decision 408

CHAPTER 22

Assessing Economic Growth and Fiscal Policy in Indonesia 409

Introduction 409

Wagner’s Law and Keynes’s Law on Economic Development 410

Assumptions and Economic Modeling 411

Defi ning Variables and Model Specifi cation 412

Autoregressive Distributed Lag (ARDL) Model 415

Long-Run Dynamic Model 417

Findings and Historical Conditions 418

Conclusion 421

Notes 421

References 421

CHAPTER 23

Bank Lending Channel and Islamic Banks 423

Introduction 423

Underlying Conditions and Assumptions 424


Econometrics Analysis 425

Findings from Econometrics Analysis 430

Conclusion 431

Note 432

References 432

CHAPTER 24

Islamic Gracious Monetary Instruments: A Theoretical Approach 433

Introduction 433

General Assumptions 434

The Islamic Gracious Monetary Instruments 436

Utility of the Islamic Gracious Monetary Instruments 448

Conclusion 450

References 451

CHAPTER 25

Assessing Gold Murabahah in Islamic Banking 453

Introduction 453

Underlying Finance Theory 454

Analysis of Gold Murabahah Financing in Islamic Banking 457

Regulating Gold Murabahah 465

Conclusion 466

References 466

CHAPTER 26

Simulation-Based Stress Testing 467

Introduction 467

Stress-Testing Guidance 467

Stress-Testing Simulations and Findings 471

Conclusion 480

References 482

CHAPTER 27

Does the Return on Islamic Deposits Mimic the Interest Rate? 483

Introduction 483


Performance of Islamic Deposit Return 484

Literature Review 486

Research Framework 490

Results of Applying Ayuda Neurointelligence 490

Interpretations of the Results 497

Conclusion 497

References 498

About the Author 501

Index 503

Buy This Book



CHAPTER 1Classic Arab Financial Contractsin Modern Financial Institutions*

INTRODUCTION

As a way of life, Islam provides not only religious values related to worshipping Godand kindness to humankind but also an economic system through special religiouscontracts (Sharia jurisprudence). Historically, these contracts began in the ProphetMuhammad’s (pbuh) era, when he first introduced Islamic values and concepts ofeconomics and trade to Arab people. Later, such Islamic economic concepts becomethe basis for modern financial contracts in Islamic financial institutions.

Actually, Sharia financial contracts are composed of some traditional (classic)Arabic economic contracts approved by the Prophet (pbuh) and some other contracts(new contracts) introduced and applied by the Prophet (pbuh) and his companions.By transforming positive aspects of classical Arab contracts and new Islamic con-tracts, the Prophet (pbuh) had successfully developed fair economic transactions andensured a stronger economic condition for Arabic society.

ECONOMIC CONDITIONS IN THE PROPHET MUHAMMAD’S (pbuh) ERA

In the Prophet’s (pbuh) era, the Arab economy was trade-based, with no naturalresources business. Trading activities were conducted internally and externally withother regions. As such, there were typically several trade links in the Middle Eastregions such as from Rome into India (southern trade link), Rome into Persia(northern trade link), and Syria into Yemen (northern and southern trade links)(Muhammad 2002, 142). Through these links, Arabic traders gained regional eco-nomic advantages by becoming intermediaries for goods delivered from and passingthrough their regions.

The economic transactions in that time used dinar and dirham as legal curren-cies, which had stable values for a long period.1 In addition, the position of Ka’bah asa central, sacred place for all Moslems guaranteed the safety of economic activities ofArabic traders.2 In addition, the Hilf ul Fudul agreement among Arab tribes to set up

*The original version of this chapter was published in Al-Liqa Journal (Palestine) 35(December 2010).

1

a peaceful business environment (wars among tribes commonly occurred) created thenecessary social conditions for trading (Ayati, as cited in Muhammad 2002, 144).

Nonetheless, despite such favorable conditions, some unfair trading contractsexisted among traders before the Islamic period. Particularly, unfair and disputabletransactions such as Talaqqi Rukban, Kali bi kali, and Riba al Jahiliah3 werecommon trading activities. Talaqqi Rukban was a practice of stopping foreigntraders before they came into the Arabic region, buying their goods, and resellingthem with a higher price margin. It was such a traditional practice of price distortionat that time.

Kali bi kaliwas a transaction in which the buyer ordered a good from the seller tobe delivered later with an installment payment basis. Usually, both of the parties(buyer and seller) used borrowedmoney to fulfill these contracts. Even before the goodwas delivered by the seller, the buyer had contracted with a third party to be the nextbuyer of the ordered good. Selling an invisible (not existing) good is prohibited inIslam and the problem is exacerbated if the parties involved use borrowed moneys.

The last practice mentioned is Riba al Jahiliah. In fact, the most dominant modeof financing during the pre-Islamic era was Riba-based borrowing. Riba al Jahiliahwas practiced among members of Quraish and Thaqif tribes and in Jewish com-munities (Kahf and Khan 1992, 11). In this case, a lender made money available toothers for a certain period of time with or without any agreement to ask for anyprofit/remuneration from the borrower. However, when the borrower failed toreturn the loan in an agreed date, he would be charged interest (for example,12 percent per annum). The same case applied if the borrowers asked for anextension to repay the loan. But, if the amount was returned on time, there was nocharge. This type of hazardous loan is also not allowed in Islam.

Despite the prohibited economic transactions described here, there were othertraditional Arab contracts that were fair and respectable trading contracts. Inter-estingly, those contracts were practiced long before the introduction of Islamictrading values and principles by the Prophet (pbuh). These contracts includeMudarabah and Musharakah, which became part of the modern Islamic modes offinancing.

Core Economic Values and Principles

Before elaborating some classic Arab economic contracts, this subsection emph-asizes the importance of Islamic values and principles in conducting business. Suchvalues characterize and differentiate Islamic contracts from the conventional ones.As such, understanding Islam as a religion with multiple purposes for society, andIslamic business values and principle in particular, is imperative to the studyof Islamic contracts.

Islam as characterized by the Prophet (pbuh) has three grand rules that governthe life of a Moslem as an individual and a member of Arabic society. The first ruleis the core relationship between a man and the Creator (Aqidah). The relationshipdeals with all matters and beliefs of a Moslem. The second rule is the transformationand manifestation of Aqidah to actions known as Sharia. Lastly is Akhlaq, which isthe behavior, attitude, and work ethics of a man (see Figure 1.1).

Sharia, which is the root of Islamic economic contracts, is composed of twocomponents: (1) rituals (Ibadat), by which the way people worship their God, and (2)

2 ISLAMIC BANKING IN INDONESIA

business transactions (Muamalat), by which the way people interact with others interms of economic and noneconomic activities (Antonio 1999, 10–20). The formeris principally unchangeable but the latter is changeable, subject to certain economicconditions and development.

Thus, all Islamic economic contracts are derived from the framework of an Islamicsystem specifically through the Sharia-Muamalat channel. In Islam, such Islamic con-tracts must be part of a man’s obedience toward and worship of his Creator. Abuse ofAllah SWT guidance in Muamalat means insubordination of Islam as the sole guidein Moslem life. Moreover, these principles should also be reflected in one’s contri-bution to the welfare of the society and people (Ummah) in general. The fairness andmutual economic benefit of business transactions with other parties are amongIslamic Muamalat values that have to be implemented in this regard. Other Islamicvalues pertain to trustworthy mutual support, risk sharing, and prohibition ofdefeating other parties, as found in the Holy Quran, Sura 26, verses 181–183:

Give a full measure and be not of those who diminish. (26:181)

And weigh (things) with a right balance. (26:182)

And do not wrong men of their things, and do not act corruptly in the earth,making mischief. (26:183)

By expressing Islamic principles and values in business that were not recognizedin the pre-Islamic era, the Prophet Muhammad (pbuh) changed the Arabic people’smindset during and after his era from pursuing unethical business practices toapplying fully ethical business principles. Specifically, he (pbuh) used divine law(Quran) and his judgments (Sunnah) to teach Islamic values and principles inMualamat to people. Besides Quran and Hadith,4 there were Ijtihad, Ijma, Qiyas,and some other sources of Islamic law that referred to the guidance of the Prophet(pbuh), his companions, and Islamic scholars. At the end, the business practicestogether with the application of Islamic law ensured happiness and prosperity forArabic people that have lasted until the present time.

Ibadat

Others

Aqidah

EconomicContracts

Muamalat

AkhlaqSharia

ISLAM

FIGURE 1.1 Islamic Framework on Economic ContractsSource: Syafii Antonio, Sharia Bank for Bankers and Practitioners (Jakarta, Indonesia: Bank Indonesia andTazkia Institute, 1999).


Meanwhile, with regard to honoring business contracts, Islam asks Moslems tohonor property rights and obligations, individual obligations, rights and self-interest,working hard, wealth, the concept of blessing (Barakah), and competition andcooperation (Iqal and Mirakhor 2007, 13). The most important one is propertyrights, which explains that the ultimate owner of all properties is Allah SWT. A manis only His vice regent and is given the right of possession and utilization of wealth.The other essential things are the principles of risk sharing, competition, and coop-eration, which became the basis for almost all Islamic economic contracts, especiallythose related to investment activities.

Finally, referring to the Hadist (Sunnah) of the Prophet (pbuh):

You know more about your own world. (Hadith narrated by Muslim)

Islam adopts legal maxims that allow any business contract unless there is prohibi-tion on it. Particularly, Islam prohibits economic contracts containing Riba, Gharar,Maysir, Qimar, and hoarding of money. At the same time, Islam encourages positivebusiness activities that utilize money to develop the real sector, including payingZakah (Islamic levy) and giving Qard Hassan (benevolent loan).

Classical Arab Economic Contracts

The first, and a very well-known, contract is Mudarabah. The Prophet (pbuh) usedthis himself when he was a trader in partnership with Khadijah, who later became hislovely wife. He was a trader for more than 15 years before the beginning of therevelation. The citizens of Mecca had adopted the Mudarabah contract as theircommon business contract for a long time. Thus, the legal ruling ofMudarabah in themodern Islamic financial institutions is Sunnah of the Prophet (pbuh), which says:

Three (things) have blessings: Sale of credit, Muqaradah (Mudarabah) andmixingwheatwithbarley forhomenot for sale. (HadithnarratedbyIbnMajjah)

Technically, a Mudarabah contract was a form of partnership where one partyprovided funds while the other party provided skill (expertise) and management. Theformer was called Shohibul Maal and the latter was named Mudarib. Any profitaccrued in this business commitment was shared between the two parties on anagreed-upon basis, while loss was borne by the provider of funds. In the case of theProphet (pbuh), he (pbuh) became the Mudarib whilst Khadijah was the ShohibulMaal. With his outstanding entrepreneurship skill, Muhammad (pbuh) successfullygenerated a lot of profit for Khadijah’s business.

Similar to Mudarabah, the second transaction is named Musharakah. However,unlike Mudarabah, in Musharakah the relationship was established under a contractby the mutual consent of the parties to share both profit and loss in a joint business. Itwas an agreement in which one party provided funds to be mixed with funds fromother party (business enterprises) in order to perform joint business financing. Allproviders of capital were entitled to participate in the management, but were notnecessarily required to do so. The accrued profit was distributed among partners inagreed-upon ratios, while the loss was also borne by all partners in proportion totheir respective capital contributions.


Besides investment-based contracts, Arab people in Medina used to practicecrop-sharing, which was called Muzara’ah and Musaqah. The former was applied toan open field used for crops and the latter referred to an orchard, especially of palmtrees (Kahf and Khan 1992, 12). A field in Muzara’ah and both field and trees inMusaqah were fixed assets put at the disposal of the working partners. Both of thesecontracts required sharing of the gross outputs and were allowed for limited flexi-bility in the contractual distribution of operational expenses.

Meanwhile, a classical Arab period also recognized a sale of goods on credit,namely Murabahah, which continues to be the favorite contract in today’s Islamicfinancial institutions. There were many sayings about the Prophet’s (pbuh) buying agood on credit, taking a loan, and sometimes giving a personal property as a securityor lien (Kahf and Khan 1992, 12).5 By definition, Murabahah stood for a sale ofgood for a mutually agreed-upon profit and on a deferred payment basis. In thiscontract, the seller is obliged to declare his cost and profit to the buyer (a practicenow called “transparency”).

Another form of buying and selling a contract was a Salam contract, as reportedby Al Bukhari from Al Bara’ bin ‘Azib:

(When) The Prophet came (to Al Madinah) we used to do Salam contractsagainst cash payment until the season. (Hadith narrated by Bukhari)

Salam was a contract in which an advance payment was made for a good (agriculturegood) to be delivered at a future time. In this case, the seller promised to supply aspecific good to the buyer at a future date in exchange for an advance price fully paidat the time of the contract assignment. Therefore, Salam provided funds for produ-cers to be used for working capital, labor, and raw materials. Nevertheless, thisdeferred selling contract could not be applied to a monetary unit (such as gold orsilver Salam) because it was judged as Riba al Fadl.6 The Prophet mentioned thatgold and silver could be exchanged on the spot basis per se. The same rule wasapplied to other food items known as Ribawi items.7

Besides the buying and selling contracts described earlier, the period of theProphet (pbuh) also recognized Qard Hassan (a benevolent loan). The Prophet(pbuh) said that:

Whoever gave two loans would have a reward (equivalent to the reward) ofone of them (be it given as charity). (Hadith narrated by Ibn Majjah).

Qard Hassan meant to give anything valuable to the other parties so that thereceiver could benefit from it. However, Qard Hassan was to be paid back ondemand or at the settled time. It was typically an honorable loan for temporarilyhelping others or for charity purposes, as it was released for a certain time with anobligation to repay it within a specified time. Classic Arab contracts also docu-mented Ijarah, which was approximately the same as present-day conventionalleasing. However, unlike leasing, the lessor in Ijarah must own the leasing asset andbear all related costs before it was leased to the lessee. In addition, there was nopenalty for a late rental payment.

Finally, there was a Wadiah (suretyship) contract, which was typically imple-mented among people in the Prophet (pbuh) era. The people in Mecca tended to put


their items (Wadiah items) to the Prophet (pbuh) underWadiah commitment withoutany guarantee from him as a depository. Before moving to Madinah, MuhammadSAW asked his companion Ali bin Abi Thalib to return those Wadiah items to theowners. Regarding this, there was another report from the Prophet’s (pbuh) com-panion Zubair. He used to encourage his depositors to consider placing Wadiahitems with him in safekeeping, rather than as a deposit. A safekeeping contractguaranteed that the funds would be returned and gave more flexibility to the keeperto use it.

DEVELOPMENT OF CLASSIC ECONOMIC CONTRACTS

For the past three decades, there has been a strong effort by Moslems to apply thoseclassic and traditional Arab economic contracts in the modern economic/financialtransactions, particularly in Islamic banking. The year 1963 was notable for the firstestablishment of a modern Islamic banking institution, namely Mit Ghamr Bank, inEgypt. Mit Ghamr provided funds for agricultural investment. Later on, triggered byat least three factors—(1) the establishment of the Islamic Development Bank (IDB)in 1975, (2) the world oil-price hike in 1973 to 1974, and (3) the increased role ofMoslem scholars in the past three decades—Islamic banks became a new phenom-enon in today’s financial system (Wilson 2006, 2).

IDB was established as a result of the Organization of Islamic countries (OIC)financeministers’ agreement inDecember 1973. Through IDB and some earlier Islamicbanks in the Gulf and Malaysia such as Dubai Islamic Bank, Faisal Islamic Bank, AlBarakah Bank and Bank Islam Malaysia Berhad, the classic Arab economic contractsweremodernized and designed to suit themodern financial practices. In today’s Islamicbanking instruments, such classic contracts are grouped into equity contracts such asMudarabah, Musharakah, Musaqah, Muzara’ah; debt contracts such as Murabahahand Salam; and other contracts such as Ijarah, Qard Hassan, and Wakalah.

However, the second factor facilitated the development of modern Islamicbanking institutions worldwide due to the massive increase of the financial resourcesof the major Gulf countries. Pioneers of modern Islamic banks were founded in thatdecade, such as Dubai Islamic Bank (1975), Kuwait Finance House (1977), BahrainIslamic Bank (1981), Qatar Islamic Bank (1983), and Faisal Islamic Banks of Egyptand the Sudan in 1977 and 1978 respectively.

The last factor is the increased role of Islamic scholars worldwide who pro-mote the ideals of Islamic financing, format the Sharia compliance contracts, andsupervise the operations of Islamic banks. They emphatically support the develop-ment of modern Islamic banking institutions, especially to interpret and modify suchclassic contracts to comply with up-to-date product requirements. Currently, thereare around 150 world Islamic scholars employed by hundreds of Islamic banks inmore than 75 countries (Dar 2006, 1). Nonetheless, among 150 Islamic scholars,only 20 of them are internationally recognized.

Application of the Contracts in the Modern Islamic Banks

Undoubtedly, after the establishment of the first Islamic bank, the strong supportfrom various international Islamic institutions and Islamic scholars, the classic Arab


economic contracts in the era of the Prophet (pbuh) and his companions have comeinto modern Islamic financial applications such as Islamic banks, Islamic insurance,Islamic multifinance, Islamic securities companies, and so forth. However, due tosome requirements and challenges in modern financial practices and public percep-tions of Islamic banking institutions, the classic contracts need to be modifiedand adjusted to be applicable and acceptable. Such modifications are done underSharia justification and Sharia scholars’ approval. Some examples are explained inthis chapter, namely Mudarabah, Musharakah, Muzaraah, Musaqah, Murabahah,Wadiah, Ijarah, Qard Hassan, and Salam.

Mudarabah Contract On the liability side of an Islamic bank,Mudarabah is formattedas a time deposit (commonly known as a Mudarabah time deposit) and on the assetside it is used in the form of Mudarabah financing between a bank and its businessborrowers. Contemporary Islamic banking theory classifies Mudarabah as equity-based deposit/financing because of its investment characteristics. Technically, boththe Mudarabah time deposit and Mudarabah financing are arranged under a profit-and-loss sharing (PLS) mechanism as drafted in Figure 1.2 (Obaidullah 2005, 58).

First, the depositors place some funds in the Mudarabah time deposits, calledShohibulMaal.The Islamic bank functions as aMudarib (step 1). The bank then investsthe funds in Islamic projects proposed by entrepreneurswho express strong cooperationand commitment (steps 2 to 3). However in this step, the bank positions itself as aShohibul Maal, or the supplier of the funds, and the entrepreneur is a Mudarib. Whenthe Islamic projects produce profit, it will be shared between the bank and the entre-preneurs, and finally the bank’s share is also shared with the originalMudarabah timedepositors (step 4). However, if loss occurs it will be borne by the depositors throughthe decreasing value of their funds (step 5). This popular mechanism in contemporaryIslamic banking contract is called a “two-tier Mudarabah contract.”

Musharakah Contract A Musharakah contract resembles a Mudarabah application inan Islamic bank, as it is the second form of equity-based financing. Nevertheless,unlike Mudarabah, Musharakah requires the contribution of funds of all partiesinvolved in the business. In modern Islamic banking practices, a Musharakah con-tract is usually found only on the asset side of the bank. As drafted in Figure 1.3, afterdepositors deposit funds in the bank deposits (step 1), under Musharakah financing

1 2

4 3

5

Islamic Bank

Islamic Project

Profit

Loss

Depositors EntrepreneurPLS PLS

FIGURE 1.2 Two-Tier Mudarabah Financing StructureSource: Mohammed Obaidullah, “Islamic Financial Services.” Islamic Economic and Research Center,King Abdulaziz University, Jeddah, Saudi Arabia, 2005.


contract, an Islamic bank and its borrowers/entrepreneurs mix their funds together inorder to finance an agreed-upon Islamic project for a certain period of time (step 2).Both of them also have a right to contribute to the management of the project.

The same as in a Mudarabah financing contract, if a Musharakah project gen-erates profit, it belongs to both parties according to the agreed-upon ratio (step 3).But, if it suffers a loss, it will be shared in proportion to the capital contribution ofeach party. As such, loss effectively brings down the value of the business assetsof each partner but keeps the shares of each partner unchanged (step 4).

Second, in Musharakah all parties (business partners) behave as both ShohibulMaal and Mudarib; there is no single Mudarib or Shohibul Maal. The feature of theclassic Mudarabah and Musharakah contracts requires that either of the parties havean option to terminate the agreement or quit from the venture at any time they want.In the termination date, profits are determined as excess of the liquidated values of allassets. However, instead of terminating the investment, the continuity of the businessis the priority for all partners.

Muzaraah and Musaqah Contracts Unfortunately, most modern Islamic banks rarelyemploy Muzaraah and Musaqah in their financing activities. This is because ban-king institutions (Islamic or conventional banks) position themselves as financialintermediaries. They prefer providing funds over retaining assets, including land, forexample. As such, the modern banks simply finance a project and conduct businessmonitoring, evaluation, and cooperation with entrepreneurs. Owning an asset (land orfarm) incurs extra costs and risks for banks, such as maintenance costs, product risks,market risks, and so forth. However, to improve the agriculture sector, intensifyingboth Muzaraah and Musaqah is one of the best options available to Islamic banks.

Murabahah Contract Modern Islamic banks use Murabahah on the asset side. This isthe most popular kind of contract, as shown by the domination of such contracts inthe composition of banks’ financing. In contemporary Islamic finance, Murabahah iscategorized as debt-based financing. The one-tier Murabahah contract in the Arabperiod is changed and adjusted to be the two-tier Murabahah contract. Hence,Islamic banks function as financing providers to clients who want to purchase andown an asset (house, car, etc.).

Depositors

Profit–3

Loss–4

Islamic Bank Entrepreneur2

IslamicProjects

1

FIGURE 1.3 Musharakah Financing StructureSource: Based on Mohammed Obaidullah, “Islamic Financial Services.” Islamic Economic and ResearchCenter, King Abdulaziz University, Jeddah, 2005.


AMurabahah contract is illustrated in Figure 1.4. First, the client approaches thevendor (owner of the asset) regarding the asset that he wants to buy (step 1a). Atthe same time, he also approaches an Islamic bank to be his financial provider toacquire the asset (step 1b). After signing aMurabahah contract, an Islamic bank thenpurchases the asset from the vendor and sells it to the client with mark-up (based on aMurabahah margin, agreed upon bilaterally) (steps 2 and 3). Finally, the client willpay the price of the asset (principal amount plus mark-up) in full or by installmentswithin a certain time period (step 4).

Salam Contract As one of the debt-based contracts, a Salam contract popularly lieson an Islamic bank’s asset side. Salam was originally designed as a financingmechanism for small farmers and traders. Nonetheless, in modern Islamic banks,Salam still functions mainly to finance agriculture or trade activities as mentionedpreviously, but it is again modified due to the bank’s core functions as a financialintermediary (see Figure 1.5).

Islamic Bank

Vendor(Owner ofthe Asset)

1b

34

1a 2

Bank’s Client

FIGURE 1.4 Murabahah Financing StructureSource: Based on Mohammed Obaidullah, “Islamic Financial Services.” Islamic Economic and ResearchCenter, King Abdulaziz University, Jeddah, Saudi Arabia, 2005.

Islamic Bank

Good’sMarket

1b

1a2

3

Bank’s Client(Producer)

FIGURE 1.5 Salam Financing StructureSource: Based on Mohammed Obaidullah, “Islamic Financial Services.” Islamic Economic and ResearchCenter, King Abdulaziz University, Jeddah, Saudi Arabia, 2005.


With a Salam contract, an Islamic bank buys (orders) a specific good from aproducer (farmer) to be delivered on a future (specified) date. On the other hand,the producer in need of short-term funds sells the good to the bank on a deferreddelivery basis (step 1a). However, unlike Murabahah where the good alreadyexists and is directly given on the spot to the buyer, the Salam producer receivesfull price in advance without any delivery of the good in the same time (step 1b).On the agreed-upon future date, the producer delivers the specified good to thebank (step 2). Finally, the Islamic bank sells the good to the market at the pre-vailing price. Since the spot price that the bank pays is pegged lower than theexpected future price, the transaction should result in a profit for the bank(Obaidullah 2005, 95).

Qard Hassan Contract The use of a Qard Hassan contract in today’s bankingoperations is seen on both the liability and asset sides of a bank (see Figure 1.6). Theliability side is very fortunate to have this classic Arab economic contract, as itmatches a modern deposit characteristic, namely, demand deposit. With this deposit,an Islamic bank is free to utilize the Qard Hassan funds at its own risk. Usually suchfunds are given to an unbankable person or to micro-finance entrepreneurs. Thedepositors, as the lenders, are not entitled to any return, because any kind of benefitpassed to depositors under Qard Hassan is deemed as Riba.

On the asset side, an Islamic bank serves its customerswithQardHassan financing.An Islamic bank is allowed to ask for collateral, as governed by the Fiqh8 rules of al-Rahn.9 Moreover, to cover the operation of the loan (Qard), the bank can also chargetheborrower someadministrative expenses (see Figure 1.6). Technically, aQardHassancontract begins with the borrower’s approach to the bank for a loan (step 1).

When the bank approves the borrower’s application, it will then advance QardHassan funds, in exchange for some collateral and a fee from the borrower toguarantee the contract and replace the administrative costs (step 2). Other thanmaintenance or operational costs, an Islamic bank is not allowed to charge extracosts in Qard Hassan lending. At the end, in an agreed-upon period, the borrowerreturns the funds to the bank (step 3).

Ijarah Contract Historically, the classic Arabic economic contract described Ijarah isa leasing or hiring of a physical asset. At present, it does not make any significantdifference. Ijarah is a fashionable debt-based product in which the Islamic bank is thelessor of an asset. Then, the asset is leased by the client (lessee) in an agreed-uponperiod. Therefore, with an Ijarah contract, an Islamic bank receives the monetarybenefits coming from the payment of the rental rate of the leased asset while the lessee

Islamic Bank

231

Bank’s Client(Borrower)

FIGURE 1.6 Qard Hassan Financing StructureSource: Based on Mohammed Obaidullah, “Islamic Financial Services.” Islamic Economic and ResearchCenter, King Abdulaziz University, Jeddah, Saudi Arabia, 2005.


gains benefit in the form of usufruct of the asset. The differences between an IslamicIjarah contract and conventional leasing are:

n Ijarah uses a noninterest benchmark in the rental rate but the conventionalleasing uses the interest rate for its rental price.

n Any risk associated with the Islamic leased asset is the responsibility of the lessor.This is not the case in conventional leasing.

n There is no charge in the case of a customer’s default in Ijarah, but there is apenalty or interest charge in conventional leasing; and so forth.

The structure as illustrated in Figure 1.7 begins when the bank’s client proposesthat an Islamic bank facilitate his Ijarah contract. The Ijarah contract is due to hisplan to use a certain asset owned by a vendor (steps 1a and 1b). After the Ijarahcontract has been approved, the bank takes over (buys) the asset from vendor (step 2)and leases it to the client (step 3). The client pays the rental rate until the end of theleasing contract (step 4).

Wadiah Contract

The same as a Qard Hassan demand deposit, a Wadiah demand deposit essentiallyprovides a safekeeping deposit of the depositors’ funds. Any withdrawal is guaran-teed and honored by the bank. Even though safe keeping deposits are free of cost forthe banks and depositors, banks can provide additional features for Wadiahdepositors. For example, depositors are given easy access to funds through a checkfacility, automated teller machine (ATM), charge cards, traveler’s checks, telephonebanking, branch services, standing instructions, quick statements, a balance enquiryfacility, remittances, and so forth.

Practically, Islamic banks classifyWadiah contracts in two forms, namelyWadiahwad Amanah andWadiah wadDhamanah. The former guarantees theWadiah funds,not only the value but also the physical accessibility. The example of a Wadiah wadAmanah product is a safe deposit box facility. However, this guarantees only the valueof the funds. Hence, by providing aWadiah wadDhamanah service, a bank can utilize

Islamic Bank

Vendor(Owner ofthe Asset)

1b

34

1a 2

Bank’s Client

FIGURE 1.7 Ijarah Financing StructureSource: Obaidullah 2005 (modified).


the funds at its own risk. Any profit or loss coming from the investment of theWadiahfunds accrues entirely to the bank.

Advantages of Implementing Classic Contracts in the ModernIslamic Banks

With their unique characteristics followed by some modifications, the classic Arabiceconomic contracts offer several benefits to the modern banking system. Islamicbanking serves as an alternative in the world of conventional financial system.Benefits offered by this new banking operation include the following:

n The classic Arab economic contracts replace the interest-based system with eithertrade-based or investment-based system with profit and loss sharing mechanisms.

n Islamic banks connect the real sector and financial sector by adopting classicArabic economic contracts. Speculative banking transactions in the foreignexchangemarket,moneymarket, or capitalmarket are strictly prohibited in Sharia.

n Islamic banks treat all related parties fairly. In fact, based on the profit and losssharing (PLS) scheme, risk and return is shared among parties involved in thePLS contracts.

n The conventional banking mindset of just looking for high profit/return isswitched into the social benefit motives by introducing Qard Hassan, Zakat,Infaq, and Shodaqoh, and so forth.

Constraints/Challenges of Implementation

The existing economic and financial environment in some ways restrains the imple-mentation of the Islamic values inherited in the classic Arabic economic contracts.Without ignoring the strong efforts of Islamic scholars, governments, and all stake-holders, the development of the Islamic banking industry still faces some challenges:

n The acceptance of the public despite the perception that Islamic banking is stillnot optimal. In many cases, the public still challenges the tenet of the Islamicbanking contracts rooted from the classic Arabic economic contracts, such asprohibition of Riba, profit and loss sharing schemes, and so forth.

n The operation of Islamic banking itself is often less effective and efficient com-pared with its counterpart. The contracts are so bureaucratic and complicatedthat the cost of acquiring financing from an Islamic bank is often higher thanfrom a conventional one.

n In some cases, the modernization and modifications of Islamic banking contractshave invited many critics. Mimicking conventional bank contracts, bench-marking on interest in determining return sharing, and so forth, are some of thecritics’ complaints.

CONCLUSION

Moslems have been trying to adapt classic Arab economic contracts for use inmodern financial institutions. The establishment of Islamic banks in the past threedecades proved the strong effort of religious Moslems to apply Islamic values and


principles in business and financial transactions. In fact, some Islamic ideas behindclassical Arabic economic contracts have been modified to be applicable in currentbanking practices. Fortunately, it has introduced fair banking system, eliminatedinterest, and offered an alternative to the existing banking system. However, forfuture development, some improvements have to be taken in order to smooth itsoperations and create a positive impression on the public.

NOTES

1. In that time, the Arab region used both dinar (Rome’s currency) and dirham (Persia’scurrency).

2. In a year, there should be four months free of any conflict, war, or pilgrimage activities, tobe maintained peacefully.

3. It means an increase over principal in a loan or in exchange for a commodity accrued to theowner (lender) without giving an equivalent countervalue or recompense (‘iwad) in returnto the other party.

4. Refers to the Prophet’s custom, habit, or way of life.5. Aisyah reported that “The Prophet (pbuh) bought some food on credit from a Jew and he

(The Prophet [pbuh]) gave him (The Jew) his mail (armor iron cloth) as a security”(Hadith narrated by Bukhari). Abu Hurairah also said that the Prophet borrowed (once)a male camel.

6. An excess in the exchange of Ribawi goods within a single genus.7. Goods subject to Fiqh rules on Riba in sales.8. Islamic law (the science of Sharia). It is an important Islamic source of law for Islamic

economics.9. Pledge or collateral.

REFERENCES

Antonio, Syafii. 1999. Sharia Bank for Bankers and Practitioners. Jakarta: Bank Indonesia andTazkia Institute.

Ayati, Mohd Ebrahim. 1979. History of the Prophet of Islam. Teheran: Teheran University.

Dar, Humayon. 2006. Banks Seek Islamic Scholars Versed in World of Finance. Dow JonesReuters Business Interactive LLC, London, United Kingdom.

Iqbal, Zamir, and Abbas Mirakhor. 2007. An Introduction to Islamic Finance: Theory andPractices. Singapore: John Wiley & Sons.

Karim, Adiwarman. 2004. Historical Thought of Islamic Economy. Jakarta: Raja GrafindoPersada.

Kahf, Monzer, and Tariqullah Khan. 1992. “Principles of Islamic Financing.” Islamic Researchand Training Institute, Islamic Development Banks (IDB), Research Paper no. 16.

Ministry of Religion. 2005. The Holy Al-Qur’an. Bandung: Diponegoro.

Muhammad. 2002. Monetary and Fiscal Policy in Islamic Economy. Jakarta: Salemba EmbanPatria.

Obaidullah, Mohammed. 2005. “Islamic Financial Services.” Islamic Economic and ResearchCenter, King Abdulaziz University, Jeddah, Saudi Arabia.

Wilson, Rodney. 2006. “Chapter Two: The Evolution of Islamic Financial System.” UnitedKingdom: Institute for Middle Eastern and Islamic Studies, Durham University.


Contents

About the Editors xv

About the Contributors xvii

Foreword xxvii

Preface xxix

Acknowledgments xxxi

PART ONE

The Nature of Risks in Islamic Banking 1

CHAPTER 1

Supervision of Islamic Banks: The Regulatory Challenge—Basel II and Basel III 3

Simon Archer and Rifaat Ahmed Abdel Karim

1. Introduction 3

2. The Structure of Basel II and Basel III: Supervisory Implications 4

3. The Islamic Financial Services Board 5

4. Contents of This Book 6

Notes 11

References 11

CHAPTER 2

Banking and the Risk Environment 13

Brandon Davies

1. The Global Risk Environment 13


2. The Regulatory Environment 15

3. The Implementation Environment (Setting Up a Risk Management Framework in a Bank) 29

4. The Future Risk Environment 38

5. Islamic Banks and the Risk and Regulation Environment 42

CHAPTER 3

Risk Characteristics of Islamic Products: Implications for Risk Measurement

and Supervision 49

Venkataraman Sundararajan

1. Introduction 49

2. Background 52

3. Types of Risks in Islamic Finance and Their Measurement 54

4. Overall Risk of an Islamic Bank and Approaches to Risk Mitigation 67

5. Summary and Policy Conclusions 69

Notes 71

References 73

CHAPTER 4

Risk in a Turbulent World: Insights from Islamic Finance 77

Sami Al-Suwailem

1. Introduction 77

2. Functions of Risk 78

3. Dealing with Risk 79

4. The Fundamental Law of Risk 80

5. Islamic Finance 84

6. Functions of Risk in Islamic Finance 85

7. Risk Exchange in Islamic Finance 87

8. Regulatory Implications 88

9. Conclusion 92

Notes 92

References 92


CHAPTER 5

Capital Structure and Risk in Islamic Financial Services 95


1. Introduction 95

2. Risk and Capital Structure in Islamic Banks 96

3. Risk and Capital Structure in Takaful (Islamic Insurance) Undertakings 102

4. Concluding Remarks 105

References 105

CHAPTER 6

Inherent Risk: Credit and Market Risks 107

John Lee Hin Hock

1. Introduction 107

2. Distinctive Risks 107

3. Inherent Risks in Shari’ah-Compliant Products and Services 109

4. Conclusion 112

Appendix 112

Notes 131

CHAPTER 7

Operational Risk Exposures of Islamic Banks 133

Simon Archer and Abdullah Haron

1. Introduction 133

2. Basel III Requirements and Their Implications for Operational Risk Management 134

3. Operational Risk: The Basel Methodology 136

4. Operational Risk in Islamic Banks 137

5. Unique Operational Risks of Islamic Financing/Investment Modes 141

6. Qard 148


Notes 152

CHAPTER 8

Information Technology Risks in Islamic Banks 153

Samir Safa


1. Introduction 153

2. Important Understandings and Facts 155

3. ITS Operational Risk—Business, Documentation, and Legal Issues 157

4. Technical and Functional Clarifi cation for the Imposed Risks 159


Note 161

CHAPTER 9

Law and Islamic Finance: An Interactive Analysis 163

Yusuf Talal DeLorenzo and Michael J. T. McMillen

1. Introduction and Overview 163

2. Islamic Jurisprudence in Modern Times 167

3. Enforceability of the Shari’ah 179

4. Enforceability of the Shari’ah: Case Law and Transactional Practice 189

5. Transactional Practice: Legal Opinions 195

6. Sukuk: Capital Markets and Secondary Markets 198

7. Summary and Conclusion 207

Appendix 209

Notes 216

CHAPTER 10

Legal Risk Exposure in Islamic Finance 225

Andrew White and Chen Mee King

1. Introduction 225

2. Defi ning Legal Risk 226

3. Greater Risk from Uncertain and Undeveloped Law and Regulation 227

4. Greater Risk from Poor Documentation 228

5. Greater Risk from Unpredictable Dispute Resolution Processes 229


Notes 233


CHAPTER 11

Shari’ah–Non-compliance Risk 237

Mohamad Akram Laldin

1. Introduction 237

2. Risk from an Islamic Perspective 238

3. The Concept of Shari’ah Compliance 240

4. Shari’ah–Non-compliance Risk and Its Impact 245

5. Dealing with Shari’ah–Non-compliance Risk 246

6. Measuring Shari’ah–Non-compliance Risk 249

7. Fiqh al-Muwazanah 251

8. Rectifi cation of a Shari’ah–Non-compliant Contract 254

9. Mitigation of Shari’ah–Non-compliance Risk 256

10. Conclusion 256

Notes 257

CHAPTER 12

Supervisory Implications for Islamic Finance: Post-Crisis Environment 261

Peter Casey

1. Regulation and Supervision 261

2. Supervisors and Shari’ah 261

3. Lessons of the Crisis and Regulatory Responses 264

4. The Issues for Supervisors 267

Notes 272

PART TWO

Capital Adequacy 273

CHAPTER 13

Risk and the Need for Capital 275

John Board and Hatim El-Tahir

1. Introduction 275

2. The Evolution of International Capital Standards 277

3. The Risk-Based Financial Regulation Approach 278


4. Globalisation of Financial Regulation? 281

5. The Short-Lived Rise of Contingent Capital Instruments 282

6. Conclusion 283

Notes 284

CHAPTER 14

Measuring Risk for Capital Adequacy: The Issue of Profi t-Sharing Investment Accounts 285


1. Introduction 285

2. Why Capital Adequacy? 285

3. Application to Islamic Banks 289

4. Pillar 2 of the Revised Framework and Risk Management 294


Note 297

References 298

CHAPTER 15

Measuring Operational Risk 299

Sandeep Srivastava and Anand Balasubramanian

1. Introduction 299

2. Operational Risk in the Context of Islamic Banks 300

3. Operational Risk Capital under Basel II 301

4. Operational Risk Capital under the IFSB Standard 309

5. Industry Practice and Implementation Issues for Operational Risk Measurement 310

Appendix 315

Notes 323

CHAPTER 16

Liquidity Risk 325

Richard Thomas

1. Introduction 325

2. The Regulatory Response to Liquidity Risk 325

3. Asset Liquidity 326


4. Trade Finance Assets as Liquidity 327

5. Government Bonds and Liquidity 328

6. Asset-Based Financings and Liquidity 328

7. The International Islamic Liquidity Management Corporation (IILM) 329

8. Liabilities (Deposits) as Liquidity 331

9. Accounting for Liquidity and Fair Value 333

10. Islamic Banks and the Basel III Liquidity Measures 334

11. Conclusion 335

Notes 336

PART THREE

Securitisation and Capital Markets 337

CHAPTER 17

Securitisation in Islamic Finance 339

Baljeet Kaur Grewal

1. Preface: An Overview of the Sukuk Market 339

2. Securitisation and Sukuk: Some General Remarks 342

3. Market for Securitisation in Islamic Finance 346

4. Securitisation Structures 349

5. Regulatory Framework 357

6. Securitisation: A Growth Driver for Islamic Finance 361

CHAPTER 18

The Role of Capital Markets in Providing Shari’ah-Compliant Liquidity 365

Prasanna Seshachellam

1. Liquidity and Its Importance to the Islamic Financial System 365

2. Traditional Role of Capital Markets in Providing Liquidity to Financial Systems 367

3. Capital Markets—Structure and Analysis 368

4. Role of Islamic Capital Markets in Providing Liquidity 370

5. Enhancements to the Critical Dimensions of ICM to Improve Its

Ability to Provide Liquidity 374

6. Products 374


7. Players 378

8. Infrastructure 379

9. Market Segments 381

10. Current Trends and Work in Progress 383

CHAPTER 19

Regulating the Islamic Capital Market 387

Nik Ramlah Mahmood

1. Introduction 387

2. The Applicability of Universal Principles of Securities Regulation 388

3. Approaches to Regulating ICM 389

4. The Shari’ah Governance Framework 391

5. Conclusion 395

Notes 395

References 397

PART FOUR

Corporate Governance and Human Resources 399

CHAPTER 20

Corporate Governance and Supervision: From Basel II to Basel III 401

Carol Padgett

1. Introduction: Corporate Governance and the Special Case of Banks 401

2. Regulation and the Corporate Governance of Listed Companies 402

3. Basel Pillar 2 and Corporate Governance in Banks 404

4. Conclusion 413

Notes 414

CHAPTER 21

Specifi c Corporate Governance Issues in Islamic Banks 417


1. Introduction 417

2. Salient Characteristics of Islamic Banks 419


3. Corporate Governance Issues in Islamic Banks 425

4. Exercising Effective Market Discipline on Islamic Banks 434

5. Regulation of Islamic Banks 440


Notes 443

References 446

CHAPTER 22

Transparency and Market Discipline: Post–Basel Pillar 3 451

Daud Abdullah (David Vicary)

1. Introduction 451

2. Compliance with Pillar 3 453

3. Transparency and Market Discipline: Specifi cities of Islamic Finance 457


Notes 471

CHAPTER 23

Human Resource Management of Islamic Banks: Responses to Conceptual

and Technical Challenges 473

Volker Nienhaus

1. Introduction 473

2. Recruitment, Retention, and Qualifi cation of Personnel 474

3. Support Infrastructure for Islamic Financial Institutions 480

4. Shari’ah-Compliance Issues 486

PART FIVE

Conclusion 493

CHAPTER 24

Concluding Remarks 495


1. Introduction 495

2. The Challenge to Financial Sector Industry Regulators and Supervisors 496


3. The Challenge to the Islamic Financial Services Industry Sector 497

4. The Challenge to Governments and Legislative Authorities 499

5. Conclusions 500

Notes 501

Index 503

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CHAPTER 1Supervision of Islamic Banks:The Regulatory Challenge—

Basel II and Basel IIISimon Archer and

Rifaat Ahmed Abdel Karim

1. INTRODUCTION

The documents of the Basel Committee for Banking Supervision (BCBS)—International Convergence of Capital Measurement and Capital Standards:A Revised Framework (generally known as Basel II) and the recentlyintroduced new major set of reforms to Basel II, which are aimed ataddressing global capital regulatory framework in light of the prevailingglobal crisis (and are generally known as Basel III)—present a real challengeto banking regulators and supervisors. This challenge is, of course, first andforemost in respect of the application of both documents to conventionalbanks. Basel II was issued in June 2004 (with some revisions in November2005) to supersede the original 1988 Capital Accord (Basel I), while Basel IIIwas issued in December 2010, with a revised version in June 2011.

The main innovations introduced in Basel II were, first, a significantlymore comprehensive and sophisticated approach to measuring credit riskand, second, a capital requirement for operational risk. With respect tomarket risk, Basel II did not supersede the 1996 Amendment of Basel I,which had introduced a capital treatment for this category of risk not spe-cifically covered in the original Capital Accord. The two approaches tomarket risk under Basel II, the Standardised Approach and the InternalModels Approach, are continued under Basel III.1 However, while the scopeof regulation has been extended under Basel III to liquidity risk, and the

3

regulatory capital requirements have been increased, and there have beensome significant alterations and additions to Basel II regulatory environ-ment, the Three Pillars of Regulation established under Basel II remain andindeed are enhanced under Basel III.

Basel I was a document of modest length that made no great technicaldemands on the reader. However, the years since 1988 have seen a verysignificant evolution in banking and finance, including the effects of theglobalisation of financial markets and developments such as the abundanceof derivatives and securitisations using structured finance. These develop-ments have significant implications for risk and capital adequacy. Hence,Basel II, which (with its appendices) runs to over 250 pages, is a fairlydaunting document that makes some nontrivial demands on the reader, bothtechnical and conceptual.

On the other hand, the development of Basel III was mainly promptedby the recent financial crises, which started to take shape in 2007. Basel IIIemphasises not only the importance of the absolute amount of a bank’sequity position, but most importantly the quality of capital held by thesebanks, two important issues that were not adequately addressed in Basel II.

The standards issued by the Islamic Financial Services Board (IFSB) havehighlighted the fact that neither Basel II nor Basel III was (understandably)written with its application to Islamic banking in mind.2 However, the rapiddevelopment of Islamic banking since the early 1990s, and the fact thatinternational financial authorities such as the World Bank, the InternationalMonetary Fund (IMF), and the BCBS understood the consequent desirabilityof building bridges between Islamic (Shari’ah-compliant) financial institutionsand the conventional (Shari’ah–non-compliant) financial sector,3 inevitablyraised the issues of how and to what extent Basel II principles and techniquesand those of Basel III are applicable to the regulation and supervision ofIslamic banks, and of the regulatory and supervisory problems to be over-come in this context.4 These issues constitute the concern of this book.

2. THE STRUCTURE OF BASEL II ANDBASEL III: SUPERVISORY IMPLICATIONS

The structure of Basel II is based on three “Pillars.” As mentioned above,these were retained and enhanced under Basel III. Pillar 1 deals with the newapproach to credit risk, which replaces that of Basel I, and with operationalrisk; Pillar 2 addresses the supervisory review process from the standpoint ofthe responsibility of the supervisor to promote the overall safety of thebanking system, and establishes a set of common guidelines for supervisoryreview, while also stressing the primary responsibility of individual banks

4 THE NATURE OF RISKS IN ISLAMIC BANKING

and the critical role of dialogue between supervisors and banks; and Pillar 3lays down a minimum number of public reporting standards on risk and riskmanagement intended to enhance the ability of market participants to beaware of a bank’s risk profile and the adequacy of its capital in relation tothis, thus involving the market in the capital adequacy regime. Building onthe three pillars of the Basel II framework, Basel III supplemented the risk-based approach by introducing new regulatory requirements (notably con-cerning liquidity risk and the quantity and risk absorbency of capital) topromote a more resilient banking sector.

Basel II and Basel III thus present all banking supervisors with a majorchallenge, both in enforcing Pillar 1 together with the disclosure require-ments of Pillar 3, and in implementing Pillar 2. The adoption of Basel II wasnot intended to be a requirement outside of the G10 countries represented onthe BCBS, and then only for banks that are internationally active. However,as Basel I had been adopted in more than 100 countries, the supervisors inthese and other countries may be expected to adopt both Basel II and BaselIII progressively over the next few years. The G10 was broadened to includeadditional members and renamed G20. Following the financial crisis thatbegan in 2007, the G20 gave more powers to the Financial Stability Board(formerly the Financial Stability Forum), which, inter alia, include oversightover the implementation of Basel III. The membership of the FinancialStability Board includes, among other standard-setting bodies, the BCBS.

For supervisors in countries where Islamic banks are located, there is thefurther challenge of applying Basel II and Basel III to those institutions.This added challenge results from the specificities of the Islamic (Shari’ah-compliant) modes of finance employed by Islamic banks. These raise issuesof capital adequacy, risk management, market discipline, and corporategovernance that differ significantly from those that arise in conventional(Shari’ah–non-compliant) financial institutions. The issues concern the typesof assets to which Islamic financing gives rise, the related risks and theavailability of risk mitigants, and the types of non-interest-bearing savingsand investment products offered by Islamic banks for funds mobilisation inplace of conventional deposit and savings accounts. The fact that these non-interest-bearing savings and investment products have characteristics similarto those of collective investment schemes, not normally the concern ofbanking supervisors or regulators, constitutes a further regulatory challenge.

3. THE ISLAMIC FINANCIAL SERVICES BOARD

The Islamic Financial Services Board (IFSB) was launched in 2002 by aconsortium of central banks and the Islamic Development Bank (and with


the support of the IMF) with the mandate to provide prudential standardsand guidelines for international application by banking supervisors over-seeing Islamic banks.

In December 2005, the IFSB issued two prudential standards for Islamicbanks that are designed to help supervisors of such banks meet the challengeof implementing Basel II, one on capital adequacy and one setting outguiding principles of risk management. A third standard on corporategovernance was issued in 2007.5 The mandate of the IFSB was extended inDecember 2005 to the domains of insurance and securities market super-visors and regulators.

The main challenge for the IFSB is to develop a framework that iscommon and applicable to all jurisdictions. However, unlike the BaselCommittee, which can rely on regulatory frameworks and best practicesdeveloped by other leading regulators and banks as a background to itsglobal framework, this process could not be readily applied by the IFSB.This is because the IFSB does not have the privilege of borrowing ideas from alarge number of countries that have developed robust regulatory frameworksspecifically for Islamic banks. Hence, the onus is on the IFSB to develop mostof the thinking to set internationally accepted common prudential standardsfor Islamic financial institutions. This involves identifying the risks in thedifferent types of Islamic finance and activities, understanding the substanceas well as the form of the contracts that govern the transactions, dealing withissues that have not been addressed in other international standards, safe-guarding the interests of other stakeholders who in principle share asset riskswith the shareholders, and adapting Shari’ah rules that would be acceptableto the majority of its members.

In addition, whereas after the financial crises the Financial StabilityBoard has been given more powers to enhance the implementation of BaselIII, the IFSB, according to its Articles of Agreement, can only recommend itsstandards to be adopted.

4. CONTENTS OF THIS BOOK

Since this book deals with a large range of regulatory issues arising from theapplication of Basel II and Basel III to Islamic banks, authors who have beenchosen are specialists drawn from a variety of relevant backgrounds:banking and capital markets supervisors; the legal and accounting profes-sions; banks and financial institutions; and academia. The book is organisedinto four main parts, reflecting different aspects of the regulatory challenge,and a concluding chapter, as outlined below.


Part One: The Nature of Risks in Islamic Banking

Part One consists of 12 chapters, this overview of the book being the first. InChapter 2, Brandon Davies examines banking and the risk environment. Helooks at the regulatory developments that have recently taken place followingthe financial crisis that started in 2007. The risk characteristics of Islamicproducts, and the complexities of some of these, such as the phenomenon ofdisplaced commercial risk, are rigorously examined in Chapter 3 by Venka-taraman Sundararajan. Chapter 4, by Sami Al-Suwailem, highlights the ben-efits that can in principle be derived from Islamic finance in light of the recentfinancial crisis, especially in enhancing global financial stability. The chapterpoints out how Islamic finance provides a framework for balancing the rela-tionship between risk and returns, which, as Sami reminds us, requires carefuland proper implementation to be practically relevant.

Chapter 5, written by the two editors of this book, Simon Archer andRifaat Ahmed Abdel Karim, examines issues of capital structure and risk inIslamic banks and takaful insurance firms. Simon and Rifaat point out thatthe capital structures of both Islamic banks and takaful undertakings presentcomplexities not found in the case of conventional financial institutions. Withrespect to the former, Archer and Karim show how capital structure and riskare linked, from a regulatory perspective, via risk weightings and capitalrequirements set out by the IFSB based on the Basel II and III Accords and theStandardised Approach to risk weighting. They highlight specific risks incontracts used by Islamic banks and the implications in these contracts for thecapital requirements, and in some cases the capital structure, of these banks.With regard to takaful firms, Archer and Karim show how the regulatorycapital of a takaful undertaking needs to meet the solvency requirements ofthe insurance operations, and how the takaful operator needs capital to coverits own business risks, especially the risk of its management fees beinginsufficient to cover its operating expenses and the “underwriting manage-ment risk” potentially arising from failure in its fiduciary duties in managingthe underwriting of the Policyholders’ Risk Fund.

The next several chapters focus on specific types of risk facing Islamicbanks. In Chapter 6, John Lee Hin Hock examines credit and market risksinherent in asset-side products. He shows how Islamic financing assetspossess risk characteristics not found in conventional loans, includingcombinations of credit and market risks. In Chapter 7, Simon Archer andAbdullah Haron analyse consequential or operational risks. For Islamicbanks, as they point out, operational risks include those that may arise fromerrors in drawing up contracts or in executing transactions that result innon-compliance with the Shari’ah, which may have serious financial con-sequences. Chapter 8, by Samir Safa, sheds light on information technology


risk, a type of operational risk to which Islamic banks are particularlyexposed. Samir claims that the lack of systems that genuinely comply withShari’ah standards and principles (i.e., systems that are built with the pri-mary purpose of supporting the Islamic finance operating model), seems tohave forced the majority of the Islamic financial institutions to adopt con-ventional banking operational systems that were available in the market.This has greatly contributed, Samir argues, to amplifying the elements ofinformation technology risk that Islamic banks face.

Chapter 9, by Yusuf Talal DeLorenzo and Michael J. T. McMillen, andChapter 10, by Andrew White and Chen Mee King, deal with a complexand daunting set of risks arising from Shari’ah and legal compliancerequirements and their interactions, which result inter alia in legal impedi-ments to the development of Islamic securitisations. Chapter 9 also providesa historical outline, from a legal perspective, of the emergence of modernIslamic banking and finance.

In Chapter 11, Mohamad Akram Laldin addresses another type ofoperational risk, Shari’ah–non-compliance risk, which is unique to Islamicfinancial institutions (IFIs). Shari’ah must be the substance of, and provideguidance for, the day-to-day operations and activities of these institutions.The Shari’ah compliance of an Islamic financial institution, the authorargues, is crucial to ensuring the confidence of IFI shareholders as well asthat of the public in the authenticity of that institution, which in turn, willaffect the profitability of the IFIs’ business in the future through its ability toattract and retain funds from the public. A serious lapse in Shari’ah com-pliance could lead to withdrawals of funds and other loss of business thatcould plunge the IFIs into crisis. For that reason, Shari’ah–non-compliancerisk is arguably a higher priority category of risk for IFIs than other iden-tified risks. In December 2009, the IFSB issued the Guiding Principles onShari’ah Governance Systems, which delineates a system of internal controlover Shari’ah compliance, comprising a continuous internal audit processand an annual review.

Finally, Peter Casey in Chapter 12 considers the implications of theserisks in the wake of the financial crisis for a financial sector regulator. Inparticular, Peter examines the supervisor’s role in Shari’ahmatters. He arguesthat in the case of a firm that claims to be Islamic, the regulator should focuson requiring that the IFI have a sound internal system to ensure Shari’ahcompliance, on which the regulator may rely while avoiding the role (forwhich it is not equipped) of judging the Shari’ah compliance of the IFI. In sucha system, the regulator may impose Shari’ah governance requirements on thefirm. Implicit in this system is that the supervisor will apply an approachsimilar to those it would apply in other (nonreligious) control areas, with theaim of achieving compliance with religiously based requirements.


Part Two: Capital Adequacy

Part Two contains four chapters. Chapter 13, by John Board and Hatim El-Tahir, examines the need for bank capital in order to absorb the economicrisks of banking. Their chapter touches on two inter-linked developments incapital regulation: first, the globalisation of financial regulation and theimpact of the global regulatory framework proposed in Basel III, which aimsat promoting a more resilient banking sector worldwide; second, the devel-opment and limitations of new forms of capital instruments (contingentlyconvertible or subordinated) introduced by some major financial institutions,including notably systemically important financial institutions (SIFIs) on aglobal scale. Chapter 14, by editors Simon Archer and Rifaat Karim, high-lights an important set of issues concerning the measurement of risk forcapital adequacy purposes that results from the use by Islamic banks of profit-sharing and loss-bearing investment accounts in lieu of conventional bankdeposit and savings products. In Chapter 15, Sandeep Srivastava and AnandBalasubramanian deal with the measurement of operational risk for capitaladequacy purposes under Basel II and Basel III. With respect to Islamic banks,Sandeep and Anand point out that Islamic banks are subject to different typesof operational risks, for example, risk of Shari’ah–non-compliance, fiduciaryrisk, and risks arising out of the complex documentation involved in Islamicproducts. However, Sandeep and Anand claim that these unique risks ofIslamic banks do not necessarily mean that these banks require differentmethodologies for measuring operational risk. Finally, in Chapter 16,Richard Thomas examines liquidity risk, an issue that Basel III addresses indepth, in Islamic banks. He highlights the liquidity management challenges,which Islamic banks face in light of the shortage of adequate high qualityShari’ah-compliant financial instruments. This challenge has been furthercomplicated by the Basel III requirement for the “high quality liquidassets” that banks should hold to manage their liquidity risk. Accordingly,Richard argues that the handicaps which Islamic banks face in managingliquidity risk should be addressed by national authorities (so as to provideShari’ah-compliant substitutes for the conventional interbank markets andlender-of-last-resort facilities), as well as by the global regulators and notablythe BCBS in terms of what may count as ”high quality liquid assets.”

Part Three: Securitisation and Capital Markets

Part Three consists of three chapters. Chapter 17, by Baljeet Kaur Grewal, dealswith the developing phenomenon of securitisations in Islamic finance, or sukuk.She provides amarket overview of the issuance of sukuk in various jurisdictions,as well as their potential. Baljeet argues that although conventional bonds and


sukuk share a similar process, structure, and end result, there are a few keyShari’ah principles, which must be adhered to, that differentiate the two typesof securities. She gives examples of the common sukuk structures that havebeen used in the market. In Chapter 18, Prasanna Seshachellam considers theopportunities and challenges in the Islamic capital and money markets, andparticularly the need to create a Shari’ah-compliant asset base and financialinfrastructure for the creation of liquid Shari’ah-compliant assets. Prasannaalso discusses the primary developments required to improve Islamic capitalmarkets in general and those that are specifically required to improve theability of Islamic capital markets to provide liquidity, which include, interalia: (a) a robust and wide suite of credible Shari’ah-compliant products; (b) astronger market infrastructure; and (c) measures (i) to attract a wider set ofinvestors, (ii) to reduce uncertainty regarding market practices and instru-ments, and (iii) to achieve a robust and reliable regulatory framework. InChapter 19,Nik RamlahMahmoud discusses the regulation of Islamic capitalmarkets, pointing out that the regulation of the Islamic capital markets posesseveral unique challenges as compared to the regulation of Islamic bankingand takaful. Nik Ramlah argues that the fundamental challenge in regulatingIslamic capital markets is whether or not the objectives and requirements ofShari’ah are compatible with the underlying principles of general securitiesregulation. She discusses various approaches that are adopted (mainly inMalaysia) in the regulation of ICM.

Part Four: Corporate Governance and Human Resources

This part contains four chapters. The first, Chapter 20 by Carol Padgett,considers some of the common features of corporate governance regula-tions affecting companies across the globe, as well as banks as a specialcase. She considers the guidance published by the Basel Committee onBanking Supervision on corporate governance in banks, where she focuseson recent changes in that guidance as it affects risk management, remu-neration practices, and transparency in banking structures. Carol alsohighlights how the recent banking crisis exposed shortcomings in each ofthese areas. Chapter 21, by the editors, examines specific corporate gov-ernance issues in Islamic banks, notably those raised by the requirement forcompliance with the Shari’ah, and those resulting from the use by Islamicbanks of profit-sharing and loss-bearing savings and investment productsin place of conventional deposit and savings accounts. In Chapter 22, DaudAbdullah (David Vicary) considers the transparency and market disciplineimplications for Islamic banks of Basel II Pillar 3, as well as the develop-ments that have been introduced in Basel III, indicating the potential


key role of the regulator in promoting or “bootstrapping” a virtuous circleof transparency. He also incorporates in his discussions the IFSB guidanceon disclosures to promote transparency and market discipline for Islamicbanks.6 In Chapter 23, Volker Nienhaus examines the human resourcemanagement implications of the conceptual and technical challenges facingthe Islamic banking sector, including the need to recruit, train, motivate,and retain highly competent personnel in an environment renderedhighly competitive by rapid growth and the presence of the major inter-national banks.

Part Five: Conclusion

In the fifth and final section, Chapter 24, the editors present some overallconclusions.

NOTES

1. For more details on Basel III, see in this volume Chapter 2 by Brandon Daviesand Chapter 13 by John Board and Hatim Al-Tahir.

2. The article in The International Journal of Bank Marketing by Karim (1996), oneof the editors of this book, was the first publication to highlight the fact that Basel1 (the Basel Accord) could not be applied to Islamic banks without taking intoconsideration the specificities of these banks. This prompted the issuance of adocument by the Accounting and Auditing Organization for Islamic FinancialInstitutions (AAOIFI) (1999), which was mainly drafted by Simon Archer andRifaat Ahmed Abdel Karim, the co-editors of this book.

3. In part, this was due to a series of conferences organised by Rifaat Ahmed AbdelKarim, co-editor of this volume, then Secretary-General of AAOIFI, notably theConference on Regulation of Islamic Banking held in February 2000.

4. The essential differences between conventional and Islamic financial intermedi-ation are explained by Venkataraman Sundararajan in Chapter 3 of this volume.

5. The IFSB standards on the supervisory review process (Pillar 2) and transparencyand market discipline (Pillar 3) were issued in 2006.

6. IFSB-4. 2006. Disclosures to Promote Transparency and Market Discipline forInstitutions Offering Islamic Financial Services (Excluding Islamic Insurance(Takaful) Institutions and Islamic Mutual Funds). Kuala Lumpur: IFRB.

REFERENCES

Accounting and Auditing Organisation for Islamic Financial Institutions (AAOIFI).1999. Statement on the Purpose and Calculation of the Capital Adequacy Ratiofor Islamic Banks. Manama, Bahrain: AAOIFI.


Islamic Financial Standards Board (IFSB). 2009. Guiding Principles on Shari’ahGovernance Systems for Institutions Offering Islamic Financial Services. KualaLumpur, Malaysia: IFSB.

Karim, R.A.A. 1996. “The Impact of the Basle Capital Adequacy Ratio Regulationon the Financial and Marketing Strategies of Islamic Banks.” The InternationalJournal of Bank Marketing 14 (7): 32–44.


Contents

Preface ix

Acknowledgments xiii

List of Abbreviations xv

CHAPTER 1

Introduction 1

Rationale for Researching Investment Portfolio Composition of Takaful Companies 1

Aims and Objectives 4

Scope and Delimitation 5

Research Methodology 6

Overview of the Book 6

CHAPTER 2

Insurance and Islamic Law: An Introduction to Takaful 9

The Concept of Insurance in Islamic Sources 9

Views of Contemporary Jurists on the Insurance Contract 13

Arguments Regarding the Validity or Invalidity of Commercial Insurance 15

Conclusion 27

Notes 28

CHAPTER 3

Takaful Models and Implementations, Trends, and Developments 31

Takaful Undertaking Principles 31

Islamic Insurance Operational Models 32

Differences Between Takaful and Other Forms of Insurance 44

Trends and Developments in the Takaful Industry 45


Conclusion 52

Notes 53

CHAPTER 4

Research Methodology 55

Methodological Shortcomings of the Literature 56

Research Strategy 56

Research Questions, Objectives, and Hypotheses 57

Research Design 58

Sampling Strategy 59

Research Methods 61

Quantitative Data Analysis 68

Qualitative Data Analysis 70

Conclusion 70

Notes 71

CHAPTER 5

Exploring Investment Behaviours and Investment Portfolios of Takaful Operating

Companies in the GCC and Malaysia 73

Total Investment Portfolio of Takaful Operating Companies for All Funds 74

Investments in Shareholders’ Fund 75

General Fund 86

Family Funds 94

Conclusion 97

CHAPTER 6

Locating the Differences Between Actual and Desired Investment Portfolios 99

Shareholders’ Fund 101

General Fund 106

Family Funds 111

Conclusion 114

CHAPTER 7

Contextualising the Findings 117


Overall Portfolio Compositions 117

Investment Accounts 125

Investment in Sukuks 129

Investment in Equities 134

Return on Investment (ROI) 138

Mutual Funds/Unit Trusts 140

Real Estate Investments 141

Conclusion 142

Notes 143

CHAPTER 8

Conclusion and Recommendations 145

Main Findings of the Study 145

Recommendations of the Study 149

Research Limitations 153

Recommendations for Future Research 153

Conclusion 154

Note 155

Appendix A 157

Appendix B 163

Appendix C 215

Bibliography 217


Index 225

Buy This Book



1

CHAPTER 1 Introduction

RATIONALE FOR RESEARCHING INVESTMENT PORTFOLIO COMPOSITION OF TAKAFUL COMPANIES

Islamic fi nance has been one of the fastest-growing industries over the past decade, with an average annual double-digit growth rate. The total Shari’ah -compliant assets worldwide were estimated at US$700 billion in 2007 compared with US$150 billion in the mid-1990s (Grewal, 2008), and are expected to reach US$1.2 trillion in 2012 ( The Banker , 2011). The Islamic banking sector dominated the Islamic fi nance industry, with assets representing 78.6 percent of total worldwide Shari’ah-compliant assets in the mid-2000s (Grewal, 2008). Moreover, the Gulf Cooperation Council (GCC) countries account for two-thirds of global Islamic assets ( The Banker , 2009), where Islamic banking and fi nance is expected to become the major banking alternative by 2025. Some believe that the industry would be able to serve 40–50 percent of the total 2.5 billion Muslims worldwide in the next eight to ten years (Grewal, 2008). According to Moody’s Report (2008), the growth of the Islamic fi nance industry has been driven by the increase in oil prices, which signals that there will be no slowdown in the growth of this industry in the future. Furthermore, all other parts of the Islamic fi nance industry are also expected to regis-ter substantial growth, such as the Islamic bonds ( sukuk ) market, Islamic funds, and Islamic insurance ( takaful ), despite the impact of the global fi nancial crisis.

The research presented in this book is concerned with the Islamic insurance industry, which has registered rapid growth over the years. During the period covered by this study, 2002–2005, there were 133 taka-ful operating companies in the world, of which 59 were located in the GCC market, which is the largest market for the takaful industry and represented

2 TAKAFUL INVESTMENT PORTFOLIOS

50% of the takaful global market as of the end of 2006 (Ernst & Young, 2008), demonstrating substantial growth in recent years. The global takaful industry has maintained a growth rate of 20% per annum; the contributions underwritten rose to more than US$4.3 billion by the end of 2010 com-pared with US$2 billion in 2006 (Ernst & Young, 2008), and are expected to increase to US$12 billion by the end of 2012 (Ernst & Young, 2012). The tipping point for the takaful industry remains the GCC region despite the fact that Malaysia has demonstrated important achievements in a proactive manner for the development of takaful industry. The growth of Shari’ah- compliant products sold by Islamic banks, reduction in government welfare benefi ts, and economic and demographic growth in the Muslim countries will be among the factors that will see the growth of this industry soar in the GCC region (Ernst & Young, 2008). The growth and development in Malaysia can be explained by the political will and business appetite for Shari’ah- compliant business. There have also been important developments in terms of Islamic fi nance as well as takaful in other countries that benefi t from a plural fi nancial system.

Although the takaful industry has been growing and gaining substantial interest, there are still several challenges facing this industry, such as asset management problems, limited retakaful capacities, and lack of expertise. This research focuses on the asset management of takaful operating compa-nies in the GCC and Malaysia by exploring their investment compositions and the gaps in the asset classes required by the companies in these regions. This research is conducted in absence of adequate literature and statistics pertaining to the industry, particularly in the area of asset management. Hence, this research is essential, and therefore the data gathered and pre-sented in this study could be considered a fi rst step toward exploring the investment behaviour of takaful operating companies.

The rationale for the interest in the Islamic insurance industry in general was motivated by many factors. First, the Islamic insurance industry has been registering substantial growth during the last fi ve years and gaining a lot of interest from international players, including the leading interna-tional insurers and reinsurers such as American Insurance Group, Allianz SE, Hannover Re, Swiss Re, and the Lloyd’s market. Second, the Islamic insurance industry is a complementary part of the Islamic banking industry, whose assets are expected to grow signifi cantly in the near future. Finally, the booming of economies in Islamic countries and particularly those within the GCC will cause this industry to fl ourish. The amount of infrastructure projects to be conducted in the region and mega-projects handled by Islamic banks will lead to the growth of general takaful business. However, reduction in government support, economic and demographic growth, and increase in cost of education could lead to the growth of family takaful business.

Introduction 3

Despite the importance of the Islamic insurance industry, there has been very limited research and literature related to this industry. In particular, not much is known about the structure of takaful operating companies. For example, the current model being adopted by takaful operating companies has not yet been explored in detail and documented. Some researchers believe that the Islamic insurance industry has been neglected in the litera-ture because of the specialised nature of insurance as a subject (Mervyn, 2005). Moreover, there is a lack of standardisation and statistics pertain-ing to this industry. All of the above mentioned problems would make understating of the operation of this industry very diffi cult for international players, regulators, and customers, whose fears might affect the growth of this industry.

The interest behind choosing asset management of Islamic insurance companies was due to several reasons. First, the Islamic insurance industry will not be able to grow and support the development of the Islamic bank-ing industry without proper investment channels that are suitable to cover their insurance liabilities. Second, the asset management of takaful could be a fi rst step toward attracting Islamic banks to give further attention to this industry. The highlighting of the gaps in asset classes that takaful operating companies require may attract some Islamic banks to play a role in develop-ing the required asset classes, especially with the potential for growth of the assets of this industry.

Until now, there has been no study conducted on the investment behaviour addressing each of the funds individually. Likewise, detailed statistics about investment portfolio composition for each fund are not available. Therefore, this study was conducted with the aim to explore the asset classes compris-ing investment portfolio of the shareholders ’ fund, general funds, and family funds of takaful operating companies. Moreover, this study compared the current and desired levels of the investment portfolio composition for each of the abovementioned funds.

The hybrid structure of takaful , which is in contrast to that of con-ventional insurance undertakings, requires special attention once an invest-ment strategy is under investigation. In particular, the investment strategy for each of the funds under the takaful structure should be individually studied. These funds comprise the shareholders’ funds of the takaful opera-tor on the one hand, and the funds of takaful participants (policyholders) on the other hand. Moreover, the latter include underwriting or risk funds and, in the case of life (or family) takaful , the participants ’ investment funds. The underwriting or risk funds include mortality risk funds in family taka-ful and, in the case of general (non-life) takaful , the relevant underwriting funds (e.g., that for motor insurance), referred to below as general funds. The reason for the need for individual study lies in the different nature of


the liabilities under each fund, which calls for a different investment strategy or composition.

The research presented in this book aims to explore the portfolio com-position and hence investment behaviours of takaful operating companies beyond the observed trends and developments. Thus, in terms of subject matter, analysis, and fi ndings, this new research line is expected to con-tribute to the literature.

AIMS AND OBJECTIVES

The research presented in this book aims to explore the investment behav-iour of the takaful operating companies in the GCC and Malaysia by focusing on investment composition of shareholders’, general, and family funds indi-vidually. Also, the study aims to identify the gaps in the asset classes that the takaful operating companies in both of these regions require to cover their liabilities under each of the abovementioned funds. Given the research problems and questions, the following objectives and hypotheses have been identifi ed:

1. To explore the asset classes comprising investment portfolio composi-tion of shareholders ’ funds, general funds, and family funds of takaful undertakings in the GCC and Malaysia.

2. To compare the actual and desired levels of the investment portfolio composition of shareholders ’ funds, general funds, and family funds between GCC and Malaysia.

This second objective was formulated into three testable hypotheses:

1. There is no signifi cant difference between the actual and desired levels of composition of shareholders ’ fund investment portfolio in the GCC and Malaysia.

2. There is no signifi cant difference between the actual and desired levels of composition of general fund investment portfolio in the GCC and Malaysia.

Due to the negligible business of family takaful in the GCC, the third hypo-thesis is confi ned to Malaysian takaful undertakings:

3. There is no signifi cant difference between the actual and desired levels of composition of family fund investment portfolios in Malaysia.

Introduction 5

As regards the research questions, the existing research in the fi eld of Islamic insurance, particularly the investment side, has been facing several diffi culties regarding the research methodology that will require further investigation. For example, a conclusion was made from a previous study that the takaful investment undertakings in the GCC countries are heavily invested in equities; however, this conclusion might be wrong as some of the takaful operating companies invested their shareholders’ funds in equities rather than participants’ funds (Fisher, 2005; Jaffer, 2008). Therefore, the study research problem breaks down into the following questions:

1. What was the investment portfolio composition of takaful undertak-ings during the years 2002 to 2005?

2. Did the investment portfolio composition of Shareholders ’ funds, gen-eral funds, and family funds in takaful undertakings differ in the GCC and in Malaysia during the years 2002 to 2005?

3. Did the takaful undertakings desire to change the current composition of their investment portfolios as of the end of 2005?

SCOPE AND DELIMITATION

In terms of scope and delimitation, this study was confi ned to two geo-graphical groups, namely the GCC countries and Malaysia, for several reasons. First, the majority of takaful undertakings in the world are concen-trated in the GCC countries and Malaysia. It should be noted that although Saudi Arabia is the biggest insurance market in the GCC, the coverage of this country was excluded at the time the study was conducted for several reasons. One of these included (at the time the study was conducted) the absence of regulation of insurance as a consequence of which all operating companies in Saudi Arabia were either unregulated or registered as off-shore companies in Bahrain or as divisions operating under existing licensed banks. Oman was also excluded due to the nonexistence of takaful oper-ating companies in that country. Furthermore, although there were many takaful operating companies in Sudan, this market was excluded due to the diffi culties faced in gathering the required information.

Second, the Islamic fi nance industry, which includes banking, insurance, and capital markets, has been established in these regions, which continu-ously represents the hub of this industry. At the time this study was conducted, the number of takaful operating companies in the market was small, so the author tried to cover the total population. Complete coverage was not achieved, but the author covered 90% of the GCC market and 95% of the Malaysian market.


It should also be noted that the research covered by this study focuses on the 2002–2005 period, and therefore the fi ndings should be contextualised within this initial period of the emergent takaful industry. Since then, the takaful industry and also the Islamic fi nance industry have demonstrated unprecedented growth and development. The development of Islamic fi nance and product diversifi cation have increased the investment opportu-nities for takaful operating companies as well in recent years.

RESEARCH METHODOLOGY

In order to achieve the designated objectives and hypotheses, a multistrategy research approach, known as triangulation , has been employed in this study. Under this approach, the data was gathered using a quantitative research strategy reinforced by a qualitative research strategy. As this is an exploratory study, the use of such a multi strategy research approach is very crucial for several reasons, which are discussed in detail in Chapter 4.

The data has been collected through an e-mailed prestructured ques-tionnaire followed by a mix of structured and unstructured interviews. The purpose of the interviews was to verify the data collected and to inquire about any certain trend or data that needed to be justifi ed. Given the detailed data required and in order to achieve the cooperation of the takaful operat-ing companies, the regulatory authorities for the insurance sector in these countries—except Qatar—were approached to gain their approval and to ask the takaful operating companies under their supervision to cooperate to fi ll out the required questionnaire.

The data collected were analysed by utilising various statistical methods through Statistical Package for Social Science (SPSS) software. Moreover, two nonparametric statistical techniques were used, namely the Mann-Whitney U Test and the Wilcoxon Signed-Rank Test. Descriptive statistics were also applied in the analysis of the data.

OVERVIEW OF THE BOOK

The study comprises eight chapters. This fi rst chapter is an introductory one that highlights the research problem, the motivation for, and the signifi cance of the study, and the research objectives, hypotheses, and research design.

The literature review is presented in Chapters 2 and 3. The review of legal aspects of insurance contracts under Islamic law is covered in Chapter 2, and Chapter 3 covers the Islamic insurance practices, with special compari-sons between Islamic and conventional insurance.

Introduction 7

The empirical work commences in Chapter 4 by fi rst presenting the research methodology applied in the study. The chapter covers all aspects of the chosen research methodology, including the research designs and methods, with special highlights of the limitations of the study and the sample chosen.

Chapters 5 and 6 present the empirical fi ndings. The results for the fi rst objective of the study are presented in Chapter 5, and the fi ndings related to the second objective are presented in Chapter 6. The analysis and discussion of results for both objectives of the study are presented in Chapter 7 by link-ing the fi ndings of both objectives.

Chapter 8 summarises the thesis and draws the study conclusion. Moreover, it offers recommendations for regulatory authorities, takaful operating companies, and Islamic banks based on the fi ndings of the study.

Contents

Acknowledgments xi

1 Introduction: Islamic Finance in the World Economy 1

Karen Hunt-Ahmed

PART I The Contemporary Islamic Finance Landscape

2 Contemporary Islamic Economic Thought 19

Mohammad Omar Farooq

3 The Legal Framework of Islamic Finance 39

Cynthia Shawamreh

4 Globalization and Islamic Finance: Flows and Consciousness 63

Karen Hunt-Ahmed

5 Islamic Science and the Critique of Neoclassical Economic Theory 75

Waleed El-Ansary

6 Juristic Disagreement: The Collective Fatwa Against Islamic Banking in Pakistan 103

Shoaib A. Ghias

7 Managing Liquidity Risk in Islamic Finance 121

Dr. Muhammad Al-Bashir Muhammad Al-Amine

8 Elements of Islamic Wealth Management 147

Paul Wouters

9 Sukuk and the Islamic Capital Markets: An Introduction 165

Michael J. T. McMillen


10 Shari’a-Compliant Mutual Funds 189

Monem Salam

11 The Evolution of Shari’ah-Compliant Indexes and Why They Outperform

Conventional Indexes over the Long Term 195

Tariq Al-Rifai

12 Takaful 203

Farrukh Siddiqui

13 Islamic Human Resources Practices 215

William Marty Martin

14 An Integrated Islamic Poverty Alleviation Model 223

Ali Ashraf and M. Kabir Hassan

15 How Does an Islamic Microfi nance Model Play the Key Role in Poverty

Alleviation? The European Perspective 245

Sabur Mollah and M. Hamid Uddin

PART II Case Studies

16 Islamic Finance in an Almost Postcrisis and Postrevolutionary World: As in

Politics, All Islamic Finance Is Local 257

Mark Smyth

17 Stepping Forward, Backward, or Just Standing Still? A Case Study

in Shifting Islamic Financial Structures Offshore 267

Umar F. Moghul

18 Islamic Mortgages 283

David Loundy

19 Shari’a Quality Rating 293

Nasir Ali Merchant

20 Islamic Mutual Funds’ Performance in Saudi Arabia 303

Hesham Merdad and M. Kabir Hassan


21 Shari’ah-Compliant Real Estate Investment in the United States 323

John L. Opar

22 Risk and Derivatives in Islamic Finance: A Shariah Analysis 331

Dr. Muhammad Al-Bashir Muhammad Al-Amine

23 Islamic Microfi nance 353

Blake Goud

About the Editor 367

Index 369

Buy This Book



CHAPTER 1

IntroductionIslamic Finance in the World Economy

KAREN HUNT-AHMEDPresident, Chicago Islamic Microfinance ProjectLecturer, DePaul University

The religion of Islam has existed for 1,400 years but Islamic economic the-ory and its financial institutions as an industry emerged only in the 1970s.Islamic banks are late twentieth-century institutions designed, against the

backdrop of a global economy dominated by capitalist business practices, to helpMuslims conduct business internationally while simultaneously upholding tra-ditional Islamic values related to trade finance and currency movement. Thebasis for their existence is the Islamic moral prohibition on charging interest—interest is a central component of capitalist banking—yet Islamic banks conductbillions of dollars of business annually in the world economy and the de factoIslamic banking transaction is—in most cases—virtually identical to a capitalistbanking transaction. The industry of Islamic Banking and Finance (IBF)1 is themanifestation of attempts to apply Islamic law and Islamic economic theory tofinancial dealings.

An Islamic Financial Institution (IFI) refers to any financial institution that per-forms Islamic transactions derived from either Islamic law or Islamic economic the-ory. An Islamic Bank is an institution that performs conventional banking services2

(or their Islamic equivalent) such as checking accounts, savings accounts, loans,and so forth. An IFI may or may not be a bank but an Islamic bank is alwaysan IFI. Islamic financial institutions include venture capital firms and insurancecompanies, and may be distinguished from conventional banks by three primaryelements (Bahrain Monetary Agency 2002):

1. Prohibition of prohibited financing arrangements and business practices.The most important prohibition in Islamic finance is the prohibition of riba(interest or usury). This means not only that financing transactions are struc-tured differently than in conventional finance, but also that the asset struc-ture of the institution is based entirely upon tangible assets and partnershiparrangements instead of on interest-based financial assets. Gharar (specu-lation) and maysir (gambling) are prohibited, as well as trading in haram(forbidden) goods such as alcohol, pork, and owning equity in riba-basedinstitutions (Lewis and Algaoud 2001).

1

2 Contemporary Islamic Finance

2. Integration of religious practices into daily life by governing business underIslamic law.

3. Existence of a Shari’a Standards Board (SSB) composed of Islamic scholars.The SSB’s purpose is to insure that Islamic law is being followed accuratelyin the business practices and financial arrangements of the IFI. A memberof the SSB (called a Shari’a Scholar) has been trained formally in Islamiclaw, but has not necessarily been trained in finance. A separate financialstandards board evaluates the efficacy of financial transactions, just as itdoes in a conventional institution, and the two boards often work together.

Ideally, an IFI should combine the elements of Islamic financial practices withsome effort to uphold Islamic daily life practices (Lewis and Algaoud 2001).

The industry of Islamic banking and finance is growing daily. There are hun-dreds of Islamic financial institutions worldwide and the world’s potential marketfor Islamic finance consists of more than one billion Muslims, in addition to non-Muslims, who are welcome and encouraged to participate in Islamic finance. WhenI began my fieldwork in 2002, Islamic assets were estimated to be around USD 200–300 billion. By 2011, estimated industry assets under management topped USD1 trillion and is growing at a rate of at least 10 percent per year.3 The FinancialTimes reports that at least one bank, Dubai-based Saadiq (the Islamic banking armof Standard Chartered Bank), saw revenue growth of 65 percent in 2011 over 2010.4

This book speaks to an audience that is dynamically involved in—or thinkingof being involved in—the Islamic finance industry. As the industry grows rapidly,finance professionals, investors, attorneys, educators, and students demand moredetailed and sophisticated knowledge. Innovations abound as practitioners findways to reconcile existing practices and regulations with Shari’a requirements.This volume will provide a useful and timely guide to Islamic finance for any-one interested in learning about basic concepts, current issues, and best practicespredominant in the industry today.

GLOBALIZATION AND MUSLIM SUBJECTIVITYWorld conditions due to globalization have contributed to the formation ofthe industry of Islamic finance. (Please see Chapter 4 of this volume.) Geo-graphic mobility and technological advances made possible (and desirable) byglobalization have profoundly changed definitions of personal, community, andreligious identities of humankind. Islamic law does not allow for individuals orinstitutions that lend money to charge interest on that money. Muslims who ori-ent themselves according to Islamic practices would be acting against their moralconstitutions to participate in transactions that involve the charging of interest.Yet in the early twenty-first century global economy, trade finance and other cru-cial banking transactions are clearly dominated by capitalist financial institutionswhose return on investment is based upon charging interest. Heretofore, a Muslimwishing to participate in the global economy has had to invest in capitalist insti-tutions and act in opposition to his or her religious and moral belief system. Asfinancial resources in the Islamic world have grown over the past three decades,Muslims have increasingly sought alternatives to capitalist investment that aremore in keeping with Islamic practice. Islamic banks provide a framework for

INTRODUCTION 3

Muslims to invest their money “morally,” in accordance with Islamic law, whileat the same time they do not miss out on profit opportunities provided by theglobal form of capitalist exchange. Islamic banking must locate itself as a Musliminstitution in the world economy, yet it is also an industry that explicitly engageswith the capitalist institution of banking and as such must be studied in the contextof globalization and its relation to capitalism.

Throughout history, Jewish and Christian religious doctrines have objectedto what they defined as unsavory business practices, including the practice ofusurious loans. De Roover (1974) emphasizes that usury at that time in historyreferred to any increase over principle and that usury was prohibited; consequently,any increase was considered excessive. Christianity and Judaism resolved thismoral problem in a way that advances capitalist enterprise—by declaring loans atinterest as acceptable transactions as long as they are not usurious, whereas Islamseems to be engaging with capitalism in a way that critiques capitalism while atthe same time advances it. The industry and its resultant institutional structureact as a culture broker (cf. Mazzarella 2004), providing a bridge between capitalistbusiness practices and a competing Muslim sensitivity for its practitioners, whoare comfortable in both cultural systems. Furthermore, IBF acts as a bridge betweencompeting subjectivities—or practices of Islam—within Islam itself.

HISTORY OF ISLAMIC FINANCEIslamic finance is a subcategory of the discipline of Islamic economics, which is inturn informed by Islamic legal thought. Chapters 2 and 3 of this volume (Farooq’s“Contemporary Islamic Economic Thought” and Shawamreh’s “The Legal Frame-work of Islamic Finance,” respectively) introduce those two concepts. In this sec-tion, I take you through a brief history of the industry’s evolution. This account isinformed by Kuran (2004), Warde (2010), and Askari et al. (2010), and draws uponthe history of economic thought as its basis. This chapter is meant to be a briefintroduction to the formation of the industry from a psychological perspective; thespecifics of Islamic economic thought, and a critique of that thought, are discussedelsewhere in this volume (Chapter 2 and Chapter 5).

Whereas textual and traditional sources of Islamic law date to the time ofthe Prophet Mohammed and the ensuing three hundred years or so, Islamic eco-nomic theory is a contemporary theory. It has its roots in postcolonial India andits tenets have been widely debated since the middle of the twentieth century.Islamic economics is always written about with reference to classical economictheories that form the basis of capitalism. Early writings about Islamic economicswere often presented as critiques of one or more economic theories prevalent in theworld, such as communism, socialism, or capitalism (cf. Chapra 1976; Zarqa 1981;Siddiqui 1981). Since the fall of the Soviet Union and the apparent victory of capi-talist economics over other forms of economic structures, critiques of communismand socialism are no longer at issue, so most of the contemporary critiques aredirect reactions to capitalist economic values. Timur Kuran, in his book Islam andMammon, recognizes the emphasis of values in the theory of Islamic economics:“at least initially, the economics of ‘Islamic economics’ was merely incidental to itsIslamic character” (italics in original; Kuran 2004, p. 82).


The framework of Islamic economic theory was developed in India in theearly twentieth century by Islamic scholar Mawlana Mawdudi (1903–1979) andexpounded upon by one of his students, economist Khurshid Ahmad. IndianMuslims as a group were relatively disadvantaged economically compared withthe majority population of Hindus. The British Raj had provided some eco-nomic protections to Muslims, farmers in particular, but it was unclear how orif a Hindu-led government would provide the same protection (Kuran 2004).Mawdudi believed that economic activity and technology were crucial to the suc-cess in the modern world, and he was dedicated to providing Muslims in India witheconomic opportunities that allowed them both to function in the modern worldand to retain their Muslim identity. Many Muslims did not participate in conven-tional banking activities because of the prohibition against riba. Mawdudi himselfadhered to this belief, as we learn from reading the notes to his own translationof the Qur’an. In particular, Mawdudi stresses different ways in which loaning atinterest can erode communal bonds between men (1988). Nonetheless, Mawdudibelieved it was detrimental to the Muslim community in India to abstain frombanking activities. He and Ahmad believed that it was possible and desirable forIndian Muslims to embrace systems and institutions of Western modernity whileat the same time adhering to the teachings and practices of Islam (Mawdudi 1980).One goal of Mawdudi was to redefine Islamic practices to conform to economicchanges. He felt that Muslims in India could use practices to retain their Muslimidentity in the face of the postcolonial Indian modernization project. In one ofhis last books, a short history of the founding of Islam, Mawdudi wrote (1974,p. 11):

The Islamic way of life can be revived and reconstructed again and again with thehelp of the Qur’an and the traditions if ever, God forbid, the freshness of its truespirit wanes. The world no longer requires any new Prophet to revive Islam to itspristine glory. It is enough to have among us the learned people who know theQur’an and the traditions of the Prophet and who are able to apply their teachingsto their own lives and stimulate others to adopt and apply them in their lives aswell. This is how the stream of Islam will continue to flow, refreshing the eternalthirst of mankind.

Khurshid Ahmad argued that economic systems are value-based systems; eventhe capitalist economic system was founded on certain cultural values, which arereflected in that system. This belief is not unlike Max Weber’s (1930) assertion thatCalvinist religious practices served to advance capitalism. Therefore, if Muslims areto be economically empowered, a theory of Islamic economics is necessary. Othertheorists took up that line of thought, such as Umer Chapra, who states: “Virtuelies . . . not in shunning the bounties of God, but in enjoying them within the frame-work of the values for ‘righteous living’ through which Islam seeks to promotehuman welfare” (Chapra 1976, p. 173). In Islam, all fields of life are interrelated.Goals and values of each segment of life should be aligned, so the economic sys-tem’s values are aligned with those of society.

Kuran (2004) asserts that the emergence of the industry grew out of the debateon whether or not Muslims in India should have a separate homeland or remainpart of a greater India after the Partition of 1947. Mawdudi favored the latter

INTRODUCTION 5

proposition—cultural reassertion—and contended that a separate homeland wasunnecessary because if Muslims practiced their religious duties faithfully, the mat-ter of a national homeland would be irrelevant. In this view, group solidaritydepends more on shared beliefs and practices than on shared geographical ter-ritory. This principle foreshadows many of the basic principles of globalization,namely the belief that group solidarity or identity can be based on somethingother than geographical place.

Mawdudi favored thinking of Islam as a way of life, rather than as a system offaith. In a treatise of his interpretation of the Qur’an published immediately afterhis death (1980), Mawdudi asserts that the kalimah5 affirms that there is one God,Allah, and Mohammed is his Prophet. Mawdudi considers this to be the primarydoctrine of Islam: The real difference between believers and unbelievers “lies in theacceptance of this doctrine and complete adherence to it in practical life.” (Maw-dudi 1980, p. 62) An emphasis of the connection between belief and practice isthe foundation for Mawdudi’s entire project of strengthening Islam worldwide. AMuslim must not only believe in the doctrine of Islam, but internalize and incor-porate its practices in everyday life. It is only in this way that Islam (and Muslims)will survive in a world that is increasingly influenced by modern inventions andsystems. We can see this idea at work in the thinking of contemporary scholarsof Islam. It had particular relevance in the anxious times of postcolonial India,and has gained relevance in a globalized and post-9/11 world in which Islam hasfrequently come under attack from the prevailing world order.

In contrast to politicians who wanted a territorial solution for Muslim inde-pendence (Pakistan), Mawdudi sought to keep Islam salient in the minds of itspractitioners without necessitating a territorial division. He fully recognized theprudence of tying economic behavior to religious beliefs. According to Kuran(2004), a technologically advanced world requires complicated economic deci-sions. In the dominant world economic order, those decisions are thought of assecular decisions. If Muslim traders and customers were making daily economicchoices based on religious thought instead of on secular economic principles, theaverage person could think of business activities as religious activities. Therefore,religion would always be prominent in their minds (Kuran 2004). In this way,Muslims would remain politically visible despite their minority status. In thissense, Mawdudi advocated the creation of an Islamic economic actor in order toallow citizens to pursue economic activities in a morally acceptable way.

According to a comprehensive survey of Islamic economic literature, ProfessorMuhammad Siddiqui has outlined some of the key philosophical underpinningsof Islamic economic theories. The practitioner is meant to use these philosophicalpoints as a guideline for developing practices in an (theoretical) Islamic economicsystem. Of course, no purely Islamic economic system exists in the world today,but it is held up as a goal to which Muslims should strive. Some of the majorIslamic economic values are (Siddiqui 1981):

� A person should be a “God-conscious” human being. He or she shouldpractice tawhid, or unity, at all times. This means that all earthly actions mustbe pleasing to the will of Allah.

� Economic enterprise is encouraged, as long as moderation is practiced andspecial attention is paid to social justice.


� Ownership has both an individual and communal component. Private prop-erty ownership is encouraged but it is a human responsibility to make surethat all humans have their basic needs met.

� Humans are encouraged to cooperate with each other in production rela-tions, rather than to compete (i.e., as in capitalism).

� Economic development is a necessary human condition and must be under-taken in the spirit of social justice.

Throughout this volume, we will see much evidence that Islamic finance practi-tioners pay particular attention to these principles of Islamic economics in discourseand in practice.

ISLAMIC BANKING: ORIGINS IN PRACTICEWhereas the theory of Islamic economics was never actually enacted systematicallyin Mawdudi’s India, it was put into practice in the Arabian Gulf. The first success-ful Islamic bank—Dubai Islamic Bank—opened in Dubai, United Arab Emirates,in 1975.6 Until this time, Muslims had been carrying on their business activitiesin one of two ways: Either they used conventional banks or they just used other,private methods of financing outside of the capitalist banking system. Islamicfinancing was originally part of interpersonal business dealings and not meant tobe an institutional function (Udovitch 1970). But by the late twentieth century, ifMuslims wanted to participate in the world economy, they would have to engage insome way with the capitalist banking system. In particular, the Arabian Gulf of the1970s was undergoing tremendous and rapid changes as significant cash pouredinto the region from recently discovered oil (Ali 2002). Businessmen sought touse their newly acquired oil wealth to put into practice an idea that was theoreti-cally conceived to solidify Muslim identity. The formation of Islamic banking wasintroduced as a practical solution to this problem.

There were several political developments in the Arab world around the sametime that contributed to heightened sense of urgency about asserting pan-Islamism.In an article written on September 9, 2001 in the online version of Le Monde, IbrahimWarde, a researcher of Islamic finance and adjunct professor at Tufts’ FletcherSchool of Business, reminds us that in 1967 Arab losses in the Six Day War hadgiven birth to Nasser’s secular pan-Arabism as well as to Saudi Arabia’s Islamistdomination in the Arabian Gulf region.7 These political developments in additionto the inflow of cash into the Gulf provided the impetus for the establishment ofthe Organization of Islamic States (OIS) in 1970. Banking reform quickly made itsway onto the OIS agenda (Warde 2010).

Dubai Islamic Bank (DIB) was the first Islamic bank in the context of thecontemporary Islamic banking industry formation (Henry and Wilson 2004). Therehas always been considerable trade between Dubai and the Indian subcontinent,especially in the late twentieth century, when large numbers of Indians/Pakistanismigrated to the Gulf as guest workers. It is highly likely that ideas such as the theoryof Islamic economics accompanied the people and goods that have always beentraded between these places. In addition, Gulf Arabs also go to India or Pakistan foran education and must have been exposed to theories such as Mawdudi’s duringtheir stay. I consider it a natural extension of the theoretical origins of Islamic

INTRODUCTION 7

banking that its practice was taken up in the Gulf: Material prosperity enabled thetheory to be enacted. This origin story seems to be important to bankers in Dubai,at least, and at any rate DIB is one of the most active of the purely Islamic banks.

A CONTEMPORARY INDUSTRYTrade and finance have always been part of Islam’s history. The ProphetMohammed, the founder of Islam, was a business owner in the seventh century ofthe Christian era, as was his wife Khadijah. Nonetheless, there was no such thing asan Islamic bank until the late twentieth century. Classical Islamic jurisprudence hasalways been concerned with regulating trade and financial transactions betweenindividuals and has produced a large body of rules on the subject; however, thoserules did not give rise to an Islamic financial system until the 1970s. Udovitch(1970) points out that trade finance was always prevalent in Muslim societies,but that merchants would provide financing instead of financial institutions. Thisarrangement is similar to the function of merchant lending in Europe at the sametime (Udovitch 1970). For example, bancherius, or merchant institutions in Venicethat accepted deposits and made loans, were not specialized and were usuallypart of larger business operations, like cloth merchants. In the mid-twentieth cen-tury, a few individual Islamic banks were started in Egypt and Turkey, but theyeither failed on financial terms or were folded into the national banking systemand converted to conventional banks (Kuran 2004, 2001). A corporation foundedin Malaysia in 1963 eventually evolved into the Bank Islam Malaysia, incorporatedin 1983.

Contemporary Islamic banks were formed in the 1970s when considerableoil wealth became available in the Arabian Gulf States. Muslim populations inother parts of the world—notably Indonesia, Pakistan, and Malaysia—have sincegenerated sufficient steady income growth to develop a network of Islamic financialinstitutions that strive to integrate themselves into the global financial system.Growing Muslim populations in the United States and Great Britain have veryrecently begun to contribute to the Islamic financial network both institutionallyand intellectually.

MY HISTORY WITH ISLAMIC FINANCEMany people wonder how I got involved with Islamic finance. The story of howand why I got involved with the industry is a large part of the story of how Istudy the industry, so I will tell the story briefly. While studying for an MBA atWashington University in St. Louis, I learned about microfinance. I began to payattention to and explore how people who cannot or chose not to participate inthe conventional financial system get their businesses financed. I recognized thatthere may often be something else driving business practices other than the profitmotive, as we are traditionally taught in a capitalist economic system. Ideas aboutmorality play a role in business decisions more often than I had thought possibleand it was interesting to me to explore those ways of thinking, especially in theworld of finance.

After working for a time in commercial banking in Chicago, my family andI moved to Dubai, United Arab Emirates, where I worked in a private equity


firm that had some “Islamic” transactions on its books. I observed that the moneyflows in a Shari’a-compliant transaction looked the same, but that the philosophybehind the transactions expressed a concern with a holistic view of the businessrelationship rather than focusing on whether that particular transaction was goingto be profitable. This was interesting, of course, but life and work took over and Ifiled away this observation while I got on with living.

As fate would have it, my family was transferred back to Chicago for myhusband’s job as an asset manager. In addition to raising children and in lieu ofgetting a “real” job I entered into the PhD program at the University of Chicago.I did not intend to study business per se, so I applied and was admitted to aninterdisciplinary social science program called Psychology: Human Development,which was more closely aligned with my undergraduate degree in psychologythan a PhD in business would have been. A discussion in one of my classes led meto recall the Islamic (Shari’a-compliant) transactions I had worked with in Dubaiand prompted me to think about the implications of applying one’s moral values ina business setting, especially when those moral values did not always correspondto prevailing practices. Thus, my research idea—and my career—was formed. Iasked the question that began this chapter: The religion of Islam has existed for1400 years. Why did Islamic finance emerge in the world financial system in thelate twentieth century? To answer this question, I needed to talk to Islamic bankersin the place where it all began: Dubai, United Arab Emirates.

My family and I moved back to Dubai for a year so that I could do dissertationfieldwork. We had family and professional connections there and had lived andworked in Dubai, so the move was almost seamless for us. After almost a yearof ethnographic observations and in-depth interviews, and almost 20 years oftraveling to and/or living in the UAE while observing Islamic finance, I nowconceive of IBF as a particularized industry highly relevant to the plight of Muslimsin the context of contemporary globalization. The existence of this industry is apartial answer to the question: How can Muslims living in the diaspora integratetheir identities as Muslims with identities as global citizens? In a sense, the existenceof IBF is an answer to the question of what happens when Muslims—and Islam—travel and live around the globe.

CONVENTIONAL FINANCE VERSUS IBFIBF claims to be different from conventional finance but most of the financialtransactions look the same to most people who examine them. Islamic financeprofessionals often explain Islamic finance with reference to conventional finance,though there is a movement in the industry to progress beyond this practice. Whenasked to compare and contrast with conventional finance, most Islamic financeprofessionals I talk to concede that Islamic finance is just like conventional finance,but without the immorality. “Immorality” in this case is related to both businesspractices (specific and general) and to the details of financial transactions. Whenasked, most Islamic bankers will tell you that the most immoral financial practiceis charging interest on loans.

Because a large part of a conventional bank’s income “is in the form of intereston the claims it holds” (usually loans) (Moss 2004), Islamic finance seeks to retainthe useful features of conventional finance while adjusting practices to adhere to

INTRODUCTION 9

Islamic principles. IBF began as a response to the needs of investment bankers andcorporate finance professionals, although more recent activities have focused onretail banking, or personal finance. Chapters in this volume address both institu-tional and personal or retail financial activities.

Credit and Risk

Just as Jews and Christians found trade to be impossible without some kind offinancing situation, Muslims recognize the necessity of finance. As with conven-tional finance, Islamic finance falls under two types: equity financing and debtfinancing. Equity financing means, generally, that the financier and the managerof a business are partners. There are different ways to structure a partnership, butthe implication of an equity partnership is that each partner will receive a return(or profit) proportionate to the amount of the investment. Debt financing simplymeans that one party (the financier) provides money for a business venture. Thefinancier expects to make a profit on the investment whether or not the businessis successful. Islamic law allows most types of equity financing, but debt is prob-lematic. Lending can occur, technically, but it must be interest-free, a so-calledbenevolent loan. The industry of Islamic finance was formed to address the prohi-bition of interest-bearing debt finance. As we will see throughout this volume, thereare various ways to finance trade using debt instruments, but we must begin witha discussion of credit and risk, and why interest is prohibited under Islamic law.

Some standard definitions of credit are as follows (quotes from dictionary.com):

� Trustworthiness; credibility.� Confidence in a purchaser’s ability and intention to pay, displayed by

entrusting the buyer with goods or services without immediate payment.� Reputation of solvency and probity, entitling a person to be trusted in buying

or borrowing: Your credit is good.� Influence or authority resulting from the confidence of others or from one’s

reputation.� Time allowed for payment for goods or services obtained on trust:

90 days’ credit.� Repute: reputation; esteem.� A sum of money due to a person; anything valuable standing on the credit

side of an account: He has an outstanding credit of $50.

The definitions of credit listed above are seven of the ten definitions found ondictionary.com. The extension of credit can potentially lead to something calledusury. The Islamic finance industry is premised on one concept: avoidance of riba,which is often translated to English as usury. This translation is disputed, as wewill learn throughout this study, but IBF practitioners generally agree that theprohibition of something called riba is the basis for the industry. Usury is definedin today’s terminology as “an exorbitant amount or rate of interest” or at a ratehigher than the legal rate (dictionary.com); however, usury at one time referred toany increase over the amount of money lent.

The definition of credit, as we can see, encompasses concepts such as trustwor-thiness, repute, or confidence. These are not merely descriptions of a transaction,


but meanings embedded in the concept of credit that speak to how humans relateto one another. For this reason, participation in a credit transaction is a situation inwhich people make judgments about one another. Credit, and by extension usury,becomes a symbol or metaphor of certain aspects of the human existence. Creditspeaks to the temporal aspects of economic life. Credit provides a way to deal withthe future in the present.

Due to the symbolic nature of credit and risk, their definitions and views aboutthem are subject to human variations and interpretations. As such, there will becultural differences between interpretations of credit. For example, usury can beused as a way to work out uncertainty about definitions of the self versus the other,the sociocultural institution’s obligations for the well-being of individuals, and theextent to which divine morality is encoded in secular law. Credit, in the sense ofloaning money for a definite period of time and for a specific purpose, has beenseen as both necessary and somehow sinister.

Another crucial difference between bank credit and financial markets is theconcept of risk. Bank credit evolved as a way to mitigate risk. Future uncertaintyis embodied in the calculation of interest and part of the function of interest is toreimburse the lender for potential future losses and for the lost opportunity to usethat money in the present. Risk in this case is a negative concept, one that must beeliminated as much as possible from the equation. On the contrary, risk has a verydifferent meaning in financial markets. Investment risk is a positive concept, onewithout which financial markets would not even exist (cf. Knorr-Cetina and Preda2005). In this case, risk means the opportunity for gain. The Islamic finance industrywas created to address matters of bank and investment credit for institutional andlarge investors, not the credit needs of small investors. Credit is the crucial wayby which investments and trade are facilitated. The prohibition of usury createsa special circumstance for the Muslim investor that distances him or her frominternational financial markets. As a result, matters of risk management are salienttopics in the discourse of Islamic finance professionals (see in particular Chapter 7of this volume).

General Business Ethics

In addition to specific prohibitions and requirements of an Islamic bank and itsfinancial transactions (see Chapter 3 of this volume), an Islamic financial institutionencourages adherence to general Islamic behavioral ethics. Lewis and Algaoud(2001) consider this increased attention to business ethics to be an importantpart of the corporate culture of an Islamic financial institution. They state that,ideally:

[T]he corporate culture of an Islamic bank should be one in which Islamic valuesare reflected in all facets of behaviour ranging from internal relations, dealings withcustomers and other banks, policies and procedures, business practices through todress, decor, image, and so on, consistent with Islam as a complete way of life. Thepurpose is to create a collective morality and spirituality which, when combinedwith the production of goods and services, sustains the growth and advancementof the Islamic way of life. (Lewis and Algaoud 2001, p. 165)

INTRODUCTION 11

IFIs do take seriously the commitment to providing an Islamic environment,and this commitment is illustrated both in the literature and in my observations.For example, in a chapter of the book entitled The Politics of Islamic Finance (Henryand Wilson 2004), Kristen Smith of Harvard’s Kennedy School of Governmentillustrates how Kuwait Finance House (KFH) takes public steps to foster a reli-gious environment by organizing communal prayer in the office, showing a hiringpreference for men who have demonstrated their devotion to Islam and by con-ducting non-banking business in a recognizably “Islamic” manner (Smith 2004).Islamic practices include providing a prayer room and encouraging prayer breaks,striving to maintain ethical business practices, structuring financial transactionsto conform to Islamic law, maintaining gender segregation, and any other activitythat falls under the jurisdiction of Islamic law. In practice, IFIs primarily strive toadhere to financial regulations, though some organizations take into considerationother aspects of human resources practices (see Martin and Hunt-Ahmed 2011 andChapter 13 of this volume).

AN OVERVIEW OF THE BOOK CONTENTSThe idea for this book was developed after I had been teaching Islamic financefor a few years to overflowing classes of students at DePaul University’s DriehausSchool of Business in Chicago, Illinois. There are few Islamic finance classes taughtin business schools in the United States and I found that young business studentswere eager to learn about this growing industry because they had heard so muchabout it in the media. My students were Muslim and non-Muslim, and all held adeep interest in international business. Most realized that if they wanted to be apart of the global financial industry, they would need to understand the basic ideasof Islamic finance, as they were likely to encounter these concepts as a matter ofcourse in international business.

Most of the books I used for teaching purposes provided excellent introduc-tory, legal, or technical material on Islamic finance, but the idea for the presentvolume was conceived when I realized there was room in the literature for abook that advanced the industry beyond descriptive terms and onto a broader,more academic discussion of some of the innovations and applications of earlierresearch and practical developments based on daily practices. It is my hope thatthis book will appeal to those new to the industry and also to practitioners andresearchers already familiar with the industry. For this reason, I have divided thebook into two primary parts: Part I, “The Contemporary Islamic Finance Land-scape,” addresses the most current thinking about Islamic economic theory andIslamic legal thought, then moves on to a series of chapters that present a new levelof thinking about a wide variety of topics in the industry. While the topics may befamiliar to the reader, these chapters represent the latest thoughts on the subject.All chapters are written by innovative academics and innovative practitioners whoare on the ground and see what works and what does not work in the industryenvironment today.

Most chapters in this volume presume that readers have a rudimentary under-standing of the basic principles of Islamic finance, but will be accessible to readersnew to the industry as well. For this reason, I have foregone the inclusion of chap-ters specifically dedicated to describing the technical aspects of basic structures.


Individual chapters include descriptions as necessary. For readers who want tolearn more about Shari’a-compliant financial structures in detail, there are manyexcellent books containing this information. I particularly recommend Ayub’sUnderstanding Islamic Finance, Kettell’s Islamic Finance in a Nutshell: A Guide forNon-Specialists, or Iqbal and Mirakhor’s An Introduction to Islamic Finance Theoryand Practice.

Novice readers may want to pay particular attention to Chapters 2 and 3 ofthis volume and may use these chapters as an abbreviated introductory text. InChapter 2, “Contemporary Islamic Economic Thought,” Farooq traces the history ofIslamic economic thought from pre-modern times though the present, highlightingthemes and concerns of the discipline and its relationship to both conventional (i.e.,neoclassical) economic thought and what we now know as Islamic finance. Farooqadvances scholarship in this area by comparing current formulations of Islamiceconomic thought and urging us to move beyond reliance on the neoclassicaleconomics paradigm by developing a more theoretically and empirically rich bodyof work on Islamic economics.

In Chapter 3, “The Legal Framework of Islamic Finance,” Shawamreh providesthe reader with a basic introduction to the principles of Islamic legal thought. Thisframework is based in a system originating in the seventh century and refinedthrough a precise juristic process in the intervening centuries. Shawamreh’s con-tribution to the literature is the recognition that Islamic finance operates withina legal framework that developed concurrently—sometimes parallel with, some-times separately from—an Islamic legal system. An often difficult task for practi-tioners new to Islamic finance is making the connection between centuries-old legalopinions and contemporary international regulatory environments. In this chapter,Shawamreh discusses some particular challenges associated with constructing andenforcing Shari’a-compliant financial transactions within a dual legal framework.This chapter is a particularly timely primer of Islamic legal thought and its result-ing financial structures, followed by a discussion that makes the evolution of legalthought relevant to today’s applications.

The cultural origin of Islamic finance is often overlooked in more practicaltreatises on the subject. Yet those new to Islamic finance often ask, “The financialstructures look the same as conventional finance. If that is the case, why do we needthis industry anyway?” Chapter 4, “Globalization and Islamic Finance,” providesa social scientific explanation for the question of why we need this industry. I reachbeyond a discussion of whether the financial structures are the same or differentto explore motivations of individual practitioners and how they think about theirparticipation in the industry.

Waleed El-Ansary, in Chapter 5’s “Islamic Science and the Critique of Neoclas-sical Economic Theory,” moves scholarship beyond a neoclassical interpretationof Islamic economics, just as Farooq has suggested that scholars approach thesubject. El-Ansary dives into this critique by connecting the analytical tools ofeconomic theory and the sciences of nature. In this groundbreaking work, theauthor connects the spiritual roots of Islamic thought with its economic princi-ples in a new way. He contends that the debate between Islamic and neoclassicaleconomics ultimately depends on the all-important debate over the hierarchy oflevels of reality and the secular philosophy of science. He critiques the overly scien-tific analytical tools currently used to evaluate the theoretical claims of Islamic and

INTRODUCTION 13

neoclassical economics and urges greater synthesis of the spiritual and scientificwhen addressing such questions.

No serious industry or academic discipline is without controversy. In Chap-ter 6, “Juristic Disagreement,” Shoiab Ghias provides evidence for the seriousnessof the Islamic finance industry in the form of a controversy over the permissibilityof the existence of the industry itself. In virtually all of the prevailing industry liter-ature, two chief principles motivate thinking on the subject: first, that riba (interest)is banned under Islamic law and second, that Islamic banking is the inevitable prac-tical expression of this ban. Ghias finds that in 2008, a panel of Pakistani Shari’ascholars issued a fatwa (legal opinion) stating that Islamic banking is unacceptableunder Islamic law. For this volume, Ghias has translated this fatwa, provides adiscussion of its authority, presents arguments for its validity, and presents us witha resolution of the matter. Because this volume is meant to address contemporaryissues in Islamic finance, the editor finds this chapter a particularly important toolto stimulate discussions within the industry.

Innovations

Chapter 7, “Managing Liquidity Risk in Islamic Finance,” written by MuhammadAl-Bashir Muhammad Al-Amine, and Chapter 8, “Elements of Islamic WealthManagement,” written by Paul Wouters, are exceptionally relevant and timelytopics for inclusion in any finance volume during and after the 2007 worldwideeconomic crisis. For this reason, this volume devotes considerable attention to thetheory and application of products in these categories. Chapters 7 and 8 presentthe reader with a general discussion of each topic, with special emphasis on prod-ucts that connect the investor to international capital markets and allow individualand institutional investors to manage wealth and the risk inherent in wealth man-agement. Chapters 9 through 12 discuss contemporary formulations of specificproducts used in these endeavors.

Michael McMillen, the author of Chapter 9, “Sukuk and the Islamic CapitalMarkets,” is an internationally respected attorney and pioneer in the developmentof sukuk structures. Sukuk are relatively new products in international financeand are designed to bridge Islamic and conventional capital markets as a riskmanagement tool. He explains the connection in Chapter 9:

Islamic capital markets will emerge from the current financial downturn as a centralfeature of the Islamic finance and investment industry and will increasingly beintegrated with the larger conventional capital markets. Sukuk will likely be thevehicle of choice in achieving that integration.

Chapters 10 and 11 focus on Shari’a-compliant mutual funds and the indicesthat measure their returns. Monem Salam (Chapter 10, “Shari’a-Compliant MutualFunds”) has managed one of the most successful mutual funds of all time; thatthis fund is Shari’a-compliant is a boon to the industry and a particular bonusfor mutual fund investors looking to invest their money according to Islamicprinciples. This success appears to be a feature of Shari’a-compliant funds, as TariqAl-Rifai discusses in Chapter 11, “The Evolution of Shari’ah-Compliant Indexesand Why They Outperform Conventional Indexes over the Long Term.” Al-Rifai


has been an industry leader in evaluating Shari’a-compliant financial productssince the 1990s and has extensive knowledge of the field. He is optimistic in hisoutlook for the industry, an opinion based on solid evidence and its track record.

A relatively new product on the scene is takaful, or Shari’a-compliant insur-ance. Insurance is both a risk management tool and a wealth management prod-uct, as it can be structured as an investment. Insurance was originally a con-troversial topic in Islamic finance, as Farrukh Siddiqui explains in Chapter 12,“Takaful.” Siddiqui traces the history and evolution of opinions on this issue andilluminates contemporary structures and fatawa supporting the creation and sus-tainability of takaful as a viable and necessary part of a functioning internationalfinancial industry.

Chapters 13 through 15 complete the section on innovations by discussingrelatively unexplored topics. Because the industry is so new, it has taken timeto develop scholarship on the arguably less glamorous (than international finan-cial structures) but crucial inner workings of an industry. In Chapter 13, “IslamicHuman Resources Practices,” William Martin examines the relatively unexploredtopic of human resource management. He reviews the purpose of attending toissues of human development in the workplace and reminds us that Islam putsgreat emphasis on this very issue. A truly Islamic financial institution must payattention to the needs of its employees including, but not limited to, providingShari’a-compliant methods of compensating employees for their work.

Chapters 14 and 15 address the uncomfortable yet vital topic of poverty alle-viation. If Islamic finance intends to stay true to its stated principles of attendingto social justice concerns, it must not ignore the parts of society that are not able toparticipate in big-money financial transactions. In fact, the competitive advantageof Islamic finance is that it is self-reflective about its role in the whole economy,not just international financial institutions. In Chapter 14 “An Integrated IslamicPoverty Alleviation Model,” Kabir Hassan and his student Ali Ashraf present amodel for poverty alleviation that utilizes the institutions of Zakat and Awqaf—also, not coincidentally, wealth management tools—to achieve its purposes. SaburMollah and Hamid Uddin, in Chapter 15, “How Does an Islamic MicrofinanceModel Play the Key Role in Poverty Alleviation?” further this discussion with amore focused look at how Islamic microfinance can work and is working towardthis goal in Europe.

Applications and Best Practices

Part II, “Case Studies,” the last part of this volume, moves away from theoryto present the reader with examples of how products and structures are imple-mented in real life. Chapters 16 through 23 show us how international marketingand financial structures are implemented in a globalized world. Offshore bankingstructures are a major part of globalization and make the international focus ofIslamic finance a reality. Mutual funds are active all over the world and we seehow mutual funds in Saudi Arabia perform, as well as how the realities of ratingsservices function worldwide. Because this is such a global industry, it is easy toforget that the United States is a relatively new market for Islamic finance, and weexplore its opportunities and challenges as a case study. We revisit the challengesof risk management by discussing individual situations in more detail. Finally, we

INTRODUCTION 15

conclude our section on best practices by comparing efforts to institute Islamicmicrofinance in various parts of the world.

A FINAL NOTEThe global nature of this industry necessitates a final word about translationsand spellings. The editor chose authors based on their proven innovative think-ing and practical experience; therefore, the authors come from many disciplinarybackgrounds, industries, and writing styles. We have chosen to leave intact eachauthor’s spellings and translations of non-English terminologies. We believe thesedifferences reflect the true nature of the industry, which is to provide a centralinstitutional structure in which many different opinions can flourish and prosper.It is the editor’s hope that readers will appreciate our efforts to provide a diversityof opinion and a format for ongoing discussions of advancements in the industryof Islamic finance.

NOTES1. I will shorten the reference to ‘IBF’ throughout this Introduction.2. A “conventional” bank is the industry term that refers to existing international, interest-

based banks.3. www.zawya.com/story/ZAWYA20110505062447/Global_Islamic_Finance_Report_2011_

Released/; accessed 5/21/12.4. www.ft.com/intl/cms/s/0/09a99422–7291–11e1–9be9–00144feab49a.html#axzz1yS3

ndpCe; accessed 6/21/12.5. La ilaha illallah, Mohammed ur-Rasulallah (there is only one God and Mohammed is his

prophet). This is also called the Shahadah.6. The Islamic Development Bank was begun in Saudi Arabia in 1975 as well.7. http://mondediplo.com/2001/09/09islamicbanking; accessed 6/21/12.

REFERENCESAli, Ahmad Mohamed. 2002. “The Emerging Islamic Financial Architecture: The Way

Ahead.” Paper presented at the Fifth Harvard University Forum on Islamic Finance,April 6–7.

Askari, H., Z. Iqbal, and A. Mirakhor. 2010. Globalization and Islamic Finance: Convergence,Prospects & Challenges. Hoboken, NJ: John Wiley & Sons.

Bahrain Monetary Agency. 2002. Islamic Banking & Finance in the Kingdom of Bahrain. Bahrain:Arabian Printing Press.

Chapra, Muhammad Umar. 1976. “Objectives of the Islamic Economic Order.” In KhurshidAhmad, ed. Islam: Its Meaning and Message. London: Islamic Council of Europe.

De Roover, Raymond. 1974. “New Interpretations of the History of Banking.” In JuliusKirshner, ed. Business, Banking and Economic Thought in Late Medieval and Early ModernEurope: Selected Studies of Raymond de Roover, 200–238. Chicago: The University of ChicagoPress.

Henry, Clement M., and Rodney Wilson. 2004. “Introduction.” In Clement M. Henry andRodney Wilson, eds. The Politics of Islamic Finance. Edinburgh: Edinburgh UniversityPress.

Knorr-Cetina, Karin, and Alex Preda, eds. 2005. The Sociology of Financial Markets. Oxford:Oxford University Press.

http://www.zawya.com/story/ZAWYA20110505062447/Global_Islamic_Finance_Report_2011_Released/

http://www.ft.com/intl/cms/s/0/09a99422%E2%80%937291%E2%80%9311e1%E2%80%939be9%E2%80%9300144feab49a.html#axzz1yS3ndpCe

http://mondediplo.com/2001/09/09islamicbanking

http://www.zawya.com/story/ZAWYA20110505062447/Global_Islamic_Finance_Report_2011_Released/

http://www.ft.com/intl/cms/s/0/09a99422%E2%80%937291%E2%80%9311e1%E2%80%939be9%E2%80%9300144feab49a.html#axzz1yS3ndpCe


Kuran, Timur. 2004. Islam & Mammon: The Economic Predicaments of Islamism. Princeton:Princeton University Press.

Lewis, Mervyn K., and Latifa M. Algaoud. 2001. Islamic Banking. Cheltenham, UK: EdwardElgar.

Martin, W. M., and Karen Hunt-Ahmed. 2011. “Executive Compensation: The Role of Shari’aCompliance,” International Journal of Islamic and Middle Eastern Finance and Management,4:3, 196–210.

Mawdudi, Sayyid Abul A’la. 1988. Towards Understanding the Qur’an, Vol. I. Chichester,United Kingdom: The Islamic Foundation.

Mawdudi, Abu’l A’la. 1980. Towards Understanding Islam. United Kingdom: The IslamicFoundation.

Mawdudi, Abu’l A’la. 1974. Islam: An Historical Perspective. United Kingdom: The IslamicFoundation.

Mazzarella, William. 2004. Shoveling Smoke: Advertising and Globalization in ContemporaryIndia. Durham, NC: Duke University Press.

Moss, Rita. 2004. Strauss’s Handbook of Business Information: A Guide for Librarians, Students,and Researchers. 2nd edition. Westport, CT: Libraries Unlimited.

Siddiqui, Muhammad Nejatullah. 1981. “Muslim Economic Thinking: A Survey of Con-temporary Literature,” In Khurshid Ahmad, ed. Studies in Islamic Economics. Chichester,United Kingdom: International Centre for Research in Islamic Economics.

Smith, Kristin. 2004. “The Kuwait Finance House and the Islamization of Public Life inKuwait.” In Clement M. Henry and Rodney Wilson, eds. The Politics of Islamic Finance.Edinburgh: Edinburgh University Press.

Udovitch, Abraham L. 1970. Partnership and Profit in Medieval Islam. Princeton: PrincetonUniversity Press.

Warde, I. 2010. Islamic Finance in the Global Economy. 2nd edition. Edinburgh: EdinburghUniversity Press.

Weber, Max. 1930. The Protestant Ethic and the Spirit of Capitalism. London: Routledge.Zarqa, Anas. 1981. “Islamic Economics: An Approach to Human Welfare.” In Studies in

Islamic Economics, ed. Khurshid Ahmad. Chichester, United Kingdom: International Cen-tre for Research in Islamic Economics.

Contents

Foreword xiii

Preface xv

Acknowledgments xvii

Part I Strategy: An Islamic Perspective 1

1 Introduction 3

Leading an Organization Is Like Driving a Car 4

Critical Thinking 5

The Problem with Conventional Management 6

The Problem with Conventional Strategic Management 7

The Value of Strategic Management from an Islamic Perspective 9

References 11

Notes 12

2 Conventional Strategic Management 13

Introduction 13

The Importance of Competitive Advantage 13

Competitive Advantage: A Means or an End? 15

The Importance of Stakeholders 16

The Strategic Management Process 17

Strategic Management in Developing Countries 19

Why Do Most Strategies Fail? 20

First Observation: Causal Ambiguity 24


Second Observation: Strategic Thinking 24

Third Observation: Profi tability versus Risk 27

Summary 28

References 28

Notes 30

3 Four Fundamental Problems 31

Introduction 31

FP 1: The Use of Interest-Based Loans 31

FP 2: Developing Sustainable Organizations 35

FP 3: Overcoming Defensive Routines 43

FP 4: Overcoming Confl icts of Interest 45

Discussion 49

Summary 51

References 52

Notes 54

4 Organizational Justice 55

Introduction 55

Elements in Organizational Justice 56

Hammer and Champy 60

W. Edwards Deming 62

Eli Goldratt 64

Discussion 66

Summary 70

References 70

Notes 72

5 Islam Transforms People and Leaders 73

Introduction 73

The Individual as the Unit of Analysis 74

Belief in Islam Appeals to the Intellect 80


Islam in the Context of an Organization 82

Islam in the Context of Multicultural Societies 83

The Importance of Prayer 90

The PIES Model 91

The Driving Analogy 91

Summary 92

References 92

Notes 94

6 The Challenge of Culture 95

Introduction 95

The Link between Culture and Strategy 96

Lessons from Research at the International Islamic University Malaysia 97

The Role of Top Management 101

Summary 106

References 107

Note 108

7 The Role of Islamic Law 109

Introduction 109

Why Do We Need Islamic Law? 109

Principles of Islamic Law 111

The Importance of Intention and Knowledge 113

Islamic Law for Top Management 114

Islamic Law for Middle Management 115

Islamic Law for Subordinates 116

Shariah and Fiqh 117

The Need for Further Research 118

Summary 119

References 119

Notes 120


8 Strategic Decision Making 121

Introduction 121

A Broader View of Strategy 124

Strategy as Problem Solving 125

Errors in Strategic Decision Making 126

Defi ning the Strategic Problem 127

Understanding the Strategic Problem 128

Experimenting 131

Strategic Decision Making 132

Evaluating the Strategic Process 134

Summary 135

References 137

Notes 139

9 Analyzing a Case 141

The Purpose of Analyzing a Case 141

Choosing the Story 148

Part II Case Studies 151

Cases in This Textbook 151

Note 154

10 Case 1: IBM and Lou Gerstner 155

Introduction 155

The Beginning 155

The Writing on the Wall 156

Finding a New CEO 157

The First Days at IBM 157

The Corporate Culture Problem 159

Do We Need a Strategic Vision? 160

Getting the Execution Right 161


The Essence of Leadership 161

Reviving the Brand 162

Compensation 162

Making the Company Grow Again 163

References 164

11 Case 2: Al Rajhi Bank 165

The Job Offer 165

Al Rajhi’s Background 166

Bilal’s Conclusions 172

12 Case 3: Bank Muamalat 173

Zabeda’s Report 173

The Beginning of Bank Muamalat 173

Top Management Structure 174

The Financial Performance 175

Putting IT to Work 176

The Competitive Environment 177

Zabeda’s Supervisor’s Comments 179

References 180

13 Case 4: Bank Rakyat 181

The Strategic Challenge 181

The Cooperative Movement 181

Bank Rakyat 182

Marketing at Bank Rakyat 183

Putting IT to Work 184

Future Plans 185

References 185

Note 186

14 Case 5: MUSLEH (Part 1) 187

The Dilemma 187

MUSLEH 187


The Founding of MUSLEH 188

The Personality of Ustaz Amin 189

The Classical Strategic Management Framework 189

Connections with Other Professionals 191

Setting a New Direction for the Group 192

Note 192

15 Case 6: MUSLEH (Part 2) 193

Introduction 193

Changes in the Middle East 193

Dr. Tareq Al Suwaidan 194

Dr. Amr Khaled 196

The Debate 196

A Trip to Kuwait City 197

What to Do Next? 198

16 Case 7: Fuji Xerox 201

The Phone Call 201

An Overview of Fuji Xerox 202

Fuji’s Emphasis on CSR and Sustainability 202

Fuji’s Marketing Initiatives 205

A SWOT Analysis of Fuji Strategy 206

An Analysis of Fuji’s Financial Results 207

Conclusion 208

17 Case 8: McDonald’s Pakistan 209

The Dilemma 209

The Company Profi le 210

Raza Ali 211

Rashid Ibrahim 211

McCafé 212

McDonald’s Target Market 213

The Main Competitor: Gloria Jean’s Coffees 213

Back to the Dilemma 214


18 Case 9: Unilever Bangladesh 215

The Appointment 215

Bangladesh 215

Industry Factors 216

Industry Players 217

The Organization’s Structure 220

Financial Management 221

Marketing Management 221

UBL Products 222

Brand Promotion 222

Pricing 223

Operations Management 223

Human Resources Management 223

Conculsion 224

Notes 224

Appendix: A Primer on Evolution 225


About the Contributors 233

Index 235

Buy This Book



CHAPTER

1

Introduction

For more than 20 years now, experts in management at the International Islamic UniversityMalaysia (IIUM) have been working on management from an Islamic perspective (MIP).Recent books in the area of MIP include Ahmad, Islam, and Ismail (2011), Ahmad andFontaine (2011), and Osman-Gani and Sarif (2011). Over the years, some researchers havespecialized in some of the subbranches of Islamic management. Some have developed aninterest in organizational behavior, others in business ethics, and yet others in strategicmanagement. The focus of this textbook1 is on strategic management from an Islamicperspective. The mention of “strategic management from an Islamic perspective” raisesthree questions:

1. What is the Islamic perspective on strategic management?2. Does strategic management from an Islamic perspective add anything new to strategic

management?3. Do organizations today apply strategic management from an Islamic perspective?

Part I will deal with the first two questions. Part II will address the last question byproviding examples of organizations applying the principles of strategic management from anIslamic perspective.

Leading an Organization Is LikeDriving a Car

In different parts of this text, we will use the analogy that leading an organization is like drivinga car. The driver (leader of the organization) needs to decide where to go (vision), how to getthere (strategy), and at what speed to drive (risk and profitability). To achieve his or her goal,the driver needs to avoid hitting other cars (competitors) while obeying the rules of the road(government regulations). The driver (leader) has a number of passengers in the car(stakeholders).

In conventional strategic management, the measure of success is speed (profitability).Passengers (stakeholders) may not have a comfortable ride and some of them might bepushed out of the vehicle in order to arrive at the destination faster.

In strategic management from an Islamic perspective, the measure of success isstriving for justice (organizational justice will be defined later). Generally, this is done bydriving safely (reduced risk) although a reasonable speed (profitability) is necessary toarrive at the final destination within a reasonable time frame. The driver (leader) has amoral duty to ensure the rights of all passengers (stakeholders). At the same time, thepassengers have a moral duty to speak to the driver to help him drive the vehicle safely.This is because they have different views of the situation that may be important to thesafety of all. Everybody agrees that none of the stakeholders ought to be sacrificed for thesake of arriving at the destination more quickly.

We realize that this analogy is far from perfect. Later, we will modify it slightly by arguingthat rather than driving one car, it is more like leading a convoy of buses (after all, manyorganizations have thousands of employees). If an organization has 5,000 employees and weassume that there are about 50 people in one bus, the leader has to coordinate the movementof about 100 buses. Nonetheless, we hope that this analogy gets two basic messages across:

1. The protection of the rights of all stakeholders is a shared moral duty. Although rules andregulations are important, a collective feeling of accountability toward God is necessary togive the passengers the courage to speak up (this statement will become clearer as thebook progresses).

2. The Islamic perspective on strategic management is visionary and more than simply a“moral version” of strategic management. A key theme is that conventional strategiesfail because many drivers take ridiculous risks. However, the short-term rewards oftaking ridiculous risks are such that many leaders are encouraged to feel that they are“better than the rest”—until the organization goes bankrupt. The need toachieve organizational goals while reducing risk is something we hope to explore insome detail.

4 / STRATEGIC MANAGEMENT FROM AN ISLAMIC PERSPECTIVE

Critical ThinkingTo be successful in business today, one must possess critical thinking skills. Critical thinkingrefers to the art and science of evaluating claims, statements, and evidences. Critical thinkingoften requires people to think carefully about assumptions that are being made. In the contextof this work, we would argue that critical thinkers need to think very carefully about existingparadigms and where we find them. In our literature review, we will discuss the fact that thestrategy literature is confusing because of the overlap between strategy and planning. Fur-thermore, some of the best ideas related to strategy are not necessarily found in the field ofstrategic management but rather are found in other academic fields. In regard to readingstrategic management textbooks, there can be two approaches.

The first approach is to assume that the existing theories found in the majority of strategicmanagement textbooks are correct. After all, if these theories are in a textbook, they must betrue. In that case, any new strategic management textbook that is different from the majority issuspect and cannot be trusted.

The second approach to assume that the existing theories found in the majority of stra-tegic management textbooks need improvement. New research is needed to improveon existing theories. In that case, new textbooks that are different from the majorityshould be welcomed because they introduce new ideas. Mackenzie and Afzalur Rahim (2003,p. 315) explain,

Strong inference is basically a simple idea. Look for an empirical counter-exampleto a theory, accept the conclusion that a theory will always need improving andmake the improvement. Strong inference is based on the robust conclusion thateventually all theories are proven wrong or in need of a restatement. It makes moresense on working on improving the theory than in trying to justify it. The best wayto improve a theory is to find out where it breaks down. That flaw will then lead toa revised version of the theory.

We have written this textbook with this second approach in mind. As authors, we tend tolook for the counterexamples that contradict existing theories of strategic management. Wehave started with a premise that might be controversial for some readers, namely that there isenough practical wisdom in the Islamic tradition that allows us to propose some new ideasabout strategic management.

At the same time, we do not intend to simply repeat what other Muslim scholars ofstrategic management have talked about. In fact, in writing this text, we have ended up quotingonly a few Muslim scholars. We have done this to make the text easy to read and to provide aseamless flow in the ideas.2 We believe that our approach is consistent with the Qur’anicinjuction to think deeply and to continuously improve. Badi and Tajdin (2005) note that theQur’an uses the following words extensively:

CHAPTER 1: Introduction / 5

• Tafakkur (the process of reflecting)• Nazar (to consider)• Tabassur (to gain insight)• Tadabbur (to ponder)• Tafaqquah (to fully understand)• Tadhakkur (to take heart—when you think about verses of the Qur’an that apply to you)• I’tibar (to learn from the experience of others)• Ta’aqqul (to use one’s mind in the right way)• Tawassum (to reflect)

This textbook reflects our collective effort, which seems to encompass all of theseconcepts.

The Problem with ConventionalManagement

Economist Paul Ormerod recently observed that more than 10 percent of all companies inthe United States disappear each year (Ormerod, 2007). He argues that many businessleaders think that they are able to control events but, in reality, they are far less in controlthan they think. Successful organizations are those that plan, but at the same time they areflexible enough to alter their plans when things do not turn out as they had planned. Otherexperts have, on the whole, confirmed that things rarely go according to plan. Bohn (2000)found that many organizations are in a constant state of “fire-fighting” as employees come upwith ineffective solutions to customers’ problems. Nutt (2004) found that managers inorganizations have a 50 percent success rate when it comes to making decisions, which isequivalent to flipping a coin. Beer and Nohria (2000) report that 70 percent of changeinitiatives in organizations fail. Deming (1994) reports that 95 percent of changes madeby management make no improvement. Starkey, Tempest, and McKinlay (2004) show that62 percent of businesses in the United States do not survive after five years; 80 percent donot survive 10 years; and 90 percent do not make it beyond 20 years. Haswell and Holmes(1989) observe that studies show different failure rates for different industries. To makethings worse, different experts have different ways of defining failure, but everybody agreesthat the failure rate is generally high. Observers point out that failure not only affects smallcompanies with limited resources, but it also affects large companies with almost unlimitedresources. Those companies that do survive often show poor results before their failure.Coveney, Ganster, Hartlen, and King (2003, p. 20) write, “More than 25% of the top 100U.S. companies that survived in 2001 lost at least 66% of their market capitlisation.” In short,organizational failure is the norm, and organizational success is the exception.


Many writers on management choose to overlook these facts. We have decided to writeour book about these facts because our basic argument is that the traditional approach tomanagement does not work very well and a new approach is needed.

The Problem with Conventional StrategicManagement

Like conventional management, conventional strategic management too has a number ofproblems. Let us first describe the symptoms and then discuss the four major causes. Considerthe following statistics. Mintzberg, Ahlstrand, and Lampel write that only 10 percent ofstrategies are implemented.3 In other words:

Success rate: 10 percentFailure rate: 90 percent

Clearly, something is wrong with the current approach to strategic management. Scholarsof conventional strategic management have discussed (and are continuing to discuss) why thisfailure rate is so high and what can be done to bring it down. Please do not misunderstand us:Scholars of strategic management know these facts very well and they are working hard toaddress them. These facts are generally not shared with students who take strategic man-agement courses. We believe they should know these facts and ponder on their logicalimplications.

The ideas of strategic management scholars will be discussed in Chapter 2 in some detail.One of the perennial problems is the definition of strategy. The word itself is ambiguous(Mintzberg, Ahlstrand, and Lampel, 2005) and there are many definitions available in thestrategic management literature. In many ways, this was our biggest dilemma. Rather thandefine the concept in the first chapter, we will simply define strategy as “decisions that areimportant for the future of an organization.”We will define the term more formally in Chapter8. In any case, many of the ideas of strategic management scholars are insightful, and we willrefer to them from time to time. However, we believe that these scholars are nonethelesstrapped in a cultural mind-set. We believe that there are four fundamental problems withconventional strategic management. We will call them FPs, or fundamental problems. Theseproblems are as follows,

• FP 1 is related to the use of interest-based loans to finance firms. As we will discuss inChapter 3, interest-based loans assume that it is possible to accurately assess the risk of abusiness transaction before the transaction takes place. As we will see, this is not possible.In practice, most people take on too much risk and most companies go bankrupt simplybecause they cannot repay their bank loans. Islam offers an alternative method of financing


where the risks and rewards are shared after the business transaction is complete, therebyreducing the risk of default.

• FP 2 is related to the problem of developing strategies that allow an organization to besustainable over the long term. This requires the ability to manage the increasing com-plexity of modern organizations. As organizations become more and more complex,strategic management becomes more and more complex as well and the risk of failureincreases. One way to reduce the risk associated with complexity is to develop a corporateculture based on cooperation rather than competition. Cooperation does not mean that astrategy will allow the organization to be sustainable but without cooperation, sustain-ability is virtually impossible.

• FP 3 applies to the behavior of individuals within the organization. Most individualsengage in what Argyris (1992, 2001) called “defense routines.” Rather than confrontingthe reality of a problem, people lie in order to avoid embarrassment. When the culture ofthe organization supports these defensive routines, there are numerous problems thataffect the processes of strategic formulation and strategic implementation.

• FP 4 deals with the conflict between the interests of the individual versus the interests ofthe whole organization. This is known as the agency problem. In short, individuals withpower have a choice. They can do what is good for them but bad for the organization asa whole. They can do what is good for the organization as a whole but they might—personally—suffer. Often, the organization’s controlling system and reward systemencourage individuals to be selfish.

As we will try to demonstrate, all of these four fundamental problems increase the risk ofdefault during periods of economic slowdown. One of these problems alone is already aformidable challenge. The combination of these four problems can be deadly.

Scholars interested in strategic management from an Islamic perspective recognize thatthese four problems are fundamental to explaining the high failure rate in conventionalmanagement. Many scholars of Islamic management believe that the Islamic tradition haspractical solutions to offer for at least three of these fundamental problems (FP 1, FP 3, andFP 4). Readers are encouraged to remember the analogy that running a business is like drivinga car. The fundamental problems highlighted here are linked to the same core problem:whether one is driving quickly (conventional strategic management) or whether one is drivingsafely (strategic management from an Islamic perspective).

We believe that this text will be of interest to two different kinds of readers:

1. Muslims who are interested in strategic management from an Islamic perspective becausethey wish to apply Islamic principles in every aspect of their lives. The reduction in riskand the rate of default is a happy side effect. However, the main desire is to please Godalone and this should be the sole motivation of Muslim business leaders.

2. Non-Muslims who are looking for an alternative style of management. The ideas found instrategic management from an Islamic perspective might thus be incorporated into a moreuniversal style of management where reducing risk and protecting the rights of stake-holders take precedence over simply making more profits.


In the Qur’an, there are two chapters that we shall analyze in some detail (see Table 1.1).As we will show with the case studies, if top management understands and applies Islamic

principles in business, they can implement the policies to create a cooperative and effectiveworking environment (e.g., Fontaine, 2011).

The Value of Strategic Management froman Islamic Perspective

Hopefully, the value of strategic management from an Islamic perspective should already beobvious. Let us consider the perspective of the society as a whole. A 90 percent failure ratemeans unemployment and loss of wealth for the society as a whole. By implementing Islamicprinciples, let us imagine that the success rate jumps from 10 percent to 30 percent. Thatmeans greater employment opportunities and wealth creation for the society.

To continue with the driving analogy, a society in which the majority of drivers are tryingto reach their destination safely is a society where public safety will be maximized. On thecontrary, a society where everybody drives quickly is a society where public safety will becompromised.

The challenge in the next few chapters is to offer something more concrete in terms ofstrategic management from an Islamic perspective. We make the assumption that religioussymbols are not important per se. For example, if employees come to work wearing religioussymbols, those symbols will have no bearing on the overall effectiveness of the organization.However, behavior that is consistent with Islamic values and principles are important.

TABLE 1.1 The Qur’anic Perspective Related to Strategic Management

The Problem The Solution

Surah Al Takathur (Qur’an, 102) Al Asr (Qur’an, 103)

Description People are competing with one another toget to their destination quickly. Theyhide embarrassing information from theboss and they play political gamesinside the organization. Their focus ison this life.

Sucessful people cooperate with oneanother because they are all in thesame car. To arrive safely at theirdestination, they need to say the truth(even to their bosses) and they need tobe patient (even when they do not getthat promotion). Their focus is on lifeafter death.

Mental model Competition Cooperation

Motivation Extrinsic Intrinsic

Perspective This life The next life

Metaphor A good driver drives quickly A good driver drives safely


For example, if somebody sees that his or her manager is about to do something unethical,then a moral and religious consciousness should give that person the courage to advisethe manager. Thus, we believe that Islamic values need to be internalized and lead toethical and productive behavior. Although we do not have data to back up our claim yet, webelieve that the benefit of applying Islamic strategic management principles is that theorganization will have a longer life expectancy and, in the long term, stakeholders will gaingreater benefit (Fontaine and Gapur, 2012). We add, though, that the extra financialrewards are not the objective of strategic management from an Islamic perspective. The soleobjective of implementing strategic management from an Islamic perspective is simply toplease God.4

As researchers, we recognize that critics (non-Muslims and Muslims) often point outthat whenever Muslims start talking about “Islamic solutions,” Muslims tend to offer vagueand generic solutions. Clearly, this will always be the case when a discipline emerges.Concepts are still fluid and data is scant. Yet Muslim scholars like Dr. Rafik Beekun haveproduced research related to strategic management from an Islamic perspective of aninternational standard (for example, Beekun, 2006; Beekun, 2011). Furthermore, the facultyat IIUM is working hard to produce PhD graduates in the area of strategic management froman Islamic perspective. These PhD graduates are expected to master the Islamic disciplines,master the management disciplines, and produce research that tests hypotheses in a mannerthat fits academic standards. We assume that over the next 10 or 20 years, more and morePhD students will graduate and make a valid contribution to the field. Today, we might notmeet the criteria for evidence-based management that is generally expected, but we aregetting there.

In this text, we will explain the methodology for strategic management from anIslamic perspective, show that it adds value to both the theory and the practice ofstrategic management, and provide some relevant case studies. As the paragraph oncritical thinking suggests, this is not the final product of our efforts. At this stage, ourevaluation of the conventional strategy literature and the Islamic literature points to thefact that reducing the risk of strategic failure is the major concern for strategists.Although the review of the literature will not be exhaustive, we will turn our attention tofour fundamental problems:

1. The financing of organizations2. The challenge of creating sustainable organizations3. The problem of organizational defense routines4. The conflict of interest between the individual and the organization

We will attempt to show that Islam provides practical solutions to all of these problems.The practical benefit should be that, on average, organizations will survive longer as theymanage their financial risks better and the corporate culture allows the real problems insideorganizations to emerge and be resolved.


ReferencesAhmad, K., and R. Fontaine. Management from an Islamic Perspective (2nd ed.). Singapore:Pearson Custom Publishing, 2011.

Ahmad, K., R. Islam, and Y. Ismail (Eds.). Issues in Islamic Management: Theories and Practices.Gombak, Malaysia: IIUM Press, 2011.

Argyris, C. On Organisational Learning. Cambridge, MA: Blackwell, 1992.

Argyris, C. On Organisational Learning (2nd ed.). Malden, MA: Blackwell, 2001.

Badi, J., and M. Tajdin. Creative Thinking: An Islamic Perspective (2nd ed.). Gombak, Malaysia:IIUM Press, 2005.

Beekun, R. I. Strategic Planning and Implementation for Islamic Organizations. Herndon, VA:International Institute of Islamic Thought, 2006.

Beekun, R. I. “Planning Paradigms and Issues.” In K. Ahmad, R. Islam, and Y. Ismail (Eds.),Issues in Islamic Management: Theories and Practices. Gombak, Malaysia: IIUM Press, 2011.

Beer, M., and N. Nohria. “Cracking the Code of Change.” Harvard Business Review May–June(2000): 131–141.

Bohn, R. “Stop Fighting Fires.” Harvard Business Review July–August (2000): 84–91.

Coveney, M., D. Ganster, B. Hartlen, and D. King. The Strategy Gap: Leveraging Technology toExecute Winning Strategies. Hoboken, NJ: John Wiley & Sons, 2003.

Deming, W. E. The New Economics for Industry, Government, Education (2nd ed.). Cambridge,MA: MIT Press, 1994.

Fontaine, R. “Islamic Entrepreneurship: An Exploratory Study.” In K. Ahmad, R. Islam, andY. Ismail (Eds.), Issues in Islamic Management: Theories and Practices. Gombak, Malaysia: IIUMPress, 2011.

Fontaine, R., and O. Gapur, “Evaluating Chris Argyris’s Ideas: An Islamic Perspective.” SecondIslamic Conference on International Business, Islamabad, February 29, 2012.

Haswell, S., and S. Holmes. “Estimating the Small Business Failure Rate: A Reappraisal.”Journal of Small Business Management 27 (1989).

Mackenzie, K. D., and M. Afzalur Rahim. “Strong Inference and Weak Data.” In M. AfzalurRahim, R. T. Golembiewski, and K. D. Mackenzie (Eds.), Current Topics in Management(vol. 8, pp. 315–340). New Brunswick, NJ: Transaction, 2003.

Mintzberg, H., B. Ahlstrand, and J. Lampel. Strategy Bites Back: It Is Far More, and Less, ThanYou Ever Imagined. London: FT Prentice Hall, 2005.

Nutt, P. C. “Expanding the Search for Alternatives during Strategic Decision-Making.”Academy of Management Executives 18(4) (2004): 13–28.


Ormerod, P. “Set Up to Fail.” Harvard Business Review June (2007): 28.

Osman-Gani, A. M., and S. M. Sarif. Spirituality in Management from an Islamic Perspective.Gombak, Malaysia: IIUM Press, 2011.

Senge, P., B. Smith, N. Kruschwitz, J. Laur, and S. Schlev. The Necessary Revolution: HowIndividuals and Organizations Are Working Together to Create a Sustainable World. London:Nicholas Brealey, 2010.

Starkey, K., S. Tempest, and A. McKinlay. How Organizations Learn: Managing the Search forKnowledge (2nd ed.). London: Thomson Learning, 2004.

Notes1. This writing of this book was made possible by a grant (EDW B11–089–0567) from IIUM.2. We thank our students for providing their feedback on our book Management from an

Islamic Perspective. They found the second chapter of that book quite confusing because wequoted too many Muslim authors.

3. According to Mintzberg, Ahlstrand, and Lampel (2005, p. 32), Tom Peters, the legendarymanagement guru, said that it is “much less than 10%.”

4. We realize that we are being repetitive, but this point has to be absolutely clear for Muslimreaders if they are truly going to benefit from applying Islamic principles when developingstrategies. This point will not be repeated in subsequent chapters.


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