The Islamic banking theory
2 - LITERATURE REVIEW
The aim of this chapter is to provide a critical review of the literature which contributes to the Islamic banking theory. The chapter is organized follows. First, the history of Islamic banking is discussed. Next Islamic banking in non-Muslim countries, prohibition of Riba (interest) in Islam, the role of management in Islamic banking, ethics and corporate social responsibility within Islamic banking environment, modes of financing, principles of Islamic financial system, Islamic and conventional banking and the Islamic banking strategy at the end.
2.1 HISTORY OF ISLAMIC BANKING
According to Abdul Gafoor (1995) the history of Islamic banking could be divided into two main parts. Firstly when it was no more than a dream or an idea still to be implemented and secondly when it finally comes to its implementation. Since then Islamic banking has been implemented in many countries either as a stand by individuals or in form of law imposed by governments. The idea of Islamic banking evolved in the late forties by then scholars who found that commercial banks are really making it in and that the current banking trends are not according to Islamic laws. Therefore the idea of Mudarabah was created which actually deals with the concept of sharing profit and loss.
It was originally started up by a group of Muslim businessmen in late 70's when a group of enthusiasts started a collaborative stand for establishing first of its kind Islamic bank in Dubai with the name Dubai Islamic Bank. After that 2 other Islamic banks were established in Egypt and Sudan. Since then 50 Islamic Banks were came in to existence although most of them are in Islamic Countries but some are in Western Europe like Denmark, Luxembourg, Switzerland and the UK.
According to Abdul Wassay Haqiqi (2005) Islamic Banking is evolved in three phases from its birth till now;
Emergence: This period is termed from 1972 to 1975, the time was well known because of its increasing oil production, other considerable events include Islamic Fundamentalist movements and establishment of other Islamic School of thoughts with that establishment year for OIC.
Expansion: This four year of time starting from 1976 to early 1980's is considered as major expansion time as in this period the Infrastructure for Islamic Banking starts spreading out from Gulf to other parts of the world including Malaysia and some western countries. By that time to bear the accounting needs of Islamic Banking some 155 Islamic banks came in origin and driven forces behind these operations started introducing their consultancies globally.
Maturity: From 1983 till date, this time is considered as maturity phase for Islamic Banking. Arab world suffered many ups and downs between these times as oil production slowed down and US dollar strengthen up. Between this time Arab banks opened its branches in United States and the practises were then widely undertaken.
Islamic banking and the success it has gained is now being widely used across the globe, and can be based as a profitable service, with reference to the needs and current scenario of modern banking as people are trying to eradicate heavy interest rates and banking will be easier than ever before.
2.2 Islamic banking in NON-MUSLIM countries
According to Abdul Gafoor (1995) the conventional banking system exists in nearly all countries of the world and it involves and modelled on the practices in Europe, especially in United Kingdom. The roots of this system revolve around the basic principles of capital certainty for depositors and certainty to the rate of return on deposits. The central banks have the powers of supervision and control for the smooth functioning of these banking systems. All conventional banks have to follow the central banks rules and that is why Islamic banks that wish to operate in non Muslim countries face difficulties in following these rules.
The concept of Islamic banking was started in UK almost 8-9 years ago. Ahli Bank of Kuwait used to have only one branch in the UK that offers some of Islamic banking services. Their first product which was Islamic mortgage called Manzil was started in 1997 with compliance to Islamic requirement. The Manzil was based on the Murabaha and Ijara mode of finance. These modes are been explained in the previous section of this report.
Conventional banks realised this opportunity and started different services which could be acceptable for the Muslims. HSBC started Islamic banking by the name of Amanah bank account. It was the first bank account without interest in UK and it also provides mortgage services that follow the Islamic law.
According to Iqbal Asaria (BBC 2003) the spokesman for the Muslim Council of Great Britain, "Some (Muslims) are wracked with guilt because they have broken Islamic law. While others' values are beyond question, they are more pragmatic in order to keep a roof over their family's head. HSBC's initiative frees them from this dilemma and is the first step to delivering a level playing field for Muslims seeking financial solutions in the UK."
2.3 PROHIBITION OF RIBA (INTEREST) IN ISLAM
Riba is the basis on which the basic concept of Islamic banking revolves. In order to explain the relation between riba and Islamic banking, we first need to understand what exactly riba is. In today's world, riba is loosely translated as meaning to be interest and an individual following Islam is therefore told that anything to do with interest is prohibited. However, in order to completely understand the meaning of riba, we need to put it into context.
The verse that prohibits riba includes the reference of the Jewish lenders of Medina, who forced the borrowers to pledge their women and children as security for the money that they were borrowing (Al-Tantawi, Banu Israel fil-Qur'an wal-Sunnah, p79). There have been several mentions of Riba in the Quran:
"And whatever riba you give so that it may increase in the wealth of the people, it does not increase with Allah."
The mention of Riba however is not only limited within the Quran. There are several Hadiths (saying of Mohammad PBUH) that explain the prohibition on riba. The following Hadiths has been explained by Mahmoud 2000.
Muslim narrated on the authority of 'Abu Said Al Khudriy; The Messenger of Allah (PBUH) said:
"Gold for gold, silver for silver, wheat for wheat, barley for barley, dates for dates, and salt for salt; like for like, hand to hand, in equal amounts; and any increase is Riba."
2.3.1 UNDERSTANDING RIBA AND ITS TYPES
Riba originates from an Arabic word and it means 'to grow'. If one takes an Islamic point of view, riba means to exchange an object with the condition of an increase in the object upon its return. So why is riba prohibited? Riba is prohibited because it ensures that the lender will get his capital as well as premium at the time of expiration and he will have earned this premium without any effort such as carrying out any labour or any kind of risk.
Before the revelation of Quran, Riba was prevalent all over Arabia. Taking anything excess over capital was defined in Riba and the Arabs were left in no doubt of its meaning (Shafi, 1993). This type of Riba came to be known as 'Riba al-Nasi"ah'.
Later, the Messenger of Allah (PBUH) added certain transactions to the definition of Riba and this came to be known as 'Riba al-Fadl'.
Riba was clearly declared unlawful by the Holy Qur'an, and was abandoned by the noble Companions the moment the verses prohibiting Riba were revealed, and the Holy Prophet (PBUH) enforced its prohibition through his judgments in the legal suits.
2.3.2 MISCONCEPTIONS ABOUT RIBA
There are several misconceptions surrounding the concept of Riba. Some argue that not all types of interests are forbidden and there are misconceptions regarding interest on commercial loans, simple interest and interest on inflammation.
In spite of all the evidence that is present, some contemporary Muslims have tried to argue that banking interest does not fall within the bounds of Riba. They support their stance through arguing for the permissibility of interest by making incorrect and unsupported claims. However, if the nature of Riba is carefully studied, it will soon become apparent that their claims have no weight whatsoever. There is a lot of evidence present that completely refutes these arguments, which I will further explain in the next two sub-sections.
INTEREST on commercial loans
One of the most common misunderstandings surrounding Riba is that people tend to believe that it was interest on consumption loans that was prohibited which would leave commercial and productive loans free from the prohibition, This argument is based on the assumption that interest was prohibited during the days of the Messenger of Allah (PBUH) because in those days there were only consumption loans and the interest that was charged on such loans resulted in causing hardship for the borrowers. However, this argument is completely refuted by historical facts.
This misconception can be further clarified by understanding that in Islamic finance, it is not of concern whether the money advanced is put into production r consumption, it is the primary motive for which the money is advanced that matters.
If your motive is to advance money in charity, you are not allowed to demand any type of profit from it. However, if your motive is profit-based, Shariah does not permit any type of arrangement in which the lender of advance is insulated from risk. If the motive of advancing money is profit based then the lender has to bear the losses as well as the gains and the borrower is not under any obligation to return a fixed amount irrespective of the outcome of the recipient's venture.
Another common misconception that people have is that interest prohibited in Islam is compound interest and not simple interest. The people under this misconception have probably misunderstood the meaning of the following verse from the Quran:
"0 those who believe, do not eat Riba multiplied many times. And fear Allah, so that you may be successful." (Qur'an, 3:130)
However, if this verse is understood in its context then this misconception can easily be clarified. In the pre-Islam Arabia, the general pattern of Riba transactions was that loans were given on Riba for a set period of time; when that period expired and the borrower was unable to pay it back, he was given an extension of time on the condition that the amount of Riba was to be increased.
Similarly, if payment was not made even on the expiry of the second deadline, the rate of Riba was further increased.
Thus we can see that if once, the habit of taking Riba is inculcated, it does not remain simple anymore; interest necessarily becomes multiplied. The amount of interest accrued becomes a part of the total amount owned by the creditor. Afterwards, when the creditor decides to lend out his money again, he will be lending out the principal amount he had previously lent out plus the interest accrued on it. Therefore, he will not only be charging interest on the previous principal amount but also on the interest he had previously gained and which has now been added to the total amount. If this chain continues, then the interest will keep on being multiplied many times and thus, every form of interest (no matter how simple) will end up increasing several times.
2.4 THE ROLE OF MANAGEMENT IN ISLAMIC BANKING
There are many definitions of management in different books among which I have taken the following three definitions.
According to (Naylor, 1999) "Management is the process of achieving organisational objectives, within a changing environment, by balancing efficiency, effectiveness and equity, obtaining the most from limited resources, and working with and through other people".
"Management is that it involves getting work done second-hand, that is true the efforts of other people". (Drucker, 2005).
"Management is the art of getting others to do all the work" (Anon, 1999).
Whatever the roles of manager wither in the private or public sector, in order to carry out the process of management and execution of work, the manager requires a combination of technical competence, social and human skills, and conceptual ability. (Mullins, J. 2005).
2.4.1 MANAGERIAL ROLES
Mintzberg in the 1960s identified ten roles that most managers appeared to occupy from time to time. Grouped into three classes, the roles are,
Most people in organisations engage in much interpersonal contact. When acting as manager, a person plays three identifiable parts-figurehead, leader and connecter.
All managers act as focal points for information. Through it they enhance their understanding of the organisation and the environment. As never centres and disseminators, they assist their staff to achieve their objectives. They are frequently nominated as speakers to provide and control information flows to outsiders.
Mangers are engaged both in change and running the business. For the former they act as entrepreneurs, stimulating and pushing through change. This role is often called entrepreneur. When running the business, they fill roles of disturbance handler, resource allocate and negotiator. The manager roles can be shown by the following diagram.
Managers should also play some activities; Fayol's (1997) explained six managerial activities which he used.
Forecasting: predicting what will happen in the future
Planning: devising a course of action to meet that expected demand
Organising: mobilizing materials and resources by allocating separate tasks to different departments, unites and individuals.
Commanding: providing direction to employees, now more commonly referred to as directing or motivation.
Co-ordinating: making sure that activities and resources are working well properly.
Controlling: monitoring progress to ensure that plans are being carried out properly.
From (Naylor, 1999) studies it is clear that management is the process of achieving organisational objectives, so objective is a target or aim to be striven for. Islamic banking will be more successful if they aim for outcomes that are challenging and achievable, Islamic banking manager needs full efficiency and managerial skill to run the organisation and make it successful to achieve the goals. From Mullins (2005) study it is viewed that Islamic banking manager requires a combination of technical competence, social and human skills, and conceptual ability, it means that much skill is important for Islamic banking manager.
For every manager in Islamic banking they need to follow Fayol's (1997) managerial activities, which is very important, Islamic banking manager should make a plan for future, distributing tasks to different department, he or she should has full command and needs to motivate the staff in different ways, co-ordinate with them and monitoring progress to ensure that plans are carried out properly. If Islamic bankers follow the same way they would be able to manage or to do their roles properly. Thus for Islamic banks and other building societies, where change has taken place slowly, changes over the past few years have been of such significance that wholly different approach to the management of the Islamic banking is required. Taylor, (1947) was a believer in the rational-economic needs concept of motivation. He believed that if management acted on his ideas, work would become more satisfying and profitable for all concerned. Islamic banking workers need to be motivated by obtaining the highest possible wages through working in the most efficient and productive way. Every organisation set some objectives and tries to achieve those objectives. Islamic banking may have some objectives which could not be achieved by the efforts of individuals on their own. The managers and employee should work together for success of Islamic banking. The manger of Islamic banking has to balance the need of adaptability in meeting opportunities presented by new technology with an atmosphere of stability and concern for the interest of staff (Mullins, 2005). If the Islamic banking wants to be successful management system should endeavour, therefore to structure the bank so that people may realise their won goals by helping the Islamic banking to satisfy its goals.
2.5 ETHICS WITHIN THE ISLAMIC BANKING ENVIRONMENT
To understand the concept of ethics and corporate social responsibility within the Islamic banking industry, it would be more helpful to explain first the important of ethics in Islamic banking.
2.5.1 IMPORTANTS OF ETHICS IN ISLAMIC BANKING
There are many definitions of ethics which is almost the same from which I have taken two definitions.
Ethics studies morality. According to (De Gorge, R. T. 2005) "Morality is a term used to cover those practices and activities that are considered importantly right and wrong; the rules that govern those activities; and the values that are embedded, fostered, or pursued by those activities and practices".
According to ( Fisher and Lovell, 2006) "Ethics are a principle of right or good conduct or a body of such principles".
Ethics is concerned with the goods worth seeking in life and with the rules that ought to govern human behavior and social interaction. Business is not just a matter of economic exchange, of money, commodities, and profits; it involves human interactions, is basic to human society, and is intertwined with the political, social, legal, and cultural life of society. De George, R.T. (1993). There is an obvious connection between business and ethics. It would be nice to be able to show that moral action is always best for business. But this seems not to be true, especially in the short run. Lying, fraud, deception, and theft sometimes lead to greater profits than their opposites. Hence, moral judgments sometimes differ from business judgments. (Kaler J.H 1993). Businesses need not be run from moral motives but the actions of businesses affect individuals, society, and the common good. If moral actions are ultimately in the common good, then running businesses in accord with moral norms is in the common good. To the extent that profit maximization conflicts with moral norms, it leads to actions which are not in the common good.
There are many ethical theories. (Fisher and Lovell, 2003) Even if you find it easy to discount some of them, because you think them trivial or ill-founded, several will remain. This raises a question for some one who wishes to think ethically. Should all or several theories be applied when thinking about an issue or should one approach be adopted that seems best suited to the matter in hand? Petrick and Quinn (1997) argued that those managers who are temperamentally attached to one of the theoretical perspectives on ethics 'fanatically rush to judgment'. They claimed that there can be no 'quick fixes' when dealing with matters of managerial integrity and that managers ought to use that ethical insights from all four quadrants to make balanced ethical decisions.
David Carse (1999) argues in his speech who is chief Executive of Hong Kong Monetary authority, that the importance of ethics in banking. It all seems too obvious. After all, what do we mean by ethics in business? It means, I would suggest, trying to be a good corporate citizen; trying as an organisation to adhere to certain ethical values; and trying to do the right thing by all the various stakeholders - customers, employees, suppliers and shareholders - that any business organisation has. It means, as one writer has put it, "choosing the good over the bad, the right over the wrong, and the fair over the unfair".
Think ethically it would be necessary to Islamic banking consider how their actions anywhere in the world - will affect their customers or be perceived by them. But customers are not the only people the Islamic banks have to worry about. They also need to take account of regulators in the various jurisdictions in which they operate, and the fact that regulatory standards may shift over time.
Islamic banking responsibility is to promote the general stability and effective working of the banking system and also responsible to protect the bank. If Islamic banks are involved in illegal or improper activities (such as fraud or money laundering) this may threaten the reputation not only of the bank concerned but also of the banking system as a whole. This in turn may lead to a loss of public confidence in the banks.
I should say that high ethical standards in banks are neither a luxury nor an abstract ideal. Rather, they are a vital aspect of protecting and enhancing the bank's brand image, and ensuring its long-term business survival. Behaving ethically is not only the right thing for Islamic banks to do; it also makes sound business sense.
The interaction between religion and economics has always been a challenging subject in the study of business ethics. Islam provides some guidelines on how this can be achieved, making a choice, especially one that involves religious values, is often deterministic. That is, the Muslim people in general tend to follow the letter of the law, but with less ethical concern. Islamic banking is not an exception.
Islamic law invites mankind to value actions not only on faith, but also on rational ground. This is done by initially looking at the benefits (manfaah) which is the fifth mode of Islamic finances and disbenefit (mudarah) generated from a particular human action. In principle, the mudarah which second mode of Islamic finance component in a prohibited action (haram) is larger than the manfaah component. Rationally, this makes sense since reason is also instrumental in determining ethical values. An action from which a mudarah is created can be considered unethical since it hurts both the individual and society. Likewise, an ethical action can be defined in the manner it generates manfaat to human beings. Thus, an ethical action can be inferred by way of reason as well as revelation. The problem remains paradoxical when Muslims tend to ignore ethics when the value of human action is defined by Allah (God). They tend to discount reason ('aql) for which God has created for man to think and ponder about his creations and their manifestations. This rigid adherence to the letter of the law has jeopardized the image of Islamic banks as they began to emulate the practices of mainstream banking.
The financial resources of Islamic banking are to be mobilized with the important condition of keeping the Shari'ah in view. They are therefore to be directed into the Shari'ah recommended goods, projects and goals. Thereby, socio-economic development and ethical prerogatives become part and parcel of the Islamic financing modes. (Siddiqi, 1983).
2.6 CORPORATE SOCIAL RESPONSIBILITY WITHIN ISLAMIC BANKING
Before defining CSR it would be better to define corporation first to better understand the meaning of CSR. According to (Benson, G.1908) " A corporation as a 'body of persons authorised by law to act as one person and having rights and liabilities distinct from the individuals forming the corporation" With this understanding, any form of organisation, be it public, private or civic qualifies to be called a corporation".
According to (Cronin, 2001) "Corporate social responsibility is concerned with treating the stakeholders of the firm ethically or in a socially responsible manner. Stakeholders exist both within a firm and outside".
According to Baker M. (2005) "Corporate Social responsibility is the continuing commitment by business to behave ethically and contribute to economic development while improving the quality and of life of the workforce and their families as well as of the local community and society at large"
Global trends show companies engaging the community in a variety of ways, including donating products or services, creating employee volunteer project, and loaning executives and mangers for a number of society beneficial reasons CSR can be define as operating a business in a manner that meet or exceeds ethical, legal, commercial and public expectations.
It is a comprehensive set of policies, practices and programs that are integrated throughout business operations and decision- making processes that are supported and rewarded by top management.
2.6.1 NATURE OF CORPORATE SOCIAL RESPONSIBILITY
The doctrine of corporate social responsibility demands that firms behave as 'good citizen' as well as pursuing purely commercial goals. Most people would probably agree that certain fundamental principles should govern the conduct of business affairs, (Bennett, R. 1999) mentioned some principles such as:
- Concern for the quality of life, including life at work and the satisfaction derived from the work experience.
- Concern for the physical environment
- Fair reward for effort and enterprise
- Involvement with and interest in the activities of the wider community
- No misrepresentation in advertising or other fraudulent activities
- Absence of unfair discrimination in hiring, promoting or dismissing employees
- Adherence to the laws and established customs of the community.
Islamic banking needs more to do to convince their stakeholders as Barclays bank Group chief Executive; (John Varley, 2005) said in his speech that we are very serious about corporate social responsibility. For Islamic banking it is the best way that everything they do under the corporate social responsibility banner is directly relevant to their business goals. So to achieve their target Islamic banking should make greatest contribution to society by being good at what they do, and doing it in a responsible way - provide products and services that help customers realise their financial goals, that drive economic growth, which will sustain a healthy financial system.
One of the most actions of Islamic banking sector for the client is to provide social services like zakat, which is the fourth pillar of Islam; for each and every Muslim who is wealthy has to pay 2.5%of their wealth in the path of Allah (God) is deducted from accounts of clients and goes to the charity.
Islamic banking on the responsibility go well beyond mere profitability goals and Coincide with the renewed perception on business recently at stake within the most advanced sectors of western business and civil societies. Far from the limits imposed by neo-classical thought, this new wave implies new sorts of responsibilities on behalf of the company falling under the rubric of corporate social responsibility (Ferro, N.2005). As its ultimate goal is the maximization of social benefits for Islamic banking as opposed to profit maximization, through the creation of healthier financial institutions that can provide effective financial services also as grass roots levels, some authors (Al Harran, 1996) argue that Islamic banking, if inserted in a new- paradigm, could be a viable alternative to the socio - economic crisis lived by the Western paradigm. Islamic banking target should not be only the profit they should have provide some social service to society and full attention should also be given to values in Islamic banking and business ethics.
2.7 MODES OF FINANCING
There are different modes of financing in the Islamic banking system and they follow the rules and laws of Shariah. As mentioned above that in Islamic financial system banks cannot charge interest from the customers as it is not allowed in the Islamic law. However in conventional banking system interest is one of the major- characteristic as conventional banks charge interest on their customers and the money generated from these interests are used to provide further services to the customers. According to (Usmani 2002) there are nine modes of financing in Islamic financial system:
According to (Usmani, 2002) Musharakah in common man's language will be sharing. The term Musharakah in the Arabic language comes from the word Shirkah and if we see the meaning of Shirkah in an Arabic Dictionary it means being a partner. Under the Islamic Law, Musharakah is a joint enterprise created for caring out a business where all the partners in that particular business share profit that is generated from the firm according to a specific ratio whereas the loss that is generated by the firm is shared according to the ratio of contribution in the business. It is considered as an ideal alternative for the interest based financing with far reaching effects on both production and distribution. The implication of the term Musharakah is little limited than the term Shirkah. In order to clear basic concepts the meaning of both the terms is defined distinguished from each other.
According to (Usmani, 2002) musharakah is a relationship formed by two or more parties through a mutual contract. The contract must be a valid contract and it must take place with the free consent of all the partners without any pressure, fraud or misrepresentation. All the partners have an equal right to participate in the daily management of their joint firm but however they could also come up with an agreement where few or maybe one partner could look after the management, so in this case the remaining partners will be treated as sleeping partners and will be entitled to only profit sharing that to according to ratio of their investment in the business.
Differences Between Interests Based Financing & Musharakah:
Following are a few differences between interest based financing and Musharakah.
Interest Based Financing
- A fixed rate of return on a loan advanced by the financer is predetermined irrespective of the profit or loss suffered by the debtor.
- The financer can not suffer loss.
- Results in injustice either to the creditor or to the debtor. If the debtor suffers a loss, it is unjust on the part of the creditor to claim a fixed rate of profit. Also it is unjust to the creditor if the debtor earns very high rate of profit but gives the creditor only a small proportion of the profit and keeps the rest for oneself.
- Musharakah does not gain a fixed rate of return. The return is based on the actual profit earned by the joint venture.
- The financer can suffer loss, if the joint venture fails to produce profits.
- The returns of the creditor are tied up with the actual profits accrued through the enterprise. The greater the profits the greater the rate of return to the creditor
According to (Usmani, 2002) Mudarabah is the partnership which comes into existence when one partner gives his money to another person for investing in a commercial enterprise. The person who invests in the enterprise i.e. the first partner is known as the "Rab-ul-maal" where as the person who takes up the responsibility of looking after the all the work and the daily management is the "Mudarib." The Mudarib does not make any sort of investments in the enterprise. The profit that the enterprise makes is shared between the Rab-ul-maal and the Mudarib in a ratio that has been fixed at the time of the partnership. According to (Usmani, 2002) Mudarabah has the following two kinds:
Al Mudarabah Al Muqayyadah:
In this case the Rab-ul-maal is the person who ascertains what business and where he wants to invest. He tells the Mudarib that this is what and where he wants to invest my capital in. This is also known as "Restricted Mudarabah."
Al Mudarabah Al Mutalqah:
In this case it's the Mudarib who tells the Rab-ul-maal which business to invest in. The Mudarib takes care of the entire business but he has no right or authority to lend any money to anyone without the consent of the Rab-ul-maal. This type of partnership is also known as "Unrestricted Mudarabah."
Questions like; in what form should the capital be? Can non-liquid assets form capital? Or should the capital be of liquid assets only? Come to ones mind. Capital should be in liquid form according to Hannifin Fiqh i.e. cash but according to other scholars capital could also be in other forms such as land, equipment etc. so assets other than cash can be used as an intermediate step i.e.
2.7.3 DIMINISHING MUSHARAKAH
According to (Usmani, 2002) Diminishing Musharakah states that, "a financer and a client come together for a joint ownership of a property or equipment, or in a joint commercial enterprise." The financer's share is divided into further unit which can be purchased one by one over a certain period of time by the client, until the client purchases all the units to become the sole owner of the joint enterprise or property or equipment.
According to (Taqi Usmani, 2004) the diminishing musharakah has been mostly used in house financing for example A person wants to buy a house and don't have enough money he or she will go to the bank for financing. Bank will pay 80% of the price of that house and rest of the 20% will be paid by the client. So the bank will become 80% owner of the property while the client owns 20%. The bank and client will buy the property jointly and the client promises to pay rent to the bank for using its share in the property. At the same time the share of financier is further divided in eight equal units, each unit representing 10% ownership of the house. The client have to purchase each unit after three months so after buying the first unit the share of the bank will decrease from 80% to 70% and it will also reduce the rent payable to the bank. This process goes on in the same way until the end of two years; the client will purchase the whole share of the bank increasing his own share to 100%.
So the proposed arrangements in this process contain the following points:
- To create joint ownership in the property (Shirkat-al-Milk).
- Giving the share of the financier to the client on rent.
- Promise from the client to purchase the units of share of the financier.
- Actual purchase of the units at different stages.
- Adjustment of the rental according to the remaining share of the financier in the property
One of the most commonly used modes of Islamic financing is Murabaha by the Islamic Banks and financial institutions. According to (Usmani, 2002) around 66% of the Islamic Banks use this mode of financing which is as old as Musharakah. According to this mode there is a seller who sells his product to another person by telling him the costs that he has incurred on that particular product and sells the product by keeping a profit for himself. Therefore it is said that the Murabaha is not a loan given on interest, infect it is a sale of a product for cash at a profit. The bank purchases a commodity/product and later sells it to the client at a cost plus profit basis, this is known as "Bai' Murabaha." The original cost and the profit margin that the bank has kept is disclosed by the Bank to the client.
According to (Usmani, 2002) the basic difference between a sale of a product and Murabaha is this that in a simple sale the cost and the profit ratio is not disclosed to the buyer whereas in Murabaha the price and profit margin of the product is disclosed to the buyer. In a simple Murabaha the payment is made strictly on ready cash whereas Murabaha Muajjal is done on deferred payment basis.
According to (Usmani, 2002) Salam is used by the modern banks and financial institutions to finance the agricultural sector. In other words, the seller in this case sells the goods to the buyer for the payment to be made in future by taking an advance payment made at the spot to the seller. The payment made is done in cash but the supply of the goods purchased is deferred. Following are a few reasons why this mode of financing is used by the Islamic banks and the financial institutions:
- According to Islam Riba which means to take usurious loans has been declared haram by Allah, so Prophet Mohammed (Peace Be Upon Him) suggested the farmers to sell their agricultural products in advance if they required any financial assistance. So in other words Salam is used by farmers who go through a financial crisis to meet ends i.e. are able to grow their crops and provide food and clothing for their family till the time of harvest.
- Secondly Salam is also used by traders to meet their needs for import and export business. According to Salam, the trader can sell its goods in advance for cash payment and then later take-up the aforesaid business.
According to (Usmani, 2002) one can benefit from Salam, in the following two ways:
- The commodity which is purchased according to Salam, the same can be sold simultaneously by a financial institution through a parallel contract keeping the delivery schedule same.
- The second benefit of dealing through Salam is that the financial institution can promise to sell the commodity to the third party at an agreed price by both the parties. This promise by the seller has to be independent from the potential buyer. The buyer in this case does not need to pay any advance price.
According to (Usmani, 2002) a sale of a product which takes place, after which the product comes into existence i.e. product is sold before it is actually manufactured. Such a transaction is known as "Istisna'." The manufacturer first takes the order of a product with an advance payment of the product and then manufactures the product using his own raw material required for the manufacturing the desired product. The price of the product is settled in advance between both the parties. Also any other specification of the product should be specified at the time of order. Either party can cancel the order (contract) before the manufacturing of the product has begun; once the work has started the contract can not be cancelled.
According to (Usmani, 2002) buying of goods from time to time in different quantities is known as Istijrar. According to Islamic terminology Istijrar is an agreement where a buyer purchases something from time to time; each time there is no offer or acceptance or bargain. Istijrar has two kinds which are as follows:
1. The price is determined after all the transactions of purchase are complete. This type is particularly associated with the Islamic mode of Financing. But it can be followed according to certain conditions, which are as follows
- In the first case the price is disclosed by the seller at the time of sale, but the transaction is only valid when the buyer actually has the purchased good.
- According to the second case the price is not disclosed every time to the buyer, but the contractors have the knowledge that the product is being sold at market value, which is specified in such a way that it does not vary.
- In the third case if a significant difference is present between the agreed price and the market value, then a conflict might arise between the seller and the contractors, so in this case at the time of possession of the goods the sale will not be valid.
2. The price is determined in advance but the purchase is executed from time to time.
Presently four types of Islamic modes of financing are being used by the Islamic Banks, namely:
Out of the above mentioned four modes of Islamic financing Istijrar is and can be applied to the first three cases. According to (Usmani, 2002) Istijrar can not be applied to borrowers of the Bank but however the same concept does apply to the suppliers of the borrower. When we talk about the concept of Istijrar being applied to the suppliers of the borrowers, in this situation the Bank enters into a Murabaha with the suppliers on the basis of Istijrar. For instance to make it more clear the Bank enters into an Agreement to Purchase with suppliers which consist mainly of the trading companies, that it shall purchase the assets of that company at a market price or a discounted price predetermined from the market price. So whenever the Bank will purchase such assets on the basis of Istijrar it then can further sell them out to their clients on the basis of Murabaha.
Ijarah means "to give something on rent". It is a term of Islamic fiqh. According to Taqi Usmani (2004) the term Ijarah is been used for two different situations. Firstly it means to employ a person and give him wages for his services. The employer is called 'musta'jir' while the employee is called 'ajir' so if A has employed B in his office as a manager then A is musta'jir and B is ajir and the wages paid to the ajir is called ujrah.
The second type of ijarah is for leasing of assets and properties. Ijarah in this type means to transfer a property or asset to another person on a rent. In English terms this is called leasing. In this case the lesser is called mu'jir and the lessee is called musta'jir and the rent is called ujrah.
2.7.9 IJARAH WA IQTINA
According to (Usmani, 2002) the term Ijarah wa Iqtina in simple English is also known as "Leasing and Promise to Gift." Ijarah wa Iqtina according to the Islamic Shariah is that instead of a sale of the commodity, the lesser signs a separate promise to gift the leased asset to the lessee at the end of the lease period, on the condition that he had made payments of all amounts of rent. The validity of this arrangement is based on the following two conditions:
- The agreement of Ijarah itself should not be restricted to signing this promise of sale or gift but the promise should be recorded in a separate document.
- The promise made should be unilateral and binding on the promise only. It should not be a bilateral promise binding on both the parties because in that case then it will become a full contract affected till the future date, which is not permitted in the case of sale or gift.
According to (Usmani, 2002) when the leased asset is being used differently by different users, the lessee can not sub-lease the leased asset unless he has the express permission of the lesser. Only with the permission of the lessor the lessee can further
Sub-lease the asset. The leased asset or property can be sold to a third party by the lessor, where a new relation will come into existence between the new owner and the lessee.
2.8 Islamic and conventional banking
Both Islamic and conventional banks offer almost offer similar services and are very important in the development of economy may be some differences accurse between these two like their social responsibilities and strategies. One difference is that the Islamic financial system operates on the relationship of investor and a partner where as the conventional banking system works on the relationship of investor and a creditor. Islamic banks have to follow Islamic rules and laws which is the prohibition of Riba. This is not the only rules there are also other things due to which Islamic banks could not do banking such as the Holy Quran has not allowed the consumption of alcohol and pork. Islam also prohibits the business related gambling such as casinos, horse racing and betting. Islamic banks cannot deal with the organisations that deal in these products or services. If we see conventional banks provide different services for example, Barclays bank issues credit cards due to which the customers should pay some interest, and also they are providing loan and insurance to the customer which is not allowed in Islamic banking. For example, Barclays bank insure customer and giving him some facility that bank will charge you £10 a month instead of which bank will give you some £750 per day, if you become injure or do accident but insurance in Islamic banking is prohibited . The diagram provided below clearly shows the basic difference between Islamic financial system and conventional system.
"Compared with non-Islamic commercial banking, Islamic banking seeks a just and equitable distribution of resources. In a non-Islamic commercial bank, if a borrower makes a loss on a project financed by a bank loan, the borrower is obliged to pay all interest due on the loan. On the other hand, if the interest rate falls and the borrower secure a high profit, other savers in the commercial bank will not benefit from such a profit. This very specific type of risk taking, which is one of the non-Islamic banking principles, is against the tenets of Islam (Siddiqui, 1985).
It is still uncertain whether Islamic banking does work on the similar principles as conventional banking. Various writers such as Muhammed Taqi Usmani (2004) and Nees Ahmed Lutfi (2004) have tried to put some kind of distinction between what is Islamic and what is conventional.
According to Nees Ahmed Lutfi (2004), he has basically summed up the differences within 8 points shown below:
As other authors have said Lutfi has clarified that Islamic banks do not treat customers as a debtor and creditor system, but mentions the whole transaction to be as a shared risk and reward practice. In Islamic terms it is Mudarib as mentioned in section 3.4.2.
2.8.2 SHARING PROFIT/LOSS
In any certain transaction between a customer and the bank a pre-fixed and declared ratio is set only for sharing profits. In any such instance where loss is being made the banks management services are delivered for operational activities to be justified. With this concept the loss on made on the investment of its equity and is shared.
2.8.3 CUSTOMER FINANCE
This is where Islamic banking differs from conventional banking. Islamic banks do not provide cash loans at all; the banks invest funds through customer participation.
2.8.4 MULTI-PURPOSE BANK
Islamic banks offer a variety of services which are either short, medium or long term investments providing that there is equity participation. It acts as a commercial bank for those regular normal users and as a Non-Banking Financial Institution.
2.8.5 FINANCIAL RESOURCES
Conventional banking usually lends money without directing it to either business or productive uses, which it does because it wishes to earn extensive profits. Even though similar processes are kept in mind of Islamic banks but the objective differs significantly as Islamic banking want to resource the developing society as a whole.
2.8.6 EQUITY BASE BANKING
The main purpose of Islamic banking is to share profits wholly on equity based funds that can be deployed in the environment. In conventional the borrower has to pay a fixed return as the funds become disposable.
2.8.7 VALUE ORIENTED
Conventional banking is neutrally valued whilst Islamic is oriented toward valuing its customers. Islamic banks will share profit which is in the use of the banks funds but conventional doesn't work on these principles and it will not sustain any loss by the utilisation of funds by the third party.
2.8.8 REVIEW & AUDIT
As Islamic banking is classified as wholly Islamic it has to reviewed and aligned against Shariah rules and regulations. Any practice that doesn't follow these rules can simply be a damaging effect on the banks. On the other hand conventional banks are just satisfied by statutory audits only.
These eight points identified by Nees Ahmed Lutfi (2004) have shown a different insight to Islamic banking but going into depth it could be argued that the conventional banking only differs on small points but the rest is majority working on the same basis to gain profits.
It would be best to take a different authors opinion as to whether to differences are really significant at all or are they just there to blind to economy in a sense that it seems Islamic to the public. It is still too early to judge whether Islamic banking is really Islamic until all dimensions are not investigated thoroughly.
With reference to Muhammed Taqi Usmani (2004), he writes that there are 5 points to be noticed when trying to identify the differences involved in conventional and Islamic banking.
Usmani (2004) talks that in conventional the client or the customer has to bear an interest loan when the banks issue any type of sum. Usmani then later says that 'the financier (bank) has no later concern on how the money is being used or utilised'. This point can be argued as banks these days require business plans when client wishes to start a business to see whether the monies involved can be returned on some type of guarantee.
In Islamic banking the client is not required to do any of the purchasing, the banks purchase the commodity (property). This finance is always backed by assets, and requires approval from the clients.
Islamic banking will only allow money to be invested as the partner for moral and ethical reasons. Conventional banking may lend money to those people who may wish to invest in businesses such as casino's or even pornography industries, as these are good customers for the bank. There is no religious restriction at all. Shariah law is essential and has to be coincided with the proposed investment as it cannot be broken at all times.
Usmani then again is emphasizes in his research as mentioned by Nees Ahmed Lutfi (2004) that any purchases that are being made are all made by the bank and not the customer. A point to be noticed in Usmani work is that the risk is always analysed before the bank sells it to the customer.
The profit earned from the transaction by the bank is not classed as interest but as a reward for undertaking the risk involved.
This is where confusion occurs; it is difficult to understand whether the profit is just interest added to the invested amount as a chance for the bank to make money.
Islamic banking only uses the agreed pre-fixed amount set as where conventional banking loans will always be on the increase as interest increases on the amount. Any unpaid instalments may act negative to the original amount and therefore interest builds not on the original amount borrowed but on the interest itself. Under Shariah there is no time due on money and therefore the remaining sum is only paid and not additional costs Usmani (2004).
From the differences pictured by the two authors it is evident that the Islamic system is trying to create real assets by following Shariah. Other authors have similar views on identifying the differences between Islamic and conventional banking. M. Q. Qasim and Anwar Ahmed Meenai (1998) who has written several journals and books on Islamic banking have clearly distinguished the principles on which Islamic banking works.
2.9 PRINCIPLES OF ISLAMIC FINANCIAL SYSTEM
Under Islamic terminology the right of ownership is allowed, providing that no damage is done to individuals. According to Dr. Mohammad Shawqi Al-Fanjari (2005) most of these principles are running according to environment and the circumstances related to time. If the application of these principles is carried out properly and precisely, Islam is confident of their good results.
To follow such principles and make sure they are running sufficiently they can be analysed under the following points:
2.9.1 DEVELOPING MANS MIND
According to Dr. Mohammad Shawqi Al-Fanjari (2005) A mans mind and the economy are two powerful sources which when combined can exploit anything. Allah say,
"In the creation of the heavens and the earth, and the alternation of night and day, and the ships that run in the sea with that which profits men, and the water that Allah sends down from the sky, then gives therewith to the earth after its death and spreads in it all (kinds of) animals and the changing of the winds and the clouds made subservient between heaven and earth, there are surely signs for a people who understanding." (The Holy Quran)
This definition has been repeated several times and it most importantly teaches us how to contemplate, with reference on how to combine relations within the world affairs.
2.9.2 FAITH IN ALLAH IS ESSENTIAL
Anyone who thinks logically and appropriate with depth will believe in the Supreme Being, Almighty Allah (SAW). If thorough contemplation is undertaken by man then he will know that he is just an atom. Allah says,
"Those who believe and whose hearts find rest in the remembrance of Allah. Now surely in Allah's remembrance do hearts find rest? Those who believe and do good a good final state is theirs and goodly return And might belongs to Allah and His Messenger and the believers, but the hypocrites know not". (The Holy Quran).
2.9.3 RECOGNITION OF PRIVATE OWNERSHIP
To undertake the differing opportunities regarding the matter of ownership, there should be any type of misconduct in terms of discrimination, either by ownership through birth, race or colour. Each and every person should be equal and appointed to work which they can perform well in.
According to Dr. Mohammad Shawqi Al-Fanjari (2005), under the Shariah people are forbidden from colleting money through usury. The use of usury increases the value of capital. Also with this in place it can harbour hatred and not give to the needy. In such a situation it has a drastic impact on the communities and therefore cannot be stabilised.
2.9.4 RESPECTING THE COMMUNITY
Under Islam the recognition of family is very important and that on this basis we find societies. Dr. Mohammad Shawqi Al-Fanjari (2005) says all members should respect the right to responsibility either towards their family or society and to understand these responsibilities.
In Islam the most important rule which is related to economics is the prohibitions of interest. The things that are strictly prohibited in Islam among them riba is strongly condemned, which is evident from the following verse:
"O those who believe, fear Allah and give up what still remains of riba if you are believers. But if you do not, then listen to the declaration of war from Allah and His Messenger (Muhammad peace is upon him). And if you repent, yours is your principal. Neither you wrong, nor are wronged." (Quran, Al-Baqarah 2: 278-279)
According to Islamic Finance (1997), the only thing that differs Islamic banking from conventional banking is that it is interest free banking.
"While a basic tenant of Islamic banking - the outlawing of Riba, a term that encompasses not only the concept of usury, but also that of interest - has seldom been recognised as applicable beyond the Islamic world, many of its guiding principles have. The majority of these principles are based on simple morality and common sense, which form the bases of many religions, including Islam".
According to Islamic scholars the interest paid to or paid by the conventional banks comes under riba. Islam does not allow any kind of income, which a person gets without doing any efforts. This also includes getting fixed interests on savings and similarly banks cannot give the loans on fixed interest rates. Some people think that it is compound interest which is unlawful but not that simple interest.
2.10 ISLAMIC BANKING STRATEGY
To know better the concept of strategy we need to define it fist, According to (Johnson, Scholes 1999) "Strategy is the direction and scope of an organisation over the long term: which achieves advantage for the organisation through its configuration of resources within a changing environment, to meet the needs of markets and to fulfil stakeholder's expectations".
Alfred D. Chandler (1962) American Business Historian, "Strategy is the determination of the basic long term goals and objectives of an enterprise, and the adoption of courses of action and the allocation of resources necessary to carry out those goals."
If we see from strategic point of view Islamic banks trying to run the banks through Islamic rules but may not be able to develop in the same way as other banks e.g. Nate- west bank, Barclays bank etc. The main problem facing Islamic banks are mainly the result of the increase change in the environment in which they operate and a failure to adapt to such changes. Even for Islamic banks and other building societies, where change has taken place slowly, changes over the past few years have been of such significance that wholly different approach to the management of the Islamic banking is required.
Johnson & Scholes six view of strategy (1993)
- Natural selection- adapt to environment
- Planning - a rational approach using systematic planning
- Logical incremental- evolutionary but more controlled than natural selection
- cultural- experiences, assumptions and belief which permeate the organisation over time
- political- emergent strategy from "bargaining & trading" between different interest groups
- visionary - an intuitive approach, often one person
Organisations need to know where they are, where they are going and how to manage the changes. Thompson, J. L (1993) Managers in these organisations need to know where their roles fit in relation to the whole and how they can contribute to strategic developments and changes. These are the issues addressed by a study of strategic management and what is strategic management we will better understand to define strategic management.
DIFINING STRATEGIC MANAGMENT
According to G.A. (1999) "Strategic management is a process, directed by top management, to determine the fundamental aims or goals of the organisation. And ensure a range of decisions which will allow for the achievement of those aims or goals in the long term, whilst providing for adaptive responses in the shorter term."
2.11 MODELS OF STRATEGIC MANAGEMENT
Strategic management model follows the approach of Johnson and Scholes (1984) and base it upon three areas of decision-Strategic analysis; Strategic choice and strategic implementation- which will be seen as interrelated and linked to monitoring and information system.
2.11.1 Strategic analysis
If an organisation understands the nature of its market and is generally aware of and responsive to changes in the environment as a whole, it can be as successful competitor and achieve profit and growth. The levels of success that it is achieving with current strategies should be assessed, and future targets, which may imply more or even less of the same, or activities which are different, determined. This requires and analysis of current results, and evaluation of current resources (strengths and weaknesses).
2.11.2 Strategic Choice
Strategic choice is concerned with establishing just what courses of strategic action is available to an organisation and how these might be evaluated and one or more selected. Whilst strategic choice decisions are important for determining future courses of action, other strategic changes may emerge from a more gradual process of trial and error.
2.11.3 Strategic implementation
A strategy is only useful when it has been implemented, and hence the organisation must have an appropriate structure, clear and contributory functional strategies and system which ensure that the organisation behave in a cohesive rather than a fragmented way. Fowling is the model of strategic management.
Strategic decisions are also likely to demand an integrated approach to Islamic banks managers. Islamic banks face a dilemma to extend financing on the profit - loss scheme (PLS) basis to firms in which broad policies, strategic plans, and day-to-day decisions are largely controlled by inside professional managers. While under PLS, Islamic banks share financial risk with the borrowing firms yet they do not have any controlling rights. Downs, A. (1996), The use of PLS as an acceptable mode of financing crucially depends on specification of management rights, claims and responsibilities on the one hand, and measurement of their performance through a system of control and compensation on the other. In a typical PLS arrangement, an Islamic bank provides the risk capital to a firm in which Professional managers are responsible for making strategic and operational decisions. The bank shares in profits and is liable to any financial loss. There is no serious problem with this arrangement if the bank is able, and is allowed, to monitor business operations of the firm. However, proper monitoring mechanisms are yet to be devised for PLS, especially in case of Mudaraba that does not provide any control rights to the financier (the Islamic bank in this case). Fiqh literature on this issue is quite out-of-date and needs serious reconsideration.
Islamic banking should develop some management strategies like training and development to be effective in terms of business success there is a well-rehearsed argument that it should be linked up front with business strategy. McClelland's research (1994) is one of many studies that show that organisations generally do not consider development issues to be part of their competitive strategy formulation, although he found that those that do so identified it to be of value in gaining as well as maintaining competitive advantage. Miller (1991 wrote specifically of management development, points to a lack of fit between business strategy and development activity. Pettigrew and others (1988) did find, though, that development issues receive a higher priority when they are linked to organisational needs and take a more strategic approach. So, for Islamic banking it needs to take strategic decision and develop their Islamic banking industries. Richardson and Thompson (1994) argue that if organisations are to be effective in strategic term they must be able to deal with the pressures and demands of change. Islamic banking manager should be strategically aware and appreciate the origins and nature of change, so effective strategy is needed for Islamic banking to their success.
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