Islamic banking across the globe

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Chapter 1 Introduction of Islam

It is important to be aware of the history and rules of Islam and to have an understanding of Islam’s position within the society which is not the same for the religious power among western countries. According to Samuelsson in 2001, he mentioned that it is not always easy for individuals who adopted in the western culture to understand the concept of Islam. (Samuelsson, 2000).

The word Islam is an Arabic term and can be defined as “submission to the will of God “which comes from another Arabic term namely “salaam” that can be defined as peace. Therefore it is said that the religion of Islam demonstrates that in order to achieve peace of mind and heart, one must live according to God divinely revealed by law. According to Samuelsson the Koran is the holy book of Islam and to be seen the time words of Allah (Samuelsson, 2000).

Objectives of study

  • What are IB
  • How IB is implemented in Different Countries?
  • Assessing the factors that affect IB in Different countries.

Organization of the study

Chapter 1 – Introduction on Islam

2 – Concept of IB

3 – Factors Affecting awareness, perception and understanding of Islamic

Banking

4 - Research and Methodology

5 – Implementation of IB in Different countries

6 – Analysis on Factors affecting awareness, perception and understanding

of IB in different countries.

7 - IB in Mauritius

8 – Conclusion

Chapter 2 : The concept of Islamic Banking.

History of IB

Following Khir, Gupta and Shanmugam (2008), IB was simply a conceptual framework until the first half of the twentieth century. It has now worldwide became a full-fledged system. IB first gained its appearance in Egypt in 1963. In the seventies, many Muslim countries help to establish Islamic financial institutions. During this time, some IBs came into existence in the Middle East. Examples are The Islamic Development Bank (IDB), the Dubai IB (1975), the Faisal IB of Sudan (1977), the Faisal IB of Egypt (1977), the Bahrain IB (1979). Later, IBs and financial houses were set up in Qatar, Sudan, Bahrain, Indonesia, Guinea, Denmark, Turkey, England, Jordan and Switzerland. Now, it is estimated that there are around more than 250 IBs operating in over 75 countries. Even in non-Muslim majority nations like the UK, Australia, United States of America, they are setting up Islamic Financial Institutions.

According to Al-Omar the method that was practiced in Egypt was based on Mudaraba and lasted until 1967. This bank was not called as IB as this time for political reasons and the aims of setting this bank is to win the trust of farmers and workers in Egypt as they were traditionally minded and were used to western Banking system. However, later on due to political decisions, the IB shut down.

Definition of IBS

IB must operate according to the Islamic norms and principles and it is a mixture of both commercial and investment bank. This system is efficient as it must protect the customer by providing them the best rate.

According to Al omar et . al., in 1996 IB expand the economy and follow the SL. Therefore, such bank cannot involve in interest, alcoholic beverage, gambling industry other activities that are restricted by Islam law. (Al-Omar et. 1996).

Principles of IBS

Following Khir et al. (2008), IB is based on Shariah principles and does not allow the existence of interest in its operations while promoting profit-sharing. It has the same objective as CB except that it must complies with the SL. The principles for IB are as follows

a)Sharing of profit and loss (equity participation)

In Islam, Muslims are encouraged to invest their money and to become partners in order to share profits and risks in the business instead of becoming creditors. Profit is recognized as the reward for capital and as such a depositor in an IB can therefore make earnings on his or her deposit in several ways. First, through return on his capital; through sharing of profit when his capital is part of the capital that is employed in a partnership, and through rental earnings on an asset that has been partially financed by his capital.

b) Prohibition of Riba. It is considered as haram (non-permissible). In the Islamic terminology, interest means profit that increases the principal amount without putting any effort.

c)Shariah-based activities. In IB, trading transactions are restricted to islamically acceptable transactions, which exclude those involving alcohol and gambling.

d) Money as potential capital. Making money from money is not allowed and money is only a medium of exchange. Thus, hoarding of money is considered to be haram.

e) Principle of certainty.The principle comprises that uncertainty, risk or speculation is also prohibited in IB.

Products of IB

Deposits Accounts

When opening an account in an IB is different from that of a Western Banking system. In IBs it is viewed as a partner relationship. According to Zineldin, IBS is built on a partnership basis which means that all the depositors, investors and borrowers need to participate in banking transactions.

  • Demand Deposits Account

In the demand deposits accounts, it means that withdrawal can be done without any condition and restrictions. Normally, customer open this type of account in order to keep their extra money and not to earn any profit. Banks do not pay any interest on these deposits. (Zineldine, 1990 ; Warde , 2000).

Normally when the deposits capital under this type of account cannot be used for risky ventures or to invest any other activities such as loans, investment and others. But this deposits can be used to provide short term loans to those who is badly in need of capital provided that the customer gives permission to the bank. At the end the profit that the will belong to the bank. (Al-Omar et al., 1996; Zineldin,1990; Akacem er . al., 2002).

  • Savings Account

Savings can occur in various ways and customer who want to save their money can use such type of account. The deposit amount can be used for other purposed provided the customer gives permission to the bank. But is it important to know that the bank ensure its customer that full deposit amount will be paid back to them. Normally if profit is obtained, they are paid to depositors and in case loss occurs no premium will be paid to the customertom

  • Investment Account

Investment Account is a form of fixed deposit account and is hold for fixed period of time known as the Profit and Loss sharing deposits. The aim is to earn profit rather than holding the money but the capital is not guaranteed. The profit and loss ratio is guaranteed which means that all profits and losses must be shared to both the bank and the depositor. According to Akacem et. al., in 2002, the ratio is agreed upon in advance and cannot be changed during the life of contract (Akacem et. al., 2002).

Contracts of IB

Since SL include special law and regulation thus it is important to determine which contracts are valid to conduct banking transactions. It is vital to have a clear rules about the contracts since it avoids conflicts, misunderstanding and confusion between parties.

Risk sharing is important under Islamic rules thus it is mandatory for both parties to agree with the risk sharing ratio upon set up of contract.

A contract must be an agreement where both parties agree on all terms and conditions.The contract must be well defined, clear and well-structured to avoid all kinds of disputes and misunderstanding.

Types of Contract

To get a better perception of IB. The contacts of IB is categorized into 3 main categories

  1. Trading Contracts.
  2. Participation Contracts.
  3. Supporting Contracts.

According to Khir et al (2008), classification of contracts in IB is important as moving of funds in terms of deposits are done through contracts based with Shariah principles

Trading Contracts

Trading contract known as sale contract that is selling of goods, cash and debt is possible. According to Khir et al ( 2008) these types of contracts are based on the principle of buying and selling of assets. Trading contracts are categorized as follows

  • Murabahah (cost-plus sale)

Murabahah is used by many financial banks.It refers to a particular kind of sale having nothing to do with financing in its original sense. If a seller agrees with his purchaser to provide him a specific commodity on a certain profit added to his cost, then it is called murabahah transaction. Murabahah is when the seller discloses the actual cost he has incurred in acquiring the commodity and then adds some profit thereon. The profit may be in lump sum or may be bases on a percentage.

Murabahah is simply a sale but what differentiate it from other kind of sale is that the seller in Murabahah expressly tells the purchaser how much cost he has incurred and how much profit he is going to charge in addition to the cost

The payment may be at spot or many be subsequent date agreed upon by parties and normally does not imply the concept of deferred payment. Murabahah can be applied in banking transactions where the bank may fund the customer by buying the asset from the vendor and then sells it to the customer at cost plus.

Khan (2010) stated that it is a sale contract in which Customer recommends the bank to buy a product for him from third party. Bank resells it to the customer on the cost plus profit basis once bank receive it

  • Bai Bithaman Ajil (deferred payment sale)

It can be defined as sale of goods with deferred payment that is not the spot sale and this method is used for property, vehicle or other consumer goods. The advantage of this financing is based on the activities of buying and selling. The asset that the customer wishes to buy is purchased by the bank and ownership passes to the bank and the bank will transfer ownership to the customer by selling the assets at mark up.

Khir et al (2008) this type of contract can be described as Sale of goods on a deferred payment basis at a price that includes a profit margin agreed upon by both buyer and seller

  • Ijarah ( Leasing)

Ijara is a contract which is accepted under the SL. It can be defined as to give something on rent and occurs between the bank and a customer where the banks purchase an asset that is required by the bank. Ijara can be defined whereby the owner of an asset transfers its assets to another party for an agreed time and at agreed considerations.

Leasing is done for an agreed upon sum by instalment and for mutually agreed upon limited period of time into a savings account held with the same bank. (Zineldin, 1990 ; Al-Omar et. al ., 1996)

Nanava (2007 described Ijarah as an where the bank buy the item needed by the customer it can be equipment or property and then leases it to the customer on predetermined fixed rate , as agreed by both parties ( Appendix)

  • Bai Salam (Future Delivery)

It means the financial institution that is the bank will buy the goods and pay in full amount in advance and the goods is delivered in future.

The payment is used to facilitate the the task of farmers long ago as it allows them to buy seeds so as to be able to produce fruits. Thus, salaam was both advantageous to the buyer and seller. The seller receive the price in advance and on the other hand the buyer benefit from lower price that price in spot rates. (Appendicx for conditions ofsalam)

  • Istina (Sale by Order)

Istina’s can be defined as asking someone to manucfacture and it is a forward contract sale that allows Islamic Financial Institution to buy a project that is under construction of building and manufacturing of aircrafts to be delivered on future date. The price must be agreed by both parties as well as specification Most importantly the manufacturer has the obligations to manufacture the goods, the contract can only be cancelled before the work begins otherwise the work has to continue at any cost.

Istina will play a major role in the short term investment and working capital schemes in the future and that Istina will replace the Murabahah as the short term financing scheme especially when used in International trade (Al Omar et. al., 1996)

Participation Contracts

Participation contracts focus on the equal based participation between lenders and borrowers on the profit and loss sharing. In this way bankers and lenders do not become the creditors of borrowers but instead they become their partners by investing their part of their money.

Participation Contracts can be classified as follow

  • Musharakah

It is a contract that creates that a joint venture between the bank and other parties for a transaction to take place and it an old way of financing. All concerned parties must be agreed on all terms and conditions made when the contract is set up else it is considered to be invalid. Under musharakah contract parties is investing the capital shares in both profit and loss which differs from CB. Al Omar et. The capital is provided on the condition that the capital owner shares the profit from the business (Al Omar et. al ., 1996).

Profit is shared among parties that must be determined and agreed upon at the time of contract and is shared according to the proportion of initial investment. If losses occurs, the amount is shared equally among partners

Khir et al(2008) simply stated that this type of contract is used for long term and medium investment.

  • Mudharabah

Mudarabah is a contract between the capital provider and the entrepreneur.The capital provider will provide all the money required for the transaction to take place while the entrepreneur will contribute professional skills, experience and commercial efforts needed for the transactions to occur.

After the transaction has occurred, either profit or loss will occur. If profit is made, the total will be shared between the parties at the predetermined ratio that has been agreed upon the setup of the contract. But in case it results to loss, the capital provider will suffer all the loss in terms of money and on the other side the entrepreneur will also be as loss as well as his experience and skills did not prove to be useful for the transaction to be successful. Thus under the SL, both profit and losses must be shared among partners.

(See more in Appendix).

Khan and Mirakhor (1987) held that the concept of PLS is theoretically more effective. Uzair (1995) said that mudharabah is the key idea behind ‘interestless banking’.Naqvi (1981) argued that simply replacing interest by uncertain profits is not sufficient to make a transaction Islamic since excessive profits can also be exploitative.

Supporting Contracts

These are additional contracts which can are used to facilitate all activities occur under SL.

  • Kafala(guarantee)

It is whereby a third party accepts a current obligations and the responsibility of someone else liability. Khir et al., (2008) stated it is an agreement guarantee by the parties. Third party becomes the guarantor of the debtor for the payment of debt assures that the debtor will repay the debt to the creditor.

  • Wadiae

Wadiae can be defined where a customer comes to deposit cash and assets in an IB for safekeeping and whereby the bank ensure the security for the safety of the item kept by it.

  • Hiwala

It is whereby debt is transferred from one debtor to another and after this transaction occurs the first debtor is free from obligations.

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