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Journal of Islamic Banking and Finance July – Sept. 2012 1

IN THE NAME OF ALLAH, THE BENEFICENT,

THE MERCIFUL

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

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

unjustly, And ye shall not be dealt with unjustly.

SURA AL BAQARA II VERSE 278-279

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2 Journal of Islamic Banking and Finance July – Sept. 2012

Journal Of

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

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Journal of Islamic Banking and Finance

Volume 29 July – Sept. 2012 No. 3 Founding Chairman Muazzam Ali (Late)

Former Chairman * Pakistan Press Foundation (Pak) * Pakistan Press International (Pak) * Institute of Islamic Banking & Insurance (UK) * Former Vice Chairman DAR AL-MAAL AL-ISLAMI TRUST, GENEVA, SWITZERLAND

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Published by International Association of Islamic Banks Karachi, Pakistan. Ph: 35837315 Fax: 35837315 Email: ia _ ib @ yahoo.com

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Board of Editorial Advisors S. A. Q. Haqqani Dr. Hasan uz Zaman Dr. Mohammad Uzair Altaf Noor Ali (ACA)

International Advisory Panel

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

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

Dr, R. Ibrahim Adebayo Department of Religions, University of Ilorin, Nigeria

Prof. Dr. Zubair Hasan The Global University of Islamic Finance, Kuala Lumpur, Malaysia Dr. Waheed Akhtar Assistant Professor, Comsats Institute of Information Technology (CIIT), Lahore, Pakistan Dr. Manzoor Ahmed Al-Azhari, PhD Legal Policy (Shariah & Law) Chair, Department of Islamic Studies Institute of Religious Education & Research (IRER) HITEC University Taxila Cantt Pakistan Professor Dr. Khawaja Amjad Saeed FCA, FCMA Hailey College of Banking & Finance University of Punjab, Lahore, Pakistan

Dr. Mehboob ul Hassan Professor, Department of Business Administration, Sindh Madarsatul Islam University, Karachi, Pakistan Mr. Salman Ahmed Shaikh External Reviewer Bankers Academy USA, Karachi, Pakistan Prof/ Dr. Habib ur Rahman Head Business Administration Deptt Sarhad University of Science & Information Technology, Peshawar, Pakistan Dr Muhammad Zubair Usmani Jamia Daraluloom Karachi


Journal of Islamic Banking and Finance

Volume 29 July – Sept. 2012 No. 3

C O N T E N T S 1. Editor’s Note 09 . 2. Analysis of Islamic Mutual Funds Operations in Pakistan 14 By Salman Ahmed Shaikh 3. Islamic home finance: legality, pricing, and profit – Models compared 24 By Prof. Dr. Zubair Hasan 4. Practices of Insurance Operators in Malaysia: Conventional 40 Vs. Unconventional Life Insurance By Sheila Nu Nu Htay, Wan Reena Zahirah Wan Rosli Shaharuddin & Hanudin Amin 5. Econometric Analysis of Attitudinal Differences of Islamic Banking in Pakistan 54 By Munawwar Ali Kartio, Dr. Anwar Ali Shah G. Syed & Faiz M. Shaikh 6. Riba Regime, Lean Purses and Angry Heavens: Palliatives 61 and Opportunities in the Nigerian Economy By Mubarak Oladosu 7. Focus on Difference between Interest and Trade Profit 70 By Muhammad Ayub 8. The Constitutionality of Islamic Banking and Financing Services 75 By A.S. Orisankoko & K.K. Eletu 9. Examining the Prudence of Islamic Banks: A risk Management Perspective By Dr. Muhammad Imran Ashraf Usmani 93 10. Development of Islamic Banking Industry Focus on Country Models: 100 ● Sudan, ● Indonesia . 9. Note To Contributors of Articles 105 10. Order Form for Subscription/Ad to the Journal 106


Editor’s Note This is a paper on “Analysis of Islamic Mutual Funds Operations in Pakistan”

by Salman Ahmed Shaikh. It pays tribute to Islamic Finance for its phenomenal growth, for its expansion to other sectors and for attracting finances from Muslims and non Muslim investors. It also shows appreciation for its good performance during the recent lean period. The paper gives two Tables showing annualized returns on Islamic and non Islamic mutual funds and Islamic and non Islamic voluntary pension funds under different categories. These show that Islamic funds earned better returns in quite a few categories.

The paper observes that KSE and Al Meezan made a debut in launching the Islamic index in 2008. Their screening methodologies, approved by the Shariah scholars, have been described in the paper. Besides this, the rules of sales of Islamic fiqha have also been quoted. It critically examined the screening rules and finds that several restrictions have been placed on investment, though they do not appear in Holy Quran and have been initiated by Shariah scholars. Similarly the paper discusses the issues in investment management and has quoted Mufti Taqi Usmani who held that Murabaha was not a mode of financing. The paper has also discussed anomalies in Income Purification Methodology and Inconsistencies in Corporate Governance.

The paper has highlighted many a deficiency in the present practice of Islamic banking which therefore deserve notice of concerned quarters.

This is an article on “Islamic home finance: legality, pricing, and profit – Models compared” by Zubair Hasan about home finance. These days house building loans are being issued to borrowers under Musharakah, Mutanaqisah Partnership model which is being considered as free of interest by jurists and bankers both. However the other method known as ZDBM model is cheaper to the borrower and also not costlier to the banker.

Housing is a vital necessity of human beings and no one can live without a house. Banks therefore started the scheme of house building loans. But the return of the loan and the profit for the bank were both a tortuous process and was a source of great trouble for the borrower and was also costly affair as return on loan to Islamic banks and conventional banks was not much different.


The writer of the article Dr. Zubair Hasan devised a Diminishing Balance Model for this purpose which did not involve much trouble for the borrower but was also cheaper. This was known as ZDBM. This model became quite popular but many queries were raised in a seminar against this system. This article has clarified all the doubts raised. It also gives an illustration to further elucidate the benefits of the ZDBM. The article also carries several Tables which also prove benefits of the scheme and also that it will not cause any loss to the banker.

Then explanatory illustration, figures and statistics, have succeeded in establishing that the ZDBM model is worth following and all queries have been reasonably answered supported by figures and diagrams. Those who raised objections may now be convinced of their futility and adopt the models for the benefit of both borrowers and bankers.

This article on “Practices of Insurance Operators in Malaysia: Conventional Vs. Unconventional Life Insurance” written by three authors i) Sheila Nu Nu Htay ii) Wan Reena Zahirah Wan Rosli Shaharuddin iii) Hanudin Amin, explores the difference between these two systems of insurance. Unconventional life insurance has adopted practices which conform to Shariah principles and thus the system has become Shariah compliant. It is surmised that no research has been undertaken before to compare and contrast the practices of both the systems. Hence the present endeavor is to fill up that gap in respect of product development and its related operations.

The paper outlines the working of both these Insurance organization in detail and finds that there was no significant difference between them. It further recommends that future researchers may focus on technical deficit and actual deficit as this aspect has not yet received attention from the researchers.

This paper on “Econometric Analysis of Attitudinal Differences of Islamic Banking in Pakistan” by three authors i) Munawwar Ali Kartio ii) Dr. Anwar Ali Shah G. Syed iii) Faiz M. Shaikh undertake a study to find out the difference in attitudes of Pakistani customers towards Islamic banking and the various factors which account for this variation. On the whole Pakistani customers have a positive outlook for Islamic banking. The paper further opines that customer attitudes depend on demographic characteristics, service attitudes and religious beliefs as has been asserted by various authors quoted in this paper. With the knowledge of this appraisal about the customers, the banks will be facilitated to make adjustment in their service to suit particular segment of customers.

Then follow the details of methodology of research and particulars of t-test embodying ten statements which the samples were required to give their opinion about. The result of research showed that the males held more favorable views about Islamic banking and the females also shared their views but on the whole they appeared to be sitting on the fence. In conclusion it is stated that in view of the findings that good attitude towards Islamic banking was not universal in Pakistan, the


Government and Islamic banks should hold seminars to spread the message of Islamic banking which will definitely result in favorable change of attitudes of all Pakistani customers.

This is an article on “Riba Regime, Lean Purses and Angry Heavens: Palliatives and Opportunities in the Nigerian Economy” By Mubarak Oladosu. It discusses many problems which are being faced by Nigerians and also suggest remedies for their amelioration. In Nigeria the population has been suffering from abject poverty.

Nigeria is a multi religions country but it has been treated as secular which is against reality. Therefore denying some demands from any community on the ground of secularity is unjustified.

A case in point is the establishment of Islamic banks in Nigeria for which Muslims had to wage a long struggle. Nigeria had a windfall of constitutions which were drawn up by succeeding governments but many of them did not make a specific mention of Islamic banking. This came in the way of their establishment although some of them contained sections granting religious and economic freedom to the citizens and could be construed as recognition by the constitution but this interpretation was opposed. Ultimately the matter was reviewed and was found that several constitutions conferred recognition on Islamic banks.

Islamic financial system is based on commandments of God, Sayings of prophet (p.b.u.h) and principles of Shariah. God strictly banned Riba and warned violators of the ban that they would face war from God.

Islamic bank, not only earns money but also accords first priority to the welfare of masses. It favors qurd-e-hasna and thus like the Grameen bank of Bangladesh, Islamic banks can play a vital role in reduction or complete elimination of poverty from Nigeria.

Several writers have justified abolition of Riba. Each has given his own reasons but broadly speaking they all converge on the point that money has no intrinsic value but its value is proportional to the commodity it can buy and therefore no interest can accrue on its own value. Islamic financial system is based on justice and fair play and its introduction will prove beneficial to the country’s economy. It has already shown its resilience during the recent recession when it was least affected by the onslaught of financial storm in which even big economies suffered heavy losses.

This is an article on “Difference between Interest and Trade Profit” by Muhammad Ayub who has elaborately discussed the question which revolves round the practice of Murabaha in which a bit higher price is charged for credit transactions. There are some writers who brand it as interest. The article has rebutted


this misconception by quotation from the Holy Quran, sayings of the Holy Prophet (p.b.u.h) juristic decisions and the principles of Shariah which all rule in favor of this mode subject to certain conditions.

The jurists and Shariah scholars opine that the credit price can be more than spot price provided one price is settled before parting of the seller and purchaser. Islamic Fiqha Academy of OIC support this mode and this also shows acceptance of time value in respect of pricing of goods. Tirmizi, the Muhaddis, says the prophet banned two sales in one contract. If a seller offers two prices one on credit and the other spot, one price should be settled before the contract is finalized.

The concept of time value of money is further strengthened by Shariah banning mutual exchange of Gold, Silver or monetary values except simultaneously in Bai Al Sarf.

Thus it is established that the time value of money in pricing assets and their usufructs is admissible but not for addition to the principal of loans and debts.

In conclusion it is stated that the mark up is allowed subject to compliance of Shariah conditions but it should not be used as a subterfuge for earning interest.

This is an article on “The Constitutionality of Islamic Banking and Financing Services Under the Nigerian Constitutions” by two authors i) A.S. Orisankoko ii) K.K. Eletu. It asserts that Nigeria, which remained under colonial rule for quite a long time, gained independence in 1960 when Muslims desired to introduce the Islamic system of finance but they had to face several objections viz there was no specific mention of Islamic banking in the constitution which was secular and it will also impinge upon the religious rights of non Muslims sector of the population. A series of constitutions were framed from time to time. Some of them contained provisions on freedom of economic and religious activities. These provisions admitted of being construed as a removal of impediments for establishment of Islamic banks.

The matter was reviewed and it was found that Islamic banks and Islamic financial sector are recognized by the current constitutional regime and those that preceded it and therefore the conclusion is “that the sections of the three constitutions, which recognize economic activities generally, have contemplation for the constitutional legality of Islamic banking”

This is an article on “Examining the Prudence of Islamic Banks: A risk Management Perspective” by Dr. Muhammad Imran Ashraf Usmani. It is a synopsis of all the permissible and impermissible acts in the economic fields as enumerated by Islamic Shariah which are based on the commandments of God in the Holy book and the Sayings of the prophet (p.b.u.h) as well as Ijma and Ijtihad. Ijma is the concurrence of Muslims on the solution of an issue and Ijtihad is the inductive derivation of result in respect of an issue from these sources. The instructions cover


the whole gamut of the economic activities and the problems that are encountered in its working.

Islam not only lays down rules for religious observance but it covers every aspect of life including economic activities, ethics and even one’s responsibilities to his fellow beings. In the economic life Riba and Gharar have been banned and indulgence in these practices have been ruled against as it is these malpractices which lead to frequent visitation of recession and other calamities in conventional financial system but Islamic financial system has withstood such storm with great resilience owing to the efficacy of this system and its avoidance of the pitfalls with which conventional financial road is interspersed with.

SBP in their quarterly Islamic Banking bulletin give the historical development of Islamic finance and its present position in Indonesia and Sudan.

Indonesia

Though with majority of Muslim population, Indonesia entered into Islamic banking field rather late than some others like Malaysia and Bahrain. It was in 1992 when the first Islamic bank came into existence followed by suitable legislation for the establishment of Islamic banks and also quite a few organizations for regulating, supervising and licensing came into being. A blue print providing programs for the next ten years was also released. Briefly speaking the Islamic finances have grown in Indonesia but their market share is still small and efforts are required for further development.

Sudan

Faysal Islamic Bank was the first Islamic bank to establish itself in Sudan in 1977. Since then the service has been growing and Sudan leads in Islamic banking service in Africa. Table 1 shows the year-wise development of Islamic banks in Sudan which has now nine Islamic banks. The conventional banking of Sudan played an important role in boosting the Islamic banking in this region. In Sudan Islamic banks and Takaful are operating on Islamic principles supported by relevant laws and Shariah Board. This state of affairs shows the sincere efforts made for enforcement of Islamic banking system in Sudan.

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

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


Analysis of Islamic Mutual Funds Operations in Pakistan

By Salman Ahmed Shaikh*

Abstract Islamic finance is a set of financial institutions representing a connected financial architecture that works based on prescribed Shari’ah principles. Growth in the industry has been stellar, but, certain principles, the strategic direction and the practices do not warrant celebration yet. This paper while noting the impressive performance of Islamic mutual funds in Pakistan, strives to a) discuss the theoretical problems in screening principles followed in investment policy, b) identifies the problematic and less ideal investment alternatives used in practice, and c) highlights the anomalies in income purification methodology. The paper argues that the vision of leading the establishment of an egalitarian and balanced financial system has taken a backseat and increasingly innovative financial engineering seems to have blurred the distinctive identity of Islamic financial system. The paper concludes with the recommendation that in the short term, Shariah regulators must comprehensively train themselves in prevalent financial reporting standards and understand their implications. In the medium to long term, centralized Shariah board and revised financial reporting standards must be structured taking into account special needs of auditing the fulfillment of Islamic principles in practice.

Keywords Islamic Finance, Islamic Banking, Takaful, Murabaha, Ijarah, Mudarabah, Musharakah, Salam, Istisna

JEL Codes E44, G11, G20h 1. Introduction

Islamic Finance industry over the past three decades has diversified itself from banking to other sectors as well and now it comprises institutions such as Islamic * Salman Ahmed Shaikh is a researcher in Islamic Economics. He is pursuing PhD in

Islamic Economics at IBA, Karachi. He also serves as a Research Associate & Lecturer at IBA, Karachi. He has authored 12 papers and a book on Islamic Economics in past.


banks, Islamic insurance companies and Islamic mutual funds. Growth has been impressive during the last decade despite the crisis that hit global financial markets during the time period.

Islamic mutual fund industry has also enjoyed success in attracting investment funds from Muslim investors and also from non-Muslim investors due to their impressive performance. In a study conducted in Malaysia, Abdullah et al (2007) concluded that Islamic funds performed better than the conventional funds during bearish economic trends. Elfakhani (2005) also noted that Islamic mutual funds might be a good hedging investment for any equity investors, if used to hedge against market downturns and recessions.

Islamic mutual fund industry has grown by leaps and bounds globally and in Pakistan as well. Mahmud (2011) analyzing the performance of fund types acknowledged that Islamic funds have shown strong growth. Razzaq et al. (2012) investigated 9 Islamic mutual funds in Pakistan and concluded that returns of these funds were according to their levels of risk.

Currently in Pakistan, there are 15 AMCs (Asset Management Companies) managing Islamic mutual funds. There are 29 open ended funds that are Islamic in the open ended funds category. Besides, there are 18 voluntary pension funds and one closed ended fund.

In Table 1, we present average annualized return of Islamic and non-Islamic open ended mutual funds in various categories during the last 365 days computed on July 12, 2012.

Table 1: Annualized Return for last 365 Days (%)

Fund Category Return on Islamic Funds (%)

Return on Non-Islamic Funds (%)

Aggressive Fixed Income 10.94 7.01 Asset Allocation 9.76 8.48 Balanced Funds 18.00 11.59 Capital Protected Funds 14.64 5.68 Equity Funds 24.67 17.67 Income Funds 10.44 9.32 Money Market Funds 10.47 11.25 Average Return 14.13 10.14

Source: MUFAP

It can be seen that apart from money market funds category, Islamic mutual funds have had higher returns than conventional mutual funds.

In Table 2, we present average annualized return of Islamic and non-Islamic voluntary pension funds in various categories during the last 365 days computed on July 12, 2012.


Table 2: Annualized Return for last 365 Days (%)

Fund Category Return on Islamic Funds (%)

Return on Non-Islamic Funds (%)

Debt Funds 8.86 10.67

Equity Funds 24.10 19.54

Money Market Funds 9.45 10.37

Source: MUFAP

It can be seen that equity funds in Islamic voluntary pension schemes have performed better than their counterparts. But, in debt and money market category, Islamic voluntary pension funds fall behind conventional funds marginally.

Going forward, in section 2, we discuss what are the investment screening principles set for these mutual funds in Pakistan by KSE (Karachi Stock Exchange) & Al-Meezan Investment Management Limited. In section 3, we critically examine these principles. In section 4, we highlight some problematic issues in placement of funds. In section 5, we introduce an anomaly in the dividend purification methodology followed by equity mutual funds in Pakistan. Finally, in section 6, we highlight corporate governance issues in Islamic mutual funds industry.

2. Islamic Screening Principles: KSE & Al-Meezan Criteria KSE and Al-Meezan Investment Management Limited launched the first

Islamic Index (KMI-30) in 2008 in Pakistan which tracks 30 most liquid and active Shari’ah compliant stocks. Their screening methodology approved by the Shari’ah Advisors of Al-Meezan Investment Management Limited is explained below.

2.1 Business of Investee Company The business of the investee company should be Halal. Accordingly,

investments in common stocks of conventional banks, insurance companies, leasing companies, Mudarabah companies, companies dealing in alcohol, drugs etc are not permissible and hence they cannot be included in the portfolio.

2.2 Ceiling on Interest Based Debt Interest based debt must be less than 37% of the consolidated total assets of the

investee company. Interest based debt includes issuing corporate bonds, debentures, Term Finance Certificates (TFCs), commercial paper or using conventional bank loans, capital lease, hire purchase agreements, preference shares etc.

Preferred stock guarantees a fixed share in profit while as per Islamic principles, actual profit either in amount or in percentage cannot be fixed. Plus, there shall be no concept of cumulative dividend as per Islamic principles. Profit sharing ratio can be agreed upon at the start of business or at the start of an accounting period. That pre-agreed profit sharing ratio can be used to distribute "actual profits" earned.


In preferred stocks, whatever is the profit level, the preferred dividend remains fixed since it is not a ratio of actual profits, rather it is calculated based on some percentage of par value of preferred stock. Hence, it is not allowable as per Islamic principles.

2.3 Ceiling on Interest Based Investments

Non-Shari’ah compliant investments must be less than 33% of the consolidated total assets of the investee company. Non-Shari’ah compliant investments include investments in conventional mutual funds, conventional money market instruments, corporate bonds, Pakistan Investment Bonds (PIBs), Federal Investment Bonds (FIBs), Certificate of Investments (CoIs), Certificate of Deposits (CoDs), Term Finance Certificates (TFCs), national savings schemes, derivatives etc.

Furthermore, investments in the common stocks of companies that are termed non-compliant due to violation of any of these principles is also termed impermissible and regarded as non-compliant investments.

2.4 Cap on Shari’ah non-Compliant Income

Non-Compliant Income must be less than 5% of the consolidated total revenue of the investee company.

Where,

Total Revenue = Gross Sales + Total Other Income Non-compliant income includes bank interest, income from gambling,

nightclubs, prostitution, casino, tobacco, alcohol, dividend income from above mentioned businesses or companies which have been declared non-compliant due to non-compliance of any of the mentioned criteria for Shari’ah compliance etc.

2.5 Minimum requirement of Illiquid Assets

Illiquid assets must be at least 20% of the consolidated total assets of the investee company.

Where,

Illiquid Assets = Total Assets – Liquid Assets

Liquid assets include cash, prepayments, advances, trade receivables etc. Illiquid assets include inventory, all fixed tangible assets such as plant, equipment, machinery, furniture and fixture and also included are intangible assets. In the context of these principles, all assets having some intrinsic value and which can be traded above or below par value are illiquid assets. These exclude things like currency which does not have intrinsic value of its own and it also excludes debt which cannot be traded/re-assigned above or below principal value.

2.6 Minimum Price of Share as per Shari’ah

As per the prescribed rules, the value of the company is worth at least the amount of liquid assets it has. Minimum market price per share is given by net liquid assets per share which is calculated as:


Net Liquid Assets Per share = (TA – IA – CL – LTL) / No. of shares

Where,

TA = Total Assets,

IA = Illiquid Assets = Total Assets – Liquid Assets CL = Current Liabilities LTL = Long Term Liabilities

Besides these, rules of sale in Islamic Fiqh also have to be observed which negate the use of short selling, blank selling, selling before possession of subject matter, sale of rights, options, warrants, future sale, forward sale, margin financing etc.

3. Critical Analysis of Screening Principles Islamic scholars have put a ceiling on how much interest based debt could be

used to finance total assets. In Pakistan, if the ratio of interest based debt to total assets is 37 percent or more, then, Islamic scholars disallow investment in ordinary shares of such a company.

Lamentably, this restriction is mentioned in neither Quran nor Hadith and is referred to as an ‘operational restriction’ by Islamic scholars. A company which has used an Islamic debt based mode of finance to finance a fixed asset or used an interest based debt to finance the same asset, then, the company will be rendered non-Compliant for investment in its ordinary shares if it has used interest based financing mode. But, from the perspective of leverage, it will have the same nature of liability and same leverage position. It is incorrect to say that this principle discourages leveraging. Fixed installments will be payable in both cases from economic point of view. But, with higher Islamic banking spreads, fixed installments to Islamic banks will be higher than conventional!

Even if the companies all of a sudden shift to Islamic finance and use Islamic debt based modes of finance, then, from the leverage point of view, their riskiness and liquidity will not be any different from the position when they were using conventional financing.

While small investors are deprived of equity investments in such companies, these companies will be provided with finance by Islamic banks with priority. Hubco, Kapco, Nishat Mills, Engro, Fauji Fertilizer Bin Qasim Limited, DGK Cement, Attock Petroleum etc are some of the companies whose shares had performed well in recent past and they had been provided with finance by Islamic banks. But, for small investors, investment in ordinary shares of these companies was not allowed solely due to an ‘operational restriction’ and on the premise of discouraging ‘leverage’ and promoting ‘Islamic debt based modes of finance’.

Islamic banks would earn exorbitant profits by providing debt based Islamic modes of finance to these companies, but Islamic scholars by way of their self-imposed restriction have deprived small investors to invest in the ordinary shares of these companies.


Small investors already earn negative real interest rate in Pakistan since Islamic banking spreads are 8.80 percent and more than 6.90 percent for the conventional banks (Source: SBP Islamic Banking Bulletin, Apr-Jun 2011). Hence, Islamic financial institutions have not only deprived small investors of a useful way to earn inflation beating returns through equity investments, but with this rent seeking mentality, they have also deprived their depositors by paying them lower profit rates and maintaining world’s highest banking spreads among major countries.

4. Issues in Investment Management To place short term funds, one investment alternative used is known as

‘Commodity Murabaha’ or ‘Tawarruq’. Basing their actions on the opinion of scholars that ‘Murabaha is allowed, even if not ideal’, the Islamic fund managers took the allowance to the extreme whereby in Commodity Murabaha transactions, the subject matter is not genuinely required by both financial institutions, but each of them takes ownership literally for some minutes and execute a complex sale resulting in a profit for one and fulfillment of liquidity requirement for the other.

Through this, the mutual funds invest their surplus liquidity usually with some conventional financial institution. But, the investment with conventional financial institutions leads to some very unfortunate outcomes. Islamic funds take investment funds of customers after convincing them about Islamic principles. But, when they pass on these funds to conventional financial institutions, the conventional financial institutions conduct interest based operations from these funds.

The argument that asset backed nature of financing would ensure effective risk management is also weak as CMOs, MBS, ABS etc were instruments with mortgage loans as their underlying assets. The problem was with excessive leveraging, lax regulation and unbridled pursuit of self-greed and not with securitization per se. Securitization in Islamic finance as in Sukuk also suffered a setback in Dubai Crisis in 2009/10.

Ready buy-future sale is a financial transaction used to circumvent day trading restriction. By taking unilateral undertaking which is binding, a two-leg transaction is executed which enables the fund to invest funds for very short term. This not only encourages shortsightedness and promotes speculation, but also disregards the concept of meaningful long term risk sharing relationship with Investee Company.

To use an alternate of margin financing, Murabaha financing is used. The respected scholar Maulana Mufti Muhammad Taqi Usmani in his article, ‘New Steps in Islamic Finance’ wrote:

“…One must not forget that these instruments are not modes of financing in their origin. They are in fact some forms of trade that have been modified to serve the purpose of financing at initial stage as secondary and transitory measures. Since they are modified versions of certain forms of trade, they are subject to strict conditions and cannot be used as alternatives for interest-based transactions in all respects. And since they are secondary and transitory measures, they cannot be taken as


final goal of Islamic Finance on which Islamic Financial Institutions should sit content for all times to come. It is a matter of concern for a student of Islamic finance, like me, that both these points are increasingly neglected by the players in the field, and especially by the new-comers in the industry.”

Furthermore, in his book, ‘Introduction to Islamic Finance’, the respected scholar, Maulana Mufti Muhammad Taqi Usmani sahab wrote:

“It should never be overlooked that, originally, Murabaha is not a mode of financing. It is only a device to escape from “interest” and not an ideal instrument for carrying out the real economic objectives of Islam. Therefore, this instrument should be used as a transitory step taken in the process of the Islamization of the economy, and its use should be restricted only to those cases where Mudarabah or Musharakah are not practicable.” (p. 72)

It can be seen that Murabaha was initially supposed to be a transitory contract recommended to be used until Islamic finance matures and develops, but now, it along with other debt based modes of financing comprises almost 95% of total financing assets of Islamic banks that are priced using interest based indexes.

5. Anomalies in Income Purification Methodology Some scholars have given income purification methodologies which try to

subtract from the dividend received any non-compliant income portion.

One such method is as follows:

Income to be purified = (Non-Compliant Income / Total Income) x Dividend Received

But, problems with such methods are as follows:

a) Non-compliant income is earned and reported independently as part of net income. Being a common stockholder, one is part owner in every asset and earning of the company whether it is paid in the form of dividend or retained for reinvestment. This has no relation with dividend policy.

b) Company may not pay dividend and still have non-compliant income reported in the income statement.

c) Company may pay dividend, has positive non-compliant income, but negative net income.

d) The formula assumes that total income and dividend paid has proportional relationship which is not true. Dividend policy may take into account many factors. Dividend payout ratio (DPO) is not necessarily constant overtime.

e) There is still a lot of inconsistency in international financial reporting standards both across time and space.

f) By simple mathematics, it can be appreciated that this method does not result in total purification of non-compliant income. Rather, by allowing capital gains


to be exempt from purification process, it tilts the preference towards capital gains and it may result in more speculative short term activities in equity markets rather than investing meaningfully in a company with long term horizon.

g) The second method is given by AAOIFI (Accounting & Auditing Organization for Islamic Financial Institutions). AAOIFI has given the correct purification methodology in its Shari’ah Standard 21. Clause 3/4/6/4 reads as follows: “The figure, whose elimination is obligatory on the person dealing in shares, is arrived at by dividing the total prohibited income of the corporation whose shares are traded by the number of shares of the corporation; thus, the figure specific to each share is obtained. Thereafter, the result is multiplied by the number of shares owned by the dealer—individual, institution, fund or another—and the result is what is to be eliminated as an obligation.”

Hassan & Michael (2011) have identified one issue with this methodology that if a company is not compliant during a period and if it becomes compliant later on, what will be the status of dividend paid during the period. But, the answer to this is that if a company is non-compliant and pays dividend, Islamic funds will not be having this stock in the portfolio in the first place.

In this methodology, stock dividend and stock splits which change the number of shares outstanding are not potential problems as long as the effect is proportionally felt in stock price at least in the most immediate instance. But, even if it is not proportional and different, there is no way, it systematically benefits or costs the investor. Plus, the most important thing is that it ensures total income purification in all cases and does not leave this matter contingent on dividend policy and particular reporting standards followed to prepare financial statements.

Why it is not used then more often enough despite the ruling of AAOIFI standards? It is because it costs more to the mutual funds and this is one example of where the prioritization of goals comes into question once again.

6. Inconsistencies in Corporate Governance Shari’ah scholars in Pakistan are in limited supply. Most noted Shari’ah

scholars are serving several Shari’ah boards at the same time. It is ironic that some are on the boards of commercial financial institutions as well as on the boards of regulators.

One very easy solution to this is a centralized Shari’ah board which could help in standardization and bringing efficiency to the whole Shari’ah compliance process. While it is acceptable that Shari’ah Advisors be paid for their services and consultancy, but, there should be a natural limit to how effectively and efficiently they can perform multiple tasks for so many multiple organizations. Indeed, as the earlier sections of this paper have shown, too much professional and commercial commitment has led to a big gap between theory and practice.

In this regard, the central bank of Pakistan – which is also entrusted with a secondary goal of Islamizing the financial system – is continuously trying to


implement and promote the use of Accounting & Auditing Organization for Islamic Financial Institutions (AAOIFI) standards.

AAOIFI standards are unique and are of pivotal significance in the sense that they are agreed upon by world renowned scholars from seven major Fiqhs (Schools of Islamic Jurisprudence).

Adopting AAOIFI standards will help in creating standardization which will not only increase the efficiency of transaction execution in Islamic finance industry in Pakistan, but it will also promote it by bringing out a unified ruling on matters. In addition to that, it will also pave way for minimizing the non-compliance errors and improve efficiency of Islamic financial institutions.

Conclusion: The Way Forward Increase in financial instruments through issuance in primary market does not

add to ‘Gross Fixed Capital Formation’ unless they are used in a way which increases the productive capacity of the economy. Islamic principles compliment the growth in ‘Gross Fixed Capital Formation’ or productive capacity of the economy by encouraging entrepreneurship in productive sector. Taking on entrepreneurial risk is at the heart of Islamic economics. This risk can only be eliminated at the cost of compromising the basic distinctions of Islamic economic principles. Effective institutions are required to perform financial intermediation that promote entrepreneurial culture rather than circumvent it.

As of now, there is no Islamic investment bank in Pakistan and there is no Islamic venture capital fund. Mudarabah companies that had been in existence since the 1980s have performed in such questionable ways that even the Shari’ah scholars advising Islamic mutual funds regard investment with these companies as non-compliant from Islamic principles standpoint. In voluntary pension funds, there are as many Islamic funds as the number of conventional funds. This just goes onto show that apart from banking, there is so much room in alternate financial institutional structure where Islamic institutions can lead rather than follow. But, their philosophy to mimic and follow the conventional trail as deeply as going towards Islamic derivatives and structured finance disappoints those who expected and hoped for a distinctive and egalitarian financial architecture. Key to that is equity based financial intermediation taking over currently debt based financial intermediation which is circularly linked with banking. But, while Islamic banks maintain higher spreads than conventional banks and have most of their products linked with interest based indexes, there is a long way to go still.

References AAOIFI (2009). Accounting, Auditing & Governance for Islamic Financial

Institutions, Bahrain.

Abdullah, Fikriyah (2007). ‘Investigation of performance of Malaysian Islamic unit trust funds: Comparison with conventional unit trust funds’. Managerial Finance. Vol. 33 (2), pp. 142-153.


Elfakhani, Said & Hassan, Kabir (2005), ‘Performance of Islamic Mutual Funds’. Economic Research Forum. Global Development Network.

Hassan, Kabir & Mahlknecht, Michael (2011). Islamic Capital Markets: Products & Strategies. United Kingdom: John Wiley & Sons.

Mahmud, Mahreen & Mirza, Nawazish (2011). ‘An Evaluation of Mutual Fund Performance in an Emerging Economy: The Case of Pakistan’. Lahore School of Economics. Vol. 16 (SE), pp. 301-316.

MUFAP (2012). Performance Summary of Mutual Funds. Available at: www.mufap.com.pk (Accessed on July 12, 2012).

Razzaq, N., Gul, S., Sajid, M., Mughal S. & Asma B. (2012). ‘Performance of Islamic Mutual Funds in Pakistan’. Economics and Finance Review. Vol. 2 (2), pp. 16 – 25

State Bank of Pakistan (2011). Islamic banking Bulletin, Issue 3, Karachi.

Usmani, Muhammad Taqi (2004). An Introduction to Islamic Finance. Karachi: Maktaba ma’ariful Quran.125


Islamic home finance: legality, pricing, and profit - Models compared

By Prof. Dr. Zubair Hasan*

Abstract The Musharakah Mutanaqisah Partnership model or the MMP is fast gaining popularity in Islamic home financing, for jurists and the bankers both validate it as a totally interest free structure. We have exploded the myth of that validation in our earlier writings and reinforce our argument here . But on a more important side, we shall show that the construct, which some now refer to as the Zubair Diminishing Balance Model or the ZDBM, is cheaper for the customer without reducing in any way the profit margin for the bankers; instead, it provides them with a competitive edge over their mainstream rivals at zero cost. The model is more efficient: it uses fewer resources, the rate of return on investment remaining unchanged. Liquidity in the system is improved and social cause is served as the price of a basic human need is lowered. In contrast, the MMP is complicated, implies compound interest in practice, and is prone to Shari’ah frowns. ZDBM is especially fairer in the treatment of default related issues. It also does not invite the tensions which rental determination/revision or property valuation creates in the MMP programs. In this context the paper refers as illustrations to actual cases from some countries where MMP is gaining ground. The innovation of charging on diminishing balance may usher in revolution in finance.

Key words: Islam; home finance; implicit interest; MMP model; ZDBM.

Introduction It is gratifying to note that Muslim countries have of late been turning to the

importance shelter has among the basic human needs which an Islamic order is obliged to meet for promoting communal peace and harmony; efforts are on the rise * The Author, Professor Dr. Zubair Hasan is a Professor of Islamic Economics and

Finance, INCEIF: The Global University of Islamic Finance, Kuala Lumpur


to bridging the yawning demand and supply gap in this vital area of civilized living. Islamic banks too have launched a number of schemes for home financing. Among them, they initially started with the structures based on the BBA but are recently shifting fast to Musharakah Mutanaqisah Partnership (MMP) models as replacement due to their apparent immunity from interest. However, Hasan (2011) demonstrated that the conventional finance and the MMP are at par with regard to interest use and that the Diminishing Balance Model -- henceforth called the ZDBM -- is a better alternative. The proposed model is entirely free from juridical suspicions and has in principle already won affirmation from a few industry leaders of international repute. That paper compared the consequences of three alternative structures for home financing – the conventional, the MMP and the ZDBM – keeping the details of the case unchanged. It was shown that the results were identical for the conventional and the MMP models; the ZDBM being not only cheaper for the customer but at once interest-free and law abiding. The paper was presented recently at the monthly faculty seminar at INCEIF to elicit comments. Some doubts about the efficacy of the model to match the current Islamic finance environ demands and modus operandi were voiced. The present revision seeks to clear those doubts and brings to light a few additional merits of the ZDBM.

The queries: The main points raised at the seminar included the following.

1. The illustration uses six-monthly installments. In most home financing cases the contracts provide for monthly payments. The results arrived at might have been different if the installments payment were kept in the illustration of the same duration.

2. The illustration does not explain why or from where it takes 8% as the rate of return to derive its results. The ZDBM is apparently cheaper because the return does not cover the cost of capital as also the risk premium.

3. If the ZDBM is cheaper for the customer by the same token it is less profitable for the banks– why should the latter accept or implement it?

4. The installments in the ZDBM are not fixed, that may confuse the customer with reference to the payment schedule. Also, the payments in the model are larger in the beginning and could be harsh on the young home buyers: the scheme is not commensurate with the lifecycle income hypothesis at the theoretical plane.

5. Banks prefer faster return of their capital and it is faster in the MMP than in the ZDBM, banks would tend to shun the latter.

6. The MMP model deployment in Malaysia is different than in other countries, a local case must have been included in the study if its claims are to carry conviction in this country.

To me, the first two of these comments hold little water. The exercise was purely illustrative meant to bring out the model differences. Using common data was a methodological imperative not an expression of ground reality and its


complications1. Whatever benchmarking the industry is using in other cases may be used for deciding the mark-up in the ZDBM. Comment three ignores the common experience that cheaper things sell more and faster. ZDBM lends the Islamic banks a much needed competitive edge in the market: what they would lose on the swings more than that they must gain on the rounds. Whether the installment amount is fixed or continually falls as in the ZDBM makes little difference to the customer as he would have the schedule of installment known before he signs the contract. Anyway, we shall revert to this objection later in the discussion. Banks do prefer faster return of their capital but the claim that recovery is faster in the MMP compared with the ZDBM is, we shall see, contrary to the facts.

The demand for inclusion of the Malaysian case is doubtless weighty and genuine. We could not lay hand on a numerical illustration as to how an Islamic bank in Malaysia determines the rental or the installment amount for home financing contracts. In our search the easiest was to look for an explanation of the Malaysian MMP operations in Rosly (2010, pp.141-143) the Head of the Banking Department at INCEIF. The reference did not simply contain the needed information: the book does not explain or illustrate as to how the amount of installment is fixed in Malaysia or elsewhere. Instead, the chapter raises a number of queries without answering any. An internet search however provided succour. The available information though not sufficiently revealing did show that even as the banks use different rental rates - fixed, floating or mixed - in home financing contracts in the Malaysian usage of MMP, the technical procedure of rental rate adjustment to arrive at the installment payments is the same2. The MayBank announcement, the ISRA paper, ‘Shaping Islamic Finance together – Malaysia’Home page plus the write up of Osmani & Abdullah (2010) were reassuring.

In any case, the fixed rental usage remains on the table in Malaysia as well. If the amount of investment and frequency of installments is known a redemption factor is added to the rental to so fix the periodic Installment that the future incoming money flows may be discounted back to the current value of investment. This is the standard amortization technique used by conventional interest financing. Calculators are programmed to help customers find out for themselves the installment amount by feeding the relevant data into the system. One such calculator is available at the Kuwait Finance House web page.

An Illustration One illustration of this sort of amortization process is available at the web page

of LARIBA the Islamic finance arm of the celebrated American Finance House; The

1 Incidentally, one may note that in MMP “the rent is calculated based on 1 year LIBOR.

The floor rate (minimum rate) and the ceiling rate (maximum rate) are stated based on which the rentals rate can vary. In agreement, it is stated that if payment is made on time, the transfer of ownership will take place accordingly” (Shaikh 2011).

2 The MMP agreement of HSBC Amanah uses in their MMP home financing the standard mainstream formula A = PVm /1 – (1 + rm) - n for discounting back the future stream of cash flows to their present monthly value A, given the present value of the flows PVm, r the monthly rate of return and the time frame n. Palpably the formula operates through a compounding of interest principle


“Lease to Purchase model” or LTP of the bank is typical of the MMP deployment in the home financing area. To explain the LTP application process the AFH takes in their illustration the cost of home as $150,000. The client pays $30,000 as down payment while the remaining $120,000 is provided by the LARIBA. The property is purchased jointly by the parties. The deferred payment is to be cleared over 15 years; the transaction involves an implicit interest rate (p.3)3. What this rate is they do not indicate in the document. However, it is not difficult to find its magnitude from the data they provide in their Table 1 as reproduced below.

Table 1: Amortization scheme under the LARIBA LTP Model

Month Return on capital

Return of capital

Payments Balance

Beginning --- --- --- $120,000 1 $800 $347 $1147 $119653 2 $798 $349 $1147 $119304 3 $796 $351 $1147 119054 --- --- --- --- --- 179 $6 $1141 $1147 870 180 $7 $1140 $1147 $0 Total 86460 120000 206460 Rate of return =86460 /15 = 5764. (5764/120000)100 = 4.82%

The rental being $1000 a month, the annual return on $150,000 will be 8% (interestingly, the same as in our example). Now, if we assume the capital redemption factor added to this rental as B, we have:

(0.08 + B) 120,000 = 1147 X 12 ($1147 is the monthly installment)… …. (1) This yields 9600 + 120,000B = 13764………………………………………….... (2) Therefore, B = [13764 – 9600] / 120,000 = 0.0347 or 3.47 %.................................(3)

Thus, 3.47% is what the AFH document refers to as the imputed or implied interest we noted above. It is easy to verify the result. Putting B = .0347 in equation (1) we get the monthly installment = $1147, the same as in Table 14. Thus, there is riba in the home financing program of the LARIBA. Still, the AFH claims and extensively publishes the world over that their model is at once Shari’ah compliant! They nicely rap up interest in a rather foxy language as to how the return on capital is determined. Conventional banks straight away tell the customer that the quoted interest rate is not sufficient to fix the installment amount that would redeem his liability to the bank on the stipulated date unless an appropriate redemption factor is

3 This disclosure had to be made in compliance with the requirements of the financial

law in the US. 4 Note that we have calculated the entire data for the Table as included in the Appendix.

To do that we have derived two formulae given below---(i) Kn = βK n -1- I, Where Kn = Outstanding balance at nth installment number, I = Installment amount β = (1+R/A) where R = Monthly rent and A = initial value of the house. (ii) r = [I- (R/A)Kn] where r = capital return component in the nth installment.


added to the rate5. But the LARIBA document states that the total monthly charge containing return of capital plus the return on it would be a fixed amount depending on the payment plan data – the agreed rental, number of installments and the initial contribution of the parties to acquire joint ownership of the house. The implicit addition of a redemption factor is not mentioned. This is happening even as AFH has the cream of world jurists at their advisory led by Sheikh Taqi Usmani who append their signatures to the document. Possibly the learned Jurists could not look into the mathematics of the model. In substance the position is presumably no different in Malaysia.

Of course, there usually is a provision in the MMP to review the rental rates for a change with mutual consent of the contracting parties especially if it is a long duration deal. But that does not alter the underlying amortization principle used with an in-built interest factor. The contract can be having time tranches using different rentals but the amortization process used for fixation of installments for a tranche remains unchanged. Meera and Razak (2009 Sections 3.1 and 3.2) have candidly demonstrated the fact using both (a) flexible rentals and (b) flexible property prices. Banks in Malaysia tend to tie the rental with movements in the BLR/BFR to impart what they call flexibility to the rental under the MMP.

Let us now explain the Diminishing Balance Model (ZDBM) and show its working using the same LARIBA illustration. Assume that the bank proposes to the client as follows. You have already paid $ 30000 to the seller as earnest money. The remaining $ 120000 the bank shall pay for acquiring the co-ownership in the house, you acting as our agent. For getting back the amount in 180 monthly installments over a period of 15 year, we shall put a yearly mark-up of 8% on our share in the cost of the house. However, the mark-up amount will be reduced proportionate to the return of our money. That would help reduce your liability to the bank. The registration of the house in the court will be in your name but you will have to sign a mortgage deed pledging the property with the bank as security until installments as per Table 2 have all been cleared in full. The Table provides the calculation for your monthly installments.

The return on capital portion in the installment is calculated at an agreed annual mark-up of 8% per annum operating on the diminishing balance. Thus, the installment would have a fixed component of capital return amounting $ 666.67. The return on capital will be calculated on the capital remaining outstanding at the beginning of each month at .08 /12 = 0.00667 or 0.667%. The return on capital RoC for any installment n can easily be found using the following formula

RoC(n) = [ A – (n-1) C ] r Where n is the required installment number A is the initial payable amount C is the fixed capital component of the installment and r is the monthly mark-up = $ 13.32 the same as in Table 2.

5 In fact conventional banks add an appropriate redemption factor to the interest rate to

ensure that the discounted income stream that installment payments generate equals to the present value (PV) of the loan. The jurists have to clarify the reason of allowing it in the MMP contracts as it imparts an interest element to the agreed upon rental rate.


Table 2: Working of the Diminishing Balance Model

Installments Number

n

Return of capital

B

Diminishing balance

C

Mark-up amount

D

Installment Payments E = B + D

0 --- 120000 --- --- 1 666.67 119333.33 799.20 1465.87 2 666.67 1118666.66 794.76 1461.43 3 666.67 1117999.99 790.32 1456.99 --- --- --- --- ---

178 666.67 1999.41 13.32 679.99 179 666.67 1332.74 8.88 675.55 180 666.67 666.07 4.44 671.11

Total 120000 --- 72395 192328 Rate of return =(72395/15 = 4826. (4826/120000)100 = 4.02%

Figure 1: Diminishing Balance Model in operation: Three independent contracts

For example the return on capital for installment number 178, we can get it as under.

RoC(178) = [ 120,000 – (178 – 1) 666.67 ] .00667 =13.32

If we add to this amount the capital component 666.67 we get Installment 178 = $ 679.99. Notice that three separate contracts are involved in completing the sale-payment process under the ZDBM program.

1. First is a contract of sale for joint ownership of the house involving three parties: the bank, the customer and the seller. The customer agrees to treat the earnest money as paid for both the partners. The seller sells the property to the co-ownership of the bank and the customer after the former pays the balance of $ 120000 to him to acquire an 80% share in the house.


2. Second is the contract between the customer and the bank, the latter selling his share in the property to him with an agreed mark-up spread at 8% a year on the outstanding amount.

3. Third is the contract whereby the customer mortgages the house with the bank until the payments are all cleared in accordance with the terms of the mortgage.

The three contracts are to be executed consecutively. The house is to be registered in the name of the customer. The customer would have to pay as return on capital (RonC) to the bank in both MMP and the ZDBM additional to the return of capital (RofC) component in the installments. The calculation of the de facto rate of return on capital is shown in the Tables above. In each case the total return is first divided by 15 the number of years involved. The result is then used to calculate the rate of return on capital $120000. It can be seen that in the MMP structure the customer has to pay a higher rate (4.8%) than under the ZDBM (4.02%). The gain of 0.8% a year i.e. $80 each month in substantial payments will be welcome to anyone – a cool $14400 saving over the contract period. This gain would increase with shortening of period or converting monthly installments to yearly ones, other things remaining unchanged.

Capital Cost Risk Coverage And Related Issues Critics argue that the ZDBM is cheaper because it ignores capital costs and risk

premium which elements are taken care of in the MMP model by adding a redemption factor to the base rental. Let us not raise here the ticklish issue as to how this component is measured and how logical is its basis. Granted for the moment that its determination is not arbitrary and quantum unfair, it is interesting to note that the ZDBM without in any way reducing the margin of profit for the bank.

It is cheaper because it reduces the funding deposits of the bank proportionate to the reduction in profit thus leaving the margin unchanged.

Price = cost of funds + risk factor + hurdle costs + overhead costs

Cost of funds includes deposit cost, statutory reserve ratio (SRR) and liquidity requirement (LAR) cost. Risk factor includes cost of capital charge to absorb market, credit and operational risk. Hurdle rate is the return the bank expects to earn.

Since objective of this brief note is restricted to showing that under the ZDBM deployment, the bank’s rate of return on capital investment remains unaffected, we have assumed that deposits match with financing amortization balance. SRR is taken at 4% with zero return and LAR at 2% on 1% minimal return. Capital charge is calculated at 4% equaling half of the 8% mark-up the bank uses. Hurdle rate and overheads are ignored to keep the matters simple. For demonstration we are using the same illustrative case of LARIBA as we used in the earlier paper.

The indicated rates in column headings being annual have been divided by 12 in each case to calculate monthly figures. The excerpts from relevant Excel worksheets are produced below for both the ZDBM and MMP cases to show that the


de facto rate of return in the two models are the same. The Tables also narrate the happenings on both the assets and liabilities sides of a bank’s balance sheet. Notice also that the return on investment is identical at 4.82% (0.41 x 12) in the two models (Column 12). However, the funding deposits are much lower in the ZDBM – about 20% less than the MMP. Thus, ZDBM is more efficient than the MMP in matters of fund utilization and possibly in granting liquidity.

Table 1: ZDBM is cheaper for the customer without being costlier to the bank

Table 2: MMP absorbs more funds inflicting higher cost on the customer

The exercise above may not be very sophisticated but I believe it does clinch the claim under discussion. The chart below makes the case clearer. One can easily see that the funds commitment curve for the MMP has a marked bulge which is both the effect and evidence of the usage of compound interest formula in the installment determination. The ZDBM follows the straight (line) path.


A related claim is that return of capital in MMP is faster compared with the

ZDBM. This too defies facts. The rent in MMP is shared in the capital contribution ratio of the parties which remains higher for the bank for quite some time thus giving it a larger chunk of rent in the fixed installment relative to the capital return component in it. In contrast, the capital recovery component in the ZDBM is fixed; the installment tapers off due to the bank share in the rental from the high to low values. Figure 3 based on data in the Appendix helps clarify the position. It is clear that until month 93 the return of capital remains higher in the ZDBM. It is uniform through out. In the MMP recovery is much slower in the initial stages but climbs up at an increasing rate becoming higher and higher after the mid-way is crossed.

Figure 3: Return of capital is higher under the ZDBM until the 98th month

Finally, it is argued that the addition of what is called the redemption factor to the interest/rental rates in the conventional/MMP models has the advantage of keeping installments uniform over the contract period which may have some psychological value for the customer. But firstly a bank offering ZDBM can explain to the customer that installment payments will be known to him in advance from the schedule attached to the contract. Secondly, if one still insists on uniformity of installments as indeed crucial one can make them uniform under the ZDBM as well.


We may divide the total payment on capital and income accounts under the ZDBM by the number of installments to obtain uniformity. From the uniform installments so obtained we deduct the monthly income to find the capital component column./ We reproduce the data of Table 2 after necessary adjustments in Table 3.

Table 3: working with uniform installments

Installments Number

n

Return of capital

B

Diminishing balance

C

Mark-up amount

D

Installment Payments E = B + D

0 --- 120000 --- --- 1 269.25 119333.33 799.20 1068.45 2 273.73 1118666.66 794.76 1068.45 3 278.13 1117999.99 790.32 1068.45 --- --- --- -- - --- 178 1055.13 1999.41 13.32 1068.45 179 1059.57 1332.74 8.88 1068.45 180 1064.01 666.07 4.44 1068.45 Total 120000 --- 72395 192328

Rate of return =(73327/15 = 4826. (4826/120000)100 = 4.02%

The exercise of making the varying installments uniform in the DBM in fact brings to focusing on a few more merits of the structure compared to the MMP. Consider the set of diagrams in Figure 4.

A Figure 4 Uniform Installments and their components B

They help highlight some more features of the model. in addition to its relative cheapness. RonC crosses the RofC earlier in the model than in the MMP. It means that the outstanding debt on a default date after that point would be smaller n the ZDBM model. The Appendix reveals that until month 77 the bank receives $34670 as return of capital under MMP and the remaining $52802 as return on it out of the total installment payment of $ 87172. Bank preference is clear; its position strengthens in a situation of default. To illustrate, suppose the default occurs in the 77th month itself. Over 70% debt in MMP is still outstanding, while the customer has paid almost 46% of the return on capital the bank would eventually get under the contract in 42% of the time. Is this a fair and equitable situation from the individual or societal view point? On the other hand, under the ZDBM the return of capital is pro rata – 42% returned in equal time and to the advantage of the bank. Finally, the non-linearity of the curves in MMP unveils the compounding element in the variables. The linear functions in the ZDBM confirm its absence.


Concluding Remarks This paper reinforces the argument of my earlier writings that the MMP model

for Islamic home financing is no better than its conventional counterpart in riba usage or its consequences for the participants in the program.6 The amortization exercise in these contracts uses not only interest but the rates invariably follow a compounding pattern, something even more severely condemned in the Quran. How Islamic jurists could stamp such agreements as Shariah compliant just beats me. It may be argued that MMP uses interest rate just as a bench mark. But for that reason the result of the model should be different if rate of interest on home finance and the rental are identical. Unfortunately, that is not the case. I trust Islamic bankers would take note of the Diminishing Balance model - the ZDBM. It is at once Shariah abiding and cheaper for the customer. Also, it avoids all the complexities of the rent or property value revision that confront us in the MMP. The relatively larger installments in early stages in the ZDBM may be a boon not a bane for younger people who may not have started the family yet or may be having fewer small kids. The life cycle income hypothesis need not haunt us; it is a tiny ghost, if at all.

In fact the model enunciates a general principle and procedure, home finance taken as an illustration. Once this principle and procedure are accorded recognition by the industry, Islamic finance modes are likely to undergo some radical and gainful transformation giving a much needed competitive edge to the system over the conventional in every sphere of economic activity. Malaysia can add another shining feather to its leadership cap in Islamic finance.

Acknowledgements The author expresses his deep gratitude to all those who sent in their comments

on the earlier versions of this paper. Among them, I would like to mention the names of the former and the current PCEOs of INCEIF Mr. Agil Natt and Mr. Daud Vicary Abdullah respectively, both counted among the leading lights of the banking industry at the global level. Mr. Daud wrote about the Diminishing Balance Model or the ZDBM for Islamic home financing on the INCEIF Blog - Diamonds in the cupboard - on August 22, 2011 as follows 6 The situation in Malaysia is unclear. Most banks using the MMP facility do not publish

unlike LARIBA the working of their models. The agreement pro forma does not explain the juridical aspect of the contract. Explanatory worksheets are not available. On the other hand, the documents hardly miss any clause to widen the discretionary powers of the banks. Even the daily receivable profit is calculated in some cases to better inform the customer – one is prompted to ask: is profit interest? It is time that the regulators lay down the minimum what the banks must reveal and cannot insert in their standard agreement forms. At present, vagueness to the bank advantage is their hallmark.


As a former practitioner I found the content not only fascinating, but also the relevance of the ZDBM structure for reducing the cost of Home Financing to the customer. I would strongly recommend that my colleagues in the profession and Islamic Finance customers alike to take a look at this innovative product and see how it can be implemented for the benefit of all as soon as possible.

Thanks are also due to Nurhafiza Abdul Kader Malim, and med Ashraf bin Mohamed Iqbal, going through a few earlier drafts for error removal, the latter making some valuable suggestions for strengthening the argument. Roslan Ahmad deserves special mention for his valuable contribution on product pricing.

References American Finance House – LARIBA: Financing alternative to the conventional ,

Riba System, Lariba.com Home Financing – Accessed on 24.10.2011 Guidance American Finance House – LARIBA: Financing alternative to the

conventional, Riba System, Lariba.com Home Financing – Accessed on 24.10.2011

Guidance: residential Shari‟ ah Compliant Finance v. Conventional Finance www.Guidanceresidential.com – Accessed on 24.10.2011.

Hasan Zubair (2011): Islamic home finance in the social mirror, ISRA: International Journal of Islamic Finance, Vol. 3, No.1 June.

HSBC Amanah Malaysia: Homesmart – 1 Facility Agreement (Revised Aug ’09 –Musharkah Mutanaqisah) Received 3 pages from a customer by E-mail on 18.11.2011

ISRA (2011): Financing based on Musharikah Mutanaqisa contracts, Downloaded on 12.11. 2011.

Malaysia International Islamic Finance Centre (November 12, 2011): Shaping Islamic Finance together – Musharikah Mutanaqisah – Last update Downloaded 12.11.2011.

Maybank2u.com (November 12, 2011: Musharkah Mutanaqisah Term Financing(MMTF-i) – A shari’ah compliant financing facility for asset acquisitions and refinancing. Downloaded 12.11.2011.

Meera, A. K. M & Razak, D. A (2009): Home financing through the Musharakah Mutanaqisah contracts: some practical issues, JKAU: Islamic Economics, Vol. 22, No.1, pp. 3-25.

Meezan Bank Easy Home works on a Diminishing Musharakah basis – Accessed on 24.10.2011

Osmani, N.M & Abdullah, M.F (July 2010): Musharakah Mutanaqisa Home Financing: A Review of Literatures and Practices of Islamic Banks in Malaysia, International Review of Business Research Papers, Volume 6, No. 2

Rosly, Saiful Azhar (Third print 2010): Islamic Banking and Financial Markets, Dimanas Publishing, Kuala Lumpur

Shaikh, Salman Ahmad (2011): Current Home Financing Structure in Islamic Finance, Halal Tanweel. http://www.halaltamweel.com//2215/ISLAMIC-FINANCE-Home-Finance Accessed 11/21/2011 12:07:17 PM

Zayan Finance: The declining balance program - integrity in financing; Shari'ah Compliance information.www.zayanfinance.com/ii-shariah-compliance.php - Accessed on 24.10.2011


Practices Of Insurance Operators In Malaysia: Conventional vs.

Unconventional Life Insurance By

Sheila Nu Nu Htay♣, Wan Reena Zahirah Wan Rosli Shaharuddin♣, Hanudin Amin♦

Abstract Risk is part and parcel of our daily life and we have been trying to find out the way to protect ourselves in the case of misfortune. That is the reason why insurance came to play an important role in our life. Unfortunately, insurance seems to be not fully complied with unconventional (Islamic) aspect and hence, it has been modified to ensure unconventional requirements. However, to our knowledge, no research has been done to what extent these two differ and hence, the objective of this research is to examine the current conventional and unconventional life insurance practices in Malaysia. Interviews and the questionnaires have been conducted and the findings show that there are no significant differences in practices except for product development and allocation of premium contribution.

Keywords – Life insurance, Family takaful, Insurance operators, Marketing strategy.

1. Introduction Humans are prone to perils and misfortune. Precautionary steps should be

taken to protect individuals from any unforeseen perils and misfortune. One of the ♣ Dr. Sheila Nu Nu Htay is an Assistant Professor at the IIUM Institute of Islamic

Banking and Finance, International Islamic University Malaysia. E-mail: [email protected]

♣ Wan Reena Zahirah Wan Rosli Shaharuddin is a graduated Master student (Islamic Banking & Finance) from the IIUM Institute of Islamic Banking and Finance.

♦ Hanudin Amin is a lecturer at the Labuan School of International Business and Finance. E-mail: [email protected]. He is also a PhD student at the IIUM Institute of Islamic Banking and Finance.


means to seek the protection is seeking the shelter from insurance coverage. There are basically two main groups of insurance products, namely general and life insurance products. In this study, it will focus on life insurance product. Life insurance policy contract is a legal contract between the life insurance company (insurer) and the person proposing for insurance (insured). Based on the contract, the insurer agrees to pay the insured a certain amount of money (sum insured) and any accrued additional benefits on the happening of some specified unforeseen events such as the death of the insured or his survival to the end of the contract. In return, the insured agrees to pay a regular sum (premium) periodically to the insurer for a specified term until the insured’s death. In Malaysia, there are seven types of basic life insurance policies which are the term insurance, whole life insurance, endowment, investment-linked, life annuity plan, supplementary rider/cover, and mortgage reducing term assurance (MRTA). However, current insurance products and their practices have been criticized from the unconventional point of view for the involvement of uncertainty, interest and gambling (Ab-Rahman et al., 2008; Billah 1998). Alternatively, unconventional insurance has been introduced by adopting conventional insurance operating processes and structure and by founding on principles of mutual assistance and the contribution is provided by the insured (Mankabady, 1989).

Based on The World Takaful Report 2011, the global unconventional insurance contributions grew by 31 percent in 2009 to US$7 billion as of 2011. The opportunities in core markets also suggest a US$12 billion industry by 2011. It is also seen that the global gross unconventional insurance contributions reached US$7 billion in 2009, and continue to boast healthy growth. The achievement of this significant growth by the unconventional insurance industry motivates us to conduct this research.

Importantly, many researchers have highlighted the distinction between conventional and unconventional insurance from the theoretical aspects. Among others, are (Anwar, 2008), (Jaffer et al., 2010) and Mubbsher (2011). However, to the extent of our knowledge, there is no research that has been done in comparing and contrasting between their practices starting from the beginning (product development stage) until the end (maturity). Hence, the main objective of this study is to compare and contrast the conventional and unconventional insurance products in terms of the product development stage and its related operations such as the term of contract, pricing, premium portion, nomination, claims disbursement in the case of suicide, termination of the policy, marketing strategies, lapse ratio and in event of deficit of the risk fund. Since the conventional insurance is repacked to be in line with unconventional requirements with the help of unconventional scholars, this study further examines their opinions on the differences between the conventional and unconventional insurance products.

2. Conventional Life Insurance In a conventional company, the company receives premiums from the

policyholders. Aside from the premiums, the company also takes fund from its shareholders. Therefore, the conventional insurance company’s capital consists of money from the premiums and the shareholders’ fund. With that, the company sets up its reserves and it generates investment income on the capital and reserves. The


conventional insurance company also pays out claims, expenses and reinsurance from the capital and reserves. According to Insurance Info (2009), the main reason for life insurance is to provide income replacement to insured’s immediate family after the demise of the insured. The other reasons include financing the insured’s children’s education, having a saving plan for the future so that the insured have a constant source of income after retirement, and ensuring that the insured have extra financial support in the event of serious illness or accident. There are four main types of life insurances offered in Malaysia and they are explained below.

The first type is whole life insurance policy. Explained in more detail, whole life insurance policy is a policy which provides protection over the insured’s entire life. The policy promises to pay the sum insured upon the early death of the insured or upon the insured reaching a specified age such as 85, 90 or 100 years (Insurance Info, 2009). The second type is term insurance policy. Term Insurance Policy provides the payment to the beneficiary if the insured dies within a specified time period. The sum insured of the policy is payable only in the event of death of the insured and nothing is payable if he survives till the end of the term. When the term ends, so does the coverage, unless the policy is renewed (Insurance Info, 2009). The third type is endowment insurance. Endowment insurance provides the payment of the sum insured (endowment) upon the death of the insured during a fixed term or at maturity if the insured is still alive. The money will also be paid if the insured suffers total and permanent disability during the specified period. An endowment life insurance policy creates two advantages for the insured; savings and protection. The fourth type is investment-linked insurance. Investment-linked insurance, under which, the insured’s premium is used to buy life insurance protection and units in a fund managed by the life insurance company. The benefits paid to the insured or the insured’s nominee will depend on the price of the units at the time the insured surrender the policy or the insured pass away.

3. Unconventional Life Insurance Similar to conventional life insurance (CLI), unconventional life insurance

(ULI) is usually used as a means to provide financial aid for a client’s dependents should the client die (Yuen, 2005). Certain types of ULI may also pay out if the client becomes unable to work due to illness or disability whether it is permanent or temporary. In other words, this type of insurance is a combination of a mutual financial indemnity and an investment scheme. Under this type of insurance, the policy holders' premium is divided between the risk fund (Participant’s Special Account or PSA) and the balance into an account for the purpose of participant’s savings and long-term investment (Participant’s Account or PA). According to Engku-Ali and Odierno (2008), the main types of ULI products are individual unconventional life insurance plan and mortgage unconventional life insurance.

Under the individual unconventional life insurance plan, upon maturity of the certificate, the policyholder shall receive the amount accumulated in the PA which is meant for the saving and investment. The policyholder will also receive any proportionate surplus, if any, that comes from the PSA (Engku-Ali & Odierno, 2008). However, in the event that the policyholder dies before the maturity, the


company will pay the benefit to the nominee of the policyholder. The sum that will be paid includes the balance due to the deceased policyholder from PA prior to the date of his/her death and the sum covered payable from PSA.

In the case of education unconventional life insurance, it provides the policyholder with protection and long-term savings to finance the higher education expenses of his/her child. The policy provides the child with financial benefits if the policyholder suffers any setbacks which are covered under the policy. The policy also gives the child long-term saving or education fund that the child can use to further his/her studies.

4. Conventional And Unconventional Life Insurance Theoretically, there are six main differences between the general practices

conventional and unconventional life insurance.

Regarding contract, in CLI, the paid premium creates an obligation against the insurer based on a sale and purchase transaction where the subject matter is the coverage offered by the contract. However, the policyholders of the ULI mutually pool their contributions and share the liability of each participant. In precise words, all participants agree to help one another. Any claims made by a policyholder in case of peril, loss or etc will be paid out of the pool (Anwar, 2008). In the case of investment, for CLI, there is no restriction imposed on the investment of funds except those arising from prudential regulations. However, in ULI, any investment made must only be invested in Shariah compliant assets (Anwar, 2008).

For risk sharing, in CLI, a risk transfer mechanism exists whereby risk is transferred from the policyholder (the insured) to the insurance company (the insurer) in consideration of the premium paid by the insured. In the case of ULI, all participants share the insurance risk. The participants do not transfer the risk to the company. Concerned with profit distribution, for CLI, the policyholders do not get any share of the profit while, in ULI, the policyholders are allowed to share the surplus depending on the ULI models adopted by the company.

Related to the payment of insurance commission and third party fees, in CLI, the commissions are paid out of the premium income fund. However, in UCL, any third party fees are part of the operational expenses and are therefore paid by the company from the shareholders’ fund. In addition to that, in practice these fees are specified in the ULI contracts. With regard to extra risk premium loading, in CLI companies, the premiums are usually loaded when extra risks are perceived for example a person in poor health or dangerous occupation such as construction worker. The practice in the ULI is slightly different. Theoretically, in the later, no one is discriminated against for foreseeable extra risk. However, according to the underwriting criteria, the contribution is higher for the participant that will bring a greater threat to the policyholders’ fund.

5. Research methodology Among the CLI and ULI products, the endowment insurance policy and

individual saving unconventional life insurance are selected since both of them have the highest demand according to the preliminary interview. The practices of selected products are examined starting from the product developmental stage until the maturity.


There are eleven licensed ULI and fourteen ULI companies. All of them are approached for interview. In this research, interviews are conducted in three steps. Firstly, the interviews are conducted to know the key practice stages involved for the selected sample products. Secondly, the interviews are conducted with the related personnel of five ULI companies and five CLI companies to find out the difference in practices. Finally, five unconventional advisors are interviewed to seek the rationale behind similarities and differences in practices. The opinions of advisors are crucial since they are the experts who approve ULI products before offering them to public.

6. Findings 6.1 Profile of respondents

There are eleven licensed ULI companies offering various products, five licensed life and general businesses, and nine licensed life businesses only. However, for the second set of questionnaire to examine their current practices, five responses from the ULI companies and five responses from the CLI companies are received. The respondents are from the senior management with at least ten years of working experience and the management team from the product development team with at least five years of working experience. Their profile can be referred to Table 1.

Table 1. List of respondents from the first set of questionnaire Respondent Gender Industry Position Area of expertise

1 Male Takaful Senior Manager Actuary Product Development

2 Male Takaful Senior Manager Family Product and Operation

3 Male Takaful Senior Manager Marketing 4 Female Takaful Management Product Development 5 Female Takaful Agent Family Products 6 Male Insurance Senior Manager Actuary 7 Male Insurance Senior Manager Product Development 8 Male Insurance Management Marketing 9 Male Insurance Agent Life Insurance Product

10 Female Insurance Management Life Insurance Product

The third set of questionnaire is sent to ten unconventional advisors who have more than five years working experience. Out of ten, five agreed to respond to the questionnaire. Their profile can be referred to Table 2.

Table 2. List of respondents from the second set of questionnaire Respondent Gender Industry Position

1 Male Takaful Shari’ah Advisor 2 Male Takaful Shari’ah Advisor 3 Male Takaful Shari’ah Advisor 4 Male Takaful Shari’ah Advisor 5 Male Takaful Shari’ah Advisor


6.2 Findings on the practices of conventional and unconventional life insurance Based on the preliminary interviews with the experts from the interviews, we

have identified that there are ten main stages of two products, namely the endowment insurance policy (proxy for conventional life insurance) and individual saving unconventional life insurance (proxy for unconventional life insurance). Only these main stages are focused to find out whether there is any significant difference between their practices.

6.2.1 Findings on product development process The main stages of process under product development and the comparison of

both products can be referred to Table 3.

Table 3: Product Development Processes List of the main processes under

product development

Family Takaful Product:

Individual Saving and Protection Plan

Life Insurance Product:

Individual Endowment

Plan The product owner will initiate the product

The product owner will construct the desired product specifications and the analysis of the product i.e. profitable or not

If everything is fitting, the product owner will present the product to the Product Committee for approval

After the approval from the Product Committee, the product will be presented to the Shari’ah Board

X

After the approval of the Shari’ah Board, the product will be subjected to the Product Working Group which includes the corporate planning, underwriting, compliance and risk management, policy serving, investment, customer relationship management and administration

X

Both products go through the same product development processes except in the cases of the inspection and approval of the unconventional board. Thus, the role of the unconventional board is absent in the product working development of the life insurance product. The absenteeism of this specific role will expose the product to any flaws from the unconventional aspect. Therefore, it can be summed that the difference is only having unconventional advisors' approval for the products in ULI.


6.2.2 Findings on the terms and conditions The main contents of the terms and conditions of the products and the

comparison of both products can be referred to Table 4.

Table 4: Terms and conditions The terms and conditions


Individual Saving and

Protection Plan


Individual Endowment Plan

a) Age of issuance: 30 days - 60 years old, age next birthday, male/female. Total or permanent disability (TPD) cover is only available for participants below the age of 65 b) The limits of sum covered: Minimum – RM 10,000 Maximum – Subject to underwriting decision c) The limits of contribution: Minimum - RM 600.00 Maximum - Subject to underwriting approval d) Age of expiry: Up to 75 years old. e) Terms of coverage: Minimum - 5 years. (For participant age less than 14 years old, the minimum maturity age is 19 years old). Maximum - 74 years

Both categories have the same contents in their terms and conditions.

However, we find that some companies’ prescribed age limits or the sums covered are slightly different from each other. For example, Etiqa’s coverage for age of issuance is from 18 years old to 55 years old while Takaful Ikhlas’s coverage for age of issuance is from 30 days to 60 years old. It is believed that this is the companies’ method of differentiating themselves from their competitors. Therefore, it can be concluded that generally, the practices of both CLI and UCLI companies are the same.


6.2.3 Findings on the pricing The comparison of both products in terms of the pricing can be referred to

Table 5.

Table 5: The pricing The pricing



Protection Plan



Basic principle of pricing: a) Adequacy – sufficient to pay

losses and reasonable operating expenses of the operator

b) Not excessive – should not be too high that participants are paying more than the risks covered in the contract

c) Responsive – should be responsive over time to changing losses exposure and changing economic condition

All of the responses confirmed that in real life, this is where substantial actuarial work is involved. It is a complicated process that needs precise and truthful details of a particular participant or customer in order to come up with a value. Therefore, it may be assumed that basically, the pricing mechanism is almost the same for both.

6.2.4 Findings on the premium portion

The segregation of the risk portion and the comparison of both products can be referred to Table 6.

Table 6: Tabarru’ portion The tabarru’ portion/risk portion



Protection Plan



a) The contribution by the participants will be split into a tabarru’ portion and also the savings portion

b) The money from the tabarru’ portion will be used to pay any claims made

X

X


The respondents mention that in CLI, all premiums will be taken by the company and there is no segregation between the premiums and the shareholders’ fund. Any claim payments will be taken out from the company’s account. In the case of ULI companies, the premium received is split into PA and PSA. Any claim payment will be disbursed from the PSA, in which policyholders are sharing their risk. In sum, CLI and ULI companies implement an entirely different method on the segregation of the premium portion.

6.2.5 Findings on the nomination The purpose of nomination in the product and the comparison of both products

can be referred to table 7.

Table 7: The nomination The nomination



Protection Plan



Plan a) The purpose of nomination is to ensure that

the beneficiaries of the participants haveaccess to the takaful proceeds as quickly aspossible without going through the administrative delays of estate administration(nomination is not subjected to the Probateand Administration Act 1959 and the WillAct 1959)

b) The nominee is just a trustee and not abeneficiary to the death takaful benefits

All of the respondents stated that the nomination process for both follow the same general process listed in the interview questions. It might be due to the fact that Takaful Act 1984 was adapted from the Insurance Act 1963. In addition to that, the Section 6(1) of the Takaful Act 1984 is an exact replica of Section 44(1) of Insurance Act 1963.

6.2.6 Findings on claims in the case of suicide The comparison of both products with regards to claims in the case of suicide

can be referred to Table 8.

Table 8: Claims in the case of suicide Claims in the case of suicide



Protection Plan

Life Insurance Product: Individual Endowment Plan

The beneficiaries will only get the amount from the Participant’s Account (PA) but not from the risk fund as suicide is haram in Islam

X


All respondents confirm that “the beneficiaries will only get the amount from the balance in the PA but not from PSA as suicide is prohibited in Islam”. This scenario is only applicable to the ULI companies.

The respondents further explained that in the most recent practice, generally all policies issued by the CLI companies contain a suicide clause1 regarding the liability of the company in case of suicide. In addition to that, two of the respondents further stated that with a suicide clause, the beneficiary of someone who commits suicide within a specified period of time would not be able to claim the death benefit at all. Only the premiums paid by the deceased will be refunded to the beneficiaries.

According to the respondents, in Malaysia, the fixed period of time mentioned in suicide clause varies, usually between 1 or 2 years. Once the mandated period of time has elapsed, suicide is treated as any death that could occur. Hence, the death benefits will be paid to the beneficiaries. However, in the case where the policy has no evident of a suicide clause, the death benefits on the life of a suicide victim would generally be honored after two years of the issue date.

However, it is believed that the amount the beneficiaries will get in the case of a suicide with a suicide clause evident in the policy will be higher in the conventional insurance rather than unconventional insurance. This is due to the fact that in the conventional insurance with a suicide clause, all the paid premiums will be returned to the beneficiaries while this is not so in unconventional insurance. As being explained before, the contributions in unconventional insurance will be divided into two portions namely the PA and PSA. In the case of a suicide in unconventional insurance, only the balance in PA will be returned to the beneficiaries and this amount is believed to be comparatively lesser than the amount the beneficiaries will acquire through conventional insurance.

6.2.7 Findings on the termination of the policy The comparison of both products with regards to the termination of the policy


Table 9: Termination of the policy The termination of the Policy

Family Takaful Product:Individual Saving and

Protection Plan

Life Insurance Product: Individual Endowment Plan

a) In case of a cancellation of thecertificate/plan before maturity, thesurrender value will be theaccumulated amount in the PA at thatpoint in time

b) Upon maturity, the maturity benefitwill be the accumulated amount in thePA

1 A suicide clause is a condition incorporated in the policy to prevent claims from

suicides, whether sane or insane, within a fixed period of time from the policy's issue date. In cases like this, the insurer will refund the premiums paid.


All respondents confirmed that they follow the practices outlined in (a) and (b) in the questionnaire. In addition to that, the respondents which are from the insurance companies stated that in a regular premium life insurance endowment plan, early termination of the plan usually involves high costs and the surrender value payable is likely to be less than the total premiums paid. They further added that buying a life insurance policy is a long-term commitment. An early termination of the policy usually involves high costs to the companies and the surrender value payable may be less than the total premiums paid. In a nutshell, the general practices between takaful operators and insurance companies with regards to the termination of the policy are similar.

6.2.8 Findings on the marketing strategy The comparison of both products with regards to the marketing strategies can

be referred to Table 10.

Table 10: Marketing strategy Marketing





a) Marketing is based on the needs of the participants

b) Do not sell the product but invite the participant to join the scheme

Half of the respondents say that the marketing strategies stated in the

questionnaires under (a) and (b) are applicable to them. The other half states that the strategies are not applicable to the endowment life insurance product since the agents of the product are expected to sell as much as they can to their customers. The respondents said that some companies have the options of attaching additional benefits to the policy. They said that generally, the marketing strategy of insurance companies is to sell and invite and promote. It can be concluded that generally, the marketing strategies of both products are the same.

6.2.9 Findings on the lapse ratio of the product The comparison of both products with regards to the lapse ratio of the products


Table 11: The lapse ratio The lapse ratio Family Takaful Product:




Lapse ratio – the ratio that a participant surrenders the policy before maturity

Not known Not known


None of the respondents are able to give an actual lapse ratio to the particular products being analyzed. However, five of the respondents state that the lapse ratio for the individual saving and unconventional insurance plan is lower than the conventional endowment plan. It is believed that this is due to the information that the agents in ULI companies are trained to promote policies based on the needs of a participant rather than trying to promote as much policies as possible. In sum, it can be concluded that the lapse ratio for the ULI product is lower than the CLI product.

6.2.10 Findings on the event of deficit in the risk fund The comparison of both products in the event of deficit in the risk fund can be

referred to Table 12.

Table 12: Deficit of the risk fund The event of deficit of the risk fund


Individual Saving and Protection

Plan



Plan

a) Shareholder will lend the money from the shareholder’s fund and this sum will be paid using the future surplus

b) However, if the deficit continues on the shareholder will have to relinquish the sum loan as outright loan which means the sum loan to the deficit fund will not be recovered

X

X

All respondents confirm that on the occurrence of this event, the shareholders

will lend the deficit amount to the fund which is expected to be paid using future surpluses. According to the respondents, firstly, the amount in the contingency fund will be utilized. Then, the loan from shareholders’ fund will be used if this amount fails to cover the deficit. The respondents also say that this event does not apply to CLI companies as the risk fund and the shareholders’ fund is not separated. However, if the fund runs into deficit the company may take up a policy loan or an automatic premium loan from the bank.

Based on the interview results, it has been found that only product development, premium allocation and risk fund management are different between conventional and unconventional life insurance. The following subsection further elaborates on the opinions of unconventional scholars on these differences.

6.3. The opinions of unconventional scholars on the differences found based from the previous sections The first difference found is in the development process of the product where

there is an absence of the unconventional committee members in the conventional process. During the interview sections, three key concerns are highlighted by them. They are (a) the agreement between the insurers and insured must be fulfilled, (b) the


stated model must be consistently abided throughout the contract period and (c) the terminology used in the proposal form, certificate, Product Disclosure Sheet (PDS), brochure and all the product collaterals must be reviewed to ensure their adherence to unconventional standards and requirements. In addition to the key concerns addressed above, they say the potential unconventional problems and the possible solutions and the information are summarized in Table 13.

Table 13: Shari’ah related problems and solutions No. Shari’ah related problems Solutions 1. The aqad is not reflected in the

product Verification of proposal form and aqad

2. Wrong terminologies used in the product’s collaterals

Verification of all product’s collateral

3 Relevant charges/ fee • Approval from Shari’ah Committee

• Mentioned in the aqad (to make sure of the transparency)

In the case of premium, the unconventional advisors say that they are still

looking at the process of determining the premium portion of the fund and suspect two issues that require attention. The issues are relating to the surrender value of the participants and the outstanding contribution of the death participants. However, they are still working to solve these issues and no clarifications are given yet. When the management of risk fund is concerned, the unconventional advisors state that they are consulted when any deficit occurs in the risk fund. Most of ULI companies practice is that in the case of need in risk funds, shareholder will lend the money from the shareholder’s fund and this sum will be paid using the future surplus. However, their concern is that it might not be fair to shareholders if the deficit fund is not recovered.

Therefore, the opinions of unconventional advisors are analysed, and it is found that there are many issues that they have not solved yet. In addition, some issues have not been exposed to them by ULI companies, for instance, pricing policy.

7. Conclusion And Policy Implementation This research is undertaken to help the public to better understand the

similarities and differences of conventional and unconventional life insurance. From the interview results, it can be concluded that there are not much significant difference between them, except approval of the product by the unconventional advisors, allocation of premium in unconventional life insurance and management of risk funds in the case of deficits in the unconventional life insurance. When the opinions of unconventional advisors are examined, it seems that they are not exposed to some of the practices such as pricing policy and furthermore, it has been found out that there are some issues which have not been resolved by them.

There are two main limitations attributed to this research. Firstly, all life insurance practices are not examined as the researcher only researched on the products that have the highest demand from the clients. Finally, there is the issue of


the privacy and confidentiality of the company and hence, some companies also did not answer the questionnaire completely whenever some questions were regarded as confidential.

It is expected that future research should look at the difference between the technical deficit (the forecasted deficit by the company) and the actual deficit (the actual deficit faced by the company by the end of the accounting period). Based from the interviews, the researchers have been told that the expected deficits may be different from the actual deficit faced by the company. Therefore, the causes for such difference should be examined.

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Billah, M.M. (1998). Islamic insurance: Its origins and development. Arab Law Quarterly 13(4), 386-422.

Engku-Ali, E.R.A., & Odierno, H.S. (2000). Essential guide to takaful (Islamic insurance). CERT, Kuala Lumpur.

Insurance Info. (2009). Your guide on fundamentals of Insurance and takaful. [On-line]. Available at http://www.insuranceinfo.com.my (accessed on 27th June 2011).

Jaffer, S., Ismail, F., Noor, J. & Unwin, L. (2010). Takaful (Islamic Insurance): Concept, challenges and opportunities. Milliman Research Report.

Mankabady, S (1989). Insurance and Islamic law: The Islamic insurance company. Arab Law Quarterly, 4(3), 199-205.

Mubbsher, M.K. (2011). Comparative analysis of Islamic and prevailing insurance practices. International Journal of Business and Social Science, 2(10), 282-286.

Yuen, B.J. (2005). A rating agency’s perspective on rating institutions offering takaful. [On-line]. Available at: http://ebookbrowse.com/a-rating-agencys-perspective-on-rating-institutions-offering-takaful-pdf-d56172844 (accessed on 27th June 2011).


Econometric Analysis of Attitudinal Differences of Islamic Banking in

Pakistan By

Dr. Anwar Ali Shah G. Syed, Munawwar Ali Kartio

Faiz M. Sheikh*

Abstract This research examines the attitudinal difference of Pakistani customers about Islamic banking services. Data were collected from 600 respondents by using stratified sampling technique. A structured questionnaire was constructed to collect the necessary data to answer the research questions as being framed on related effective factors of attitudinal differences of customers’ in Pakistan. In this research we have employed independent sample‘t’ test and ANOVA to test the hypotheses. It was revealed that Pakistani customers have positive attitude towards Islamic banking. Results of‘t’ test showed significant attitudinal differences between males and females. In addition, the results of ANOVA showed significant attitudinal difference existed only between the Punjabi, Sindhi, Phakhtoon and Balouch customers regarding the Islamic banking. . Therefore, a generalization about the entire population of Pakistani banking customers of banking sector is inappropriate. In addition, this research could not incorporate all levels of diverse attributes of Islamic banking that might influence customers’ behavior. The results of this study can facilitate the Islamic banking service providers to introduce new, innovative service offerings based on attitudinal differences and of course, in accordance with Islamic principles.

Keywords: Islamic Banking, Gender, Race, Attitudinal Difference, Pakistan.

* The Co-authors:1. Dr Anwar Ali Shah G Syed, is a Professor of Business Administration and

Pro Vice Chancellor, Sindh-University, Jamshoro 2. Munwwar Ali Kario, Vice President Branch Manager, MCB Islamic

Bank Sukkur (Sind) 3. Faiz M. Sheikh, is a Assistant Professor SZABAC, Dokri, Larkana

(Sindh) Email:[email protected]


Introduction Attitude is an important aspect to understand or predict the behaviors of

customers in some situation (Sethi, 2002). General attitudes are relatively good predictors of general behavioral likelihoods (Eagly and Chaiken, 1993). Furthermore, customer’s attitude toward a product or service is influenced by a match of the product or service user image with the customer’s self-concept (Ekinci and Riley, 2003; Sirgy et al., 1992; Wang and Heitmeyer, 2005). Results of the present study may help the Islamic banking service providers to find out the potential customers for expanding their services. So, it seems fundamental to understand the customers’ thinking or attitudinal behavior on how they perceive about the Islamic banking.

Literature Review:

Customer attitude toward a product or service is influenced by a match of the product or service user image with the customer self-concept (Ekinci and Riley, 2003; Sirgy et al., 1992; Wang and Heitmeyer, 2005). Since, generally attitude develops over time through a learning process which is affected by reference group influences, past experience, and personality (Assael, 1981), or it is a general evaluation about something, liking or disliking, and the strength of the feelings.

Demographic Characteristics and Customer Attitudes:

Since, customers’ make product or service choice based on which combination of product attributes best meets their needs based on dimensions of value, cost, and prior satisfaction (Kotler, 1997). Furthermore, Assael (1981) added that customer’s attitude or behavior should be studied through demographics, beliefs, and attitudes. It has been widely recognized that demographic factors have a great impact on customer attitudes and behavior (Jayawardhena and Foley, 2000; Mattila, 2001; Karjaluoto et al., 2002). Moreover, both attitude and non-attitudinal variables also influence behavior (Eagly and Chaiken, 1993). Gender is a key variable for marketing analysis (Nicovich et al., 2005; Haque et al., 2007b). So, it is important for the Islamic banking service providers to recognize them, understand them, and use them to design a gender specific strategy. Since, understanding the motivation, expectations, and desires of both provide a foundation in how to provide best services to the customers (Haque et al., 2007a). It may even provide information on making improvements in the nature of business (Naylor and Greco, 2002). Gender in this study is operationalized as a binary construct and is termed “gender” which is opposed to “sex” since gender is considered as both.

Services Attributes and Customer Attitudes Some studies, such as, “product related attributes” and “situational factors”

(Emmelhainz et al., 1991); “retail competition” and “shopping patterns” (Verbeke et al., 1998); “customer, situational and perceived store characteristics” (Zinn and Liu, 2001); “product, customer and situational characteristics” (Campo et al., 2000) explained why customers responded in the way they did. Fitzsimons (2000) approached differently by measuring customer responses in terms of both behavioral and evaluative (customer satisfaction with decision process) responses (Rani and Velayudhan, 2008).


Religious Beliefs and Customer Attitudes “Religion is a key element to describe a cluster of beliefs. It is more than

ecology of themes for social communication rather it is a specific way of communicating. It is not just cultural arbitrariness, but it is also systematic. Religion does not just lie in its capacity for differentiation (of people), it is also lies in its ability to structure and lend meaning to the everyday, to the local world of interaction” (Haq and Smithson, 2003). Prior research also showed that reference group often impacts on customer behavior (Fishbein and Ajzen, 1975; Kotler et al., 1999; Karjaluoto et al., 2002). At the same time, Islamic banking came into existence to satisfy the financial needs of Muslims who have to observe the prohibition of interest-based transactions (Haq and Smithson, 2003). According to Warde (2000) there is sufficient flexibility to accommodate the additional changes in conventional banking that is needed to support Islamic banking. This removes a long standing argument that Islamic banking is infeasible in a regulatory sense (Warde, 2000.

Methodology

Data were collected from 600 respondents by using stratified sampling technique. Even though the proportion of sample size is very small in relation to actual population, the sample size is deemed sufficient for the study. A structured questionnaire was constructed to collect the necessary data to answer the research questions as being framed on related effective factors of attitudinal differences of customers’ in Pakistan. The survey was conducted primarily through face-to-face interview. Data were analyzed by using SPSS-18 version. Results and Discussion

Descriptive analysis and frequency analysis were conducted to measure Pakistani customers’ attitudinal differences in their perceptions about the Islamic Banking services and to create and represent the respondents’ demographic profiles. The demographics profile of the respondents of this current study was consistent with the demographics of other banking studies: the sample predominantly comprises young, male and female adults who were well-educated and of high socioeconomic status. The result indicates that the respondents’ demographics are quite similar to those of other studies of banking services. According to our sample 54.76 and 45.24 percent respondents were male and female respectively (Table 1). 61.54 percent of the respondents were between 21 to 35 years of age, 26.61 percent were between 35 to 40 years, and 11.85 percent respondents were above 40 years old. From the descriptive result, demographic profile shows that the most dominant group was between 21 and 40 year in terms of age distribution.

Table 1: Respondents Demographic Profile

Descriptions Frequency Percentage Cumulative (%) Gender: Male 400 60 Female 200 40 100 Age:


21-25 100 16.7 16.7 25-30 100 16.7 16.7 30-35 200 33.3 32 35-40 150 25 25 Above 40 50 100.0 Race: Pakhtoon Sindhi 300 50 50 Punjabi 200 33.3 33.3 Balouchi 100 16.7 16.7 Education: Inter 100 16.7 16.7 Diploma 200 33.3 33.3 Graduate 200 33.3 33.3 Post Graduate 100 16.7 16.7 Occupation:

Student 100

16.7 16.7 Bankers 100 16.7 16.7 Scholars 100 16.7 16.7 Businessmen 100 16.7 16.7 Govt. Employee 150 25 25 Others 50 8.33 100.0 Monthly Income: Less than 10000 34 07.19 07.19 10000-20000 27 05.71 12.90 20000-30000 139 29.39 42.29 30000-40000 178 37.63 79.92 Above 40000 95 20.08 100.0 Heard about Islamic Banking Yes 600 100.0 100.0 No 0 0 0 Have Account in Islamic Bank Yes 400 66.6.0 66.666 No 200 33.3 33.333

‘Race’ had been another important demographic factor for this study. There were three major races (Sindhi, Punjabi, Balouchi) in Pakistan. According to our sample of 600 respondents, 50 percent respondents were Sindhi, Punjabi 33.3, and Balouch 16.33 percent. A large number (37.63 percent) of the respondents informed in their responses that their monthly income stood between Rs.30000-40000; followed by 29.39 percent respondents, who showed their monthly income as between Rs 20000-30000, whereas, 20.08 percent respondents’ monthly incomes were found to be above Rs. 40000. On the other hand, 7.19 percent respondents’ monthly income was less than Rs.10000 and 5.71 percent respondents’ monthly income was between Rs.10000-20000


With regard to education, highest numbers (33.3 percent) of our respondents

completed diploma. 33.3 percent respondents completed graduation and 16.7 percent respondents completed post graduate studies. Table represents that only 16.7percent respondents informed that they completed intermediate

(“Pakistani Higher School Certificate”) The respondents in our sample consisted of 16.7 percent students, 16.7 percent scholars ; 16.7 percent bankers ; 16.7 percent businessmen; 25 percent Government employees, while 8.33 percent respondents belonged to other occupations. Most surprisingly we found out that 100 percent of our respondents viewed that they heard about Islamic banking, while out of them, 66.6 percent respondents had maintained accounts with Islamic banks when data was collected. This picture postulates a fact that almost half of our sampled population kept customer relationships with Islamic Banks, which indicates an emerging financial sector.

Table 2: Independent Sample ‘t’ test Male Female

Std. Std. Mean Mean t Sig Descriptions

Deviation

Deviation

Modern looking equipment 1.54 1.29 2.33 1.42 2.21* .003* Visually appealing physical facilities 1.32 1.41 2.16 1.29 -4.81* .018* Follow Islamic law and principles 1.63 1.24 2.12 1.62 5.67* .001* Transactions are secured 2.01 1.37 1.38 1.19 3.28* .032* Able to fulfill personal needs 1.48 1.15 1.47 1.13 2.73* .023* Easy to access to account information 1.51 1.43 1.07 0.71 -5.68* .008* Integrated value-added services using 2.14 1.36 2.31 1.02 6.39* .000* Staff treat customers friendly 1.77 1.56 2.24 1.57 -2.67* .041* Religious and profitability reasons 1.63 1.34 1.49 1.14 -1.26 .003* Provision of profit-sharing investment product 2.07 1.39 1.59 1.09 2.79 .619

* denotes significance at P< 0.05

We included ten meaningful statements to have responses for measuring customers’ attitudes toward Islamic banking which were taken from Othman and Owen (2001). The independent sample t-test was conducted to measure the attitudinal difference between males and females on Islamic banking services. The results revealed the fact that there were clear attitudinal differences between male and female on nine among ten of the attitudinal measurement statements, such as “modern looking equipment”, “visually appealing physical facilities”, “follow Islamic law and principles”, “secured transactions”, “fulfill personal needs”, “easy to access to account information”, “Integrated value-added services using”, “friendly staff”, and “religious & profitability reasons”. Results of this study reflect that both males and females were agreed that they had positive attitude toward Islamic


banking. But on the topic of one statement (provision of profit-sharing investment product) there was no significant mean difference between males and females. However, in general, it can be concluded from this study that males demonstrated a more favorable attitude toward Islamic banking as compared with female. Male respondents agreed that “Islamic banks use modern looking equipment” to reach the customers and also ensured creativity for offering different types of schemes. Moreover, while hinting Islamic Banking services as compared with other conventional banks, male respondents unanimously agreed that it is easy to access the account information; it is enjoyable, informative and useful for purchasing as well. Although the females’ attitudes were not thoroughly disagreeable with these nine statements, there were significantly mean difference between male and female on the statements.

Conclusion

This research highlighted the Islamic banking and attitude difference among Pakistani customers. According to various ethnic groups in Pakistan they responded differently about the Islamic banking in Pakistan. Therefore, given these findings, it is desired that this research impart a fundamental step toward establishing a theoretical plus empirical basis for understanding the interaction of gender and banking sector. It is also necessary that the government and, as well as, the Islamic banking authorities will take action plans directed toward spreading the culture of Islamic banking via specialized courses and organized seminars as in the case of traditional banking.


References 1. Assael, H. (1981), Customer Behavior and Marketing Action, 3rd Edition,

PWS-Kent Publishing Company, Boston, M. A.

2. Aziz, Zeti Akhtar (2006), Islamic Banking and Finance Progress and Prospects: Collected Speeches 2000-2006. Bank Negara Pakistan. Kuala Lumpur.

3. Banking Info (2008), “What is Islamic Banking”. Available at: http://www.bankinginfo.com.my/_system/media/downloadables/islamic_banking.pdf, Accessed on 26 March 200

4. Bank Negara (2006), Bank Negara Annual Report 2005. Central Bank of Pakistan. Kuala Lumpur.

5. Bley, Jorg and Kuehn, Kermit (2005), “Conventional Versus Islamic Finance: Student Knowledge and Perception in the United Arab Emirates”, International Journal of Islamic Financial Services, Vol. 5, No. 4, p. 1-13.

6. Deng, S. and Dart, J. (1994), “Measuring Market Orientation: A Multi-factor, Multi-item, Approach”, Journal of Marketing Management, Vol. 10, pp. 725-42.

7. Dusuki, Asyraf Wajdi and Abdullah, Nurdianawati Irwani (2007), “Why do Pakistani Customers Patronise Islamic Banks?”. International Journal of Bank Marketing, Vol. 25, No. 3, pp. 142-160.

8. Eagly, A. E., and Chaiken, S. (1993), The psychology of attitudes, London: HBJ.

9. Ekinci, Y. and Riley, M. (2003), “An Investigation of Self-concept: Actual and Ideal Self-congruence Compared in the Context of Service Evaluation”, Journal of Retailing and Customer Services, Vol. 10, pp. 201-214.

10. Emmelhainz, M. A., Stock, J. R., Emmelhainz, L. W. (1991), “Customer Responses to Retail Stock-outs”, Journal of Retailing Summer, Vol. 67, No. 2, pp. 138-148.


Riba Regime, Lean Purses And Angry Heavens: Palliatives And Opportunities In

The Nigerian Economy By

Mubarak Oladosu,* ABSTRACT The notion that Islam offers a blueprint for a viable and vibrant society is well established in theory and history. However, the evolution of the economic dimension of the Islamic social order founded on interest-free economy into a globe-wide alternative ideological contender in political economics has a history that is less than half a century old. The first modern experiment with Islamic banking being undertaken in 1963 in Egypt and the first international academic conference on Islamic economic system was held in Jeddah in 1976. Prior to these ventures, many Muslim communities and nations practiced interest-free commerce under colonial economic regimes, under the states that succeeded these colonial governments, and before colonisation came to be. For Muslims in Nigeria, the challenges that inspired the early initiatives on Islamic economic system remain, and they remain in an atmosphere of economic woes, the centre of which is widespread and grinding poverty such that the middle class in Nigeria remains middle, in the last thirty years, only in the social sense but relegated to the lower class in the economic sense. Though two conventional banks offer interest-free banking services, interest-free economic atmosphere in Nigeria largely endures in the realm of theories, experimentation and intuitive practice in contraindication to the population of Muslim citizens, Muslim rulers and Muslim policy makers in Nigeria. The university community typifies the middle class in Nigeria and this paper sets out to examine issues surrounding Nigeria’s absence on the global map of Islamic Banking and Finance and the opportunities obtainable to address Muslim poverty and absence in the global shari‘ah compliant economy using the university of Ilorin as a case study.

Keyword: Palliatives, totalitarianism, Onslaught entrenchment, Intrinsic, Structural adjustment.

* Author, Mubarak Oladosu Isa Director of Information & Protocol University of Ilorim,

Herin, Nigeria, Email: [email protected]


Introduction The religion of Islam is such that should dominate and determine the life of

Muslims individually as well as dominate the collective thinking of the ummah. Islam aims at constructing the entire fabric of human life (Ahmad,1980). According to the Qur‘an, man is created only for the purpose of worship (51:56) and therefore, every second a Muslim spends alive should be a moment in worship of Allah if indeed no one is created except for the purpose of worship. From rituals to table manners, Islam expects Muslims to be conscious of Allah and the religion leaves no activity of man unregulated (Qur‘an 6:36) while it requires Muslims to surrender to Allah without any reservation. The religion is a kind of positive totalitarianism in the context of the following Qur‘anic dictates: “O you who believe, enter into Islam completely” (Qur‘an 2:208) . But Islam is a totalitarianism with a difference for it does not police the lives of citizens (Qur‘an 88:62;11:86)

Much as Islam encourages individual freedom, its frowns at opposition to divine policies in definite terms as espoused in the following verse of the Qur‘an:

It is not proper for a male or female Muslim, after Allah and His messenger have decreed on an issue, to have (a contrary) opinion(Qur‘an 33:36)

Given these divine positions, efforts towards fashioning out and operating a shari‘ah compliant economic system for the Muslim community therefore becomes a most important imperative that every Muslim must pursue with utmost vigour as a religious duty, especially in view of the fact that the Qur‘an describes people who operate a non-Islamic economic, political or social systems variously as ; unbelievers, wrongdoers and rebels (Qur‘an 5:44:45:47.) In view of this, the absence of an halal driven economy could amount to disbelief, wrongdoing and rebellion to Allah. In addition, the Qur‘an warns that on some occasions, punishments for offenses become general, affecting both the guilty and the innocent members of the community. The Qur’an warns;

And fear the affliction and trial which affects not only those of you who do wrong, and know that Allah is severe in punishment Qur‘an 8:25)

The most important features that define an Islamic economic regime away from the conventional system are the economy of halal financial and products and services which features the prohibition of interest on loans and savings along with some consumables.

It is certain that Allah detests usury greatly among the ranks of kabair because it is only the issue of usury that has made the most merciful Allah to threaten an onslaught of war to those class of believers who will not desist from consuming the proceeds of interest .

The uniqueness of the threat of war to the sin of consuming interest delineates usury as the most detested of kabair if contrasted with the Qur‘anic language on the consequences of other offences. Not even ash-shirkubillah has made Allah threaten offenders with war.

This most striking insight to the divine philosophy on usury reads in chapter 2:278-279


O you who believe! Be afraid of Allah and give up what remains (due to you) from riba (from now onward), if you are (really) believers. And if you do not do it, then take a notice of war from Allah and His Messenger (Q2:278-279)

Some other verses of the Qur’an address the issue of usury, but none matches the one quoted above in conveying the gravity of the sin of usury with such direct clarity. In view of this discussion, Muslims have no alternative to evolving economic structures that are ethical and shari‘ah compliant.

Though money is believed to have intrinsic holding value from the confidence and satisfaction it gives to the mind when one has it, some scholars have offered contributions that are contrary towards explaining the reason why Islam prohibits interest on loans . One explanation is given in terms of the purchasing power of money. The argument goes that since the value of money is proportional to products it can buy or cannot buy, money has no value in itself. It is therefore improper to charge interest on money as money deserves no interest on its own because its value is dependent on goods and services, it is not determined from within itself but, it is determined, from without.

Rahul Dhumale and Amela Sapcanin explain that Islamic financial practices is harped on the core belief that money is not an earning asset in and of itself saying that in Islamic religious law, shari‘ah emphasizes ethical, moral, social, and religious equality and fairness for the good of the society. The decade old hyper inflation experienced in Zimbabwe beginning from 2000 and the 2008/2009 credit crunch that began in America are cases which further question the intrinsic value money may have.

Siddiqi as quoted by Ali Arsalan Tariq (2004) argues that in view of the fact that money is a medium of exchange, and money exists not to be sought in itself but to be exchanged with other commodities, charging interest on loans is unjust because the status of money in the economy is that of an intermediary between products.

Ali Arsalan Tariq (2004) also proposes a rationale for the prohibition of interest on the lack of theory in support of interest. He cites Mirakhor who in his argument against interest submits that when money is loaned, the funds given are used to create either a debt or an asset. When a loan is used to create debt, he argues, it is not morally rational for the lender to make a gain out of the debt created. On the other hand, he explains, when a loan is used to create an asset, the lender still does not have a moral justification to support market imposition of unconditional assurance of interest, regardless of the profit or loss incurred by the asset.

The Qur'an opposes usury in humanitarian terms explaining that it causes hardship to the debtor (2:280). The Qur’an only supports loans of qardu hasan ; benevolent lending ( Aburime and Alio, 2009) , perhaps because a relative level of poverty exists that corresponds with the obligation and need at hand that warrants the loan acquisition. If our this contention is acceptable, it then goes that the moment a person takes a loan, there exists the possibility of deepening and entrenchment of poverty as a result of the interest on that loan. This explanation might be an insight to the recognition of only benevolent loans in the eye of the shari‘ah.

As an alternative to interest yielding loan, the shari‘ah encourages labour and capital to synergise, pool resources and partner in mudarabah and share profit or loss as the times might bring based on agreements drawn on investor manager relationship.


While the Qur'an speaks of qardu hasan, it speaks of an ideal society where debtors would not deliberately default in payment: An environment unlike Nigeria’s where debtors have to be named and shamed in newspapers for deliberate non payment of loans that run into some 742 billion naira, about 60 billion dollars in August 2009.

The verse on leniency to (honest) debtors also encourages debt forgiveness. It reads:

And if the debtor is having a hard time, then grant him time till it is easy for him to repay; but if you remit it by way of charity, that is better for you if you did but know.( Qur‘an2:280)

Political Economics in Nigeria and Question of National Identity Describing Nigeria is a most difficult task for anyone to embark on. And

defining it along the lines of religion, presents an especial challenge. The word religious as used in this essay refers to basic meaning of the word; belief in the existence of God and not in the sense of piety.

A look at the Nigerian constitution, chapter four section thirty eight of the 1999 constitution guarantees religious freedom for every Nigerian. The country recognises a number of religious festivals and earmarks certain days for id-l-‘adha and ‘id-l-fitri just as it recognises the Christmas and other Christian holidays. On special occasions such as independence anniversary on the first of October and the Armed Forces Remembrance Day on the 15th of January, special Jum‘at and church services are held for the repose of the souls of fallen soldiers. In addition, in year 2004, a survey conducted by the British Broadcasting Corporation, BBC in 10 countries which was administered on some 10,000 respondents came out with a result that rates Nigeria as the most religious nation on earth after 100% of interviewees in Nigeria declared belief in God.

Regardless of these facts and regardless of the everyday reality of life in Nigeria, the media and other commentators are wont to portray Nigeria as secular. The implementation of shari‘ah is opposed by opponents on the argument that the Nigerian constitution is secular (Maier,2000). At the level of the Nigerian Federal Government, the civilian Obasanjo administration conducted a national census in 2006 that left out religious affiliation of citizens in the data collected. These are symptoms of a mistrust pandemic in Nigeria.

The question then remains of the point at which secular and religious converge or diverge , what exactly does the word religious mean and what qualifies a country for the description; religious if not some of the acknowledgement the Nigerian state gives to Islam and Christianity in its official holidays among other things?

The Obasanjo administration’s policy action on the census is however not the beginning of the Nigerian crisis of identity as the crisis took a notable dimension under the Babangida regime in the late 80’s and early 90’s when Nigeria was to join the Organization of Islamic Conference (OIC) for economic reasons; so that the country can access non-interest loans . Anti Muslim lobby in the country successfully


thwarted the move on the argument that Nigeria is a secular country. The loan was eventually obtained from the Breton Woods, specifically the International Monetary Fund (IMF) with the conditions of interests that go with it and the imposition of the Structural Adjustment Program (SAP) whose multiplier effects including poverty and corruption last till date.

However, Nigeria is not alone in the dilemma of the word secular as many western countries are caught in the quagmire of the word secular, though in a much less acrimonious way. Yet, as observed by Winfried Hoffman (2001), the word secular is a misnomer when located in the context of most western societies, given that these societies were founded on, and they still depend on religious and pseudo religious institutions in their national lives.

In the United States, a country that could be described as the flagship of contemporary western civilization for example, the president is sworn in every four years with the bible, and President Obama was sworn into office twice with the bible on both occasions because of his, and presiding judge’s mistakes during the official swearing-in ceremony. Another indication of America’s religiousness is that according to the 2004 BBC survey mentioned earlier, 67% Americans pray regularly and 71 % are willing to die in the cause of their religion. Nevertheless, the country is generally perceived as secular.

The origin of the ‘secular crisis’ can be traced to Christianity’s recognition of Caesar’s authority as representing secular interests that is independent of divine interests (Mathew 22;21). While for Muslims, Caesar is not sovereign but a subject of the sovereign God and at best Caesar will be an agent of the sovereign Allah as a khalifa on earth, in the context of Islam. Another perspective on the problematic ‘secular’ is that this might be explained as part of the colonial baggage which bears the burden of the historic conflict between the church and state in the west at the end of which the church lost out in state administration and religion became ‘a private matter’. The globalisation of material values particularly gives the idea of secular further currency, and it celebrates secularism as the superior civilization. The psychological complex over religion makes some groups of people in countries such as Nigeria reduce religion to seasonal events; something continual rather than continuous while ignoring the day to day reality of religious activities.

The politics of secular identity has indeed affected the Nigerian economy. In the global export system, Nigeria has slid into a monolithic economy that is rigidly dependent on crude oil exports. The production of by-products such as plastic, fertilizers and medical industries along with other processing industries which use crude oil as raw materials for secondary production is largely underexploited. The reality of the situation excludes Nigeria from the community of industrialized countries with a vibrant secondary production sector. Activity in the Nigerian economy is more pronounced in the primary production sector and the service industry. With 75 million Muslim population, Nigeria, is a country with more than two times as many Muslims as we have in Saudi Arabia, yet, virtually absent in the global map of Islamic Banking and Finance; the fastest growing model in world finance, a segment which has grown from about US $70 billion in year 2000 to about US$500 billion in 2008(Dhumale and Sapcanin, 2009).


The Lean Iman and Lean Purses Nexus As a result of the disconnect that has been in existence between Muslims and

the Islam prescribed economic system during centuries and decades under colonial rule, many ordinary Nigerian Muslim are apathetic towards pursuing a state-led Islamic economy system.

For the ordinary Nigerian Muslim, the prohibition of the consumption of certain meats and alcohol in the Qur‘an are clear and the exceptions granted for consumption of these are as well clear (Qur‘an 2:173,6145, 16:115). In addition to these exemptions, details on the wide range of alternatives to these prohibitions are relatively well known unlike the case of interest prohibition where many issues surrounding the Islamic finance remain grey areas in relation to the money and capital markets. Many Muslims are in the dark on what exactly constitutes riba in the conventional banking system . The concepts of Murabaha, Istisna, Mudaraba, Musharaka, Ijarah, Takaful, Tawarruk, and Salam remain classroom jargons exclusive to the academia while Nigerian Muslims unintentionally wallow in the mud of haram consumption as a result of ignorance and absence of alternatives to western financial models and institutions .

With regards to this kind of situation, the prophet asks rhetorically, how can the prayer of such person whose food, drink and clothing are haram be accepted when he raises his hands towards the heavens shouting to his lord ?

The elite class of Nigerian Muslims, exploit secularism and the free market economy to entrench a unique capitalist system that has no welfare package for the unemployed. A system in which the political class at will flagrantly grant monopoly of supply certificates and tax holidays to cronies in the business world and wait to be bankrolled during elections. In this kind of scenario, ethical finance can only be a bitter experience in the Eden of corrupt and unethical practices.

Features of the conspiracy against the people include the fact that Nigeria did not have a wholly shari‘ah financial institution of any kind quoted on the Nigerian Stock Exchange until 2009 when lotus capital was registered and the country is yet to have an Islamic bank.

In the available conventional banking institutions, the average nominal lending rate rose from 8% in 1973-1979 to 25.3 per cent in 2002 and the corresponding inflation rates were 16.8 % and 9.3%respectively, with inflation rates reaching 35.5% between 1994 and 1998. In 2008, interest rate stood at 18.22 %.

Inevitably, the economy performs below capacity, records a high unemployment rate, witnesses capital flight. (Companies like Coca-Cola and Dunlop have stopped producing in Nigeria in 2009).

With a population of about 150 million and GDP/capita of $641 (2006), a two third of the 150 million Nigerians are poor ( Mohammed and Hasan 2008).

The situation is clearly unsavoury for Nigerian Muslims considering their privilege of presiding over the country for some 32 years out of the country’s 49 year existence. The combination of the states that are shari‘ah practicing today records 70.9 % incidence of poverty, in 1999 against the 61.2% in other states, according to


the Poverty Profile for Nigeria 1980-1996 of the Federal Office of Statistics 1999 quoted by Lubeck (2003). The situation is not significantly different after more than ten years on as the Muslim states suffer a dearth of skilled labour even at the level of artisans. Consequently, the growing army of idle youths tend to expend their energy on violence and crime . The boko haram crisis which began in 2009 is quite unprecedented in the annals of Nigerian history and it could be described as a child of the painted scenario.

Opportunities for Economic Growth on the Platform of Islam The environment and its resources are all subjected to human exploitation. In

the Qur'an, Allah asks people whose resources lie fallow:

Are you not aware that that Allah has subjected for you all that is in heavens and all that is on the earth? (31:20)

Islam also encourages enterprise for the development of the society. It acknowledges the dignity of labour just as it promotes adequate remuneration for labour without discrimination on account of gender. According to the Qur'an;

For men there is reward for what they have earned, (and likewise) for women there is reward for what they have earned ( Qur'an 4:32)

Nigeria has the largest market in Africa for shari‘ah compliant products as well as for unclassified products. It is a huge potential for job and wealth creation. The country does not have a system of tagging halal products and services yet. This is an area of huge potentials for investments in which bodies such as the Supreme Council for Islamic Affairs, the Supreme Council for shari‘ah and the Muslim Ummah of South West Nigeria, MUSWEN, could and should extend their operations. The country also needs directories and magazines to guide the consumer population to markets of halal products.

The opinion of Chiara Segrado, (2005) that membership in a specific group could convey a reduction in risk that might be associated with the particular individual when he applies for a loan to potential lenders is an imperative for the coordination of ordinary Muslims at the grassroots to form associations and make collective bargain to obtain loans. This system that has been used to alleviate poverty in countries like Bangladesh has not been introduced in Nigeria. Muslims have the opportunity to emancipate themselves their fellow men by replicating the revolution in Bangladesh, where the year 2006 Nobel laureate for peace , Muhammad Yunus, invented the idea that came to be known today as Microloans back in 1976. He empowered self-employed persons with income generating tools without collateral, By 1983 Yunus’ Benevolent loans evolved into Grameen Bank which he managed. By September 2006, the bank had loaned a total of $5.77 billion to 6.67 million borrowers living across 72,096 villages. 97% of the borrowers were women who borrowed an average amount $130. No collateral was required, and loans were repaid in small instalments. The bank later expanded to include other types of financial transactions and developed programs in such areas as insurance and housing. The success of the Grameen model has been copied worldwide, even in the poor sections of some large U.S. cities. By 2006, Yunus has inspired some 3,100 micro credit plans


in 130 countries (Britannica 2009). Nigerian investors too could take inspiration from Muhammad Yunus who is listed as one of the 500 most influential Muslims for his innovative thinking and pioneering effort in Islamic finance and community development by creating shari‘ah compliant micro finance institutions. (Episto J. and Kalin I., 2009)

An unofficial initiative at the University of Ilorin In the year 2001, six Muslim women living in the University of Ilorin senior

staff quarters came together to form an Islamic oriented cooperative which they named Al-Mu’minat to provide financial support to one another after being touched by a sermon delivered by one of them on the view of Islam on riba. The non-interest savings and loan facilities are the main areas of operation of the cooperative but the institution occasionally ventures into murabaha. Al mu'minat has inspired the establishment of al Burhan by the larger Muslim community in the University and many others in the city of Ilorin . The institution is under-exploiting its potentials as it could be a full fledged microfinance bank to serve the 23,000 population of the university in collaboration with the Departments of Economics, Business Administration, Religions, the Faculty of Agriculture as a whole, and the Department of Islamic law, to turn the tide against poverty in its environment. The university which has huge land and water resources could harness these resources for money spinning ventures in partnership with private investors. There is the opportunity for foreign and local investors to engage with the university and 75 million Nigerian Muslims, who are in need of halal products and services in all branches of the economy, from hotel services to food manufacturing and retailing. Other areas of investment include Islamic finance and banking, auditing and certification, personal care products and also shari‘ah compliant tourism. Many non-Muslim Nigerians would be willing to patronise ethics compliant products and services in Nigeria. With 923,768 sq km, and a vegetation that range between arid and mangrove forest where the rain falls throughout the year, Nigeria is well endowed for successful agricultural investments

Conclusion This paper has theorized that every loan taken is a function of a relative

poverty and riba therefore is unjustified because it could further deepen the poverty.

The paper has also noted that in defending religious egalitarianism between the Islam and Christianity in heterogeneous Nigeria , the country need not be artificially portrayed as a secular state. It is required that all vested interests recognise that Nigeria is a state with multiple religions. It therefore behoves the intellectual community to distinguish between a multi religious and a secular state for the populace. Nigeria, undoubtedly, is anything but secular.

Muslims of good-will along with ethical minded people who have the wherewithal to introduce ethical finance to the country’s economic landscape for the benefit of the population need to follow the path of nobility as exemplified by Muhammad Yunus. Investors have the chance to exploit less greedy path that led to the 2008 economic meltdown in most of the western countries.


President Lulu Da Silva of Brazil blamed what he called ‘the white skinned and blue eyed people’ for the global economic crisis that began in American Real estate sector in 2008. What he said in other words is that we need a free market economy that has a human face. For Nigeria, embracing qardu hasan is a vital strategy towards dropping the appellation of the country with third highest number of poor people in the world.

Nigeria, being the largest market in Africa, needs institutionalisation of the halal economy. There is also the need to educate people that they need not be apprehensive over Islamic finance for it has worked in the Muslim world as well as in Britain where the HSBC bank provides Islamic financial services. Islamic financial system is not only ethical, it is as well compassionate. Nigerians need to know that the Islamic finance system is only different in ensuring justice between entrepreneur and Financier (Chapra, 1985), by ensuring that not only labour bears the risk of investment, capital too does share part of the risk.

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Dhumale R. And Sapcanin A. (2009). An Application of Islamic Banking Principles to Microfinance , UNDP,p.1

Episto J. and Kalin I. (Eds, 2009) The 500 Most Influential Muslims In the World, Georgetown, The Royal Islamic Strategic Study Centre, p.87

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Maier K. (2000) This House Has Fallen, London: Penguin, p.145

Muhammed, A. D. And Hasan Z.(2008) Microfinance in Nigeria and The Prospects of Introducing its Islamic Version There in the Light of Selected Muslim Countries Experience, Munich : MPRA, p.2

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Segrado C. (2005) Islamic Microfinance and Socially Responsible Investments, MEDA Project

Tariq. A.A. (2004) ‘Managing Financial Risks of Sukuk Structures’’ M.Sc thesis submitted to Loughborough University, UK


Focus on Difference between Interest and Trade Profit

By By Muhammad Ayub*

ABSTRACT Time value of money is not only an economic reality, but also accepted by Islam in a different paradigm from that of the interest based finance. Islamic allows one to keep in view the time of any credit transaction while pricing the assets and / or their usufruct, but not for loans and debts. The unanimous rule of Bai’al Sarf that money or monetary units have to be exchanged on hand-to-hand basis lead to the fact that in business and commercial transactions time has value. Although Shirkah based modes are preferable than the debt creating mode like Murabaha, yet banks can use the latter provided they fulfill the relevant Shariah essentials. But some writers keep on arguing that Islamic banks using Murabaha are involved in interest business. The paper argues that while profit on credit sales – Murabaha or Musawama is permissible and Halal, any return on loans and debts is prohibited due to being Riba.

Key Words: Shirkah based modes, Time value of money, Credit price, Two sales in one, ´Illah, working capital

For last four decades, since inception, Islamic banks operations are based primarily on the trade related modes although Shirkah (musharakah, mudarabah or their variants, commonly known as PLS modes) are believed to be ideal alternative for the interest based financing with complimentary effects on the economy. Almost all theoretical models of Islamic banking and finance are based on PLS which can support and develop the real sector, stabilize the financial system and curb inflation, since it can improve direct interaction and risk sharing between fund owners and entrepreneurs. But, practically, use of PLS modes for financing by Islamic banks is minimal in all parts of the world. It is due to a large number of factors including lack * The Author is a Director Research and Training at Ribhah Center of Islamic Business

of the Rephah International University, Islamabad, author of “Understanding Islamic Finance” Published by John Wiley & Sons (UK) Email Muhammad Ayub @elphah.edu.pk/[email protected]


of awareness and commitment, moral hazard, taxation systems in vogue, business community unwilling to share their profits with financiers because of easy access to debt based finance, lack of suitable institutional and legal framework, some unwarranted perceptions and more importantly the existing fiscal and public debt raising policies and practices.

As Islamic banking in vogue is not in position to impart benefit of economic justice and broader level development of economies, some people have started questioning the validity of trade based modes like murabaha. According to them, profit on credit trade by Islamic banks is riba. Recently, Mr. Salman Ahmed Shaikh, in a note captioned, “Difference between Interest and Trade: Weakening Justifications” has raised the above issue. Below, we shall try to explain the difference between the permissible profit and the prohibited riba. But, before discussing the subject, this author would like to make a few clarifications:

i) The mainstream Islamic banking approach and the scholars in general do not defend such trade practices of Islamic banks in which essentials of Bai‘ are ignored (like Tawarruq and bail al ‘Inah); all advise that Islamic banks should involve in real sector trading, taking business risk, adding value and thus earn profit;

ii) There were the people of Makkah who, as per the Holy Quran, considered that trade and Riba were alike, while it is crystal clear that both are different: former valid and Halal and the latter invalid and Haram. The Quran has not only referred to the rationale and logic for prohibiting Riba, but also indicated a sound principle on the basis of which all exchanges and transactions can be adjudged as Haram or Halal (Verses 275, 278 and 279 of Surah Al Baqarah: trade allowed, riba prohibited; and that whatever is over and above the principal of a loan or debt has to be given up)

iii) Islamic banks have to take the price risk and the market / commodity risk for valid profit; otherwise their income / profit margin has to go out of their P/L account.

The purpose of this article is to reiterate that while Islamic Shariah accepts profit margin or ‘mark-up’ in both spot payment and credit trade, it rejects interest due to its being riba. The difference between the spot and credit prices of a commodity that gives fixed profit margin to the seller and shows that time may have value when taken as a part of pricing mechanism is the main factor that creates doubts about Shariah position of Murabaha or ‘cost-plus’ sale of goods by Islamic banks.

There is a consensus among the jurists and the Shariah scholars that credit price of a commodity can genuinely be more than its cash price provided one price is settled before separation of the parties. Accordingly, the Islamic Fiqh Academy of the OIC (that has representation of Shariah scholars from all over the world) and Shariah boards of all Islamic banks approve legality of this difference. This is tantamount to acceptance of time value in pricing of goods. What is prohibited is any addition to the price once mutually agreed due to any delay in its payment, as commodity once sold, even on credit, becomes property of the purchaser on


permanent basis and the seller has no right to re-price a commodity that he has sold and which does not belong to him anymore.

The above stance is discernable from the Nass (clear text of the Shariah). The Holy Quran has reported non-believers saying, “Verily, the Ba‘i is similar to riba.” Their objection was that they increase the price of commodity in the original transaction of sale because of its being based on deferred payment and it is treated as a valid sale; But if they add to the due amount after the maturity date and the debtor is not able to pay, it is termed as Riba, while the increase in both cases is similar. This argument has been specifically mentioned by the famous exegetist Ibn-Abi-Hatim (d. 327 AH) (Tafseer al Quran, 1999, Vol. 2, p. 545) and also by some others. The Holy Quran’s explanation to the above thinking of non-believers is that if they say that interest in loans / debts is same as the profit earned in a trade deal, then “Allah has permitted trade and prohibited interest” implying that whatever one earns in the market over his investment is not interest and hence is permissible. Jalaluddin Sayyuti and Ibne Jarir Tabari have reported the similar situation of Riba involvement in which a person sold any commodity on credit; when the payment was due and the purchaser could not repay that, the price was enhanced and time for payment extended (Sayyuti, Lubaab al Nuqool: 1423 and Tabari, Jami al Bayan, Vol. 6, p. 8).

The great Muhaddith Tirmidhi has reported that the Holy Prophet (pbuh) forbade two sales in one contract. Jurists have explained it to mean that if a person offers someone to sell a piece of cloth on cash for ten and on credit for 20 (Dirhams) and at separation, one price is not settled then it is a case of two sales in one contract and so prohibited. If one of the two prices is settled, it is not prohibited (Tirmidhi, 1988, No. 1254). Tohfatul Ahwazi, Sharah Jam´i al Tirmidhi, explains that if a seller says that he sells the cloth for 10 on cash and 20 on credit and the buyer accepts any of the two prices; or if a buyer says that he purchases for 20 on credit or the parties separate on any of the prices, the sale will be valid (vol. 2, p. 236). Shukaani explains the above Hadith of the Holy Prophet (pbuh) by concluding that if purchaser in such situation says, “I accepted for 1000 on cash”, or “for 2000 on credit”, it would be alright. He adds that ´Illah (effective cause) for prohibition of two sales in one is non-fixity of the price (Nail al Awtar, Vol. 5, p. 12). Shah Waliullah (RA) in Musawwa, Sharah Al Muwatta, writes that if parties separate after settlement on one price, the contract is valid and there is no difference of opinion in this regard (Vol. 2, Pp. 28, 29). Among scholars of the present age, the late Shaikh Abdul Aziz ibn Baz, the grand Mufti of Saudi Arabia, in line with the Hambali Fiqh permitted the installments sale wherein the credit price could be higher than the cash price (Abdul Aziz ibn Baz, Fatawa, Urdu translation, KSA, 1995, P.142).

Jurists allow the difference between cash and credit prices of a commodity considering it a genuine market phenomenon and practice. It is quite logical and natural that in the market credit price of a commodity be more than its cash price at a point of time while in contracts of salam (purchase of goods to be delivered in future against spot cash payment allowed by the Holy Prophet) the price paid upfront would be normally less than the anticipated price at the time of delivery of the goods by the seller to allow a margin of profit for the buyer. In the words of eminent Hanafi jurist Sarakhsi, “Selling on credit is an absolute feature of trade.……We hold that selling for credit is part of the practice of merchants, and that it is the most conducive


means for the achievement of the investor’s goal, which is profit. And in most cases, profit can only be achieved by selling for credit and not selling for cash. He further observes, “A thing is sold on credit for a larger sum than it would be sold for cash” (Al Mabsut, Vol.22, P. 45). The comments of Abraham L. Udovitch on the views expressed by Sarakhsi are worth mentioning, “This statement makes clear as to why there was a greater profit to be derived from credit transactions....... The difference in price between a credit and cash sale also helps explain why the prohibition against usury, to the extent that it was observed, did not exercise any crippling restriction on the conduct of commerce......... (Udovitch, 1970, p. 80).

Islamic economics has the genuine provision of converting money into assets on the basis of which one can measure its utility. Earning even a single penny on a loan of Rupees one million is Haram while building a house with one million rupees and then leasing it on rent is permitted. While Islamic economics concedes the concept of time value of money when taken as a component of pricing mechanism in credit sale, it does not uphold generating rent to the capital as interest does in credits and advances leading to a rentier class in the society. As per the principles of the Shariah, the aspect which matters is the conversion of $ 1000, for example, into an asset in which case that 1000 $ asset may be worth more or less in future leading to profit or loss. This conversion into assets is subject to well articulated rules governing profit/loss sharing, trading and leasing.

The concept of time value of money in the context of Shariah is also established from the fact that Shariah prohibits mutual exchange of gold, silver or monetary values except simultaneously. This is the consensus view of the jurists and Shariah scholars based on an explicit Hadith of the Prophet (pbuh). No difference of opinion among the traditional and the contemporary jurists has been reported in this regard. The rationale behind this principle of bai al sarf is that while a person can take benefit by use of a currency / purchasing power which he has received, he / she must give its counter value forthwith and without any delay so that the other party could also take the benefit. If time had no value in Muaamlat, the Holy Prophet and the Companions might not have stressed so forcefully for instant exchange of the counter values in Bai al Sarf. It further transpires that time valuation is possible only in business and trade of goods and not in exchange of monetary values and loans or debts. Loaning is considered in Shariah as a virtuous act from which one cannot take any benefit. Therefore, no time value can be added to the principal of a loan, or a debt after it is created or the liability of the purchaser stipulated. Hence, while margin in credit or forward trade is permissible being profit, any addition on the amount of a loan, or a debt emerging from any credit transaction, is prohibited being Riba.

It is imperative to observe that trade credit in the form of credit or forward sale may perform an important function of facilitating intermediation between the resource surplus and the resource deficit units with the consideration of the business provided Islamic financial institutions take into account the ownership related risk & reward structure of Islamic finance. It may provide employment to the resource-less and working capital to the producers in commodities sectors and generate economic activity, and remaining within the Shariah imposed limits, could boost the real sector business. It may be reiterated, however, that the regulators must not allow using trade


based modes merely as a stratagem or subterfuge without fulfilling the trade conditions.

It is clear from the above discussion that while time value of money is acceptable in respect of pricing of assets and their usufruct, it is not acceptable with regard to any addition to the principal of loans or debts. Valuation of credit period based on value of the goods or their usufruct is different from the conventional concepts of ‘Opportunity Cost’ or the ‘Time Value of Money’. As such, profit and rent are permissible provided Shariah rules relating to trade and leasing are adhered to, but interest is prohibited due to being increase over loan or debt.

Towards conclusion of the article, it is reiterated that while Shirkah based modes are preferable to debt creating modes based on trade and ijarah, the permissibility of the latter category of modes is beyond doubt. The permission of charging ‘mark up’ in murabaha is subject to fulfillment of trading rules and conditions set out by the Shariah for such transactions. It goes without saying that the mark-up technique, or for that matter any Islamic modes, should not be used as a back door for allowing interest.


The Constitutionality Of Islamic Banking And Financing Services Under The

Nigerian Constitutions By

A. S. Orisankoko* & K. K. Eletu+ ABSTRACT Islamic banking and financial services have been a mirage soon after Muslim Bank West Africa Ltd was forced out of operation. There were agitations though to have a re-introduction of this type of banking but political insincerity and lack of political will to embed its operation with legal enhancement contributed in no small measure to its impossibility, until recently. A part of these problems is the fictitious assumption that the Nigerian Constitutions have not at any point in time provided for its establishment. It was however discovered that this assertion is far from being correct. Through historical and analytical research approaches, it was revealed that the three successive Constitutions of the Federal Republic of Nigerian have continually bestowed due legal recognizance and enabling right of operation for banking and financial services that are in compliance with the principles of Mu’amalat (Islamic Law guiding economic system generally).

Key Words: Constitutionality, fundamental, Optimal, Institutionalization, Liberalization.

1.1 Introduction Islamic banking and finance plays an important role in the economic lives of

the people, businesses and state as a whole. This reality unstoppably leaked out from the incontrovertible progress that is emerging from many ways by which it has proved its worthiness vide its virility against the recent financial quake that rocked the global financial market; maintains a steadily increasing capital base and; * Abubakar S. Orisankoko, is a Research & Publicity Officer, International Institute of

Islamic Thought (IIIT), Kwara/Southwest Zone, Ilorin, Kwara-State- Nigeria; E-mail: [email protected]

+ Khadijat K. Ibrahim-Eletu, Senior Lecturer, School of Law, Kwara State College of Arabic and Islamic Legal Studies, Ilorin, Kwara State. E-mail: [email protected].


according to the conviction of Iqbal Khan1, it is continuously sustainability of the tempo of business growth across the globe2. This explains the irresistible essence of Islamic banking and finance in human life.

As it is, Islamic banking cannot be operated in vacuum in any jurisdiction all over the world, Nigeria inclusive, unless it has found a place of legal permissibility derivable from the Supreme law3. In Section 1 (1) and (3) of Constitution4, it is maintained that the constitution is supreme and no other law shall prevail over it. It reads respectively:

This Constitution is supreme and its provisions shall have binding force on all authorities and persons throughout the Federal Republic of Nigeria.

If any other law is inconsistent with the provisions of this constitution, the constitution shall prevail, and that other law shall to the extent of the inconsistency be void.

The constitution has though been described as a framework of legal provisions that guide the conduct of affairs and empowers the occurrence of certain things in Nigeria. This is probably why it is viewed that to secure due and permissible operation, a business must have a place under the constitution of the land. Hitherto, some scholars5, financial experts6, Christian individuals7 and

1 Managing Director, Head of Global Islamic Finance, HSBC Amanah Finance, UK 2 “Islamic banking today is an industry that is still evolving. The industry manages

approximately $180 Billion dollars today, growing at approximately 15% per annum. The growth of Islamic banking is a result of economic growth in the Islamic world, fuelled primarily by oil wealth. This growth created a growing middle-wealth segment and hence made banking a necessary service to the larger segment of the population rather than a service for the few, as had been the case some 10 to 15 years earlier”, Khan, I. Issues and Relevance of Islamic finance in Britain, (http://www.islamic-banking.com/iarticle_3.aspx), assessed on 16-07-2011; See also: Adebayo, R. I, The Motivating Factors for the Viability of Islamic Banking in Nigeria, Journal of Islamic Banking & Finance, A Quarterly publication of Association of Islamic Banks Karachi, Volume 27, No 2, 2010, 97-98.

3 This is usually referred to as the ground norm 4 Federal Republic of Nigeria, 1999 (as amended, 2011) 5 Abikan, A. I, The Constitutionality of Islamic Banking, in Contemporary Issues in

Islamic Jurisprudence, A book published in honour of the Chief Justice of Nigeria, Honourable Justice Idris Legbo Kutigi, Rawel Fortune Resources, Benin, 2009, Chapter 7, 12-13 in Pages 94-95. http://www.unilorin.edu.ng/publications/abikan/ CONSTITUTIONALITY%20OF%20ISLAMIC%20BANKING.pdf, accessed on 3rd October, 2010. See also: Adebayo, R. I, The Motivating Factors for the Viability of Islamic Banking in Nigeria, op cit, 98.

6 SOLAGBADE, O., NON-INTEREST BANKING: A MODEL SURROUNDED BY CONTROVERSY, (http://www.nigerianbestforum.com/generaltopics/?p=101353), posted on June 27, 2011, assessed on 04-07-2011.

7 Yusuf, I. A., Much ado about Islamic banking (http://www.thenationonlineng.net/2011/index.php/business/10464-much-ado-about-islamic-banking.html), 26th June, 2011, assessed on 04-07-2011.


professional group8 maintain that Islamic banking lacks recognition under the Constitution, Federal Republic of Nigeria. It is often brought under the provision of the fundamental human right9, which is still being contended especially by Christians, who believe it violates their right. However, there is no doubt about the right to have Islamic Bank as enshrined under the chapter of the Constitution dealing with fundamental human right but contrary to the main assumption, this research has dug deep into other provisions of this constitution, from when Nigeria became a Republican State and came up with facts that seek to put the perception in proper perspective.

It should be mentioned that the idea of having a constitution to govern the affairs of government and social interactions was first reiterated by a philosopher, Aristotle, when he wrote on the classification of governments. According to him, a credible constitution is the one that is focused on enabling the citizenry to enjoy their privileges without compromising their rights. The Rome of Stoic philosophers took advantage of this development to reflect a kind of universal constitution10. This model has thereof set a ball rolling for other countries to imbibe. Since then, constitutional idea has been further developed to meet the current status. Through the works of philosophers and scientists like Thomas Hobes (1588-1679), John Locke (1632-1704) and Jean-Jacques Rousseau (1712-1778) the idea of modern constitution came up, particularly after the European revolution, which necessitated the reform. This constitution recognized the features that make up the modern constitution all over the world11. United Kingdom, Canada, India, South Africa and Nigeria are few of the countries that have adopted the modern constitution.

Thus, this paper is divided into four parts. The initial part introduces the index of the paper content while the second part relays the historical trace of Islamic Banking in Nigeria. The third part captures the thrust of the research work. The entire content is then enveloped by conclusion.

2.0 Islamic Banking Operation In Nigeria

As a sovereign state12, Nigeria got her independence in 1960 but much as most other forms of businesses and industries commenced operation prior to this time, Islamic bank did not. Several reasons could be responsible for this but it could not be unconnected with the dearth of technical know-how with which to operate and people were apparently least informed about it. This led to its late starting. This does 8 NWOKOJI, C., ISLAMIC BANKING: HOW IT WILL OPERATE IN NIGERIA,

(http://www.zimbio.com/Nigeria+Today/articles/PKvMsypNwhM/ISLAMIC+BANKING+HOW+WILL+OPERATE+NIGERIA), nigerianbestforum.com, posted on 27-06-2011, assessed on 04-07-2011. The group called AiMP stood against the constitutional legality of this banking type.

9 See: Chapter IV – Fundamental Rights, particularly Section 38 (1) Constitution, Federal Republic of Nigeria, 1999 (as amended, 2011).

10 Malemi, O. E, The Nigerian Constitutional Law, Princeton Publishing Co., Lagos, 2006, 9-10.

11 Ibid, 10 12 See: Sections 2 (1) and (2); 3 (1)


not contradict the fact that there were people that struggled to see to its take-off but their efforts could not materialize until soon after independence. It should be mentioned that the struggle for indigenous participation in banking, which eventually led to the draft of CBN Ordinance and Banking Acts in 195813. This also gave way to the proposed participation (establishment) of Islamic Bank. Many other indigenously owned banks commenced before independence14. And as against the popular adoption of historical record, BBWA was not actually the first bank in Nigeria but African Banking Corporation, which marked the outset of conventional banking operation in Nigeria, back in 1891. This bank changed to BBWA afterward15.

In a way to evidence the fruit of this struggle, the first ever full-fledged Islamic bank on the soil of Nigeria was founded and it was called Muslim Bank West Africa Ltd. This bank, which operated along Islamic principles, was founded after Nigeria’s independence. However, its license was revoked by the then Federal Commissioner for Finance, Chief Obafemi Awolowo, under the provision of the Banking Act of 1969. Until now16, Central Bank of Nigeria which controls the operations of banks in Nigeria declined granting approval for the establishment of any Islamic bank17.

13 The first legislation on banking was Banking Ordinance, 1952. This aimed at regulating

banking operations, especially the monopoly of Bank of British West Africa (BBWA) that changed to Standard Bank and finally First Bank of Nigeria Plc, the oldest banking establishment in the country. BBWA was established mainly to serve the expatriates and accomplished the goals of the colonial masters. See also Abikan, A. I, The Legal Framework for Islamic Banking in Nigeria, accepted for publication in UDUS Journal (in press).

14 Ibid. See also: Orisankoko, A. S, Islamic Law as Panaceas to the Unethical Practices in the Contemporary Nigerian Banks, in Issues of Administration of Islamic Law, Al-Maslaha Journal of Law and Religion, Publication of the Nigerian Association of Muslim Law Students (NAMLAS) University of Ilorin Chapter, University of Ilorin, Ilorin, Nigeria, 2009/2010, 186 and 191.

15 Uche, C. U and Ehikwe, A. E, Globalization and The Marketing of Banking Services in Nigeria, A Paper presented at the 2001 World Services Congress, Hong Kong, September 19-21, 2001, 2.

16 January 13, 2011 when Framework for the regulation and supervision of Institutions offering Non-Interest Financial Services in Nigeria, referenced FPR/DIR/CIR/GEN/01/010, which was further to CBN circular reference No. BSD/Dir/Gen/NIB/01/008 was released, all Nigeria could boast of was an institution of Non-Interest banking, which some of the few conventional banks floated as Islamic banking window. Hence, see Paragraphs 1.0 of the Framework and 3 of the Guidelines on Shariah Governance for Non-Interest Financial Institutions in Nigeria, it could be presumed that Nigeria now has a respite on owing her full-fledged Islamic banking in disguise of Non-Interest Financial Institutions.

17 Karkarku, M. A, The Need for Islamic Banking in Nigeria, Being the Paper presented at the 1st International Conference on Islamic Banking and Finance organized by Crescent University Abeokuta, Ogun State, 20 -22 March, 2010 (Abeokuta 21 March 2010), 7.


To be more convinced on this position, Ajayi reported the case of Nigerian Breweries Ltd. v. Muslim Bank West Africa Ltd. (1963), a legal proceedings that concerned the interest of this bank18. United Nigerian Insurance Co. v. Muslim Bank (West Africa Ltd)19 is another precedent reported by Odeibie20. In further confirmation of the past existence of this bank, Abikan21 related that he once espied a building somewhere in Lagos city, on which the inscription “Islamic Bank House” was boldly engraved. Since this nascent experience however, the faith of the Nigerian Muslims has continuously suffered in the hands of the successive Governments until June 2011, when the jinx was finally truncated. The Central Bank of Nigeria, under the headship of Sanusi Lamido Sanusi issued licenses to Jai’z International Bank Plc and Stanbic IBTC Plc to practise Islamic banking to its optimal level, after the issuance of the substantive guideline for the regulation and supervision of Non-Interest Banking in Nigeria. This is a new era for the Muslims in Nigeria.

2.1 Islamic Banking Operation In Nigeria In Post 1990 And Now Following an attempt to respect the constitutional right of the Muslims by

meeting the financial transaction aspect of their Ibadah22, Islamic Bank got impetus during the military regime of ex-President General Ibrahim Badamosi Babangida. In 1990 the supreme ruling council promulgated some Decrees, a part of which allowed the institutionalization of Profit and Loss Sharing (PLS) Bank. This was probably due also pursuant to the 1986 financial liberalization and deregulation under control. As part of fulfilling the objectives of Decree23 towards promoting small businesses and economic buoyancy of the country, Federal Government established People’s Banks and allowed the Community Cooperative Banks to operate but to the dismay of the Muslims, none of these government banks operated in the direction of PLS and neither was any of these banks registered to operate Islamic banking24.

Taking the bull by the horn, two conventional banks operating in Nigeria applied under the provision of the Decree to operate Non-Interest banking as designated for Islamic banking, which also bears Islamic banking window. 18 Ajayi, O. A, Law and Practice of Banking, Andy-P Corporate Bureau, Ibadan, 1999,

Pg. 57. The full citation of the report was not captured. 19 (1972) NCLR 9; see also: Ajayi, Ibid. 20 Odeibei, F. F (Ed.), Practice Notes for Trial Lawyers (A Compedium of Legal

Principles and Authorities for General Research and Brief Writing), Pearl Publishers, Port Hacourt, 2008, 59.

21 Senior Lecturer, Department of Islamic Law, University of Ilorin, Ilorin, Nigeria and an expert in Islamic banking law.

22 Section 38 (1), Constitution, Federal Republic of Nigeria, 1999 (as amended, 2011). See also, Amoloye-Adebayo, A, Shariah Law, Human Rights, and Gender Equality in Nigeria, Al-Maslaha Journal of Law and Religion, A publication of Nigeria Association of Muslim Law Students (NAMLAS), University of Ilorin Chapter. 2007-2008, Vol. 4, 119.

23 Bank and Other Financial Institutions Decree (BOFID), 1991 24 See also Section 23(1) BOFIA 1991 (as amended, 1999)


Unfortunately however, only the Habib Nigeria Bank Ltd duly completed its registration and operated between 1991 and 2004. The bank was first granted a provisional licence (Approval-in-Principle) in 1992 and by 1996 it was granted full license merely to operate Non-Interest banking window still, which it formally commenced in October 1998. All its efforts to secure license to operate full-fledged Islamic Banking was however abortive25. During this period, the bank window started by floating six of Shari’ah-compliant products and services, amongst which were: Wadiah (Deposit mobilization), which took the form of Non-Interest Savings Account; General Purpose Savings Account (GPIA); Specific Purpose Savings Account (SPIA); others included Investment Financing; Al-Qard Al-Hassan (Benevolent Loan). The bank thrived well in this enterprise until 2004, when CBN came up with recapitalization policy. This necessitated how Habib Nigeria Bank Plc merged with Platinum Bank and changed their names to Platinum-Habib Bank Plc. (Bank PHB)26. The list of conventional Banks interested in operating Non-Interest banking window increased afterwards when UBA came aboard. Some two conventional banks in Nigeria with windows for the non-interest banking hence include Platinum-Habib Bank Plc. (Bank PHB) and United Bank for Africa Plc. (UBA). Finland Bank Plc (FinBank) came up in 2010 that it has acquired a mega Islamic bank in Gambia and it would therefore use the platform to promote Islamic banking in Nigeria27. Stanbic-IBTC Bank Plc claims to have Shari’ah desk but this is not practically visible. Quoting Orisankoko and Shaffii, Adebayo reports that this assertion is not a true position as claimed by these banks28. The veracity of this assertion was further verified through an interview with Mr. Bashir Oshodi29, when he said: “My bank has commenced Islamic Banking”30. Through a follow-up interview, it further revealed that the bank has commenced operation of Non-Interest banking by the provision of the new CBN regulation31. Another conventional Bank, Afri-Bank Plc, had opened a Non-Interest Banking Window. This therefore brought the total number of the conventional Banks operating valid Islamic banking window to three. Aside this, Al-Barakah Micro-finance Bank Ltd is a newly established bank in the category of Microfinance and it is operating on the pedestal of Islamic principles. Adjoining to this is the Lotus Capital Investment Limited, which is an investment company that operates in line with Shari’ah-compliant rules. So far, it is

25 Bello, F, Emerging Opportunities for Divine Banking in Nigeria, Paper presented at the

First Orientation Seminar on Islamic Banking and Finance in Nigeria, Kano, Nigeria, 25th November 2000, 15.

26 Bank PHB is the acronym, which is popularly called in the sector. 27 This is according to the website report (www.finbank/portal.com). 28 Adebayo, R. I, op cit, 5 – 6. 29 Head, Shari’ah Banking (now Manager, Islamic Banking Risk & Compliance) at the 1st

International Conference on Islamic Banking and Finance organized by Crescent University Abeokuta, Ogun State, 20 -22 March, 2010 (Abeokuta 21 March 2010),

30 Ibid, 15-16. 31 This was confirmed by Mr. Bashir Oshodi, op cit. 22nd February 2011.


sufficient to conclude that the sector of Shari’ah-compliant banking and finance is making progress, far above the past record.

3.0 The Nigerian Constitutions In Focus Constitutional enactment in Nigeria started before the country’s attainment of

independence. It started back in the colonial days, when the Governor Generals posted to administer the affairs of Nigeria thought it wise to have a directive guide for the legitimization of government businesses and the conduct of the citizenry. Before this time, Nigeria was made up of several settlements, each of which was identified with its characteristic features: language; ethnic identity; administrative and governmental style32. So, following the colonization of these territories, the British masters, who represented the interests of the Queen of Britain became the overlords overtime and oversee the affairs of these colonies, which gave birth to a nation after amalgamation33 on January 1, 1914. For effective administrative processes and other factors each of them deemed it fit to have a constitution to guide his reign.

The first of these Governor-Generals to make the pioneer Constitution in Nigeria was Lord Luggard (1914-1921). His constitution recognized the need for a Council34 that would see to deliberation of the affairs of the country35. The second regime came up with another constitution, titled: “Clifford Constitution of 1922.” This was the reign of Sir Hugh Clifford, the Governor and Commander-in-Chief of the Armed forces of Nigeria. The basic focus of the constitution was to create an expansion of the Council to accommodate more of the stakeholders, recognition of some other essential communities and election of the legislators36. This constitution was replaced by the Richard’s Constitution of 1946. Sir Arthur Richard (1945-1951) saw the need for a new constitution as precipitated in the Sessional paper No.4 of 1945, which identified four bases37. The fourth was of the Sir John Macpherson (1951). This constitution, titled “Macpherson Constitution of 1951”, saw to the advancement in the political administration of the country by ensuring increase in the list of law makers at the legislative councils; provisions of Assembly in each region for the legislators and executives; stooped direction into the central legislatures but

32 Yakubu, J. A, Constitutional Law in Nigeria, Demyaxs Law Books, 2003, 15. 33 Ibid 34 This council according to the constitution comprised of the Governor, two Lieutenant

Governors, the Executive and the Legislative Councils for the Northern and Southern provinces..

35 Idowu, O. O, (ed.), Citizenship Education, Vol. 1, Revised Edition, 2006, 14. See also: Gboyega, A, Obiyan, S and Mimiko, F, Exam Focus Government for WASSCE & SSCE, University Press Ltd, Ibadan, 73

36 Yakubu, J. A, Constitutional Law in Nigeria, op cit, 17. 37 Sessional paper No.4 of the Nigerian Legislative Council of 1945. These reasons were

to foster the unity of the country and promote participation of the African citizens in the administration of their affairs and; develop a constitution that would cater for the sustenance of the country and see to the re-establishment of the legislative council, which will allow the representative participation of Nigerians.


through sending of representatives from the regional legislators, among others38. Lyttleton Constitution of 1954 was enacted to round off the pre-colonial Nigerian constitutions. Mr. Oliver Lyttleton was the secretary of the State for colonies. His constitution was as a result of the 1953 London conference of Nigerian political leaders. This constitution was more standard in outlook and contents than those before it. It provided for a true system of federal government which had three regional administrations under the practice of separation of powers. Civil service and judicial systems were both regionalized. The constitution also recognized bi-cameral legislature for the North and the West while unicameral was approved for the East. There were also the offices of Regional Premiers and Regional Governors and the Ministers39. Each of these successive constitutions had their merits, which influenced the need to retain some of their provisions or have them built upon, as well as demerits that at different times impelled the need for another constitution.

Nigeria came up under self government for the first time with her own constitution, titled “Independence Constitution of 1960”. This constitution came into force on the 1st October 1960. Inspite of the spirit of independence, the constitution still recognized the Queen as the Head of State, who was represented by the Governor General, Dr Namdi Azikwe. This constitution fulfilled the dream of an independent country40. The force of this constitution however truncated, when Nigerian attained republicanism in 1963. Hence the most recognized constitution for Nigeria was the 1963 because it consolidated the provisions of the 1960 and truly gave Nigerians their dreams41.

It is worthy to mention that one irrepressible feature of the modern constitution, particularly in Nigeria is the classification of the entire affairs into exclusive list, concurrent list and the residual list. The principle behind this classification is that each of the matters pertaining to the country must have an entity that should deal with it accordingly, depending on its nature and area of jurisdiction. Federal Government is usually saddled with any matter affecting national issue in its entirety42; there are some that are left to be jointly handled by the governments of the States (federating units) and the federal government while some are left to either the states governments or local government authorities to look after, depending on their nature, sensitivity to the state security and public benefit. In this regard, Constitution is usually allowed to recognize these affairs and their various lists but the involvement 38 Gboyega, A, Obiyan, S and Mimiko, F, Exam Focus Government for WASSCE &

SSCE, op cit, 74 39 Idowu, O. O, (ed.), Citizenship Education, op cit 19. 40 Yakubu, J. A, Constitutional Law in Nigeria, op cit, 19-24. This constitution further

recognized the enactment of Constitution for the Northern, Western and Eastern regions but the provisions of the Nigerian Constitution shall prevail over those of these regions in case of conflict. See Section 1, Nigerian Constitution, 1960. See further Ibid, 25-39.

41 Malemi, E, The Nigerian Constitutional Law, Princeton Publishing Co., Lagos, 2006, 38-39

42 This includes Banks, banking bill of exchange and promissory notes. See: Item 6, Second Schedule, Legislative Powers, Part I, Exclusive Legislative List, 1999 Constitution, Federal Republic of Nigeria, (as amended, 2011).


of the legislature at the three tiers of government assist in spelling them out43. The Constitution cannot make specific provision for every aspect of the national and citizens’ lives but such power has been constitutionally vested in the National Assembly to make an Act that will specifically permit the operation of each of these aspects, as may be necessary44. Section 315 (1) (a)45, provides thus:

(a) an Act of the National Assembly to the extent that it is a law with respect to any matter on which the National Assembly is empowered by this Constitution to make laws;

3.1 Legalization Of Islamic Banking And Financial Services Under The Nigerian Constitutions Constitution is regarded as the most crucial and foremost legal instrument of

any country. Yakubu46 describes constitution “as a blend of strict law or legal concepts or principles and political conclusions.” Corroborating this view, Malemi47 holds that “a constitution is the supreme law by which a state or country is governed.” These explain the true stand of constitution in any sovereign state, like Nigeria. However, given the facts that constitution has the sacrosanct roles of “strict law or principles” as well as its “supremacy” over the governance of affairs of the state, as mentioned by Yakubu and Malemi, it then gives one the respite to believe that the issue of business and economic related matters, which come under the exclusive list shall not be excluded. To this end, Islamic Banking will be examined from the provisions of the Constitution of the Federal Republic of Nigeria, with particular focus on the 1999 Constitution (as amended), though historical trace will be made to the 1963 Constitution. Nigeria has enacted several constitutions, some of which ended up as mere draft and proposed constitutions because of certain circumstances that surrounded their implementation48.

3.2 1963 Constitution 1963 constitution of the Federal Republic of Nigeria came into force of

operation soon after Nigeria transformed into a Republican state on the 1st of October 1963, 43 These include the National Assembly that comprises of Senate and House of

Representatives at the Federal level; House of Assembly at the State level and; Local Government law makers. The law made by the National Assembly is called ‘Act’; State House of Assembly is called ‘Law’ while Local Government Law maker is called ‘Bye Law’. Gboyega, A, Obiyan, S and Mimiko, F, Exam Focus Government for WASSCE & SSCE, op cit, 2

44 Section 318(1), 1999 Constitution, Federal Republic of Nigeria, as amended 2011. 45 CFRN, 1999 (as amended), 46 Yakubu, J. A, Constitutional Law in Nigeria, op cit, 1. 47 Malemi, E, The Nigerian Constitutional Law, op cit, 2 48 There was the 1989 Constitution, enacted by the military President, Ibrahim Babangida;

there was also the Draft Constitution of 1995 made by late General Sanni Abacha. The logic behind the two proposed constitutions was to launch them into democratically elected Presidents. But because their regimes were truncated the use of the 1979 Constitutions was retained until 1999, when another Constitution was enacted to repeal the former. 48 Malemi, E, The Nigerian Constitutional Law, op cit, 9-10.


three years after independence in 1960. Hence, the new name ‘Federal Republic of Nigeria’. This development marked a total departure from affiliation with the British colonialists. But historically, Olakanmi49 observed that this change of status assumed no substantial meaning in terms of constitutional change due to the fact that a combination of factors fuelled serious political crises, suspended the 1963 Constitution and ushered in the military intervention on 15th January, 1966.

That notwithstanding, administration over national issues were not affected. The economic aspect of the constitutional provision and its enforcement was one of those that were not disrupted by military intervention. It can therefore be maintained that the contents of this constitution had some salient provisions that allow the activities of Islamic banking and finance in Nigeria. However, there is no express provision in this Constitution that specifically mentioned or recognized Islamic banking and financial services as such an economic and commercial enterprise that an individual or corporate institution should operate, yet the provision of Section 26 (1) gives a tenable ground for the promotion of economic and commercial activities generally, which did not exclude Islamic finance system. The provision reads thus:

Every person shall be entitled to assemble freely and associate with other persons, and in particular he may form or belong to trade unions and other associations for the protection of his interests50.

Looking at this provision apparently, one will be deluded to believe that there is no relationship between the focus of the discourse and the cited provision. It would ordinarily be argued that the provision expressly deals more with the welfare of trade unionism and association. But it should be seen from the perspective that the provision is made up of two interconnected clauses, each of which can as well be independently applied to different situations. The underlined portion: ‘Every person shall be entitled to assemble freely and associate with other persons…for the protection of his interests’ is expressly permitting the coming together of people of like-minds to protect their interest, which can be in any form known to them; promoting their economic interest is one. If people fraternize for this sole reason, their liberty is derived from this provision, since there is no contrary provision; this therefore becomes automatically the permitting provision of the constitution to be relied upon. But the interpretation of this provision will be narrowed and too limited if it is only made to apply to fraternity and welfare of trade unionism and association only. It is clear beyond scintilla of doubt that this provision is like a double edged sword because the provision reads: “and in particular he may form or belong to trade unions and other associations”. The underlined section denotes a summation of purpose. Grammatically, it is a coordinating conjunction. From the above underlined excerpt, it is clearly understood that the provision is a permitting clause for any group of people that have a reason to come together to promote economic activity, which could come in various legitimate ways, scales and nature like Islamic banking

49 Olakanmi, P. O., The Nigerian Constitutions: A Compendium, Lawlords Publications,

Abuja, 2008, Pg. ii 50 Underline is ours for emphasis


and finance; no single individual can form an assembly to promote such an interest. Moreso, the setting up of Islamic bank is underlaid by the coming together of promoters (shareholders)51, employees and customers. The business cannot operate in vacuum, unless with the people that joined interests. In line with the provision of Shari’ah, Majlis Aqd is germane to the validity of a business52.

As part of other measure by which the Constitution confers right to promote Islamic banking and finance is through its religious permissibility, as mentioned earlier. This is found in Section 24 (1) and (4) (b) respectively:

Every person shall be entitled to freedom of thought, conscience and religion, including freedom to change his religion or belief and freedom, either alone or in community with others and in public or in private, to manifest and propagate his religion or belief in worship, teaching, practice and observance.

For the purpose of protecting the rights and freedom of other persons, including their rights and freedom to observe and practise their religions without the unsolicited intervention of members of other religions.53

Looking at these provisions, it suffices to behold the fact that Islamic banking and financial services are a matter connected with the pursuit of religious fulfilment. Since religion is respected as a right that is fundamental to every individual,54 it thus becomes guaranteed for such individuals and or group to engage in such financial dealings. It is constitutionally allowed and legally permissible. It would thereof not

51 See: Section 18 CAMA, CAP C20, Laws of the Federation of Nigeria, 2001 52 Orisankoko, A. S., The Legal and Regulatory Frameworks of Islamic Mortgage

Financing in Nigeria, Being an LLB (Common & Islamic Law) Long Essay, submitted to the Department of Islamic Law, Faculty of Law, University of Ilorin, Ilorin, Nigeria, 2011, pp. 36, 48 and 88.

53 Underlines are mine for emphases 54 Ahmad v. Inner London Education Authority (ILEA) [1978] 1 Q. B. 38; Arch. Bishop

Olubumi Okogie v A.G Lagos State (19811) NCLR218; See also: The celebrated case of S. J. Bamigbade & 9 ors v Vice Chancellor, Obafemi Awolowo University (Unreported Suit No. HIF/MISC/20/2002). This is premised on the regulation of dressing on campus. There was an enactment by the University authority, which forbade certain Muslim women’s dress (Jalbab) in to the laboratory. Some aggrieved Muslim students challenged this instrument in court. And while granting an interim injunction against the defendant university, in their favour, the Court per Awotoye J. of the High Court of Osun State sitting in Ile-Ife on 9/5/2002 held that the purported dress code enacted by the institution was unfair, discriminatory, oppressive, baseless, unwarranted and amounting to a gross violation of the rules of natural justice and of the Applicants’ respective Constitutional rights, and it is thereof declared unlawful, null and void to the extent of its incompatibility. Jalbab was declared legitimate and the status quo ante restored.


be wrong to presuppose that these provisions had accorded the required leverage for the floatation of the defunct Muslim Bank West Africa Ltd.

3.2 1979 Constitution Even though the disruption of the political stability shortly after Nigeria

transformed into a Republican could not make the erstwhile Constitution work for too long, Nigeria got another Constitution on the 1st October 1979 courtesy the General Olusegun Obasanjo (Rtd.) through the efforts of:

1. The Constitution Drafting Committee (CDC), under the chairmanship of late F. R. A. Williams and 49 other members.

2. The Constituent Assembly (CA) headed by Hon. Justice Sir Udo Udoma.

The operation of this constitution was suspended on the 31st December 1983 when Major General Muhammad Bukhari and his counterparts late Major General Babatunde Idiagbon overthrew the government headed by Alhaji Usman Shehu Sagagri (1979-1983). Notwithstanding, the constitution enjoyed a fair share of its tenure as an ultimate legal instrument for Nigeria.

Since the defunct Muslim Bank West Africa Ltd. commenced under the force of law of the 1963 Constitution, and stopped operation, there had been no Islamic financial institution until later in 1992. That notwithstanding, there were some provisions of 1979 Constitution that could have accommodated the operation of Islamic banking and finance. To begin with, Sections 16 (1) c and 37 of 1979 Constitution particularly focused on the permissibility of financial dealings, respectfully. In the words of the provision:

The state shall, within the context of the ideals and objectives for which provisions are made in the Constitution –

(c) without prejudice to the right of any person to participate in areas of the economy within the major sector of the economy, protect the right of every citizen to engage in any economic activities outside the major sectors of the economy;55

In connection with the constitutional right of the citizenry to operate Islamic banking and finance, there is a lucid clarification to the effect that Islamic banking and finance was treated with legality and permissibility under this particular provision of the constitution. The benchmarks for this assertion include:

(1) The state is operating the economy of the country without prejudice to the economic interest of the individual citizen;

(2) There is delineated area of economic activities that the citizens can venture into and;

(3) The major sectors of the economy, which the citizenry are prohibited from exploration include oil and other resources unless with due authorization.

55 This is adumbrated in the current Constitution, Federal Republic of Nigeria, 1999 (as

amended, 2011).


Islamic banking and finance is excluded from this major sector because Central Bank of Nigeria is vested with the supervisory and regulatory power to control the banking sub-sector of the economy. The floating of Islamic banking and finance as an area of economic interest does not require specialized authorization except due authorization from the CBN.

Moreso, the connectivity of this provision to the transaction of the Islamic banking can be found in Section 37 of the Constitution, wherein it is declared that as a matter of fundamental right:

Every person shall be entitled to assemble freely and associate with other persons, and in particular he may form or belong to any political party, trade unions and other associations for the protection of his interests.

The earlier argument made on this (similar) provision is adumbrated forthwith to avoid tautology. But it should be mentioned that assuming but not conceding that what affirms the religious permissibility of Islamic banking under this provision are the elements of religious undertone, even though the provisions were enacted to enjoy vast applicability in the light of the provision of Section 39 (1) (a)56, the possibility of invalidating the combined effects of this constitutional provision in recognizing Islamic banking has been checked by the provision of Section 35 (1) of the same constitution. The provision reads thus:

Every person shall be entitled to freedom of thought, conscience and religion, including freedom to change his religion or belief and freedom (either alone or in community with others and in public or in private) to manifest and propagate his religion or belief in worship, teaching, practice and observance.57

As a matter of religious obligation, doctrine and practice, it is as of right that Islamic banking and finance could be operated against the backdrop of its inalienable connection with the propagation of the Islamic faith58. Thus, under the 1979 Constitution, Islamic Banking and financing services is legal and cannot be declared ultra vires, to the extent of its compatibility and consistency.

3.3 1999 Constitution (As Amended, 2011) This amended constitution is a step ahead of the erstwhile Constitutional

legislation59. Following the incomprehensive nature of the said Constitution, it became necessary to carry out the amendment in order to give room for what were

56 Right to Freedom from discrimination protects every citizen from being discriminated

against on the matter of religious affiliation, propagation or practice. 57 Underline mine for emphasis 58 See: Dallas v. Mitchell 16 C. J. S. p. 199. 59 Constitution of the Federal Republic of Nigeria (Promulgation) Decree No. 24, 1999,

which came into force on the 5th May 1999.


considered highly essential to be included and excluded60. The amended Constitution was signed by the Clark to the National Assembly61 on the 6th Day of January, 2011 and assented to by President Goodluck Ebele Azikwe Jonathan on the 10th Day of January, 2011 to give it force of legitimacy.

Regarding the constitutionality of Islamic banking and non-banking financial institution services, it has been argued in some quarters, as observed earlier, that no Constitutions of Nigeria had made provision for Islamic Banking and non-banking financial institution services save as provided under some provisions, where it has enjoyed the protection of Islam as a faith. One of these scholars submits that there is no place in the Constitution of the Federal Republic of Nigeria 1999 or the ones before it where provision is/was made for Islamic banking or any other type. This must be pointed out from the outset. This implication of juristic thinking is that the Constitution does not pretend to be capable of making provisions for all matters that need to be. Rather, by its supremacy, it portends to give validity to all the laws of the land as the makers of such laws derive their law making powers from it62.

It is quite right though that the Constitution does not expressly and specifically provide for each and every aspect of life and even governmental affairs but it will at least make a general framework under which each of these aspects of life especially can derive its force of law to be able to operate with elements of legality. The Constitutions of the Federal Republic of Nigeria, as partly x-rayed above, had evidenced the place of Islamic banking and non-banking financial institutions under the past constitutions, as demonstrated by various provisions that allow the pursuits of economic and commercial activities generally. Islamic banking and non-banking financial services are classified under a sector of the economic interests and no more. In the light of this63, it is beyond balance of probability that they have not been captured directly/indirectly under these numerous Constitutions of the Federal Republic of Nigeria64.

However, the current Constitution of the Federal Republic of Nigeria (as amended, 2011) has not discriminated against the constitutionality of Islamic banking and finance either. Generally, as it has been reiterated, there is no particular provision that specifically authorizes the operation of Islamic banking and finance but this is not in exclusion of other varieties of the economic and commercial

60 The altered Sections of the 1999 Constitution include: Sections 66, 69, 75, 76, 81, 84,

107, 110 116, 132, 135, 137, 145, 156, 160, 178, 180, 182, 190, 200, 228 (a) and (b), 229, 233, 239, 246, 251, 272, 285, Alteration of the Schedule to the Constitution an Citation. See: Alteration of the 1999 Constitution and the Constitution (First Alteration) Act, 2010; Alteration of Section 5 and Section 76 (2) of the Constitution See: Alteration of the 1999 Constitution and the Constitution (Second Alteration) Act No. 5, 2010

61 Salisu Abubakar Maikasuwa. 62 A. I. Abikan, The Constitutionality of Islamic Banking, Op cit. Pg. 12. 63 This is akin to an Islamic jurisprudential maxim: “The basic presumption is that all

transactions are permissible unless they are prohibited by a text.” 64 1963, 1979 and 1999 (as amended)


transactions either. Conventional banking, mortgage services and even the day-to-day commercial activities or any other form of economic enterprises are not exempted. It is therefore upheld that all these are collectively treated under the provision dealing with economic freedom under the current Constitutional regime. The Constitution needs not be specific, particular or direct in making provision that will affect each of the institutions or economic activities/products/service, being a supreme legal framework for the entire issues affecting the generality of Nigerians and governmental affairs. This is not peculiar to the economic aspect alone; it has not made comprehensive or particular provisions for electoral activities, other than mere and skeletal mention of the generalized provision65. This is why Nigeria has a separate Electoral Act in operation66.

To further clarify this assertion from the lenses of the Constitution, Section 16 (1) (c) and (d), which bothers on economic objectives amiably accommodate the promotion of this Islamic banking owing to the fact that this provision is constitutionally addressing economy67 generally without delimitation in term to a class of economic activities. The section reads:

(1) The state shall, within the context of the ideals and objectives for which provisions are made in this constitution –

(d) without prejudice to the right of any person to participate in areas of the economy within the major sector of the economy, protect the right of every citizen to engage in any economic activities outside the major sectors of the economy.

Furthermore, this provision has justified the right/privilege of every citizen to venture into any legitimate economic activity, provided no liability is considered against the major areas of the economy, as mentioned above68. The maxim applies: 65 The same applies to matter affecting the particular and specific interests of judiciary

and the executive. Constitution does not need to be too specific or direct but it is just to enact a kind of blanket provisions for all varieties of interests.

66 See Electoral Act 2011 (as amended). 67 Economy is divergently defined as “the organization of money and resources within a

nation or community, etc, especially in terms of production, distribution and consumption of goods and services”, Robinson, M. and Davidson, G. (Eds.), Chambers 21st Century Dictionary, Chambers Harrap Publishers Ltd., 1999, Pg. 417.; “Economics, social science concerned with the production, distribution, exchange, and consumption of goods and services. Economists focus on the way in which individuals, groups, business enterprises, and governments seek to achieve efficiently any economic objective they select”, Lekachman, R., Economics, Microsoft® Encarta® 2009 [DVD]. Redmond, WA: Microsoft Corporation, 2008.

68 Out of misconception, a professional group in Nigeria called AiMP was of the view that the provision is rather in support of their antagonistic stand. See: NWOKOJI, C., ISLAMIC BANKING: HOW IT WILL OPERATE IN NIGERIA, (http://www.zimbio.com/Nigeria+Today/articles/PKvMsypNwhM/ISLAMIC+BANKING+HOW+WILL+OPERATE+NIGERIA), nigerianbestforum.com, posted on 27-06-2011, assessed on 04-07-2011.


“The basic presumption is that all transactions are permissible unless they are prohibited by a text”. Though this provision comes under the non-justiciable chapter of the Constitution, which is generally treated with reservation because it has only conveyed privilege and not right69, yet it has been used to mention the constitutionality of Islamic banking. This is further substantiated in sub-section (1) (c):

(c) without prejudice to its right to operate or participate in areas of the economy, other than the major sectors of the economy, manage and operate the major sectors of the economy;

In another development, 1999 Constitution recognizes Islam as a religion for the Muslim citizens of Nigeria70 and their rights to mundane and religious affairs are jealously protected. Abikan and Adebayo have centered their argument on the fact that the operation of Islamic banking is only possible as of (religious) right. This is protected by the Section 38(1):

Every person shall be entitled to freedom of thought, conscience and religion, including freedom to change his religion or belief, and freedom (either alone or in community with others, and in public or in private) to manifest and propagate his religion or belief in worship, teaching practice and observance.

It can be deduced analogically that at this juncture the 1999 Constitution (as amended) has predicated the right of the Muslims to venture, enterprise in and manage their affairs of Islamic banking and finance without any form of constitutional inhibition.

This Constitutional position does not differ fundamentally from the position of Shari’ah on the Islamic banking and finance. All the sources of Shari’ah, the Noble Qur’an, prophetic Sunnah, Athar (sayings) of the rightly guided ones had not specifically mentioned “banking” other than economic enterprises. This is another good reason to believe that the mere mention of “economic activities” is an express/implied inclusion of Islamic banking, non-banking financial institutions as well as their products and services.

4.1 Jurisprudential Justification Of The Context Of ‘Constitutionality’ The constitutionality of Islamic banking and non-banking financial institutions

may have to be re-emphasized because of the narrowed provision of the Constitutions. Jurisprudentially, the words of the constitution appear vague though but this only informs the restricted interpretation being accorded it by scholars, who are of the stand that the Constitution did/do not predetermine the inclusion of Islamic bank in any of its vast provisions. This is due to a proper link of the intention of the draftsman and the intended wide applicability. But to further drive this point home, 69 See: Section 6(6)(c) CFRN, 1999 (as amended) 70 This is why the provisions of Sections 260 – 264; 275 - 279 and 237 (2) (b), CFRN,

1999 (as amended) are made to guarantee the right of the Muslims to justice in their own way, form the inferior Courts to the Courts of record as partly mentioned.


Sanni observes on the construction of statute that Legislations or Statutory instruments are not always clear and direct in their import and where they are, questions may arise as to the competence of a person or body of persons to do certain act within the letters of a Legislation or an enabling law and as to whether certain things come within the application of its provisions or exceptions created by it. These questions have no undisputable answers. They have evolved certain aids or guides in the interpretation or construction of statutes or legal writings in general over the years 71.

There are two of those canons or maxims that aid the understanding of this how the comprehension of statute is attained. They are the ejusdem generis and Expressio unis est exlusio atterius. The former implies that “where there is a list of particular species which fall under an identical class followed by general words, the scope of the general words is restricted to things belonging to the class to which all the specific or particulars fall”. The latter connotes that “the express mention of one thing results in the exclusion of others.”

Given the above position, it will be conceded to that following the latter canon, the mention of “economic activities” is an irrepressible capture of banking and non-banking financial services. All these constitute economic activities outside the major economic sector.

From the former maxim, it is perceptible that the words “economic” and “activities” are mentioned pari pasu. The “activities” is a plural word that does not restrict its relevant applicability to any particular aspect of the economy but rather made a general expression. Likewise, the “economy” interprets to mean “the organization of money and resources within a nation or community, etc, especially in terms of production, distribution and consumption of goods and services”72; “Economics, social science concerned with the production, distribution, exchange, and consumption of goods and services. Economists focus on the way in which individuals, groups, business enterprises, and governments seek to achieve efficiently any economic objective they select”73. Hence, the scope is not pre-intended to be narrowed beyond any level that will exclude (Islamic) banking or jettisoned non-banking financial institutions or undermine the services and products floated by these institutions. Against this backdrop, it suffices to conclude that all the Constitutions of the Federal Republic of Nigeria with the afore-mentioned provisions have declined from not taking cognizance of the operation of Islamic banking, non-banking financial institutions as well as their products and services. The rule of this mode of interpretation is intern dem with the above quoted jurisprudential maxim of Shair’ah: “The basic presumption is that all transactions are permissible unless they are prohibited by a text”.

71 Sanni, A. O. (Ed), Introduction to Nigerian Legal Method, Obafemi Awolowo

University Press Limited, Ile-Ife, Nigeria, 2006, Pg. 222. 72 Robinson, M. and Davidson, G. (Eds.), Chambers 21st Century Dictionary, Pg. 417. 73 Lekachman, R., Economics, op cit.


5.0 Conclusion Islamic Banking otherwise known as Shari’ah-compliant banking or Non-

Interest banking in Nigeria is no fundamentally different from the other businesses. Each business is to be operationally legalized by the supreme law of the land. This is the legal order in every jurisdiction, where economic activities take place. But the only legal instrument that is legislatively recognized to permit the operation of this kind of banking and financial services in the Nigerian jurisdiction is the Constitution, Federal Republic of Nigeria. Given the argument that the Nigeria Constitution does not recognize the operation of Islamic Banking appears to be an aberration to the legality enjoyed by its operation in Nigeria, as claimed by some scholars. This claim has therefore been reviewed and, it is discovered forthwith from all indications that Islamic banking and financial services in its operation is duly recognized by the current constitutional regime and those that preceded it. Thus, the conclusion is that the sections of the three constitutions, which recognize economic activities generally, have contemplation for the constitutional legality of Islamic banking.


Examining The Prudence Of Islamic Banks: A risk management perspective

By Dr Muhammad Imran Ashraf Usmani*

ABSTRACT Islam is a complete code of life. It not only lays down rules for religious affairs but it also covers every aspect of human activities including economic matters.

It not only bans riba and gharar but also all ancillary practices which under the subterfuge of trade may surreptitiously be adopted to dodge the ban. It has, therefore, specified the types of transactions which should not be undertaken and closed all back doors for trespass of these evil practices into Muslim economic arena. It is on account of these restrictions that risk in Islamic finance is well managed and the system remains immune from the ravages of the storms which often appear on the financial firmament of the world.

Keywords: Prudence, perspective, riba, gharar, risk mitigant tools, hedge funds, put options and straddle options.

Riba (interest) free and Gharar (uncertainty) free nature of Islamic banking together with real asset/service-backed transactions ensure that an efficient, effective and robust risk management mechanism is in place in Islamic banks. Innovative collateral arrangements and keeping away from investments in complex, risky and speculative instruments maintains the risk quality of the assets of Islamic banking institutions.This article discusses and explains the theoretical foundations of Islamic finance and examines how Islamic banks ensure the risk quality of their assets facing additional risks than conventional banks due to their Shariah compliant operations.A brief comparison of the investment operations of conventional and Islamic banks is made and it is argued that Islamic banks are in a better position to manage risks and avoid such financial crisis which the banking industry is currently facing globally. * Author: Dr Muhammad Imran Ashraf Usmani is A Shariah Advisor and Group Head

of Product, Development & Shariah Compliance Department at Meezan Bank Ltd. Author of numerous Publications related to Islamic finance & other Shariah related subjects. Email: [email protected]


The theoretical foundation of Islamic finance Islam is a complete religion in which we find teachings about all spheres of

life, from beliefs to worship and from socio economic issues of life to ethical values. Adhering to the teachings of Islam does not merely fulfill our duty to Allah Almighty; it is also in favour of humanity in this world as well.

In our economic life, Islam provides certain rules to be followed in our economic pursuits.These rules are derived mainly from the sources of Shariah i.e. rules of Islam which are: 1. Holy Quran. 2. Sunnah (the way of the Holy Prophet, peace be upon him). 3. Ijma (consensus of Muslims on a particular issue). 4. Ijtehad and Qiyaas (inductively seeking ruling of Islam on a particular issue in

the light of the Holy Quran, Sunnah, Ijma and objectives of Shariah derived from them).

If we try to cover all the rules of Islam concerned with our economic life, it would be very difficult to collect and mention all of them in this brief article. However, some of the basic rules would be worth mentioning, through which other rulings towards some particular business transactions could be determined.These basic rules are as follows:

Riba Riba (Interest) is not allowed in Islam. Riba has two basic kinds:

i) Riba Al Dain:Any excess benefit required or given as the case maybe as consideration in a loan transaction. Due to the prohibition of Riba Al Dain, all of the following types of transactions are not allowed:

• Interest-based loans. • Discounting of receivables. • Trade of debts with profit. • Trade of all interest-based securities.

ii) Riba Al Fadhl:Any excess in spot or deferred barter trade of some specific homogeneous commodities (such as gold, silver, all weighable or measurable things like wheat, petrol or commodities that are used as a medium of exchange like currencies). Any excess on spot or deferred barter trade of such commodities is not allowed if they are homogeneous, even if they are different in quality. However, if they are exchanged heterogeneously in a spot sale (one genre of good with another genre of good, i.e. wheat with barley or dates with salt), then excess of any one of the goods or difference in value is allowed.

This type of Riba was disallowed by the Sunnah (the Sayings of the Holy Prophet p.b.u.h.) and not by the Holy Quran.The reason for the prohibition of Riba-al-Fadl is that by exchanging these homogenous commodities in unequal amounts, there is a fear of developing the rationale in a person eventually leading to interest-based earnings.Therefore, spot and credit sale of unequal amounts of some specific


homogenous commodities and the credit sale of heterogeneous commodities (one genre of good with another genre of good) is disallowed to avoid bringing interest from the back door.

Due to the prohibition of this type of Riba, the following transactions are not allowed:

• Spot or credit sale of gold with gold in excess.

• Exchange of currencies of same country in excess as all the currency notes of same denomination are considered same and equal.

• Credit sale of gold with silver in excess is not allowed. But in spot sale, difference in value is allowed as the market exchange rate is ascertainable in spot sale.

• Credit sale of one country’s currency with the other country’s currency with excess in amount is not allowed, but in spot sale, excess in amount is allowed.

• Trade of one litre petrol with two litres of petrol or one kilo steel with two kilos of steel is not allowed as sale of petrol with petrol and steel with steel falls under the ambit of sale of homogenous commodities.

Gharar Gharar is not allowed in Islam. Literal meaning of Gharar is deception and

uncertainty. In Islamic Shariah, it includes the following types of transactions:

• Deception, cheating or fraud in a transaction.

• Uncertainty or ambiguity in the transaction. It includes the following types of features in transactions:

(i) Diction of the contract is unclear, subject matter or price of transaction is not known, or the contract is contingent to an uncertain event or chance.

(ii) One party’s consideration is certain and the other’s is uncertain.

(iii) One party’s consideration is based on the loss of the other’s. It means that either party only gains at the loss of the other as in a zero-sum game.

Due to the two prohibited types of transactions mentioned above, the following transactions are not allowed:

• Gambling or speculative transactions having any of the abovementioned elements present in such contracts.

• Purchasing a risk for any consideration without owning an asset, because of having the abovementioned second type of Gharar, as in the case of insurance.

• Sale of debt or receivable, because one party’s consideration is predetermined while the other‘s is not certain. For instance, if the debtor defaults, the buyer of the debt does not remain to have any recourse to the seller of debt or receivable. Secondly, if there is any profit obtained by discounting of debt, it will be tantamount to Riba as any excess over and above the principal amount on a loan is Riba.


• Selling, transferring or assigning a risk with consideration is not allowed because if one party purchases the risk of the other party at a predetermined consideration, then one party’s consideration is known while the other’s is not known or uncertain. However, the following situations are allowed:

(i) Assigning a debt having recourse to the assignor in case the debtor defaults.

(ii) Providing a guarantee while the guarantor has recourse to cover the guaranteed amount from the guaranteed person if the guarantee is invoked.

(iii) If some or any one person assumes the risks of the other voluntarily without any consideration.

• Future or forward transaction in which both sides of consideration i.e. price and subject matter of sale is deferred is not allowed due to the following reasons:

(i) Sale of debt with debt.

(ii) Sale contract is contingent to a future period, performance of which is uncertain as it is not executed now and it is not certain that both the parties as well as both the considerations i.e. price and subject matter of sale would be present or available at the time of maturity. They could only promise to do something at a future date, but cannot execute a transaction now which is contingent to a future date.

(iii) Short sale or sale before goods actually come into existence or sale of a thing without owning, taking possession and bearing the risk and reward of the subject matter is not allowed because of uncertainty of deliverability of the subject matter in the sale contract.

Furthermore, Shariah compliance also ensures Corporate Social Responsibility (CSR) and ethical compliance. Islamic banks discourage business and transactions with companies producing tobacco, alcohol, drugs or engaged in the business of gambling, casinos, nightclubs, prostitution, etc.

Risk management in Islamic banking: An applied perspective Now a question may be asked that if the abovementioned transactions are not

allowed, then how can the different types of risks be managed or mitigated in a Shariah compliant investment framework?

Before we answer this question, we should keep in mind the abovementioned rules as well as the following rules:

• It is not allowed to earn money without taking risk of an asset.

• Risk alone cannot be sold or transferred with a consideration without transfer of ownership of the asset.

• On voluntary basis, one can assume the risk of other/s.


Now, we will answer the abovementioned question concerning how different risks could be managed, mitigated, covered or hedged in Islam.There are different types of risks in the trade and there are various ways available to mitigate these risks.We can name these tools as Shariah Compliant Risk Mitigating tools. First,we compare what are the types of risks in conventional banking and Islamic banking.

Risks In Conventional And Islamic Banking Risk management is a continuous and vigilant process. It is an activity more

than an action. It is designed to manage the risks inherent in the bank’s business. The goal of an effective risk management system is not only to avoid financial losses, but also to ensure that the bank achieves its targeted financial results with a high degree of reliability and consistency.

A conventional bank is generally exposed to the following types of risks: credit risk, market risk, liquidity risk, operational risk, regulatory risk and reputation risk. A conventional bank lends money and earns interest on the lent money. It lends money for any financial need, be it for the purchase of assets or not. Even, if it provides financing for the purchase of assets, it does not own the assets and is only concerned with the return of its principal amount and interest. Therefore, it avoids facing many risks that Islamic banks have to face due to their Shariah compliant operations.

However, the flipside to this is that conventional banks – by way of freedom to lend money only – get themselves involved in excessive leveraging and their money – based financial assets are theoretically exposed to unlimited risks as compared to Islamic banks who by way of asset-backed financing are exposed to risks only to the extent of diminishing value of the real asset.

An Islamic bank faces a variety of risks in addition to the risks faced by a conventional bank i.e. reputation risk, Shariah non-compliance risk, product/mode of financing risk, process risk, counterparty risk, etc. Apparently, Islamic banking transactions look more risky compared with the conventional banking transactions. But, if we thoroughly consider many prevalent products of conventional banking and finance, we can easily differentiate that Islamic finance has limited risks on its assets as all financing provided by Islamic banks are real asset/service backed. Figure 1 shows the risk management framework in Islamic banking.

Risk Mitigant Tools In Islamic Banking There are different Shariah compliant ways to mitigate or minimise the risks

mentioned above in Islamic banking which are as follows:

• Innovation in collateral arrangements. This mitigates the credit and default risk. Credit and default risks are more important in Islamic banks as rollover and sale of debt at a discount/premium is not allowed in Islamic Shariah.

• Third-party guarantees. This mitigates the credit, default and counter-party risk.This ensures that the bank has recourse to cover its actual losses in case the counter-party defaults.

• Seeking credit ratings of clients from specialized and credible institutions. This mitigates credit risk, default risk, counter-party risk, information risk and asset


quality risk. Furthermore, it solves the problem of moral hazard and adverse selection arising from asymmetric information.

• Selection of appropriate financial instruments available in the Islamic financial product mix to manage risks profitably. Appropriate use of Islamic financial instruments in a particular transaction mitigates process risk and liquidity risk. Wrong use of a mode of financing may result in profits going into charity or the bank having to disinvest immediately creating liquidity crunch for the bank.

• Precise cost estimation so that price is quoted after adding an appropriate profit margin for Islamic banks to cover the market and price risk. This mitigates transaction risk and price risk. It ensures that over the period of the term of financing, the bank is able to cover the actual direct costs it incurred incidental to ownership and earns a profit as well.

• Takaful coverage (an alternate to conventional insurance) to hedge against unforeseen events which can shorten the life of the asset and its effectiveness. This mitigates subject matter risk against fire, theft, marine accident, shipment failures, etc.

• Making prior Shariah approval for all financing transactions necessary to ensure Shariah compliance mitigates reputation risk. Furthermore, apprehensions about Islamic banking are removed by publishing and distributing books on Islamic banking, arranging seminars, designing and delivering Islamic banking courses,workshops and various training programmes.

Islamic and conventional banking operations: A risk management perspective

Now we will compare briefly the investment operations of Islamic and conventional banks. Following is a list of securities and investment operations which are very risky and prohibited in Islamic Shariah. But, they are allowed and used in conventional banking and finance and have caused financial crisis in East Asia in the 1990s and even more severe and disastrous financial and economic crisis today, the depth of which is still not known.


• Securitisation of receivables without being 100% backed by fixed assets.

• Issue of bonds especially junk bonds and convertible bonds which can disrupt the company’s capital structure without it being willing to do so.

• Short selling of stocks, commodities and other securities.

• Future and forward transactions in stocks and commodities.

• Sale of debt or debt swap which increases the size of financial claims and not the real assets and hence eventually brings inflation in the economy.

• Discounting/factoring of receivables.The difference between the discounted value and par value is Riba and hence it is not allowed.

• Buy back agreements, and repos/reverse repos.

• Margin financing which multiplies the investment one can make and hence increasing the leverage. In economic downturns, it may result in loss beyond original investment.

• Lending financial securities as financial securities themselves are just equivalent to cash i.e. consumables and hence no consideration can be asked or given as the case maybe on consumables. Permissible financial securities (not involving Riba and Gharar and conforming to other Islamic Shariah rules) can only be sold with transfer of ownership as well as risk.

• Derivatives like forwards, futures, swaps, credit default swaps, FRAs, put options, call options, straddle options, etc.

• Hedge funds which take on unnecessary risk and make capital markets more volatile wherever they go.

• Credit sale of currencies for speculation.

• Other similar transactions.

Concluding remarks The abovementioned transactions involve either Riba and/or Gharar.Therefore,

they are not allowed by Islamic Shariah and if we analyse the current financial crisis,we would find that a major cause for such crisis is rooted in the use of Riba and Gharar based transactions. If the rules of Islamic Shariah are followed,we can save ourselves from very risky transactions ensuring smooth running of the financial institutions and hence the economy. Furthermore, the objectives of fair distribution of wealth based on real business and productive enterprise will be achieved as Islamic Shariah only permits taking on risk proportionate to the real value of asset and not beyond the value of the real asset.


Development of Islamic Banking Industry Focus on country Models

Indonesia Despite having the largest Muslim population in the world, history of

Islamic banking and finance in Indonesia is relatively new compared to countries like Malaysia and Bahrain. Islamic financial services began in Indonesia with the establishment of Bank Muamalat Indonesia in 1992, the first Indonesian Islamic Bank. However, it was as late as 1999 when the real infrastructure for Islamic Banking and Finance started developing in the country with the establishment of National Shariah board (Historical developments are summarized in Table 1 below).

Islamic banking services in the country are currently being provided by three different types of institutions i.e. Islamic Commercial Banks (BUS), Islamic Banking Windows/Unit (UUS) and Islamic Rural Banks (BPRS). It is pertinent to note that despite showing strong growth the market share of Islamic banking in overall banking assets still remains low.1 A wide range of products based on Islamic financing modes such as Murabaha, Ijara, Mudaraba, Musharaka, Salam and Istitsna'a are being offered by Islamic banks in Indonesia.

Table 1: Historical Development of Islamic Finance Industry in Indonesia

Year Development 1990 Conference of Indonesian Ulama Board (MUI) 1992 Act No. 7 of 1992 on Banking, allowing establishment of Islamic banks

in the country 1992 Bank Muamalat Indonesia, first Indonesian Islamic bank was

inaugurated 1998 Amendment of Act No. 7 of 1992 on Banking allowing Islamic banks to

operate fully as Islamic Banks (BUS) or by opening Islamic Banking 1 According to Bank Indonesia, the market share of Islamic banking assets in overall industry has reached 4 percent as of end year 2011 compared to 3.28 percent a year earlier. However, annual average growth of Islamic banking assets is more than 65 per cent in the last five years. Source: Islamic Banking Quarterly Bulletin , State Bank of Pakistan


Windows/Unit (UUS). 1999 Establishment of National Shariah Board 1999 Central Bank Act No. 23/1999 was established 2000 Establishment of Jakarta Islamic Index 2001 Establishment of Islamic Banking Bureau 2002 Bank Indonesia released “The Blueprint of Islamic Banking

Development in Indonesia” 2008 Bank Indonesia released “Grand Strategy of Islamic Banking

Development” 2008 Law 19/2008 on selling of sovereign Sukuk was constituted 2008 Law 21/2008 an authoritative law on Islamic finance in Indonesia was

constituted 2008 Introduction of Islamic Banking Act

Historical Development:

The efforts for Islamic Banking in Indonesia can be traced back to 1990 when the conference of Indonesian Ulama Board (MUI) proposed the establishment of Islamic bank in the country to serve the needs of Indonesian Muslims who wanted interest free banking services. It took another two years when in 1992 Banking Act No.7 was enforced by Bank Indonesia allowing the establishment of Islamic banks in the country. In the same year Bank Muamalat Indonesia (BMI), the first Indonesian Islamic bank was inaugurated, thus beginning Islamic banking services in the country (see Table 1).

Despite the inauguration of BMI, Islamic banking services remained limited in the country during the decade of 1990s as the mentioned BMI remained the only institution providing Shariah compliant financial services. However, in 1998 Banking Act No.7 of 1992 was amended, that allowed Islamic banks to operate fully as Islamic Banks (BUS) or by opening Islamic Banking Windows/Unit (UUS). This paved the way for establishment of new Islamic banks. An important development during this period was the establishment of National Shariah board by the Indonesian Ulema council in 1999. The National Shariah board was set up as an independent body authorized to issue rulings on Shariah products and the infrastructure for Islamic banking and finance started developing in the country. In the same year Central Bank Act No. 23/1999 was enacted in which the central bank was mandated to regulate, supervise and develop Islamic banks. The Act also gave authority to Bank Indonesia to conduct its monetary policy based on Sharia principles.

The following three years witnessed important developments in the Indonesian Islamic banking and finance industry. These developments included the establishment of Jakarta Islamic Index in 2000, the establishment of Islamic Banking Bureau in 2001 for regulating, supervising and licensing Islamic banks and the release of “The blueprint of Islamic banking development in Indonesia” in 2002 (for details see section on “The blueprint of Islamic banking development in Indonesia”).

2008 was also an important year in the history of Indonesia’s Islamic banking industry; Bank Indonesia’s “Grand strategy of Islamic Banking Development” also


known as market development strategic program, was released. The comprehensive strategy covered strategic aspects, such as: determining the vision of 2010 as the leading Islamic banking industry in ASEAN, creating the new image of inclusive and universal Islamic banking, mapping a more accurate market segment, developing new products, improving services as well as adopting new communication strategy of Islamic banking. Law 19/2008 supporting legal framework enabling government to issue Sukuk2 as well as Law 21/2008 covering various aspects of Islamic finance in the country3 were constituted in 2008. Islamic banking Act, aimed at promoting the expansion of Islamic financial services in the country was also introduced in the same year.

Blue print of Islamic Banking in Indonesia: In 2002, Bank Indonesia released “The Blueprint of Islamic Banking

Development in Indonesia” for the period 2002-2015, in order to provide guidance to stakeholders of Islamic banking. The revised blueprint of 2005 defined the vision and mission of Islamic banking providing clear priorities for the next ten years (2005-2015). In particular the six programs to be implemented till 2015 included:

a) Increasing the Shariah compliance; b) Increasing the quality of prudential banking operations; c) Increasing the operational efficiency and competitiveness; d) Increasing the stability of banking system; e) Increasing the expertise and quality of human resources; f) Optimizing the social roles of Islamic banks in developing the small and

medium enterprises (SME).

Conclusion: From the above discussion it can be concluded that Islamic financial services in

Indonesia have shown growth over the years. However despite having the world’s largest Muslim population the market share of Islamic banking assets in the country still remains relatively small. Efforts are thus required from all stakeholders to provide an enabling legal, regulatory and Shariah compliance environment for increasing the scope and outreach of Islamic financial services to hitherto a potentially untapped market. Sources:

� Global Islamic Finance Report 2011

� Bank Indonesia website.

� Rifiki Ismal “The Indonesian Islamic Banking: Theory and Practices”, Gramata Publishing 2011.

2 Following the law two sovereign Sukuk structured as Sukuk Al-Ijarah were issued in

2008. 3 The law covers areas including company formation, permissible and prohibited forms

of Islamic transactions, corporate governance and dispute resolution.


Sudan Islamic financial services began in Sudan in 1977 with the establishment of

Faysal Islamic Bank, the first full-fledged Islamic bank in the country. Since then Islamic financial services have witnessed significant growth in Sudan and the country is generally considered as one of the leading countries providing Islamic finance in the African region.

According to Central Bank of Sudan Annual Report 2010, there are 39 banks operating in Sudan. Amongst various modes of financing, Murabaha remains the dominant mode constituting more than half of the financing.

Historical Development: Following the establishment of Faysal Islamic Bank, three Islamic banks began

their operations by 1983. In the same year under strong political and legislative will, process of adopting a purely Islamic banking system initiated in the country (see Table 1 for details of Historical Development of Islamic Finance Industry in Sudan). It took nearly a decade for the country to be completely transformed into Islamic banking system following the Banking Law 1992 that required all financial transactions to be Shariah compliant.

Table 1: Historical Development of Islamic Finance Industry in Sudan

Year Development

1977 Establishment of first Islamic Bank (Faysal Islamic Bank) 1983 Initialization of Process of Adopting a purely Islamic Banking System 1992 Banking Law; Complete Islamization of Financial system 1993 Establishment of High Shariah Supervisory Board (HSSB) 1999 Issuance of First Islamic Bonds 2002 Central Bank of Sudan Act 2003 Law of Insurance and Takaful 2006 Amendment in Banking Law following Comprehensive Peace

Agreement (CPA) in 2005 2008 First Sovereign Sukuk of USD 147 million issued

Role of Central Bank of Sudan: The Central Bank of Sudan has played an active role in promoting the process

of Islamization of banking industry in the country. The first step in this direction was drafting of Banking Law 1992. Later, the central bank established the High Shariah Supervisory Board (HSSB) in 1993 (for details see below). The Central Bank of Sudan introduced financial reforms in the country over the period; 1999-2002, according to which Basel requirements, aligned with the Shariah principles, were introduced in the country. In 2002 the Central Bank of Sudan Act was enforced that categorically required all banking system to act in accordance with Islamic Shariah. However, a comprehensive peace agreement between the Northern and Southern Sudan in 2005 amended the Central Bank of Sudan Act and subsequently in 2006 it


was agreed that the Banking industry in the Northern region would continue to work under Islamic Shariah whereas the Southern region was allowed to set up conventional banking.

High Shariah Supervisory Board (HSSB): In 1993, High Shariah Supervisory Board (HSSB) was established in the

country to oversee compliance

and facilitate the Shariah compliant operations of all banks. The board comprises of Islamic scholars, bankers and economists. The HSSB remains the supreme authority with regards to all Shariah matters of Islamic banking industry in the country. However, rules for all Islamic banks are set by the Bank of Sudan (central bank) while individual Shariah boards of banks act to monitor day to day activities. Most members of individual Shariah boards of banks are also members of HSSB. The HSSB acts as an appeal authority for disputes between Islamic banks, Islamic banks and the Bank of Sudan, and an Islamic bank and its customers.

Liquidity Management: Following the Islamization of banking sector, financial certificates complying

with Islamic financial principles are issued on behalf of the government. The first Islamic bond of this kind was issued in 1999 and to date Government Musharaka Certificates (GMCs), also known as Shahama bonds, are used by the state to borrow money in domestic markets. Apart from GMCs other Islamic bonds including Government Investment Certificates (GICs) and Central Bank of Sudan Ijarah Certificates (Shihab) are also used for liquidity management. Sudan is also active in issuing Sukuk and the first sovereign Sukuk of USD 147 million were issued in 2008.

Insurance and Takaful: History of Takaful industry in Sudan dates back to 1977 when Faisal Islamic

Bank set up Islamic Insurance Company of Sudan. In 1992, the state passed a ruling which required all insurance operators in Sudan to comply with Shariah principles. However, it took another eleven years for the Law of Insurance and Takaful to be passed in the country and at present a fully Islamized insurance sector is working in the country.

Conclusion: In general, from the above discussion it can be concluded that sincere efforts

have been made in Sudan for converting the entire financial structure into an Islamic one supported by favorable legal, regulatory and Shariah compliance environment and has thus enabled Sudan to become a regional leader in Islamic banking and finance.

Note: Information in this section has been obtained from Global Islamic Finance Report 2011 and Central Bank of Sudan website.


Note to contributors

Journal of Islamic Banking and Finance is an official publication of International Association of Islamic Banks Karachi, Pakistan. It is a refereed quarterly journal, as well as a pioneer in the field of Islamic banking and finance being published since 1984. It provides a forum for researchers, particularly in Islamic Banking and Finance, wishing to share their expertise with a vast intelligentsia in the form of articles, research and discussion papers and book reviews. Major areas of interest for the journal include: (i) Theoretical issues in banking and financial industry specially from Islamic perspective; (ii) Empirical studies about the Islamic banking and financial institutions; (iii) Survey studies on issues in Islamic banking and financé; (iv) Analytical studies of applied Islamic banking; (v) Comparative studies on Islamic and conventional banking systems; and (vi) Short communications and interviews investigating the perceptions of leading bankers and banking experts as well as policy makers. Articles Submission:

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