islamic and conventional banking. summary of the previous lecture we studied the concept of time...
TRANSCRIPT
Summary of the Previous Lecture
We studied the concept of time value of money
•In the conventional economic system and its basis
on interest at a fixed rate.
•Under Islamic economic system it is based on
price for a commodity with a difference for cash
and credit sale.
Learning outcomes
After today’s lecture you will be able to understand
•The governing principles of Islamic banking based on the literature mostly discussed in the 2nd and 3rd lecture.
•Major difference between the Islamic and conventional banking system.
•Modes of financing or products offered by the Islamic banks.
Basics of Islamic Banking
• Islamic Banking is based on Shariah Laws.
• Shariah covers every aspect of our life, it provides
principles how to live at individual level, in the society,
legal and economic system, etc. or simply it is a
complete code of life.
Governing principles of Islamic Banking
1. The prohibition of interest or riba based transactions
2. Avoidance of speculations (gharar)
3. Avoidance of oppression (zulm)
4. Introduction of Islamic tax (zakat)
5. Financing of Sharia Approved activities and discouraging the production of goods and services which are not allowed in Islamic values (haram).
1. The prohibition of interest based transactions
Those who charge usury (riba’/interest) are in the same position as those controlled by the devil’s influence. This is because they claim that usury is the same as commerce. However, God permits commerce and prohibits usury. Thus, whoever heeds this commandment from his Lord and refrains from usury, he may keep his past earnings and his judgment rests with God. As for those who persist in usury, they will incur Hell, wherein they abide forever.” (2:274)
1. The prohibition of interest based transactions
• Riba’ literally means “increase” or “excess”. An increase in a loan transaction or exchange of commodity accrues to the owner without giving an equivalent compensation in return. For example
• Exchanging 1kg of grapes with 1.5kg of grapes that are
of the same type, quality and value.
• Exchanging Rs.1000 for Rs.1100.
For the same items any difference in their exchange value
is interest whereas pricing of different items while
exchanging is allowed.
1. The prohibition of interest based transactions
Prohibition of Riba will promote an economic behavior
which is
•economically just (value addition)
•socially fair and ethically correct (equal opportunities).
Inequality is definite in the situation where the lender is
guaranteed a positive return without assuming any share of
the borrower’s risk whereas the borrower takes upon
himself all sorts of risks in addition to his skills and labor.
1. The prohibition of interest based transactions
Riba violates the principle of property rights
Money lent on interest is used either productively that it
creates additional wealth or otherwise. When money used
(together with labor and entrepreneurial skills) to produce
additional wealth, such money lent cannot have any
property rights claim to the incremental wealth because
there was no prior bargain over it. Instead ‘interest’,
demanded a guaranteed return regardless of the enterprise.
1. The prohibition of interest based transactions
Promotion of profit-and-risk-sharing
The sharing of risks and uncertainties of the enterprise is
fundamental to Shariah contracts. Shariah condemns the
act of guaranteeing (even by the entrepreneur) to restore
the invested funds intact.
1. The prohibition of interest based transactions
Lending is a virtuous act
Lending should be a generous act. If money is needed other
than for commercial purposes (thus, risksharing), such need
should not be exploited where the borrower is put under
undue burden.
Allah says in Quran “
Who is he that will lend unto Allah a goodly loan, that He
may double it for him or his may be a rich reward…(57:11)
2. Avoidance of speculations (Gharar)
• Definition of Gharar
An Islamic finance term describing a risky or
hazardous sale, where details concerning the
sale item are unknown or uncertain. Gharar is
generally prohibited under Islam, which explicitly
forbids trades that are considered to have
excessive risk due to uncertainty.
2. Avoidance of speculations (Gharar)
• Most of the Islamic scholars view Gharar as ‘both
ignorance of the material attributes of the subject
matter of a sale and also uncertainty regarding its
availability and existence.
• Majority of derivative contracts are forbidden and
considered invalid because of the uncertainty involved
in the future delivery of the underlying asset such as
forwards, futures and options, short selling, and
speculation.
2. Avoidance of speculations (Gharar)
Gharar is prevented when transactions are
transparent with:
•all details agreed in advance; and
•ownership undisputed.
However, Gharar may be tolerated if there is an
important Maslahah or public benefit.
2. Avoidance of speculations (Gharar)
• Preventable uncertainty is present in any contract subject to risks in the ordinary course of business – Istisna or salam contracts.
• Prohibition of Gharar is indirectly a risk management technique in Islam therefore encouraging the exercise of due diligence and avoidance of contracts with high degree of information inconsistency with high turnover.
• Treating Gharar as risk has its penalties i.e. trading of risks therefore is prohibited where the traded risks may have been transferable in derivative format.
3. Avoidance of oppression (zulm)
• Zulm refers to all form of inequity, injustice, exploitation,
oppression and wrong doing.
• A person either deprives others of their rights or does not
fulfill his obligations towards them.
• Zulm also refers to trading in matters which are prohibited
(haram) under Shariah such as:-
a. alcoholic drinks/beverages; and
b. non halal poultry/meat, pork.
• An extension of the social justice and fair economics.
Comparison of Islamic with Conventional Banks
Islamic banks
The functions and operating
modes of Islamic banks are
based on the principles of
Islamic Shariah.
Conventional banks
The functions and operating
modes of conventional
banks are based on fully
manmade principles
(capitalism theory).
Comparison of Islamic with Conventional Banks
Islamic banks
It promotes risk sharing
between provider of capital
(investor) and the user of
funds (entrepreneur).
Conventional banks
The investor/lender is
guaranteed of a
predetermined rate of
interest or returns.
Comparison of Islamic with Conventional Banks
Islamic banks
It also aims at maximizing
profit but subject to Shariah
restrictions.
Conventional banks
Unrestricted profit
maximization illustrated by
derivatives trading, deposit
multiplication, etc.
Comparison of Islamic with Conventional Banks
Islamic banks
In the modern Islamic
banking system, it has
become one of the service-
oriented functions of the
Islamic banks to be a Zakat
collection centre and they
also pay out their Zakat.
Conventional banks
Conventional banks do offer
the service of Zakat
deduction but the depositors
are reluctant to pay Zakat
from their accounts in
conventional banks.
Comparison of Islamic with Conventional Banks
Islamic banks
Participation in partnership
business is the fundamental
function of the Islamic
banks.
Conventional banks
Lending money and getting
it back with compounding
interest is the fundamental
function of the conventional
banks. Money is a
commodity and the
motivation.
Comparison of Islamic with Conventional Banks
Islamic banks
Islamic banks have no
provision to charge any
extra money from the
defaulters except for
compensation and is used
for charitable purposes.
Conventional banks
It can charge additional
money (penalty and
compounded interest) in
case of defaults.
Comparison of Islamic with Conventional Banks
Islamic banks
Importance is given to the
public interest or maslahah.
Its ultimate aim is to ensure
growth with fairness.
Conventional banks
Banks interest is the main
objective. It makes no effort
to ensure growth with
equity.
Comparison of Islamic with Conventional Banks
Islamic banks
For the Islamic banks, it
must be based on a Shariah
approved underlying
transaction.
Conventional banks
Interest-based commercial
banks don’t care about the
activities being performed
with their financing.
Comparison of Islamic with Conventional Banks
Islamic banks
Since it shares profit and
loss, the Islamic banks pay
greater attention to
developing project appraisal
and evaluations.
Conventional banks
Since income from the
advances/loans is fixed, it
gives little importance to
developing expertise in
project appraisal and
evaluations. Risks are
transferable at a price
(insurance).
Comparison of Islamic with Conventional Banks
Islamic banks
Greater emphasis on the
viability of the projects.
Conventional banks
The conventional banks give
greater emphasis on
creditworthiness of the
clients.
Comparison of Islamic with Conventional Banks
Islamic banks
Islamic bank can only guarantee deposits for deposit account, which is based on the principle of al-wadiah, thus the depositors are guaranteed repayment of their funds, however if the account is based on the Mudarabah concept, client have to share in a loss position.
Conventional banks
A conventional bank has to
guarantee all its deposits.
4. Introduction of Islamic tax (zakat)
• Islamic banks perform as their obligatory duty to take
care of the whole system of Zakat as its principal
religious liability, and they pay Zakat themselves as well.
• Naturally Islamic banks will be trusted more than the
conventional banks to perform this job.
• Islamic banks will make sure that funds are used
only in Sharia approved economic activities, e.g.
businesses of alcoholic goods, narcotics, haram
meat, pork, casinos, and prostitutions, etc.
5. Financing of Sharia Approved activities
Islamic Modes of Financing
Participatory Modes1. Mudarabah
2. Musharakah
Sale Modes1. Murabaha
2. Salam and parallel salam
3. Istisna and parallel Istisna
Rent based Modes1. Ijarah
2. Ijarah wa Iqtina