islamic economics

Khaki Audil Rashid (MFC) University Of Kashmir

Concept of Islamic Economics; Public Finance, Islamic Banking and Islamic Investments.

Submitted By:

Khaki Audil Rashid MFC 4th Semester (2009)

Department of Business and Financial Studies

(Erstwhile Department of Commerce)

University of Kashmir.


Introduction

History of Islamic Economics begins with the advent of Islam. Throughout the fourteen centuries of Islamic History we find continuity of work in which economic issues were discussed in the

light of Shari'ah. The early Islamic Jurists have explored the different issues and aspects relevant to Public Finance such as economic responsibilities of the ruler, mechanism of revenue collection, its disbursement,

equity and justice in its administration, public expenditure, its role

in economic development, work of public utilities, utilization of idle resources for the development of economy. However, this study focuses on Public Finance, Islamic Banking and a brief idea about Islamic Investments.

This study is divided into three parts. The first part contains explanation of the basic terms associated with Public Finance and the mechanism thereof. The second part is an attempt to throw light on the mechanism and issues relating to Islamic Banking. However, in the final section a brief explanation of the issues relating to Islamic Investments is given.


Development of Public Finance

Public finance is that branch of economics which deals with the provision, custody and disbursement of the resources needed for the conduct of the functions of the government. It is concerned with the issues of the fiscal nature, and attempts to analyse the effects of government policies like taxation and expenditure on the overall economic situations of individuals and institutions, and examines

their impact on the economy as a whole. The systematic study of fiscal problems or the development of public finance in modern terminology is believed to be a late fifteenth

century phenomenon. It developed and acquired the new significance with the emergence of „Nation States‟ in Europe. In his encyclopedic work, J. A. Schumpeter, a noted historian of economic analysis

points out: “Public finance especially modern taxation first developed in the course of fifteenth century in the Italian city republics, Florence in particular, and in German free-towns (Reichsstadte).” However, the publication of Adam Smith‟s „Wealth of Nations‟ gave a new direction to this discipline. In this masterly work, Smith very

intelligently summarized the earlier works on the subject and broke new grounds by giving his own views and formulating new ideas. His

maxims of taxation, his emphasis on the role of state, his treatment of public revenue, debt and expenditure are his strong contributions to the subject. Indeed, the ideas given by Smith remain the main source and basis for all treatises on the subject.

Public Finance in Islam With the fall of Roman Empire, the world witnessed the emergence of Muslims as a source of power, civilization, culture, science and system of government. Rising from the Arabian Peninsula in the late seventeenth century, the Islamic State extended its boundaries to

North Africa and Spain in the west and to Central Asia and China in

the east. As a matter of fact, it is quite obvious that such a large empire which existed for several centuries and dealt with large population with a huge budget must have established a consistent and operational system for fiscal administration. From the historical

records of the early Islamic History, we find that fiscal planners and policy makers of the period dealt with a host of fiscal issues that we


classify today under the banner of public finance such as revenue

collection, rate and structure of taxation system, the distribution of tax burden in accordance with the Islamic values of Equity, Justice, distribution of revenue for the welfare of the people and development

of economy and so on. The Muslim contribution to the evolution of public finance remained almost neglected by the historians of the subject till now. Interestingly these ideas came in an era when Europe was sinking into what historians commonly called “the Dark Ages of Europe.” Public finance as practiced in the early Islamic period had a clear

basis in the overall ethical and social philosophy of Islam. It was not merely a fiscal operation at the discretion of the ruler; rather it was

based on the guidance from Islamic Shari‟ah and aimed at public interest. The main sources from which ideas of public finance are derived in Islam are:

# The Holy Qur‟an. # Sunnah of the Prophet (SAW). # Consensus of the opinion. # Analogical reasoning of experts of Islamic Law for the Public Interest. In the Islamic system of public finance, the public money is

regarded as a trust in the hands of a ruler and must be directed, in the first place, to the weaker and needy sections of the society in order to bring social security, general prosperity and equitable

distribution of income among various sections of the society-the concept same as Modern Social Cost Benefit Analysis (SCBA). The Holy Qur‟an recommends:

“What Allah has bestowed upon His Messenger (and taken away) from the public of township, belongs to Allah, to His Messenger and (his) kindred, the orphans, the needy, and the wayfarer in order that it may not (merely) make a circuit between the wealthy among you.” In the early Islamic literature on public finance, there is much emphasis on equity and justice in tax collection and its assessment.

On the other hand, the manhandling of tax payers and oppression are severely condemned. The imposition of taxes is rationalized on

the ground that their income should be spent on the care of the have-nots of the society. Also the rates of taxes and taxable items were subjected to change according to the needs of the economy and the paying ability of taxpayer.


The economic role of the State The theory of public finance finds its foundation in the principles, policies and role of the state in economic life. The State is regarded as agency acting for the provision of the collective good of the society.

Its role is rationalized on the ground that the market mechanism alone cannot perform all economic functions and public policy is needed to guide, correct and supplement the private sector. In the Islamic System of government, organization is viewed primary concern. Since Islam focuses on the organization and authority in public affairs, the state assumed an active role for the realization of

material and spiritual goals. It becomes a moral obligation for

authorities to help realize the well being of all, preserve the interest of the people and maintain stability and growth of economy. According to the 13th century Jurist Al-Ghazalli; “It is incumbent on the ruler to help the people when they are facing scarcity, starvation and suffering especially during a famine or

when prices are high, and people fail to earn a living in these circumstances and it becomes difficult for them to make both ends meet. The ruler should in these circumstances feed the people and give them financial assistance from their treasury in order to improve their lot.”

Provision of Social Goods through the State Social goods (actions) that provide benefit to all citizens of the society are to be supplied by the state and made available free of direct charge. This widely discussed theme covers not only that but fulfillment of basic needs such as, food, clothing, shelter, education, etc,. has also been regarded as the primary objective of the state.

Besides, the state has to provide infrastructure needed for the development of the economy and general prosperity. As pointed out by the famous jurist - Al-Mawardi, there are some „public services‟ that should be provided by the state‟s treasury (bayt al-maal). He

mentions:

“If the living in the city becomes impossible because of the non-functioning of its drinking facility (spring) or destruction of its wall then the state is responsible for its remedy (from its own resources and if it lacks funds, it must find a way to get them).” Besides, it has been mentioned at places by various jurists that any action which is by its nature beyond the controls and affordability of

individuals (citizens), and which is economic either in the sense that


it adds to the state treasury or in that it is for the overall good of the

society, should be carried out by the state from the State‟s Treasury (Bayt al-maal) Funds.

Supply of social goods through voluntary sector Besides the supply of the social goods by the government, there was a mechanism which added to the economic well being of the State. This mechanism which worked with the help of voluntary contributions came to be known as an institution of Waqf. Under

this scheme a particular property was earmarked and dedicated to a cause so that the income occurring from that would be extended for

expenses in that Cause. The provision known as Waqf (endowment) is a well known practice in Islamic traditions. The voluntary institution of Waqf supplemented the state in fulfillment of its

obligations towards the provision of public goods.

Functions of the state The state played an active role in the economic life represented basically in its commitment to cater for the minimum standard of living to all members of the society. These economic functions

include:

Provision of conducive environment for economic activities.

Provision for public administration, judiciary and enforcement of

Islamic legal code.

Collection of revenue from available sources and also to raise

revenue by imposing new taxes if the situation so requires.

Disbursement of funds on those heads that are obligations on the

treasury.

Protection of the community from its enemies.

Maintenance of law and order among the people in order to prevent

mutual hostility and attack upon property. This includes improving safety of the roads.

Supervision of such general matters that involve their livelihood and

mutual dealings as food stuffs and weights and measures in order to prevent cheating.

The Executive For the implementation of various policies, a state requires an efficient and honest administration. As described by Prophet (SAW):


“An office is a trust, it would be a humiliation on the day of

judgement except for those who rise equal to the task and pay anyone his due. The worst of the officials are those who are harsh and unkind.”

Defense There is also an emphasis on the need of the state for enough power to attain and maintain military strength in order to preserve the sovereignty and independence of the state.

Social Security

The Islamic state must be committed to provide social security to all its citizens especially those who volunteer themselves for the cause of Islam and the state. This includes the scheme of granting pensions and aids in order to provide benefits to the „have-nots‟ of the society and extend support to those who have done something beneficial to the Islam and the Muslim state.

Economic Activities and the state The jurists of the Islamic Governance stress on the obligations of every citizen to earn a living to support himself and his family. Umar

II in this regard suggests: “Look into the state lands in your province and distribute them on the condition of share-cropping at half of the yield or even less,

reducing the state share to one tenth. However if the land is so infertile that nobody likes to cultivate it even at one tenth, give it for nothing. If even then there is nobody to accept it, spend on its cultivation from the state treasury (Bayt al-maal) so that no land under your control is neglected.”

Economic Development

In Islamic State, maintenance of a healthy treasury and achievement of a high rate of growth have remained major issues of concern for economic development. The various development steps have been suggested, for example Abu Yousuf once said:

“The expenses of the upkeep of the walls on the river bank to prevent flooding and expenses of the dams and of the water locks must be borne by the state treasury, because it is in the public interest that they should be kept in order as any malfunction will


cause damage to agriculture and decrease the income from

taxation.” Islamic state always targets full utilization of its resources and high rate of economic growth. The revival of dead lands has always

remained the top priority of Islamic Development.

Distribution function The fair distribution of income on the welfare of the people always remains the top priority in the public finance in Islamic Systems. Caliph Umar placed much emphasis on the distribution aspect of

budgetary policy. He states:

“Taxes are justified if they are collected in a just, legal way, and that they are spent justly and legally. I consider myself, with regard to the taxes collected, as a guardian of an orphan‟s property. The people have the right to question whether I spend the taxes collected,

in a legal way.” A distinctive feature of the role of Islamic state is that all economic activities and fiscal policies are guided and constrained by Islam‟s own ethical philosophy. Thus, social justice, fulfillment of needs and distribution of income and wealth is not an economic and social end but it is religious duty and a social obligation as well. The public

policies are not guided by the whims of the rulers arbitrarily. Rather

they must be within the constraints of the Islamic Shar‟iah.

Sources of Revenue For the smooth running of an Economy, there must be some system of revenue collection. In the Islamic System of public finance,

the revenues from various sources are broadly classified into three main categories:

Ghanimah Revenue.

Sadaqah Revenue.

Fay Revenue.

Ghanimah(war booty): Ghanimah is the property which Muslims

seize from the enemy. This constituted one of the main sources of

revenue of the early Islamic State. The discussion of ghanimah as a source of state revenue is justified by the fact that one-fifth of the total proceeds belonged to the state and the remaining four-fifth was divided among the fighting army. Thus one fifth (khumus) of the entire volume of ghanimah was available as state expenses. However


the khumus (one-fifth of ghanimah) was not a full-state revenue in

the ordinary sense, as it was/is earmarked for special beneficiaries clearly mentioned in the Holy Qur‟an. The verse reads:

“And know that out of all the booty that Ye may acquire (in war(, a fifth share is assigned to Allah and to the Messenger, and his

near relatives, the orphans, the needy and the wayfarer.” Sadaqah Revenue: Sadaqah revenue is the most important

component of Islamic revenue system. It comprises the Zakah (alms)

collected from the wealth of Muslims and custom duties collected from Muslim traders on articles of trade trafficking through octroi posts. Zakah is the hub of Islamic public finance since it is the most

important source of revenue for any Islamic state. It provides relief from poverty and brings other forms of social security. Abu Ubayd states that Zakah is the share of the poor in the property and wealth of the rich. The assets are liable to Zakah only when they exceed a certain

minimum value called „nisab‟ which varies for each item. The fundamental requirement implies that only those who have sufficiency to pay and possess wealth beyond their needs for a period of one year are liable to pay Zakah. The Zakah is therefore, a determined right of have-nots in the property of the rich and

prosperous.

To sum up, it would be appropriate to say that although the Zakah has been practiced centuries before the birth of modern taxation, it embodied various aspects of modern canons of taxation.

Fay Revenue: Literally meaning of „fay‟ is „return of a thing‟. Legally speaking it denotes all the property received from enemy without actual fighting. It legally includes the levy charged from these lands (kharaj), poll tax (jizyah) and custom duties collected from non-Muslim traders. However, this revenue did not belong to Zakah or

Ghanimah category. Since the state had a full authority in disposing off „fay‟ revenue, it can be regarded as full-state revenue, the benefit

of which was generalized for the common good of the entire population. Al-Ghazali has termed it as amwal al-masalih i.e., the

revenue of the public welfare. From the view point of taxes all lands under the rule of Islamic state has been divided into two categories: # Ushr lands, the levy on which is regarded as Zakah and it is earmarked for specific charitable heads.


# On the other hand, the revenue of fay lands can be utilized

for the general expenses of the state. Regarding revenues on „fay‟ lands, there is a consensus that the

ruler has the authority to distribute it among the fighters as a war booty. However, if he thinks it better the ruler may return it to its owners and levy kharaj tax as a permanent source of income to the State.

Regarding the State ownership of lands, the unclaimed and

abandoned land which is not owned by anyone, nor brought to

life by anyone is ultimately at the disposal of the public authority (iman). Abu Yousuf holds that state is the owner of all those lands which have fallen into the hands of the state either

by means of war or taken by a peace treaty and where no signs of cultivation or building of anyone is found, nor are they a

common land or grazing grounds of a village and did not belong to anyone and not in the possession of anyone.

Revival of Dead land: As a principle the ownership of a dead

land remains with the state, but he who revives any dead land acquires the right of ownership to it. And in return of the ownership, he will have to pay ushr levy if the land is from ushr

category and kharaj levy for kharaj land. The main objective of giving permission to individual ownership

of the dead land is to encourage the cultivation and development of dead land. The utilization of unused land, naturally benefits the treasury in monetary terms by generating more revenue through land tax.

Another concept of the revival of dead/unclaimed land is related to the granting of land of this category by the state in return for the ushr or kharaj. The state being the owner of the said lands have general authority to grant them to someone in order to bring them into cultivation and increase the revenue

from taxes. The procedure of granting unclaimed land is referred to as iqta in legal terminology.

The purpose of revival of dead land and granting iqta is totally economic as it is intended to bring unutilized lands for cultivation in order to increase the agricultural production and augment the revenue of the state.

Sources of „fay’ revenue: The fundamental component of „fay‟ revenue comprise of kharaj. The other major components of „fay‟


revenue are jizyah, custom duties and other miscellaneous

sources, as briefly discussed below: Jizyah: The term jizyah is derived from the word „jaza‟

meaning compensation. In Islamic fiscal terminology, the term is used for the levy taken from the non-Muslim inhabitants of the state in lieu of the protection provided to them. Jizyah is a financial obligation on the non-Muslims of the state in lieu of which they are granted protection of life

and property and freedom to practice their religion. Jizyah is not only a tribute of military defeat and political subjugation, rather by its payment the non-Muslims enjoy protection and other benefits from the Islamic State. Thus the aged and

destitute of non-Muslim community are granted social

security as a Muslim citizen. Abu Ubayd reports that caliph Umar ordered taking care of aged people and destitute and exempted them from the payment of jizyah. Jizyah is to be taken from those who decline to embrace Islam. However,

those who are unable to pay should be exempt, and people should be encouraged to reform and plough their land, for tilled land adds to their happiness and reinforces their energy to fight against enemies. The status of every individual (among dhimmis) should be checked and to whom you find too old and feeble to earn a living, to each of them allocate

money as is necessary, to ease their financial plight.

Custom duties: The taxation of goods at the frontier-posts or on a crossing a fixed boundary line has been practiced almost since the beginning of inter-regional and international trade. In pre-Islamic Arabia, it was customary for the market chiefs

to impose a duty of 10% on the goods brought for trading by foreign traders in their territory. In Arabian peninsula each tribe collected these taxes on the goods imported by the foreign traders passing through their tribe. However, Prophet Muhammad (SAW) after establishing the political authority

over the peninsula condemned the collection of taxes by the

tribes. The aim was therefore, to subjugate the tribes to the political authority of Islam. However, later in the time of caliph Umar, taxations were introduced, which were collected at octroi posts established at the boundaries of the peninsula to enhance international trade by avoiding undue taxations

as practiced earlier. However, the level of taxation depended on the status of the trader and his tax paying capability.


Miscellaneous Sources:

# Waqf (endowment): The provision of waqf is a well known practice in Islamic traditions. The precedents of waqf for the benefit of the Muslims have been prevalent throughout the Islamic history and it became a regular source of income for

the Islamic state. As the income from waqf is generally earmarked for the specific charitable and welfare heads, the state has no full authority over its dispensation.

# Property of a deceased with no legal heir is being transferred to the treasury.

Additional taxation and borrowings: So far we discussed

various sources of revenue namely kharaj, jizyah and custom duties. Sometimes the revenues from all these heads may not be sufficient to finance the defense, development and welfare

heads as they are linked and proportional to a certain tax-base such as agricultural produce, and thus resulting in the deficits. In such cases however, historically voluntary contributions were made. Besides voluntary contributions

state treasurers resorted to public borrowing as well and the amount was paid back as soon as the fund was available.

Public borrowing has been approved in Islam as categorically stated by Al-Ghazali:

“One cannot deny permissions to the ruler to borrow from the people when needs of the state so require and if it is backed by the existing and anticipated economic conditions. However, if the state does not anticipate future income, in

such a case public borrowing is not at all permitted. Regarding additional taxes, Ibn Azam and Ibn Taymiyah in making such an argument state:

“It is the duty of the rich in every society to support the poor. If the revenue from Zakah and Fay does not suffice for

this purpose the ruler will oblige them to fulfill this responsibility. Enough funds will be mobilized for these (needy) people to provide them with food, clothing for summer and winter and a house that protects them from rain and sun and gives them privacy.”


Concept of kharaj taxation: Literally kharaj means lease, rent or

simple yield. In Islamic fiscal terminology, kharaj is the levy on the land/land produce which the peasants of conquered territories pay to the Islamic state. Kharaj is imposed in accordance with the tax

bearing capacity of the land. The factors determining the tax bearing capacity of the land are: Fertility of Land. Type of crop. System of irrigation.

Thus the assessment of kharaj should vary according to the

above factors with each affecting the amount of kharaj. The fertility of land is an important factor since by virtue of it, the production is

more or less. Since the prices of various crops vary with their nature thus the taxes should be adjusted for that factor too. Also for the

crop that has been irrigated by manual labour cannot stand the same rate of taxation as the land irrigated by natural means. Furthermore, there is another factor which also needs to be adjusted which is the distance from the market place. Assessment of Kharaj: The kharaj is levied only on those lands

which come under the definition of kharaj land, irrespective of whether the kharaj land is held by a dhimmi or a Muslim. Al-Mawardi recommends any one of the following ways for the

assessment of kharaj:

Assessment may be made on the basis of the measurement of land.

The method termed as misahah requires imposition of fixed kharaj irrespective of whether the land is cultivated or not provided it is cultivable.

Assessment may be made on the basis of cultivable lands only,

leaving uncultivated land out of consideration.

The third method of assessment is the muqasamah (proportional kharaj) under which the kharaj may be charged as percentage of the

produce. The proportional kharaj is to be collected after the crop is harvested.

Administration of tax collection: Islamic point of view in this

regard is against tax farming. Islamic Fiscal system recommends that the tax be collected in a fair and transparent manner and no merging of

different heads of collection is allowed. A person of good character, pious and trustworthy should be selected and appointed as a tax administrator. He should be a person, who when authorized with the collection of taxes to take what is allowed and keep away from what is


forbidden, and will be left free to decide what to collect and what to

exempt from tax. If such a person is just and reliable, he cannot be trusted with such discretion concerning the collection of taxes.

Principles of Taxation: Taxation policies of Islamic state are guided

by the basic ethos and principles of Islamic Shar‟iah. The principles relating to taxation in an Islamic state are briefly explained below:

Conditions for Imposing Taxes: The fundamental point of taxation

in Islam is that only rich and prosperous who have sufficient resources to pay and are able to bear the main burden of taxes, are subject to taxation.

Defining Tax Base and Tax Rate: A defined and certain tax rate

and a clear tax base is one of the basic features of Islamic taxation policy. This is also one of the basic canons of taxation attributed to Adam Smith who states that the amount of taxes should be certain and known.

Principle of Equity: The equity criterion implies that each tax payer

should contribute his or her fair share to the cost of government.

Flexibility in imposing of Taxes: In the Islamic system of taxation,

the rates of taxes and the tax bases are subject to change to suit the changing circumstances in order to benefit the tax payers and increase the revenue of the treasury.

Economy and Convenience to tax payers and economy in tax

collection must be followed in the matter of tax collection.

Care should be taken to avoid double taxation.

Tax incentives: Sufficient provision for tax incentives to increase

the volumes of production and trade.

Theory of public expenditure Distribution function is the distribution of income and wealth to ensure conformity to what is known as fair and just state of

distribution. A considerable amount of attention has been given to


this aspect of the fiscal policy in Islamic Economies. The analysis, in

a very pragmatic way, as to how the state funds have been allocated for the achievement of certain goals such as fulfillment of needs, welfare of the people and development of the economy. In Islam, the

fundamental point regarding principles of public expenditure is that the public resources are like trusts in the hands of the ruler. He is the guardian and the trustee of the public funds and is responsible to spend them in the best interest of the people and the state in accordance with the principles of Shar‟iah.

Role of Bayt al-maal: The inflow of revenue from the

conquered territories required to establish a permanent office of finance during the earlier periods of the flourishing of Islam.

A regular department of finance called diwan (commonly known as Bayt al-maal) is being established to keep the income from various sources and disburse it for the general welfare of

the society. Regarding this mechanism , fiscal operations are being carried out, in general, by local units of Bayt al-maal in their provincial branches. Revenue from each province is applied to meet the expenses of that province. If the expenses are less than the local income, the governor remit the balance to the central treasury. On the other hand, if the expenses

exceed the revenues, the surplus from other provinces or central treasury is transferred to balance the deficit.

The liabilities of Bayt al-maal has been classified by Al-Mawardi into two categories:

Liabilities resulting from the property kept in the bayt al-maal as a trust for special categories of beneficiaries. This category of liabilities of bayt al-maal is related to the revenue from Sadaqah

Liabilities arising with respect to the revenues which are treasury‟s own assets like the income related to fay revenues.

Besides the mandatory obligations of the state, public interest (masalah) provides a permanent basis for public expenditure,

which either should be met by the state from its own assets or otherwise financed indirectly by well-to-do inhabitants of the state.

Expenditure pattern: The first and the foremost factor in

determining the public expenditure is the principles of Shar‟iah. The expenditures under various heads of expenditure is regulated by the


principles of Shar‟iah regarding that head. The pattern is briefly

discussed below:

The Sadaqah revenue are only for poor and the needy and

those employed to collect them and those whose hearts have been reconciled to the truth and for those in bondage and in debt; in the cause of Allah, and for the wayfarers. Zakah will be collected from the rich and returned to poor.

Ghanimah (movable war booty), like zakah, did not

constitute the asset of bayt al-maal as it is not a full state revenue. In accordance with the general direction laid down

in the Holy Qur‟an, four fifth of ghanimah is to be distributed among fighters and remaining one-fifth (termed as khumus), is to be retained by the state for specific purposes.

The Fay revenue constituted the main component of public

budget in the earlier times. Thus all types of welfare projects and other general expenses of the state are financed through this source.

The various heads of expenditure in the theory of public finance in

Islam are:

Need fulfillment.

Defence.

Administrative services.

Social security.

Pension and grants.

Education

Development heads.


Islamic Banking and Islamic Investments

Concept of Banking in Islam It is generally believed that there can be no banking system in Islam as Interest. However, the veterans of Islam propose that a sound system of Banking is possible in Islam which should be based on the concept of Mudharaba. The concept of Mudharaba is a simple system of partnership, which will work by the distribution of half

yearly profits to the account holders/customers who in fact are the shareholders to the Bank. The bank will accept deposits from the

community both for safekeeping and profit sharing purposes. A certain personal loans while the major portion will be utilized to meet the credit requirements of the business and the industry. The interest-free banks will provide credit facilities and perform

all the functions of commercial banks. Being partner in business and industry, they will supervise the progress of work and under the vigilance of Bank staff the chances of loss are minimized. The profit sharing principle will provide incentive to the investors who will invest their money in the Bank. The partners in such banks shall have mutual gain and mutual loss whereas in the modern banking

the losses are borne by the borrowers alone and the lender always

stands to gain. When speaking about the consumer loans, the well-to-do should grant loans to the needy. Or the credit unions and cooperative societies be formed as to provide interest free loans to the members. There is a concept of nationalization of the function of financial

intermediation; however that does not suitably fit within the principles of Shariah.

Islamic Society in its real sense is an association for the purpose

of harmonious co-existence. The actions of individuals in the Islamic society should carry on the code of moral values and conduct.

Islamic society is thus, based upon righteousness and mutual help.

“Help ye one another unto righteousness and piety, but help ye not one another unto sin and transgression” is the call of Qur‟an. Since things have changed due to astounding development of science and technology, the Muslims are confronted today with the new problems due to the great revolution of science and technology

and thus the economic rules have taken a new direction and demands wholesale measures to combat these hurdles. However, in


evolving a system of banking we have to take into consideration all

the material facts like the necessity of credit etc., and the fact that the Muslims have to deal with the non-Muslims within their own country and outside. The various dimensions of the Fit of Islamic

banking within the present capitalistic world will be discussed in the following sections.

Mudharaba: The basic concept on which earlier Islamic Banking

functions depended and flourished was Mudharaba. Mudharaba, according to jurists, is a social contract whereby one gives his

property to another to carry on business therewith and the profit to be shared between them according to the specked terms such as

one-half, one-third or so. In Mudharaba, the entire loss is always attributed to and deductible from the capital Mudharib and thus agent has nothing to loose except his labour. There is yet another

marked difference between Mudharaba and other kinds of partnership; whereas all other kinds of partnership may consist of two or more persons, Mudharaba consists of only two – one is the financier and the other his agent. The financier invests his capital and the agent his skill. Whereas in other partnerships each partner

is and agent of and for each other, there is no case of Mudharaba. The capital must be surrendered to the mudharib so that he may handle it alone (without any interference, whatsoever, from the

lender or principal). Loss, if any should be assigned to the capital, the agent or Mudharib will not bear it, neither should Mudharib

invest anything of his own nor bear any material loss. Now the question remains that Whether Mudharaba is practicable or not. Mudharaba becomes impracticable as the

complexities of business increase. Say for example in case of accepting/financing a trade bill, the credit will be allowed only if the issuer of the bill holds 1/3rd of the bill amount in the current account of the bank. But this is not possible because of the diversity and complexity of the nature of International transactions. Mudharaba is also a risky proposition as the partner may lead the

bank to other encumbrances. As explained by Pollock, such person may bind his firm by any of the following acts:

1. He may sell any goods or personal chattels of the firm. 2. He may purchase on account of the firm any goods of any kind

necessary for or usually employed in the business carried on

by it. 3. He may borrow money on credit of the firm.


4. He may, for the purpose, pledge any goods or personal chattels

belonging to the firm. Due to these and other limitations, Mudharaba is of a limited

scope and risky proposition for banking. But if Mudharaba is not a universal solution to Islamic Banking then what is? To answer this question let us have a look at the Islamic Laws relating to Loan transactions, Pledge, Lien and other things which are explained in

the following section.

Islamic law relating to Loan: Let us briefly analyse what Qur‟an

says about the loan transactions:

“O ye who believe! When ye deal, one with another, in lending for a fixed term, reduce it to writing. Let a scribe write down faithfully as between the parties: let not the scribe refuse to write: as Allah has

taught him, so let him write. Let him who incurs the liability dictate, but let him fear his Lord Allah, and not diminish aught of what he owes. If the party liable is mentally deficient, or weak, or unable himself to dictate, let his guardian dictate faithfully, and get two witnesses, out of your own men, and if there are not two men, then a men and two women, such as ye choose, for witness should not refuse

when they are called for evidence. Disdain not to reduce to writing for your future period, whether it be small or big: it is jester in the sight of Allah, more suitable as evidence, and more convenient to prevent doubts among yourselves but if it be transaction which ye carry out on the spot among yourselves, there is no blame on you if ye make a commercial contract; and let neither scribe nor witness suffer harm. If

ye do (such harm), it would be wickedness in you. So fear Allah; for it is Allah that teaches you. And Allah is well acquainted with all things.” The motive of this text is to explain that lending is allowed both in spot and in future, for fixed term and on demand. The first part of

the text deals with the transactions involving future payment and the second part with transactions in which payment and delivery are made on the spot. As narrated by Ibn Abbas, while Riba (usury or interest) is prohibited, salam which is in fact a short term loan is allowed. Such

transactions may be of two types Salaf and Qard. The word Salaf literally means a loan which draws forth no profit for the credit. In its wide sense it includes loans for specified periods


(short, intermediate and long term loans). But if it is immediately to

be paid it is called Qard or loan payable on demand. This is in fact, a particular type of Salaf. Lending and borrowing, are indeed,

unavoidable in this worldly life, and, therefore, permissible in Islam. To sum up, it will be appropriate to say that loan under Islamic law is permissible, and may be classified into Salaf and Qard, the former being for a fixed time and the latter on demand. And every loan that draws forth or stipulates profit is unlawful. For this

purpose it is necessary for us to understand the nature of unlawfulness-which in fact is Riba.

Riba: The word Riba literally means „increase‟ or „excess‟. As an

excess over the principal is Riba, it covers usury and interest both. Therefore, it cannot be contended that Riba applies to usury or

lending of money at an exorbitant rate which is cruel, while interest at a low rate is allowed, nor can there be any distinction between the interest for productive purposes and the interest for non-productive purposes. There are two kinds of Riba:

Nasia which means delay granted to the debtor. It is used in this sense because the creditor, so to say, overlooks the delay in payment of the debt in consideration for something in excess over the principal.

Fadhal signifies the excess charged in the exchange or sale of things of homogenous nature of the same species.

Considered from the legal point of view, while Nasia relates to the excess charged in loan transactions, Fadhal relates to the excess charged in sale transactions. While Nasia is forbidden, Fadhal is prohibited. The adverse effects of Riba can suitably be explained with

the help of an example. Suppose an amount is advanced as loan for a fixed time, then the creditor continues adding to it, and for each delay in payment of debt, a further additions are being made, to the extent that the whole property of the debtor is consumed by a small

amount of a loan, and often so happened that the debtor payment of the debt went on extending time on a promise to the creditor, of

something more towards interest which ultimately resulted in his complete ruin. This is destructive to the society and thus forbidden.

Loans and Securities: Banks borrow and lend again and very

lender must have a lively regard to the chances of repayment since no lender from the earliest times has been content to rely upon mere


words to borrower to pay, but has demanded some tangible security

to which he could have a recourse in the event of failure by the borrower to fulfill his obligations. Islam is not repellant to the idea and has laid down some broad principles in this regard.

According to Islamic law, pledge is a security for the satisfaction of debt if the debtor failed to repay it and whatever validity forms the subject of sale may be given as a security. However, if pledge consists of an object, which needs maintenance such as animal, the pledge can benefit by it for what he spends towards its maintenance. The permission of the pledger is not needed in the case. Otherwise in

cases in which security consists of objects which do not need maintenance, permission is needed from the pledger to derive

benefits from such security.

Lien: Apart from pledge, the Islamic Bank has the right of lien i.e.,

right to retain the property belonging to another possessor lien, which may be permissible under Islamic law on the analogy of a

seller who has been invested with the right to retain the property, sold by him, in his possession, until its price is paid to him.

Mortgage: Mortgage has no place in Islamic Law as interest only in

the property is transferred to the Mortgagee and not possession.

Discounting: Depending upon the nature and amount of discount

on the bill, discounting in certain cases has been suspected as Riba.

The loan that draws forth or stipulates profit is Riba. Thus in case of Discounting, it has been agreed that if the Bank discounts the bill to the extent of its service charges only, the discount in that case does not account to Riba.

Islamic Bank: According to Islamic law, partnerships are of

various kinds but one best to the purpose of banking is a partnership whereby two or more persons join in business, each of them being an agent for the other. The capital is not necessarily to

be shared equally and profit to be distributed according to the terms agreed upon between them. Under the principle of what is not forbidden is permissible, an Islamic Bank may be a company, an

association or a concern owned by an individual.

Central Bank of the Muslim State: Bayt al-maal is often spoken

as the Central Bank of the Muslim State but it is entirely concerned with the public finance, its collection and expenditure. Each Muslim


State, shall have to establish a Central Bank to act as its fiscal agent

and the custodian of treasury funds. It will control the credit by acting on the system of special deposits as introduced by the Bank of England, (but these deposits will not earn any interest for the

depositoe banks), and alteration in the reserve requirements. Besides note issue and control of currency it will act as the depository of the banks and the lender of the last resort. Regarding the International transactions, if Banks, on their foreign account or accounts with the foreign correspondent banks, earn interest on these deposits, they in such a case must have a reserve to be given to the poor and needy to

save them from starvation. The Central Bank shall keep an account of this amount and, if necessary, hold it as its own reserve for

charitable purposes.

Muslim World Bank: For the establishment of interest free

banking, there must be a Muslim World Bank on the lines of World Bank. The Central Banks of Muslim States may on behalf of their

Government have a share in the Equity of the Muslim World Bank. There can also be an establishment of a Dinar zone, the same pattern as Euro zone. As to the method of investment, priority must be given to the development of natural resources in which a Muslim State is in an

advantageous position over their counterparts. This will pave way for

economic internationalism, which, as opposed to economic nationalism (a potent cause shall contribute largely to the peace and prosperity of the World). The establishment of such institutions will not only develop the resources of the Islamic State but also unite them together in close cooperation and mutual help which itself negates the idea of Riba.


Islamic Investments

Islamic Investments: Central to Islamic banking and finance is an

understanding of the importance of risk sharing as part of raising capital and the avoidance of riba (usury) and gharar (risk or uncertainty).

Islamic law views lending with interest payments as a relationship that favors the lender, who charges interest at the expense of the borrower. Because Islamic law views money as a

measuring tool for value and not an "asset" in itself, it requires that

one should not be able to receive income from money (for example, interest or anything that has the genus of money) alone.

Deemed riba (literally an increase or growth), such practice is proscribed under Islamic law ( haram, which means prohibited), as it is considered usurious and exploitative. By contrast, Islamic banking exists to further the socio-economic goals of Islam.

Accordingly, Shari'ah-compliant finance ( halal, which means

permitted) consists of profit banking in which the financial institution shares in the profit and loss of the enterprise that it

underwrites. Of equal importance is the concept of gharar. Defined as risk or uncertainty, in a financial context it refers to the sale of items whose existence is not certain. Examples of gharar would be

forms of insurance, such as the purchase of premiums to insure against something that may or may not occur, or derivatives used to hedge against possible outcomes.

The equity financing of companies is permissible, as long as those companies are not engaged in restricted types of business--such as the production of alcohol, pornography or weaponry--and only certain financial ratios meet specified guidelines.

Below is a brief overview of permissible financing arrangements often encountered in Islamic finance:

Profit-and-loss sharing contracts ( mudarabah). The Islamic bank pools investors' money and assumes a share of the profits and losses. This is agreed upon with the depositors. What does the bank invest in? A group of mutual funds screened for


Shari'ah compliance has arisen. The filter parses company

balance sheets to determine whether any sources of income to the corporation are prohibited (for example, if the company is

holding too much debt) or if the company is engaged in prohibited lines of business.

In addition to actively managed mutual funds, passive ones

exist as well, based on such indexes as the Dow Jones Islamic Market Index and the FTSE Global Islamic Index.

Partnership and joint stock ownership ( musharakah). Some structures are most common:

Declining-Balance Shared Equity: Commonly used to finance a

home purchase, the declining balance method calls for the bank and the investor to purchase the home jointly, with the institutional

investor gradually transferring its portion of the equity in the home to the individual homeowner, whose payments constitute the homeowner's equity.

Lease-to-Own: This arrangement is similar to the declining balance described above, except that the financial institution puts up most, if not all, of the money for the house and agrees on arrangements with the homeowner to sell the house to him at the end of a fixed term. A portion of every payment goes toward the lease and the balance

toward the purchase price of the home.

Installment (Cost-Plus) Sale ( murabaha): This is an action where

an intermediary buys the home with free and clear title to it. The intermediary investor then agrees on a sale price with the prospective buyer; this price includes some profit. The purchase may be made outright (lump sum) or through a series of deferred (installment) payments. This credit sale is an acceptable form of finance and is not to be confused with an interest-bearing loan.

Leasing ( 'ijarah/'ijar): The sale of the right to use an object (

usufruct) for a specific time period. One condition is that the lessor

must own the leased object for the duration of the lease. A variation on the lease, 'ijarah wa 'iqtina provides for a lease to be written whereby the lessor agrees to sell the leased object at the lease's end at a predetermined residual value. Only the lessor is bound by this promise. The lessee, by contrast, is not obligated to purchase the item.


Islamic Forwards ( salam and 'istisna): These are rare forms of

financing, used for certain types of business. These are an exception to gharar. The price for the item is prepaid, and the item is delivered

at a definite point in the future. Because there is a host of conditions to be met to render such contracts valid, the help of an Islamic legal adviser is usually required.

Basic Investment Vehicles

Here are some permissible types of investment for Islamic investing:

Equities. Shari'ah law allows investment in company shares

(common stock) as long as those companies do not engage in lending, gambling or the production of alcohol, tobacco, weaponry or pornography. Investment in companies may be in shares or by direct investment (private equity).

Islamic scholars have made some concessions on permissible companies, as most use debt either to address liquidity shortages (they borrow) or to invest excess cash (interest-bearing instruments). One set of filters excludes companies that hold interest-bearing debt,

receive interest or other impure income, or trade debts for more than their face values.

A further distillation of the aforementioned screens would exclude companies whose debt/total asset ratio equals or exceeds 33 per cent; companies with "impure plus nonoperating interest income" revenue equal to or greater than 5 per cent, or companies whose accounts receivable/total assets equal or exceed 45 per cent or more.

Fixed-Income Funds

Retirement Investments. Retirees who want their

investments to comply with the tenets of Islam face a dilemma

in that fixed-income investments include riba, which is forbidden. Therefore, specific types of investment in real estate, either directly or in securitized fashion (a diversified real estate

fund), could provide steady retirement income while not running afoul of Shari'ah law.

Sukuk. In a typical ijara sukuk (leasing bond-equivalent), the issuer will sell the financial certificate to an investor group,


which will own them before renting them back to the issuer in

exchange for a predetermined rental return. Like the interest rate on a conventional bond, the rental return may be a fixed or floating rate pegged to a benchmark, such as LIBOR.

The issuer makes a binding promise to buy back the bonds at a future date at par value. Special purpose vehicles (SPV) are

often set up to act as intermediaries in the transaction. A sukuk may be a new borrowing, or it may be the Shari'ah-compliant replacement of a conventional bond issue.

The issue may even enjoy liquidity through listing on local,

regional or global exchanges, according to an article in CFA Magazine titled "Islamic Finance: How New Practitioners of

Islamic Finance are Mixing Theology and Modern Investment Theory" (2005).

Basic Insurance Vehicles

Traditional insurance is not permitted as a means of risk

management in Islamic law. This is because it constitutes the purchase of something with an uncertain outcome (form of ghirar), and because insurers use fixed income--a form of riba--as part of their portfolio management process to satisfy liabilities.

A possible Shari'ah-compliant alternative is cooperative (mutual) insurance. Subscribers contribute to a pool of funds, which are

invested in a Shari'ah-compliant manner. Funds are withdrawn from the pool to satisfy claims, and unclaimed profits are distributed among policy holders. Such a structure exists infrequently, so Muslims may avail themselves of existing insurance vehicles if needed or required.

Conclusion

Islamic finance is a centuries-old practice that is gaining recognition throughout the world and whose ethical nature is even drawing the interest of non-Muslims. Given the increased wealth in Muslim nations, expect this field to undergo an even more rapid evolution as it continues to address the challenges of reconciling the disparate worlds of theology and modern portfolio theory.

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