islamic finance

Islamic FinanceAuthor(s): Imtiaz A. PervezSource: Arab Law Quarterly, Vol. 5, No. 4 (Nov., 1990), pp. 259-281Published by: BRILLStable URL: http://www.jstor.org/stable/3381929 .Accessed: 02/05/2011 09:39

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Imtiaz A Pervez*

ISLAMIC BANKING

Introduction

Islamic banking has only recently emerged in the contemporary financial world. From the first example of Egypt's Mit Ghamr Savings Bank in 1963 it has grown steadily to today's 100 or so Islamic financial instituiions worldwide. However, we must quesiion whether this growich necessarily reflects the system's complete maturity or even its wider operational scope. There are still a large number of unanswered questions and Isla}nic banks are faced with several unresolved problems.

However, the conventional banking system has evolved over a period of time on the basis of research and experience and stands instintionalised. It is supported by sophisiicated infrastructure and regulated by coherent legislaiion.

To address the quesiions posed, it would be periinent not only to exanune and explain the nanJre and ingredients of the system's processes, the rationale behind the prohibiiion of interest ("riba"), but also to obtain an overview of the Islamic religion itself from which the principles of Islamic economics, and in turn of Islamic banking, are basically drawn.

Samuel Butler (Elementary Morali@, 1902) believed that the true laws of God are the laws of our own well-being. And well-being of humanity, in its individual or collective form, remains the ultimate objective of all religions. To prevent injustice, deliberate or otherwise, religion identifies and separates the lawful from the prohibited. This concept has been known to all mankind smce ancient times. However, people have differed, in relation to supersiition and myths, in the deflniiion of the scope, variety and causes of taboos and F>rohibitons. The divinely-revealed religions that followed spelt out clearly the laws and injunctions through which to ensure the rights of individuals and thereby allow digIiity to humty. Islam enumerates these in great detail. Muslims believe this was the mission of all prophets and messengers in human history and it was the same fundamental faith revealed to Moses, Jesus and Mohamed (peace be upon them).

According to Godfrey Jansen, Islam is not merely a religion. It provides for Muslims a complete code catering for all areas of human existence; iu}dividual and social, material and moral, economic and poliiical, legal and cultural naiional and . *

nternatona ..

*General lWanager, Faysal Islaniic Bank of Bahrain E.C. Paper submitted to the Internaiional Bar Association SexIiinar, on "Internaiional Finance and the Arab World in the l990's" Pans, France, 2s22 June 1990. Other papers presented at the seminar are available from: 1BA, 2 Harewood Place, Hanover Sq., London WIR 9HB.

ISLAMIC FINANCE

260 ARAB LAW QUARTERLY

It iS a comprehensive way of life, religious and secular; it is a set of beliefs and a way of worship; it iS a vast and integrated system of law; it iS a culture and a civilisaiion; it is an economic system and commercial norm; it is a polity and a method of governance; it is a society and a family conduct; it prescribes for inheritance and divorce, dress and eiiquette, food and personal hygiene. It is a spiritual and human totality; thus worldly and other-worldly.

The Holy Qu'ran and the Sunnah (word and tradition of the Holy Prophet peace be upon him) together are the source for these laws. Qiyas, Ijma, and iitihAd are meant to provide unterpretation, and thereby facilitate future development and implementation of the Islamic judicial system.

Qiyas is a deductive analogy by which a jurist applies to a new case a ruling made * . * a

prevlous y m slml ar cases.

Ijma is the consensus of the Islamic communlty, umma. It is through this principle that democracy makes its impact on the conduct of Islamic polity. While it opens up law tO popular opiIiion, it is a conservative exercise as the consensus has to be by a very large proporiion of the umma. The Holy Prophet's firm belief in his umma is evident from his famous saymg, "my commty will not agree on what is wrong".

Ijtihad, on the other hand, is independent judgment provided by scholars of Islc laws for which clear prlnciples and procedures are siipulated in the Qu'ran and Sunnah. It is an extremely important tool that provides development and adaptaiion through research.

Some visible developments in the world of Islam in the past couple of decades synchronise with the so-called Islamic revival that has taken place at about the same time, attrsbuted mainly to the following reasons:

(1) Muslim populaiions discovermg identity of their selves and religious values following independence from coloIiial regimes;

(2) Dissaiisfaciion of Muslims with the materialist ideologies of capitalism and commllnism;

(3) The recent unprecedented boost in the oil-related income of many Muslim Arab naiions giving them economic recogniiion.

An outcome of this revival is the emergence of a new academic discipline, i.e., Islamic economics. This discipline is based on the hlowledge and applicaeon of the injunctions and norms of Shari'a which prevent injustice ln the acquisition, management and disposal of material resources.

The Islc economic system encourages trade and enterprise but is inimical to self-interest and undue profiteering. It is non-discriminatory to human society and builds a relaiionship between the individual and the cornmunity through co-operaiion, integraiion and duty. Being largely humanitarian in character and socially orientated, it provides saisfaction for human beings by enabling them to perform their obligaiions to Allah and Society. This is contrary to the dictates of modern economics that have, over iime, become more or less a value-free empirical social science akin to applied

ISLAMIC FINANCE 261

mathematics without much relevance or regard to the needs of inclividuals. Islaltiic Shari'a provides rules that cover the allocation of resources, property rights,

management, production, consumption, the functions and working of markets and the distribution of income and wealth. It also defines, in broader terms, the framework for the design of monetary and banking systems. Since the Islamic econoniic system was not implemented in its entirety in a diversified environment for a significant duration in the past, its analysis, the requirements respecting its implementation in the present-day environment, and its economic consequences, are not as yet well elaborated or verified.

As Creator, God is The Owner of the Universe. Man is His Vice-Regent and must, therefore, carry out his duties as prescribed by the Creator. Wealth is a trust from the Owner and is best used in a manner which will lead to the enlarging of the interests and welfare of humanity, in accordance with the rules laid down for the purpose.

Islam is not an ascetic religion. Neither miserliness nor prodigality are encouraged. It advocates an healthy balance between the material and spiritual aspects of life. Thile it dictates strictly for the periodic, even quotidian, performance of spiritual duties, it provides for, and in fact details dispensation for, materials things. It permits humanity to avail themselves of the bounties provided by God but in a manner whereby others are not deprived either by discrirni£lation or exploitation, and that the prescribed values

* . are mamtamec . When the prayer is ended, then disperse in the land and seek of God's bounty . . . (Qu'ran 62.10)

Zakat, an obligatory tax on the wealth of Muslims, is a mechaIiism that forces productive use of wealth since cash or near-cash accumulation is fully taxable on an annual basis while deferral is permitted for most long-term productive investments. It provides for the equitable distribution of wealth, and ensures subsistence for the needy. Coupled with other taxes and charges which an Islamic state may levy, it meets the needs of the state for the welfare of its people.

Private enterprise is given full approval. Application of money in asset-related commercial activities is meant to allow for the generation of real wealth, and in turn ffie filtering through of the benefits of such additional capital generation to all the human factors of production, including the grower, labourer, trader, user and the investor etc.

Doubts have been expressed as to the ability of the Islamic economic system to effectively respond to the challenges of such a fast changing time. The example given is that of today's Muslim countries generally lagging behind the advanced nations in industrialisation and technology. Against the Industrial Revolution that transformed North America, Europe and the Far East in the past two centuries, no comparable development took place in Muslim countries. To Western observers, the Ottomans' inability to evolve and umplement the economic policies needed to promote industrialisation are attributed to the inadequacies of the system.

While it is true that Islamic countries have not kept pace in industrialisation and technology with developed non-Muslim nations, it is not justifiable to ascribe this failure to the Islamic system itself for the following reasons:

(1) The Islamic economic system was never implemented extensively in the


past except for a short time in the very early period of Islam. During that time, Muslims actually obtained phenomenal social, poliiical, economic and geographical development and expansion;

(2) C'iiMa and "iitihaS' wich provide de ab tO meet chaXenges of changmg es were not fully utilised by Muslims. These are two major aspects of Islc religion that ensure that it is widely acknowledged as the most modern of the religions;

(3) It was the political and alministrative failure of Islamic regimes in the past that resulted in most of their populaiion being subjugated for long periods to colonial or other inimical regimes during which time their development on all counts remed ignored<

Prohibition of Illterest

The prohibition and elimination of interest is the core of the Islamic financial system. God's ense disapproval of interest is evident from some of the verses from the Holy Quran: O you who believe, fear Allah ald give up what remnins due to you of interest if you are indeed believers. And if you do not then be warned of war (against you) by Allah and His Messenger, while if you repent you shall have your capital. Do not do wrong and you shall not be wronged. (2.27>279)

Those who swallow usury caot arise except as he arises whom the devil prostrates by (his) touch. That is because they say trading is like usury. And Allah has allowed trading and forbidden usury. (2.275)

In Jlldalsm, interest was prohibited or not encouraged as per the following: If you lend money to any of My people with you who is poor, you shall be to him as a creditor, and you shall not exact interest from him. (Ex.22:25)

He that hath not given this money upon usury; nor taken reward against the innocent. He that doei these things: shall never fall. (Psalm 15)

To a foreigner you may lend upon interest, but to your brother you shall not. (Deut. 23.19)

The moral teaching of Jesus in this direciion was clear and absolute: Love your enemies and do good, lend, expect nothing iIl return. (Luke 6.35)

Aristotle rejected interest on the basis that sCmoney is sterile". Cato even compared it with homicide. In biblical iimes all payments for the use of money were forbidden. In 340 B.C.) Lex Genucia prohibited interest in Republican Rome. When the Roman Empire became Chrisiianised in the fourth century, the Church forbade the clergy from taking interest. In 594 B.C., Solon cancelled all private and public debts when he reformed the Athenian constitution. In the eighth century, Chariemagne made usury a cral offence. St Thomas Aqumas believed that money was invented chiefly for the purpose of exchange and that its principal use was its consumption and alienation whereby it is sunk in exchange. Hence, it was unlawful to make payment for the use

263 ISLAMIC FINANCE

of money lent. In the early Middle Ages, Popes and Councils continued to fulminate against it and civil governments passed laws forbidding interest. The anti-usury movement reached its height in 1311 when Pope Clement V made the prohibition of usury absolute and declared all secular legislation in its favour null and void. By the 1700s, interest had become an acceptable business practice but still most people opposed it until 1945 when King Henry VIII changed national laws to permit charging some form of interest.

According to Dr Mahmoud Abu Saud, money, under Islamic laws, is considered as a means of exchange. It cannot be equated with commodity for the following reasons:

(1) Money has a technical (or ariificial) property of yielding its owner real income simply by holding it, i.e., without exchanging it against other goods;

(2) It is liquid and has no carrying cost, no production cost (almost), and no substitute;

(3) Demand on money is not genuine as it is derived from demand for goods that money can buy;

(4) Money is exempt from the law of depreciation to which all goods are subjected; and

(5) Money is the product of social convention having a purchasing power derived mainly from the sovereignty as against the intrinsic value of other goods.

Interest is construed by Islamic economists as only a theoretical concept that does not correspond to or is representative of real growth of capital. Any excess of money paid by the borrower to the lender over and above the principal amount for the use of the lender's liquid money over a certain period of time will count as interest.

In more precise terms, Dr Mohsin S Khan defines interest as:

(1) That which is positive, fixed ex-ante and tied to time-period and amount of loan;

(2) That its payment is guaranteed regardless of the outcome of the venture in which the capital is invested; and

(3) That the state apparatus provides for and enforces its collection.

According to him, Islam recognises two types of individual claims to property:

(1) The property rights that are a result of the individual's labour and natural resources; and

(2) The property that is obtained through exchange, remittance of the rights of those less able to utilise the resources to which they are entitled, outright grants and inheritance.

Money represents the monetised claim of its owner to property rights created by assets that were obtained either by (1) or (2) above. Lending money is a transfer of these rights from the lender to the borrower. All that can be claimed in return for it is, therefore, its equivalent. Interest on money loaned, therefore, represents an unjustifiable property rights claim because it is outside the legitimate framework of individual property rights recognised by Islam.


Bohm-Bawerk tried to explain the rationale of interest and the rate of interest in terms of tinle preference, i.e., the concept of technical superiority of present over future. According to him, an average person prefers present over future and if he is required to forego the present comfort or use of his funds, he should be entitled to some remuneration, i.e., interest. However, it is not clear what rate of remuneration.

Some argue that the nominal interest rate is justified being a fair compensation for inflation, otherwise value of money is depreciated by time. According to the Fisher equation, nominal rate of interest is the real rate of interest plus inflation rate. While it is practically impossible to accurately predict an inflation rate for a reasonable subsequent period of time, or is customary to do so, there is much more to it than compensation for inflation alone. How much above inflation is something depending on priorities? Monetary authorities use interest as a tool to control the demand and supply of money, to influence currency exchange rates and inflow or otherwise of international investments. In these circumstances, the proportions to which the nominal rate extends itself are llnlimited. The following example of a situation that so often appears in today's environment will illustrate the discriminatory properties of arbitrary nominal interest rate and in turn its devastating effects on certain sectors of society.

Example

To tackle high inflation persisting for some time, acute anti-inflationary measures are in effect. Inflation is down to 7% but interest base rate is still high, say at 15%. Market demand has declined considerably and recession set in. Due to reduced demand, the borrower's earnings from the use of borrowed funds have declined to say 8%, i.e., much lower than at a time when demand was high or even normal. Banks are commitiing on average say 14% interest to depositors and charging 18% to borrowers, i.e., 11% above the inflation rate. The borrower ends up paying 10% (interest rate of 18% less 8% increment obtained on the borrowed funds) from his personal assets. If this situation persists, the borrower will have, over time, exhausted all his personal assets. Meanwhile, to safeguard the depositor's interests, the bank calls in receivers and initiates bankruptcy proceedings against the borrower well before his assets are exhausted. Since the interest rate offered on deposits did not have any relevance to the rate of actual capital generation, the system discriminates in favour of the cash-surplus section of society at the expense of the producer/provider of goods/services. Under this example, it is the user of the funds who ends up discriminated against despite the fact that it is he who provides immense benefit to society by creaiing employment, adding value, and thereby creating real wealth, which eventually contributes to the general welfare of society. After a fsed pre-determined return has been guaranteed to depositors, the conventional bank is forced to charge the borrower a nominal rate to cover the

265 ISLAMIC FINANCE

cost of funds and to provide return to its shareholders. When the actual generaiion of wealth is higher, it is tantamount to discliniination agst the investor and when lower, against the user. Socio-economic justice in Islam is not an isolated phenomenon but a way of life. Islam considers interest in its present form as unjustified and hence injurious to the health of society. For conslunption loans interest nolates one of the basic funciions for which God created wealth, i.e., so that the needy can be supported with surplus wealth. In the case of production loans, pre-deterniined nominal rate of interest is unjust because of the uncertainty surrounding the entrepreneurial profits. At the same time, interest encourages creation of an idle class of people who receive income without having to put in any labour for it. Society is, therefore, deprived of their labour and enterprise.

Islamic Finance The Islamic financial system allows for the replacement of mterest by a return obtained from investment activities and operaiions that actually generate extra wealth. Under this system, capital) or any mcome thereen, is guaranteed in advance to the depositor. As such, the Islamic bank has no pre-deterniined cost of funds and is not under pressure to put up an arbitrary price on the cash that it leds. The lncome generated from the assets underlying the invested funds is passed to investment depositors ("Investors") after deducting the Islamic bank's management fee. When higher retutn is obtained from investment activiiies, Investors in terms of their risk-sharing relationship with Islamlc banlcs receive the relevant higher benefits of such investments. In the event of loss, however, the bank loses its fees while the Investors absorb the loss unless such loss was due to gross negligence on the part of the bank, proved as such. To a classical banker, business is first and foremost an economic aciivity that converts resources into goods and/or services which meet che needs of society. In certain aspects, financial instituiions, in ffieir capacity as trustees of oders' assets have over iime, moved away to some extent from their classical role and approach. Today's aggressive fund manager has overtaken traditional investors, i.e., pension funds and insurance companies. To conservativeness and produce of the classical investment banker, has been added certain speculative aspects and high leveraging which has given rise to volatility. Too many instruments move across trading floors without adequate inherent econoc substance. In the options market, a fraction of the whole business is actually concluded by delivery while so many make and lose money in the meantime. Leveragmg is one of the key factors facilitating take-overs, mergers and acquisiisons to alarniing proportions. A corporate eniity on its own today finds it hard to stave off acquisiiion fnendly or hostile-whecher such acquisitions are for genuine and fair economic reasons or merely aimed at erasing compeiiiion or stripping of assets. Today's financial institutions in their typical form are generally quite vulnerable for the following reasons:


(1) Their capital is at great risk due to high leveraging with their liabilities generally 12 to 30 times their capital. This is well opposed to their own yardstick under which a corporate gearing of even 2 is deemed uMealthy.

(2) The definition of a bank has undergone many changes. The modern-day commercial banks are no longer operating in their classical form by confining their operations mainly to short-term. Against their shorter term liabilities, a part of their assets are of longer maturities. While, these guarantee repayment of deposit plus interest, some of their assets may be of unsound quality. Upon forced sale, these could deteriorate in value or be unconvertible quickly. Should unusual payment calls be received from depositors due to any negative developments or rumours, it may be impossible for these financial institutions to easily convert all their assets into cash and honour their commitments.

With the liberalising of and opening of domestic banking and capital markets, the increasing range of borrowers as well as the instruments, regulatory authoriiies continue tightening policies and malcing stringent prudenual ratios. However, it cannot be denied that even today, should a general crisis develop, it may not always be effectively possible for an authonty to bail out the country's entire financial sector despite its commitment, best efforts and mteniions. Mini crises have occurred in the recent past and continue to occur while there are fears of major crises loog. Too much fmancial, rather than commercial and economic, consideration of these operations renders the markets inherently weak, prone to high volatility, which could contribute to future crisis.

Within the scope of the existing basis of the relationship, Investors have no stake or commitment with the financial institutions or the assets acquired against their investment funds. A small crisis could, therefore, grow by their panic withdrawals. As a consequence, such financial assets will depreciate in value shattering the economic order of society.

Islamic barlks generally perfollll the same functions as conventional banks. They act as financial mtermediaries, mainly in a trust capacity, as well as altninistrators of the economy's payments and transfer system. While conventional banks exploit market imperfections (surplus, deficits, information, transaction costs, search and acquisition, financial claims etc.) solely to obtain maximum results for the benefit of their shareholders, the Islamic bank maintains a greater balance between the interests of the Investor, shareholder, user and society. This is because it is required to contribute to socio-economic justice within the framework of its functions of financial * * *

mtermec latlon.

Due to the very nature of its contractual relationship with the Investors, the Islamic bank is not exposed to the same vulnerability on the following grounds:

(1) For the Islamic bank, the Investors' deposits ("Investment Funds"), being on a trust basis, do not count as its own liabilities. Since the Islamic bank is liable only in the case of gross negligence in the performance of its trust functions, if proved as such, Investment Funds may count only as its contingent liability. In this sense, the Islamic bank is not a highly leveraged institution unless

267 ISLAMIC FINANCE

current account balances in its books are several times its capital base, which

is not normally the case. (2) Certain ratios such as Gearing Ratio and Return on Assets ("ROA") have no

particular relevance to the Islamic bank, Gearing Ratio for the reason that

Investment deposits do not constitute the Islamic bank's liabilities. Lower

ROA of a conventional bank reflects weakness and vulnerability in the case

of volatility of conditions on both sides. Even a slight negative interest-rate

mismatch between those guaranteed to depositors and obtained from assets

could erode profitability. In the case of the Islamic bank, there are no

guarantees to investors and, therefore, no fLxed cost of funds. Variation in

income from assets remains to be for the account of the Investors whose funds

are originally employed for the acquisition of such assets. This provides for

automaiic and, in fact, natural adjustment of assets with liabilities without the

need for any external *ntervention. (3) The Islamic bank as trustee has full discretion on the application of the

Investment funds under its mutual contractual relationship with the Investors.

On the other hand, Investors as, more or less, equity holders or sleepmg

partners, have natural cotment in the trustee's decisions, and in turn to

the underlying assets.

RAISING OF CAPITAL

As m the case of all developed economies, capital remains one of the key resources in

the Islaniic economy m that there are not many commercial activities which can be

carried out without capital. However, it requires the financial intermediary to allocate

capital in a manner which will provide socio-economic justice to society by the creation

of wealth and avoidance of discriniination, exploitation or any other form of injustice.

Monopoly, unfair price manipulation and hoarding are some of the anti-social practices

opposed by Islam, as is interest as a pre-deterlIiined nominal rate.

Funding is raised by Islac banks basically through two vehicles, current accounts

and investment accounts.

Current accounts

Current Accounts with the Islamic bank do not earn any income for the depositor

directly or indirectly. The Islamic bank receives these funds as a loan and their

repayment to the current account customers is absolute and unconditional on its

part. If these funds are used by the Islamic bank for productive purposes, the Islamic

bank and not the customer bears the risk and reward, and the former assumes full

responsibility for all consequences of their use. The Islamic bank may, if conditons

require, charge fees to cover expenses to service current account customers.

Balances in current accounts are direct liabilities of the Islamic bank. Accordingly,

these balances are reported above the line of the Islamic bankss balance sheet as its

own direct liabilities and are guaranteed by its capital resources.


Inveshnent Accounts

In these accolmts are the amounts received from Investors to be invested by, and

generally under the full discretion of, the Islamic bank, on a trust basis strictly in

conformity with the terms and conditions of the relationship between the Investor

and the Islamic bank. The Investors assume all the risks and rewards relevant to

such investments. As trustee, the Islamic bank receives a fixed percentage of the

profit earned as its management fees, the maximllm extent of which is provided for

in the relationship contract, although the Islamic bank may, at its sole discretion and

without any obligation whatsoever, forego a part of its share of profit for the benefit

of the Investors. If at any time, assets acquired by the Islamic bank for the benefit of the Investors

through their Investment Funds obtain a net loss, it is borne by Investors on a pro

rata basis. For that time, the Islamic bank is deprived of its management fee since such

fee can only be a percentage of the profits obtained. The Islamic bank is liable for loss

only in the event of its gross negligence in the perfotmance of its trust functions, if it

is proved as such.

Reserve Account

It is also customary within the provisions of the contractual relationship between

Investors and the Islamic bank to permit the bank to deduct and provide up to a

maximum of a certain percentage from the profits earned as a donation to a reserve account. The balances in this account are meant to offset any unforeseen losses that

may be caused to existing assets or those to be acqliired in the future. The reserve

account provides a safety net and enhances stability to income stream for the Investors. Reserve Account balances are maintained only for the benefit of the existing and

future Investors and the Islaniic bank is barred from obtaining any benefit and

comfort for its own capital unless it was invested along with investment accounts

under the same conditions as for investment accounts. In the event of winding up

of the portfolio of Investment accounts, unappropriated balances in a reserve account

after meeting all claims of the Investors may be donated to recognised charities.

Modaraba Investment Accounts

It is a pool of funds similar to conventional mutual funds. Investment Funds are

received into the Modaraba which are generally represented in units. Periodically, the

assets underlying the Modaraba are revalued and any increment in value thus obtained

is indicated by a relevant change in the unit price of the Modaraba. If the Modaraba

terms permit, new Investors enter the Modaraba by buying units at the latest price

prevailing at the time of their entry. The existing Investors leaving the Modaraba receive the latest value of the units held by them. The difference between their

initial deposit and the value received according to the new unit price will represent

the Investor's profit or loss from the relaiionship.

269 ISLAMIC FINANCE

The Investor's risk in the Modaraba is confined to the extent of his individual amount of participaiion. Should losses ln a Modaraba exceed the total capital resources there is no recourse against the Investor's personal assets outside the Modaraba. Islamic banks as trustees maxlage the Modarabas with the utmost care, using prudent policies and conservatse practices diversifying risk m such a manner that any unfavourable development in any one investInent sector will have minimum overall effect on the Modaraba profitability. In many countries, Modarabas are established as separate compaxiies under special laws and are listed on stock exchanges. These marketable securities are an esseneial part of Islamic financial markees. Many scholars of Islamic economics consider Modaraba as the major inserument contributlng to the replacement of interest. Theories have been produced under which the Modaraba instrument can be used as a tool for market operations and hence the main instrument for effecing monetv policies of Islamic states. If an Islamic bank has also committed its own funds along with other investment funds, such funds are subject to the same terms and conditions as are applicable to Investrnent Funds. In order to provide liqliidity, Islamic banks do commit their own funds on the basis of unit value and accept all the risk and rewards relevant to such amounts under the principles of Islamic banking. Under the relai}onship contract Investors have no votjilg rights or say in the management of the Modaraba which rests with the Islamic bank under the provisions of the relaionship contract. Depending on the terms of the Modaraba, the Islamic bank may raise financing for the benefit of the Modaraba to conduct profitable transactons which cannot otherwise be undertaken within the capital resources of the Modaraba. In countes where Modaraba companies exist under special local statutes, such conduct for the benefit of the Modaraba Investors is dllly regulated by local laws.

Levsng CertiNcates

Leasing sn the conventional form with a few modificaiions is an acceptable mode of investment for Islamic banks A striking difference of the lease contract from other financing vehicles is that rental can be periodically fixed by mutual consent for each subsequent period. Secondary markets can be created for certificate which carry the ownership of good assets and when external financial institutes providing redempiion faciliies for such certificates are saiisfied with the quality and health of such assets, their proper use and mtenance, since it provides fiqWity and is conducive to ie development of Islamic financial markets, such an instrument meets the SpeCiflC needs of the Islamic bank and Investors. A brief outline is discussed under the Use of Funds section below.

Use of fullds On d}e one hand, the use of funds under the Islamic mode of financlng is expected to meet socio-economic objectives. On the other, it is imperative that the interests of


the Investors are duly safeguarded by a sound and efficient decision-malsing process as well as a management process that governs careful maintenance and moIiitoring of assets to mininnise losses and enhance increment in value of unvestments.

The healthy balancing of these two objeciives is obviously a monumental task facing Islamic banks. It requires a full understanding of the economic needs of society at all levels, of various sectors and factors, an excellent grasp of credit assessment techniques and closer involvement tSough sustained exercise of financial arlalysis of the enterpnse receiving funds well) and to ensure that the use of funds is proper and iimely. The Islamic bank is, therefore, expected to perform the dual funciions of: i) an investment bank, in the sense that it performs trust, corporate managerial, financial planning, advisory and consultative funciions along with the provision of medium-to-longer term equity and project finance: and ii) a commercial bank in relation to its short-term investments) financing functions, as well as providing customer services of varied type and scope.

Against the wider scope of its financing responsibilities and operaiions, the Islc bank even now has access to very limited forms of fmancmg. major forms of flnancing follow.

FORMS OF FINANCING

Modaraba financing

Modaraba is a contract bebreen an Islamic bank and a Client whereby the Islamic bank provides a specific amount of funds to the Client for an enterprise for defined purposes in exchange for a reasonable and higSy predictable profit. The Client receives a share in the profit as compensaton or a fee for his know-how and management.

Entrepreneurs with strong technical and managerial skills but without adequate financial scrength find it extremely difficult in ehe contemporary financial world to raise capital for the establishment of viable economic unies, or execuiion of contracts which provide for such sufficient cash flows and earning capability as will allow attracive renlrn on the Investors' capital, m addition to permittg reasonable compensaiion to the entrepreneur for his know-how and management.

Under this contract, the entire capital is provided by the Islaic bank who looks to the user of funds ("Client") for the management and technical know-how and basically to the feasibility (technical, commercial, financial and legal) of the economic unit providing adequate cash flows and earnings that will pet the repayment of principal, return on investment, and in addition incentive to the entrepreneur within a reasonable time-frame. Depending on the viability of the enterprise, this form of fmancing is highly conducive to the creation of new entrepreneurs who are technically proficient and have the ability to efficiently run specific enterprises to the highest levels of efficiency and productivity but have no cash resources of their own. In fact, it encourages conversion of know-how and services into capital.

The Islamic bank allows all costs of production including management expenses of the Client himself and his labour as deductible expenditllre. In addiison, the Client

271 I S LAMIC FINANCE

is permitted a fixed percentage of profit as a fee for his know-how and management without which the economic unit would not be in existence and producing. It is normally 15-30% of the profits, depending on the extent and quality of technology, management efforts and expertise involved. This form of remuneration provides considerable incentive to the Client to earn high income and buy out the Islamic bank from the management fees earned out of net profits of such enterprise.

However, it remains a high risk method of financing. Although the Client has sufficient incentives to make the uIiit a success, he has no capital committed to the enterprise. The Islamic bank, therefore, puts in extraordinary efforts to carefully scrutinise feasibility and projections provided by the Clients using the most sophisticated credit risk evaluation, analysis techniques and criteria for its decision-making process.

Following credit approvals, the Islamic bank takes necessary steps to guard, as far as possible, against completion and operational risks and such common causes of project failures as completion delays, cost-overrun, technical obsolescence and failures, changes in regulatory risk factors, raw material shortages and ineffective marketing while it requires the enterprise to be managed to the highest standards to ensure that the projections are achieved.

After the project's completion, the Islamic bank maintains a strict check on operational risks such as the quality, quantity, availability and price of raw materials, any changes in the regulatory and environmental conditions, productivity and effective output at desirable cost levels, adequacy of infrastructure and continued availability of qualified and skilled labour and managerial personnel. If required, Islamic banks may put a member on the Client's board of directors to keep abreast of the developments within the unit.

Cross-border Modaraba financing entails varied types of risks. Political and regulatory risks are among the most important as are tax burdens. Consequently, this most desirable form of Islamic finance has not found favour in taxable societies in the West and in unstable environments of developing countries. Local laws in certain countries do not permit baSs to take equity stake in the manner prescribed.

The following are some of the characteristics of the Modaraba relationship:

(1) The relationship is entered into between the parties for a certain duration in which the repayment of capital is provided for on the basis of mutual agreement.

(2) Deterniination of profit distribution and principal repayment is mutually agreed for a certain fixed duration and the date on which such deterlIiination is carried out. On such date of determination, audited financial accounts including balance sheet and income statements are submitted to the parties for necessary deterlIiination.

(3) From the net profit after payment of all costs including management costs (including the salary of the Client hitnself) the Client is paid his management Fee at the rate prescribed under the relationship contract. The balance of the profit goes to the Islamic bank for distribution to Investors.


(4) While fixed ratios are permissible, fixed amounts of profit for either party are not permitted under this form of financing.

(5) Liability for loss rests solely with the Islamic bank unless it is proved that the Client was grossly negligent in the performance of his trust functions in which case the entire loss will have to be borne by the Client.

(6) If two or more Islamic banks are involved in providing capital for the Modaraba, the distributable part of the profit, i.e., after payment of management fees, will be distributed between them pro rata to the amount invested by each.

(7) Each party exercises business discretion strictly in terms of the relationship contract and discretionary authoriiies so approved. This avoids confusion and provides clear-cut functional process.

(8) The Modaraba capital is only consumed for the purposes approved under the relationship and the Client has no authority to invest such capital in other ventures without prior approval of the Islamic bank.

(9) During the relationship, the Client is not permitted to introduce his personal and any other external capital in the unit ualess provided for and previously approved by the Islamic bank.

(lO)It is expected that the Client achieves the projections provided to the IslalIiic bank at the time of the initiaton of the relationship on the basis whereby the Islamic bank decided to enter such a relationship. Should the actual results fall far short of these projections, the Islamic bank will be within its rights to seek full explanation for such variance and the Client is obliged to provide the same. Should such explanation be found unsaiisfactory, the Islamic bank may seek recourse against the Client for misrepresentation.

(ll)The Client is not allowed to appoint another management for the enterprise unless it is provided/approved by the Islaniic bank as being necessary for the success of the enterprise.

(12)The Modaraba is not permitted to obtain financing from third quarters without prior express permission of the Islamic bank. However, the client may engage in normal trade credit operations which are normal for such a type of business and were duly provided for in the feasibility study previously submitted to the Islamic bank.

(13)Liabilities of the Islamic bank under the Modaraba are limited to the extent of its capital provided to the Client under the Modaraba contract. Creditors have no recourse to other assets of the Islamic bank should any of their claims remain unsettled against the resources of the enterprise.

(14)Either party in the Modaraba contract has the right to terniinate the contract. If there be more than two partners, the contract may continue in favour of the remaining partners. Many Islamic jurists agree that at the time of termination of the contract, all the goods and capital should have been converted into cash. Even in the case of a fexed-period contract, it will not be legitlmate to bind the partners not to terIninate the contract until the date of maturity. The Modaraba also terminates upon the death of any one of the partners.

273 ISLAMIC FINANCE

This principle renders the Modaraba contract relationship weak, pariicularly when the Modaraba contract covers a long-term project. Modern scholars of Islamic economics have recommended review of certain principles, including this one, in order to eliminate such weaknesses whereby undue advantage or disadvantage to either parw is eliminated.

Conveniional equities are one of the most desirable Islamic flnancing vehicles. However, all the equiiies are not approved for IslaxIiic banks for the following reasons:

(1) The main line of business of a number of corporate eniiiies such as banks, insurance companies, other conventional financial institutions, alcohol manufacturing/trading etc.? is itself prohibited under Islam.

(2) A number of corporate entities themselves issue interest-based debt instruments. Since equity ading, howsoever small, of such entities means part ownership, the same is permitted.

Investment in equities is generaXy risky due to volatility of markets and acute fluctuaiion in prices. To cover such volatility through diversificaiion, eqwty portfolios comprise a large number of selected equiiies picked from diverse business sectors. Some of these may belong to the above-meniioned nvo groups Someiimes, even when an eniity was not engaged in issg a debt instrument at the time an Islac bank joins such portfolio, there is no guarantee that it will not opt to do so while the Islamic bank is still involved in the equities portfolio and leaving at the time may not be in the interest of the portfolio. Due to these constraints it has not been possible for Islamic banks to freely engage in equity-related investments. Besides, certain types of operations such as "puts" without ownership of the equity are not permitted in Islam. Constraints in the seleciion of equities and transactional processes due tQ strict stipulations of Islamic law do not allow diversificaiion, a Viti essence for such investment type. These factors have rendered equity invesjunent unsafe and hence unattraciive to Islamic banks.

Accounttng Treatment

Income from a Modaraba relaiionship is entered in the books of the Islamic bank when cash represeniing the same is actally alised. It may also be booked when it is recopsed or when there is reasonable certainty of its realisaiion after it has been duly deterniined and quaniified.

. Musharaka Financlng

Musharaka financmg is the same fnancing contract as Modaraba except that the Client also provides a part of the capital, in addition to providing management and know-how. On the other hand, the Investor may provide a part of the management arld know-how, in addition to capital. In that case, the sharing of the profit from the unit is adjusted accordingly on both sides and the discretionary authority of each


parmer and a relationship framework is clearly defined. It has also the same relevant implicaions as listed under Modaraba Financlng.

. * n Ihorabaha Fmancmg

Under this contract, the Islamic bank as Investor purchases goods, raw materials, equspment) machinery or any other items of economic significance from a third party at the request of a Client and sells such goods to the Client on a spot or deferred payment basis at its own price. The difference between the purchase cost of the Islamic bank and the sale price to che Client forms the profit available to the Islamic bank from the relaiionship.

The contract normally caters for short-term financing requirements of Clients tbrough legsate trading praciices. Without the fmancmg from the Islamic bank, it will not be possible for the Client to undertake his trading aciiviies to the required extent of his business proporiions.

Followlng the Islamic bank and che Client entering into a contract for such a relaiionship, the bank issues a letter of credit or any other relevant document ordering the pu:rchase of the goods irl question from the manufacturer or supplier for onward delivery to the Client.

Since Morabaha entails a fLxed pre-deterlIiined rate of retum to the Islamic bank, arguments have been raised as tQ its sitnilarity with conventional interest. However) since the Islamic bank bears several risks untfl the compleiion of the delivery which equates it with actual trading, such transactions are considered as legite under the provisions of Islamic banking. This contract has the following implicaiions:

(1) The customer has the right to reject the goods should these not conform tO

the required qualit;y. (2) The Islamic bank is not permitted to assign the benefits of, and recourse under,

the manufacturer's warranty to the Client. The Islamic bank is responsible for providing services under such warranty to the Client and may) therefore have to act as an intermediary between the Client and the manufacturer andlor supplier.

(3) The Islamic bank is obliged to provide the break-down of its cost and profit and all other expenses involved as are charged to the Client under the sale price.

(4) The Client only promises to purchase the goods and is not legally bound tO

necessarily take delivery of the goods upon arrival at the port of destaiion should it have a reasonable and justifiable excuse for such refusal.

(S) The Islamic Bank always obtains iitle to the goods before passirlg these on tO

the Client. (6) In countries where imports are subject to duiies and taxes the Islaic bank's

profit is treated as a part of the purchase price and is, therefore, subject to such levies and taxes as are charged on imported items thereby increasing the cost of import to the Client. This is because financing by the Islaniic bank is treated as tradirlg and not recognised as "debt". Due to this difficulty, trade fmancing by

275 ISLAMIC FINANCE

Islamic banks with such countries where import taxes and duties on imported goods are charged, has not developed satisfactorily.

The Morabaha contract prondes mostly for short-term financing needs of Clients. Due to the inherent liqwdity element that this form of financing carries with it, Morabaha financing has been quite widespread with Islamic banks. Unfortunately, due to che non-existence of the inter-Islamic bank market, Islaniic banks are hard-pressed to maintaln higher liquidity posiiions than their conveniional counterparts. This is one of, the m reasons why a large part of the Islamic banks financing portfolio comprises morabaha.

Accounting Treatment

Where the ultimate income is both contractually deterniinable and quaniiflable at the commencement of the transaction, the same is accrued on a straght-line basis over the period of the transaction.

Qard Hassan Financing

This type of financing is a benevolent type of loan provided free of any charge to cert Cliexlts This form of Islamic financing for commercial purposes is normally made to an enterprise in difficulty which is separately receiving financing for defined puIposes. Such a loan provides financial assistance to the enterprise at no extra cost whereby the viability and profitability of such enterprise itself is considerably enhanced. After the enterprise has reverted to profitability and the two parties agree, Qard Hassan may be converted into eqliity but not with retrospective effect.

This type of fmancing is also used to provide loans to the needy on humanitarian grounds if the resources of the Islamic bank allow the provision of such loans without uxlduly affecting its profitability for the Investors and shareholders.

This is one form of Islamic finance which incorporates an unconditional obligation on the part of the Client to repay the amount loaned. The Islamic bank has the right to ask for collateral as security. It may also seek full recourse against the client for the recovery of amounts due from him.

* * . IXara Flnancmg

This is a contract whereby the Islamic bank purchases an asset and leases it to a Client. The lease contract specifies the leasing period, the amount and iiming of lease payments and the responsibilities of both parties during the life of the lease. Leases can be simple rentals or more elaborate contractual arrangements committing the parties to future actions.

Islamic prlnciples of finance permit the purchase of an asset for subsequent rental which may include cert profit to the Investor. A commercial or individual Client wishing to acquire the use of capital equipment may request the Islamic bank to purchase such asset and oblige itself to rent such asset from the Islamic bank.

2?6 ARAB LAW QUARTERLY

Subject to the fulfllment of certain conditions, the Client has the opiion to purchase the asset duriDg the term of the lease. The opiional purchase price declines over the term of the agreement. As the customer is not obliged to purchase the asset funanced under the Ijara contract at the expiry of the lease, the Islamic bank will not noImally take a substanti risk with respect to itS residual value at the expe of the lease. Two most frequently used types of leases are the operaiing lease and the financing Iease. Full amoriisation of cost differentsates the funancing lease from the operating lease, both of which are acceptable under Islamic principles of finance under specific conditions. The Islamic bank's standard Ijara contract differerltiates bet:ween the operating and financing lease with regard tO itS oMm responsibiliiies and liabilities. In the former the Islamic bank is esseniially acting as warrantor of the asset leased although the Client makes undertalcings as to the utilisation of the asset and its maintenance etc. In the flnancing lease, the Client must deal drectly with the manufacturer or supplier in all matters relating to the leased assets and assumes risk of loss on receiving possession in terms of the stipulaiions of the lease contract.

The Ijara Wa Iktina type lease is a vanation of the standard financial Ijara agreement. The Islamic bank purchases the equipment and leases it tO the Client but the Client is obliged tO purchase the equipment at the end of the lease term. Ijara funancing is ideal for the securitisation of the Islamic financial paper, provided that the paper carries adequate redempiion underwriiing support from financial insti^aons facilitating redemption on demand. On the other hand, the underlying asset should be easily convertible into cash and so it is imperaiive that the asset is of high quality, is marketable, is used and mainted to high internaiional standards which are specified, malntalns demand and therefore normally adds its market value above its book value) is movable and easily repossessable in the event of default. The instrument also permits some mismatching of short-term liabilities with long- term assets because:

(1) The instrument is marketable and is converiible into cash on demand. (2) Periodic rent reviews are permitted. Accordingly, even though it is a longer- term form of financing, the Investor will never be tied down to a ftxed type Of return which may not meet its snvestment objeciives. Rent review can be tied by mutual consent to any internaiional index that reflects relevant market * * conc ltlons.

If the asset is of high quality, the Islamic bank may not have to rely so much on the credit risk of the client as on the asset itself. This allows a relaiively weaker credit risk Client to obtain Ijara financing. These considerations make lessing an attraciive type of finance for Islamic banks and there is growing interest on their part in this fonn of financing. However, the main quesiion is the selection of the assets which meet the criterion. At present, Islamic banks tend to opt for commercial passenger aircraft although it is a very big iicket ieem and financing for such an asset involves very long periods. Also impOrtaIlt is ehe quesiion of taxation smce the Islamic bank's sncome from this form of financing is taxable in many developed and under-developed countries.

ISLAMIC FINANCE 277

Islamic Syndication

It is usually a large financing facility granted to a key industrial or trading organisation lead-managed by an international bank of standing which is also often the "agent". Since the amount involved is large, a mlmber of financial institutions pamcipate by lending money andlor by taking one of several different management functions.

It is impossible for Islamic banks to pariicipate in conventional syndicated transactions since these are mostly interest-related or involve such other forms as are prohibited by Islamic principles. The first ever Islamic syndicated transaciion was recently launched by Faysal Islamic Banlc of Bahrnin E.C. through a composite structure which has now found considerable interest among many Islamic and conveniional financial insiitutions worldwide.

Special Modaraba

A Special Modaraba is floated by the Agent bank ("Modareb") in which other financial institutions-Islamic and conventionalz pcipate with their participaiion amounts. The Special Modaraba condiiions siipulate not only the conditions of pancipaiion but also clearly spell out the relevant use of funds, the contract documentation used for such use of funds, the Client, the guarantor to the Client's obligaiions and all other legal documentation required in the relaiionship from the parties to the wansaciion.

Agent

The Agent performs his functions strictly in accordance with the terms of the Special Modaraba contract.

Morsbahs Agreement

Bemg normally short-term, it is normally under the Morabaha contract, as provided for under the Special Modaraba contract, and is signed between the Agent and the Client for the transaciion relaiionship.

Guarantee Document

The stipulated guarantee on the approved legal form is obtained by t}le Agent from the guarantor to the Client's obligaiions before releasing the syndicated facility.

Other Legal Documents

The Agent obtains legal opixiions from his own international lawyer, his lawyer in the country of the Client, the Client's own lauryer, and the guarantor's lawyer


relevant to the covenants, conditions precedent and other relevant terms of the relationship reqtiiring legal opunions for the satisfaction of the Agent and partlclpants.

Upon completion of this documentation, the Agent proceeds accordingly and maintains the relaiionship. The pariicipating banks do not have any direct relationship with the Client as the Agent acts for them for all purposes under his own name.

The entire management responsibiliiies are carried out by the Agent except in the begnning when the pariicipant banks decide on the credit risk and legal docllmentation. Thereafter, there is very little aslministrative work, and in turn adnzinistrative costs, involved for the pariicipants. Therefore, the instrument is very popular among Islamic and conventional banks alike. Seven syndicated transactions for a total amount of US$600 million offered by the Faysal Islamic Bank of Bahrain E.C. were all immediately consumed. The last transaction for US$100 million was 100% oversubscribed within a week of the first solicitation.

This experience indicates the viability of Islamic financial products among Islamic and conventional financial instruments. Provided that legal requirements of today's complex environment are met effectively and loopholes adequately plugged, there is no reason why other forms of Islamic finance should not be accepted by the financial institutions and the financing clients. On the other hand, Islaniic banks also look to conventional financial institutions for instruments and portfolios that meet their objectives and are wiffiin the prescribed bounds of the principles of Islaniic banking. Islamic banks are also willing to join hands with conventional institutions in order to produce such instruments and portfolios in which Islarnic financial institutions can participate. There are already a number of examples in this respect and it is hoped that this co-operation will grow further in the due course of time.

Meanwhile, from experience Islamic banks are endeavouring to iron out problems and weaknesseoperational, structural and legal in order to make their own instruments viable. In this regard, Islamic economists and jurists are meeting together at various forums trying to investigate the considerations of Shari'a in this respect.

General Problems Faced by Islamic Banks

Islamic banks suffer from a number of problems-operational, legal, and infra- structural. Some of these follow.

Loss of Opportuniw

In the event of failure on the part of the Client to repay its fixed obligations to an Islamic bank on the due date, damages are permitted under Islam for payment to the Islamic bank. However,- these are subject to the following

. . conc 1tlons:

279 ISLAMIC FINANCE

(1) Several warning letters are issued in a certain iime to the client asking him tO repay the amounts overdue.

(2) The first occurrence of non-payment will not count as admissible for charging damages.

(3) It is to be ensured that the Client has the flnancial capacity to meet his commitment. A temporary cash flow problem will not be regarded as the Client's genuine inability to repay but rather be treated as financial mismanagement on his part.

(4) Such damages will be equal to the rate of profit which the Investors under the relevant Modaraba would have otherwise received had the repayments been made on iime.

These conditions, being protracted, contribute to inefflciency in the collection of dues from customers. Pariicularly in the retail trade, this process will considerably increase costs of the Islamtc bank. When larger amounts are involved, a remission in the first period of default will be substantial in monetary terms. Since margins of profit in internatonal trade are highly competitive and thin, Islamic banks cannot afford any opportunity loss. Accordingly, this subject needs considerable further study, discussion and review by Islamic jurists.

Shari'a Law's Admissibilit in Intentational Courts

The matter of admissibility of legal contracts bound by Shan'a laws in internaiional courts has many implicaiions. Even when contracts between two pariies may be acceptable in certain courts, in the event of a dispute, local law will prevail should any of the Shari'a provisions violate the relevant provisions of the local law. Should such provisions of the local law mean violaiion of the Shari'a law itself, the same will not be acceptable to the Islamic bank. This leaves the Islamic bank in a great quandary as it may not be able to obtain full recourse against the Client under the contract that was prepared in accordance with the provisions of the Shan'a.

Manpower Shortage

Unwillingness on the part of many to move away from the mainstream of conveniional banlcing is a situaiion that IslatIiic banks are faced with today which is hampering the building of their manpower resources md furffier development. This is because Islamic banking as an alternative financial system is not considered by many in conventional banlcing as a well established phenomenon. Nor do Islamic establishments have such a wide network and scope so that a professional m conveniional banking may comfortably look towards a future career in the same sense as he looks to the conventional ones. Opting to change over to Islamic banlEng for a conventional banker amounts to him sacrificing his interests unless he is religiously committed to the concept. Accordingly, manpower development within Islamic banking is faced with added difficuliies on that account alone.


Track Record

Only a couple of decades old) Islamic banlcing in practice is relatively very yolmg. The lack of a long established track record in Islamic banlcing does not give investor an adequate sense of comfort. Even a slight negative movement in results can, therefore, induce this lack of comfort and may lead to a run on deposits. Islamic banks are, therefore) forced to maintain an unusually high level of liquidibr which aderersely affects thew profitability.

Undeveloped Interbank and Financial Markets

Inter-Islarnic-bank markets are almost non-existent so that Islaniic banks cannot place or raise funds from ong themselves on an established pattern. Only in Pakistan and Iran do such markets exist, but these are relevant to the local currencies only.

On the other hand, financial markets as exchange systems that allow for trading of fmancial instruments are not yet well developed in the Islamic financial world. These markets comprise persons, agents, brokers, instituiions and illtermediaries who operate under laws) contracts and extensive communication networks, all of which are not ideal for Islamic fmancial instruments or else ideSy developed within the Islamic world. Islamic financial insiitutions are, therefore, hard-pressed to produce instruments which will function and achieve their objeciives within the contemporary situaiion, or in a more restricted environment such as limited secondary wading within a certaxn group of financial insiituiions supporiing a certain mstrument. The development, over e, of Islamic banking in general, and their instruments in pariicular, as well as a change of regulaiion within Islamic countries, will in d}e long run contribute to the development of Islamic financial markets. Stock exchanges are coming illtO existence in many Islamic countries, as are certain instuments, but there is still a long way to go before Islamic financial markets attain maturity.

Lack of Unifonn Accounting Sundards for Islamic Banking

Among Islamic fmancial institutions, there is generally no uniformity in accounting policies and standards. As a result, there is no consistency in the accounting treatment of various operations; even the presentation of their financial statements. In this situation, the reader of financial accounts of an IslalIiic financial insiituiion finds it hard to relate the results of one instituiion with another. For example, the Investment Funds in one insiituiion are expressed as the Funds Under Management and reported below che liIle of itS balance sheet on the prese that according to the Shari'a, such funds are invested for the benefit and at the risk of the customer and being fiduciary in nature do not folLa part of the bank's liabilities. Another bank will report the sarne above the line within its balance sheet because the relevant regulatory authonty in whose jurisdiciion it operates requires it to do so for reserve and other prudential raiio evaluation purposes. Similarly, the treatment of accrual of morabaha profit over the period of oche transacion also differs. While one IslaIIiic financial insiitution may book

281 ISLAMIC FINANCE

the entire transaction profit on the day of the sale, the other may amoriise it over the transaction period on "straight line" basis to provide relevant income on investment throughout the period.

Islamic banks have recently agreed to establish an accounting standards board ln Bahrain which should ultimately solve this problem.

CONCLUSION

Despite the weaknesses, handicaps and problems faced by Islamic banks, they have proved themselves by their viable operational existence in the past over two decades. The future looks promising for them if only they adhere to the ethical codes of their trust functions and hold dearest to them the objectives of Islamic banking. As Henry Kaiser said, "problems are only opportunities in work clothes" which Friedrich Durrenmatt describes, in his "21 Polnts", as "what concerns everyone can be resolved by everyone".

BIBLIOGRAPHY

Abu Saeed, Dr Mahmud; Money, Interest and Qirad. A1 Qaradawi, Dr Yousuf; "The Lawful and the Prohibited in Islam", I.I.F.S.C. Kuwait. Anwar, Dr Muhammad; "Modelling Interest-Free Economy", The Institute of Islamic Thought, Herndon, Va.22070, USA. Chopra, M. Umar; "Towards a Just Monetary System", The Islamic Foundation, Leicester, UK. International Monetary Fund; "Islam Banking". Jansen, G.H.; Militant Islam. Khan, Dr Moshin S.; "Monetary Policy in an Islaic Economy", Islamic Banking Conference, Bahrain 1990. Montefiore, Hllgh, Bishop of BirlIiingham: "Banking World December 1984". Siddiqui, Dr Muhammad Nejatullah; "Partnership and Profit-Sharing Islamic Law", The Islamic Foundation, UK.

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