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Journal of Islamic Banking and Finance July – Sept 2017 1

2 Journal of Islamic Banking and Finance July – Sept 2017


In The Name of Allah,

The most Beneficent, The most Merciful

“O Believers: devour not Riba, doubled and redoubled;

and fear Allah, in the hope that you may get prosperity.”

Sura Ale-Imran (verse No. 130)

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The articles published in this Journal contain references from the

sacred verses of Holy Qur’an and Traditions of the prophet (p.b.u.h) printed for the understanding and the benefit of our

readers. Please maintain their due sanctity and ensure that the pages on which these are printed should be disposed of in the

proper Islamic manner


Journal of Islamic Banking and Finance

Volume 34 July – Sept 2017 No.3 Founding Chairman Muazzam Ali (Late) Former –Vice Chairman Dar Al-Maal Al-Islami Trust, Geneva, Switzerland

Chairman Basheer Ahmed Chowdry Shariah Advisor Uzair Ashraf Usmani

Editorial Board

Ahmed Ali Siddiqui Mufti Bilal Qazi S. A. Q. Haqqani Dr. Hasan uz Zaman Dr. Mohammad Uzair Altaf Noor Ali (ACA)

Editor Aftab Ahmad Siddiqi

Associate Editor Seemin Shafi Salman Ahmed Shaikh

Manager Publication Mohammad Farhan

Published by: International Association of Islamic Banks Karachi, Pakistan. Ph: +92 (021) 35837315 Fax: +92 (021) 35837315 Email: ia _ ib @ yahoo.com

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Academic Advisory Board

Dr. Mohammad Kabir Hassan Professor of Economics & Finance University of New Orleans, USA.

Dr. M. Ishaq Bhatti Associate Professor of Finance and Financial Economics, LA TROBE University, Australia.

Dr. Riham Rizk, Associate Professor in Accounting Durham University Business School, UK Dr. Zubair Hasan, Professor Emeritus INCEIF Global University of Islamic Finance, Malaysia.

Dr. Rodney Wilson Professor Emeritus, INCEIF, Lorong Universiti A Malaysia/France.

Dr. S. Nazim Ali, Professor and Director, Center for Islamic Economics and Finance, Hamad Bin Khalifa University, Doha, Qatar.

Dr. Mohd. Ma’sum Billah Professor IEI, King Abdul Aziz University, Kingdom of Saudi Arabia.

Dr. Mehboob ul Hassan Professor, Department of Economics, (CBA) King Saud University, Saudi Arabia. Dr, R. Ibrahim Adebayo Department of Religions, University of Ilorin, Nigeria.

Dr. Huud Shittu Department of Religion and Philosophy, Faculty of Art University of Jos – Plateau State, Nigeria.

Dr. Manzoor Ahmed Al-Azhari, Associate Professor (Islamic Law) Ph.D, Legal Policy, Fac. Shariah & Law. Alazhar University, Egypt. Post Doc. Fac. of Law, Univ.of Oxford, UK.

Dr. Waheed Akhtar Assistant Professor, Comsats Institute of Information Technology (CIIT), Lahore, Pakistan.

Dr. Muhammad Zubair Usmani Jamia Daraluloom Karachi.


Journal of Islamic Banking and Finance

Volume 34 July - Sept 2017 No. 3

C O N T E N T S 1. Editor’s Note ---------------------------------------------------------------------------------07 2. Analysis of Minor Proposals Outside the Mainstream ------------------------------11

Islamic Finance in Pakistan By Salman Ahmed Shaikh

3. Medical Takaful (Insurance) Reform Models and Structures ---------------------22 By Prof. Dr. Mohd Ma'Sum Billah

4. Combination Of Contracts In Sovereign Sukuk Structure -------------------------39 in Indonesia And A Proposed Sharī’a Parameters By Muhammad Iman

5. Working Model of an Islamic Bank: -----------------------------------------------------56 How different it is from conventional banking By Muhammad Ali Shaikh 6. Understanding on Islamic Banking: The Perception and -------------------------68

Thoughtfulness of Customers about Islamic Banking in the Context of Balochistan

By Jameel Ahmed, Safia Bano & Lubaina Dawood 7. Risk Management and Performance of Islamic Banks: ------------------------------81

Using the Income of Mudharaba and Musharaka as a Moderator By Vatmetou Mokhtar Maouloud, Ghazi Zouari & Anwar Hasan Abdullah Othman

8. Profitability of Islamic Banks: Case of Malaysia -----------------------------------90 By Huma Nawaz & Prof. Dr. BarjoyaiBardai

9. Book Review: The Bottom Billion --------------------------------------------------------104

10. Country Model: Luxembourg---------------- ---------------------------------------------106

12. Islamic Banking Indicators ---------------------------------------------------------------108


Editor’s Note Islamic banking and finance is well and truly making its mark in diverse regions.

At the same time, it is facing challenges in assimilating into regions where the environment is not as much conducive as it should be for a level playing field. Several countries in East Asia and Europe have accorded tax neutrality to Islamic banking and finance products. However, still a lot needs to be done in order for Islamic banking and finance products to penetrate into markets in North America, Central Asia, South America and countries in Europe other than in the Western part of Europe. To achieve tax neutrality, awareness among regulatory, monetary and fiscal authorities is necessary.

Islamic banking and finance primarily provides Shari’ah compliant financial products and services to the faith-conscious Muslims who want to avoid non-compliance with the injunctions of their faith. At the same time, Islamic banking and finance products have an equally strong congruence with products which have ethical and social undertones. For instance, Islamic banking and finance products do not charge fixed interest on the simple loan of money. They provide asset backed financing and earn rents and profits from the sale and lease of asset whose ownership is borne by the Islamic financial institution. Islamic banking and finance products also avoid transactions with socially and morally undesirable activities, such as financing weapons, night clubs, casinos and activities which exhibit vulgarity.

Islamic banking and finance products are equally competitive if a level playing field is provided to Islamic banking and finance products. They can enrich the financial market by catering to the faith conscious and socially conscious clients by providing faith compliant ethical products and services which are also priced competitively. But, for this to happen, it is necessary that the regulators provide a level playing field which can improve the financial market depth, inclusiveness, competition and efficiency.

Islamic banking and finance providers need to expand their coverage geographically. This can be expedited if new institutions are provided with incentives to enter into the market. At the same time, conventional banks existing in the markets can also extend their services in the Islamic banking and finance segment to cater to a broad range of clients with different needs. The growth in Islamic banking and finance is exemplary. However, it still forms a very small percentage of global financial assets. It is important to provide a level playing field to Islamic banking and finance products by removing extra taxes, duties and registration charges. This can enable the Islamic banks to withstand the price competition from large conventional banks and provide Shari’ah compliant and yet competitive products to the clients.


In financing provided by international development finance institutions and multilateral financing between governments, the Sukuk structure can be effectively utilized for development finance of real estate infrastructure, high-cost equipment and facilities. The recent success in the use of Sukuk by even the non-Muslim majority countries provides credence to the view that Islamic finance is broad in its appeal and scope to different clients as well as to their different needs. If development finance is structured using Islamic finance structures, then necessary mobilization of funds can be ensured to obtain finance for meeting sustainable development goals. This could be vital for underdeveloped Muslim majority countries. Furthermore, it will enable Islamic finance to exhibit its potential in contributing to economic development more directly and boost its economic stature and appeal beyond being a faith-compliant financial system alone.

This issue of Journal of Islamic Banking & Finance documents scholarly contributions from authors around the globe. Contributions in this current issue discuss the theoretical underpinnings of an Islamic economy, contemporary issues in Islamic finance and performance based empirical studies on Islamic banking and finance. Below, we introduce the research contributions with their key findings that are selected for inclusion in this issue.

The paper “Analysis of Minor Proposals outside the Mainstream Islamic Finance in Pakistan” by Salman Ahmed Shaikh discusses the minor proposals which are outside the mainstream Islamic finance in Pakistan. Some of the minor proposals like two-tier Mudarabah are not used widely because of lack of preparation, government incentives and initiatives at the practical level in the current scenario. In the presence of practiced Islamic banking and its growing penetration, accessibility and growth, Islamic banking should be preferred over conventional banking and finance products if one wants to be compliant with Islamic injunctions.

“Medical Takaful (Insurance) Reform Models and Structures” paper is written by Mohd Ma’Sum Billah, is an attempt in this paper to analyze possible reformed models and structures of medical insurance appropriate for the Kingdom's environment. In establishing the idea, some experiences will be analyzed as a reference from the existing practices of the Kingdom of Saudi Arabia and also the Malaysian practices of medical takaful as the pioneer of the scheme.

The paper “Combination of Contracts in Sovereign Sukuk Structure in Indonesia and a Proposed Sharī’ah Parameters” by Muhammad Iman Sastra Mihajat discusses how to deal with the use of combinations of contracts in Sukuk issuance. The paper reveals that majority of contracts in Sukuk market (corporate and sovereign) are using double and multiple of contracts in their ‘aqad’ structure. However, based on hadith of the Prophet, it is prohibited to combine more than one contract in single transaction. Therefore, the paper cites some Muslim scholars who have questioned the level of compliance with Shari’ah law in Sukuk issuance. The paper concludes that not all combinations of contracts are prohibited as long as they follow the Shari’ah parameter guidelines.


In his article “Working Model of an Islamic Bank: How different it is from

conventional banking” Muhammad Ali Shaikh, teaching subjects of financial management and Islamic finance at leading business schools in Karachi, has given a very comprehensive list of differences between conventional and Islamic banking. He, very rightly, argues that since the two are diametrically different, not only should the products they offer be different, but so should the presentation of their accounts. The difficulties or handicaps must be removed so that the IB products are truly Shariah compliant. Organized and coordinated research in product development and joint market penetration strategies, he says, will help increase overall market share and acceptability and will benefit the IB industry as a whole.

“Understanding Islamic Banking: The Perception and Thoughtfulness of Customers about Islamic Banking in the Context of Balochistan” contributed by Jameel Ahmed and Safia Bano both Assistant Professors, University of Balochistan, Quetta and Lubaina Dawood Lecturer, Sardar Bahadur Khan Women’s University, Quetta attempt to examine the basic knowledge about Shariah principles on which Islamic banking is based and to analyze the clarity of different modes of financing and offerings of Islamic banks among the customers. This inquiry is qualitative in nature and attempts to explore how people in Balochistan feel regarding Islamic banking. In the final analysis they find that a great deal more information and knowledge needs to be transmitted to the market and customers even though their desire to bank with Islamic banks is existant, their knowledge is imperfect.

The paper “Risk Management and Performance of Islamic Banks: Using the Income of Mudharabah & Musharakah as a Moderator” by Dr. Vatimetou Mokhtar, Ghazi Zouari and Anwar Hasan Abdullah Othman employed unbalanced panel data regression analysis on 16 Islamic banks from different countries over the period 2012 to 2015. Their results showed that the income of PLS products had a moderating effect particularly on the relationships between performance and liquidity risk, and operational risk. However, it had no moderating effect on the relationship between performance and market risk.

Huma Nawaz, doctoral student at Al Madinah International University, Malaysia, supervised by Professor Dr. Barjoyai Bardai of same university, has documented her research in the article “Profitability of Islamic Banks: Case of Malaysia”. Her study is focused on two Malaysian Islamic banks and how they compare on performance efficiency between them and what variables determine such profitability. The researcher has based her study on banks financial ratios over the period of 2010 to 2015 and used Linear Regression Model and Correlation analysis to arrive at her conclusion.


Readers Comments Dr. Adebayo, R. Ibrahim, Associate Professor, University of Ilorin, Nigeria.

E-mail: [email protected]

“The journal is gaining more popularity and it is being cited by many in the academia because of rich information contained therein. The journal has become a household material in the hand of scholars in Islamic banking and finance. I therefore commend the efforts of the association in this direction. May Allah continue to enrich you more in wisdom, wealth and health”.

Disclaimer

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

The opinions, suggestions from our worthy readers are welcome, may be

communicated on

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Website: www.islamicbanking.asia


Analysis of Minor Proposals outside the Mainstream Islamic Finance in Pakistan

By Salman Ahmed Shaikh*

Abstract This paper is a humble attempt to discuss the minor proposals which are outside the mainstream Islamic finance in Pakistan. Some of the minor proposals like two-tier Mudarabah are not used widely because of lack of preparation, government incentives and initiatives at the practical level in the current scenario. Some other proposals like rationalizing bank interest through non-textual arguments (other than in Qur’an and Hadith) are not in compliance with Islamic source texts (Qur’an and Hadith). Furthermore, some minor proposals have misapplied the Islamic contracts, such as Qard-e-Hasan as in Time Multiple Counter Loan. There are several features in conventional banking and finance which contradict with Islamic injunctions directly without any ambiguity. Islamic banking first and foremost attempts to be interest-free as well as avoid other non-permissible elements in Islamic contract law and rules of sale. In the presence of practiced Islamic banking and its growing penetration, accessibility and growth, Islamic banking should be preferred over conventional banking and finance products if one wants to be compliant with Islamic injunctions. Islamic banking alone might not be the only solution to meet all sorts of economic and social objectives. The simultaneous growth of Islamic social finance in the form of Waqf and institutionalization of Zakat and Qard-e-Hasan based microfinancecan contribute in completing the access to Islamic finance to people of different economic standings. Now, people of all socio-economic sections can be served through either commercial Islamic banking and/or through Islamic social finance institutions. Thus, Islamic finance itself as a combination of commercial and social finance institutions is fast appearing to be a comprehensive and

* Author: Salman Ahmed Shaikh is Ph.D scholar in Economics.

E-mail: [email protected]


complete alternate financial system for the faith conscious clients. As a result, there is no need to rationalize conventional interest based banking in part or in total.

Keywords Riba, Islamic Banking, Insurance, Takaful

1. Introduction Ever since the establishment of Pakistan, there was a great zeal to introduce Islamic

institutions in the socio-economic milieu to realize the vision for which the independence struggle was carried out. Muhammad Ali Jinnah, the First Governor General of the country stated in his address at the inauguration of State Bank of Pakistan: “The adoption of Western economic theory and practice will not help us in achieving our goal of creating a happy and contented people. We must work our destiny in our own way and present to the world an economic system based on true Islamic concept of equality of manhood and social justice. We will thereby be fulfilling our mission as Muslims and giving to humanity the message of peace which alone can save and secure the welfare, happiness and prosperity of mankind.”

Later on, the political turmoil did not give adequate attention to this vision. However, given the increased focus in the 1970s around the Muslim world to develop an Islamic financial system for Muslims, the positive effects were also felt in Pakistan. The 1973 constitution of Pakistan in Section 38(f) stated that Riba should be eliminated as early as possible. However, lack of political will in the subsequent governments has still remained as a hurdle in the way of completely replacing the interest based banking system with an Islamic one. Nonetheless, Islamic banking has begun its journey. At the same time, outside the mainstream Islamic finance, there have been some minor proposals proposed by certain quarters. This paper gives an account of these minor proposals to explicate why these proposals are not part of the mainstream Islamic finance. This paper is divided into 3 sections. After a brief background introduction in Section 1, Section 2 provides a critical account of some minor proposals which have been put forward in Pakistan. Section 3 discusses how the mainstream Islamic finance has streamlined the development of Islamic finance products by giving primary emphasis to compliance with Islamic injunctions (Qur’an and Sunnah) and by keeping in line with market dynamics and needs of faith conscious clients and stakeholders in the current scenario.

2. Minor Financial Proposals Outside the Mainstream Islamic Finance Besides the mainstream Islamic banking that operates in Pakistan under the careful

supervision of Shari’ah Advisors, some other proposals had also been put forward by other writers. In this paper, we analyze these proposals and alternate perspectives and see as to why they did not become the mainstream view due to Shari’ah related or other practical difficulties.

2.1 Two Tier Mudarabah Framework Uzair (1978) envisaged two tiers of Mudarabah partnership, one between

depositors and bankers and the other between bankers and investors. These parties may share the profit according to a pre-arranged ratio. These ratios may be regulated by the


market or the central bank and may be used by the latter as an alternative instrument of credit control. This framework has remained outside of mainstream Islamic finance not because of its socio-economic merit or its lack of affinity with Islamicprinciples. Rather, this proposal had been favored by early academicians. Shaikh Mufti Taqi Usmani has repeatedly emphasized the preference of Mudarabah and Musharakah over other modes of financing from the socioeconomic, income distribution and Maqasid-e-Shari’ah perspective. Mufti Taqi Usmani (2004) in his book “Introduction to Islamic Finance” stated at least 5 times that Mudarabah and Musharakah are ideal modes of financing on page 12, 17, 72, 107 and 164 respectively.

The reason why these modesof financing had not been used often in practice owes to practical difficulties such as non-standardization of accounting, tax disadvantage to equity over debt finance, the weak motivation of commercial stakeholders and the agency problems. Some authors have emphasized agency problems in Mudarabah, such as Bacha (1997), Khalil et al. (2002), Dar and Presley (2000), Warde (1999) and Rosly and Zaini (2008). Nonetheless, the lack of this proposal’s practical use is not due to its nonconformity with Shari’ah principles.

2.2 Narrowing the Scope of Riba Prohibition in Contemporary Finance In the early period since the establishment of Pakistan, there were some

intellectuals who had given some non-traditional views on Riba. For instance, Rehman (1964) gives this definition of Riba: “An exorbitant increment whereby the capital sum is doubled several-fold, against a fixed extension of the term of payment of the debt.” Rehman (1964) and Saeed (1996) argued that only the exorbitant rates of interest charged on consumption loans from the poor borrowers by rich lenders were condemned by Islam. However, this view has been effectively and comprehensively dealt with both in academics and then subsequently in the legal sphere.

Early writers in Islamic Economics like Mawdudi (1961) defined Riba as follows: “Excess money which is obtained on determinate conditions and at a fixed rate for the principal loaned out in consideration of the period for which the money has been lent”. The Pakistan Council of Islamic Ideology (1980, p.1) clearly reflected a consensus view when it concluded in its 1980 report on the elimination of interest from the Pakistan economy: “The term riba encompasses interest in all its manifestations irrespective of whether it relates to loans for consumption purposes or for productive purposes, whether the loans are of a personal nature or of a commercial type, whether the borrower is a government, a private individual or a concern, and whether the rate of interest is low or high.” Subsequently, the Historic Judgment on Interest settled the debate both in academics as well as in legal sphere.

On the other hand, some authors attempt to contextualize the scope of Riba. One suggestion put forward is that government national saving schemes for retired employees are allowable since government gives the premium on principal on its own and can change the premium by its own desire. This understanding is based on the misconception that government borrows funds for investment purposes and gives the residual from the returns on investment projects to the borrowers. As per this understanding, issuing prize bond is also a source of finance adopted by the governments to finance investment

Analysis of Minor Proposals Outside the Mainstream …….


projects. Since governments pay premium or prize unilaterally, that is why it is not akin to interest prohibited in Qur’an. Though it is undesirable, the needy persons can benefit from this scheme.

In response to this view, we should note the fact that Pakistan pays around half of all the tax it collects in the form of debt servicing. If the payment of interest is regarded as completely permissible, then the government could opt for more debts. These domestic borrowings by the government are mostly used for non-development expenditures. Development expenditure is a very small portion of government’s total expenditure. The government has run a fiscal deficit in almost every year since its independence. The possibility of project based and development infrastructure finance is promised by the instrument of Sukuk structure in Islamic finance.

For the individuals who are risk averse and who want relatively regular incomes, Islamic asset management companies have designed tailor-made income funds, cash funds and capital protection funds. There are at least 19 Islamic income funds operating in Pakistan to date. There are 5 full-fledged Islamic banks and at least 17 conventional banks with Islamic banking windows. The total branch network of Islamic banking in Pakistan alone has reached 2,300 in number. In the developed world, even more structures and variety is available. It would be a worthwhile effort to make people know about these products, especially when Islamic finance is being offered in all major countries of Asia, Africa and Europe and is set to grow further.

Entering into an interest based transaction is a voluntary contract between two parties who can enter into a contract with their free will. In contemporary finance, most of the borrowers are organized businesses operating as corporations. In Pakistan, around 70 percent of the financing provided by banks is concentrated with corporate clients. These clients are corporations established with equity first and most of them have their shares publicly held. Other than 5 fully-fledged Islamic banks and 17 banks with Islamic banking operations, these corporations also have access to capital markets for obtaining equity finance through the issuance of shares.

The reason why equity based modes of financing are not widely practiced in Pakistan owes to the fact that these corporations are comfortable in obtaining bank finance and to pay a fixed interest rather than sharing their high return on equity with banks. As a whole, most of these corporations overall have a higher return on equity than the average interest rates which they pay to the banks. The insistence of bigger and profitable corporations on debt based finance and their reluctance on using equity based modes of financing is one of the great hindrances in fostering equity based financial intermediation. That is why it makes a lot of sense that they are as much part of the status quo in fighting the interest based debt finance as the conventional financial institutions themselves.

As a matter of fact, bank interest had been declared un-Islamic by the Supreme Court of Pakistan since a long time ago. Mufti Taqi Usmani has given a detailed account of the case and verdict in his book ‘Historic Judgement on Interest’. Amidst the ruling of prohibition of bank interest by the Supreme Court of Pakistan and wide access to Islamic banking, granting unqualified freedom to borrowing on interest basis voluntarily is not a justifiable stance.


Conventional banks provide loans as debts rather than providing finance on the

basis of equity participation. Their receivables are the debts and the interest on these debts. It does not matter whether the debts are provided for the purchase of real assets or lent in the form of money. It makes no consequential difference whatsoever to the cash flow commitments decided between bank as lender and the client as a borrower. If the nature of finance provided creates debt, then banks cannot demand a premium over and above the principal amount of debt as per Islamic injunctions. What conventional banks charge is a proportional predetermined increase over the principal amount quoted as a percent of the principal amount. We can take a very simple example to illustrate the point. If the borrower obtains a loan of Rs 100,000 for two years at a rate of 10% and earns Rs 200,000 in the first year and incurs a loss of Rs 50,000 in the second year, then the amount payable to the bank in the form of interest is Rs 10,000 in each year. The proposal to not charge interest in the period of loss does not change the contractual relationship of debt based lending. It also does not justify the pre-determined Rs 10,000 taken as interest no matter whether the profit is Rs 100, Rs 10,000 or Rs 1,000,000.

If we look at the product structures in both conventional and Islamic banking, only Islamic banks become the owner of the assets and bear the risks related to the ownership. Conventional banks do not take ownership or bear any risk related to the assets. They start charging interest as soon as the loan is sanctioned and not from the date of transfer of an asset in usable condition. They continue to charge interest even when the asset is not in usable condition. If the client wants to obtain a loan for purchasing an asset from a conventional bank, the only thing that changes is that the loan would be considered as more secure for the bank as it has a ready collateral available for effecting repayment, in case of eventual default. From all perspective of cash flow commitments, contractual rights, responsibilities, accounting, recording, regulation and documentation, the bank remains the lender only. If during the mortgage finance term, the client wants to give back the asset or property in use to the bank/financier, it is not possible because mortgage finance is simply not a rental agreement. The installments have no connection with market rents for the same or similar assets or properties. For financing different years of finance, the same amount of property will have different installment structure, i.e. higher installments for a shorter duration of the lease and lower installments for a longer duration of the lease. This is because the bank wants to recover all its costs alongwith interest from the cumulative sum of installments. Nowhere, a conventional bank even mentions that it is entering into a rental agreement in the documentation, accounting books, financial statements or even in marketing supplements or brochures.

2.3 Time Multiple Counter Loan This model was presented by Shaikh Mahmud Ahmad. Ahmad (1989) builds his

model on the premise that ‘time is an ingredient of a loan as the value of loan itself’. Specifically, what the proposal practically implies is that if a person needs a loan for any purpose from a bank for a certain period of time, he should also give a loan to that bank in an amount such that the ‘values’ of the two loans are equal. For example, if a person needs a loan of Rs. 1,000 for one year, he should give a loan of, say, Rs. 100 for ten years to the bank. At the expiry of the stated period, both parties will repay their loans in original. This is the essence of Time-Multiple Counter-Loan (TMCL) based interest-free banking.



This model has some issues from the perspective of Shari’ah as well as from the perspective of its practical implications. With respect to Shari’ah, two contracts cannot be executed contingent to each other. Also, from the Shari’ah perspective, time is not a commodity. A commodity can have different prices in different states of the time. However, time itself cannot be factored in price in monetary loans.

From the practical standpoint, savers and borrowers have different financial situations and needs. Savers have surplus money when they lend or invest the surplus money. They do not require a monetary loan in reciprocation. Thus, by lending Rs 1,000 for one year and getting a loan of Rs 100 for 10 years, the values are not even balanced even in a purely zero-interest economy.

In a positive inflation rate economy, the value of the medium of exchange will decrease overtime. To counter that, some authors suggested inflation-adjusted loans. Nonetheless, OIC Fiqh Academy has ruled out this proposal. If this proposal of indexing loans with inflation benchmark is suggested at the macroeconomic level in financial intermediation, then this is not practical. The bank is an intermediary between those who have surplus funds and those who need funds and itearns profits through the difference in interest rates on deposit and financing side. Indexing loans with inflation will not yield any return for the intermediary (the bank) in the two-tier loan based banking. Secondly, inflation is measured by an index which has an urban bias as Consumer Price Index (CPI) inflation is calculated by looking only at the prices in the urban areas. It has a period bias since in indexing; the choice of base year makes the calculations very different. It also has a representation bias as inflation in urban areas is not a true representative of inflation in all areas, especially if rural areas comprise two-thirds of the population in some developing countries. Plus, inflation is just a measure and there are at least four varieties of inflation measures used by Pakistan Bureau of Statistics (Consumer Price Index, Wholesale Price Index, Sensitive Price Index and Producer Price Index). The results depend on the methodology; the particular commodities in the index which change from time to time and not everyone have the same basket of goods relevant to them. Thirdly, cost-push inflation is driven by supply shocks resulting in higher oil, gas and electricity prices. Therefore, in this case, deterioration in real purchasing power is caused by factors, not in the control of the borrower. He cannot be held liable to compensate in a matter in which he was not responsible.

3. Why Current Islamic Finance is Mainstream in Pakistan Upon reflection, it seems that time value of money is the basis of interest. As per

Islamic principles, it seems that time value of money is the problem for the investor to avoid keeping his/her money idle and to avoid forgoing the use of money that may bring positive value to his/her investment. However, it does not mean that the investor can demand an arbitrary increase as the cost of using money without taking the risk of a productive enterprise. As per Islamic principles, a financial investor has to undertake the risk of the productive enterprise by becoming self-entrepreneur or an investing entrepreneur as an equity partner in others’ business to have any justifiable compensation out of the production process. In short term finance, there are some Islamic debt based modes of finance which ensure distinct asset ownership of the financier in order to enable


the charging of rents or profits on an asset sale. In a conventional debt based financing, this feature is absent and the interest is charged no matter whether the asset exists and no matter whether it is available in usable condition or not.

In Pakistan, the first full-fledged Islamic bank was established in 2002 with the name of Meezan Bank. Currently, Islamic banking in Pakistan is an established industry with 11.7% and 13.2% market share in total banking assets and deposits respectively as at March 31, 2017. The industry experts are further aiming at a 20 percent market share for Islamic banking in the overall banking industry by 2020. There are 5 full-fledged Islamic banks operating in the country along with 17 conventional banks with Islamic banking branches. The market share of Islamic banking assets has grown from a meager 0.5% in 2002 to 11.7% in 2017. By year-end 2016, the total Islamic banking assets in Pakistan stood at Rs 1.88 trillion ($17.95 billion) while the total Islamic banking deposits stood at Rs 1.57 trillion ($15 billion). With increased participation of conventional banks in Islamic banking industry, the branch network has surpassed the mark of 2,300 branches by year-end 2016. With the launch of innovative products like Running Musharakah, now the Islamic banking is catering to the working capital needs of the corporate sector. This has also helped the industry to make effective use of equity based modes of financing and reduce the share of debt based modes of financing.

One can argue that the economic substance of Islamic banks is also no different in terms of economic outcome as argued by Siddiqi (2014), Shaikh (2013), Kayed (2012), Choudhury (2012), Siddiqi (2007), Haniffa & Hudaib (2010), El-Gamal (2005& 2007) and Hassan and Bashir (2003) to name a few scholars in Islamic economics literature. Nevertheless, except for El-Gamal, the other scholars in the idealist camp are critical of Islamic banking not for its legitimacy of product offerings, but with regards to their limited product offerings to achieve the redistribution objectives. This criticism is widely known and appears even from within. The respected scholar Mufti Muhammad Taqi Usmani (2009) in his essay ‘New Steps in Islamic Finance’ writes:

“…One must not forget that these instruments are not modes of financing in their origin. They are in fact some forms of trade that have been modified to serve the purpose of financing at the initial stage as secondary and transitory measures. Since they are modified versions of certain forms of trade, they are subject to strict conditions and cannot be used as alternatives for interest based transactions in all respects. And since they are secondary and transitory measures, they cannot be taken as the final goal of Islamic Finance on which Islamic Financial Institutions should sit content for all times to come. It is a matter of concern for a student of Islamic finance, like me, that both these points are increasingly neglected by the players in the field, and especially by the newcomers in the industry.”

Furthermore, in his book, ‘Introduction to Islamic Finance’, the respected scholar, Mufti Muhammad Tami USANi (2004) writes:

“It should never be overlooked that, originally, Murabaha is not a mode of financing. It is only a device to escape from “interest” and not an



ideal instrument for carrying out the real economic objectives of Islam. Therefore, this instrument should be used as a transitory step taken in the process of the Islamization of the economy, and its use should be restricted only to those cases where Mudarabah or Musharakah is not practicable.” (p. 72)

The realist camp scholars argue that these redistribution objectives will be taken care of by Islamic social finance institutions which include Zakat, Wirssat, Islamic microfinance and Waqf while Islamic banks will continue to serve the short term recurrent finance needs of businesses and middle to urban class households and for which mostly the debt based Islamic modes of financing are the suitable options. In Malaysia and Indonesia, Islamic microfinance, Zakat and Waqf institutions have been used as social finance vehicles in the overall Islamic finance architecture very successfully. In Pakistan also, the institutions like Akhuwat have shown how Qard-e-Hasan can be used to help the downtrodden on a large scale. Mufti Muhammad Taqi Usmani (2004) has been a strong proponent for introducing equity based financing and regards them as more preferable in order to achieve Islamic egalitarian and redistributive objectives even through the Islamic banking institutions. But, the idealism from a financial and development perspective does not determine legitimacy and illegitimacy of the other alternatives which may lack in contributing significantly to the redistributive ideals, but which nevertheless provide a practical solution to avoid Riba and its ramifications. In his book, ‘Ghair Soodi Bainkari [Interest Free Banking], the respected scholar, Mufti Muhammad Taqi Usmani (2007) has clarified that the criticism on underachievement of the ideal redistributive objective in current practice is different from the status of legitimacy of Islamic banking which by and large has to use Islamic debt based modes of financing. But, it does not help in improving the chance to use equity financing any better if an unqualified legitimacy is accorded to interest based borrowing by the borrowers, especially when the large majority of them are the corporate clients and well-to-do professionals. Banks do not finance anyone except in the top income quintile of income distribution by having collateral and income based lending criteria.

At the very least, Islamic banks take ownership of the asset for which they provide finance, bear the risks alongwith mitigating these risks as a custodian of depositors’ funds, charge rent after the asset is transferred in usable condition and charge these rents only until the asset remains in their ownership and is being possessed by the client in usable condition. They do not charge late payment penalties as income. In practice, it is found that late payment surcharge is seldom charged and it is used in the contract to avoid the very real moral hazard problem and the eventuality of customers willfully defaulting on loans. As a result, the non-performing loan to financing ratio in Islamic banking has remained much lower than conventional banks in Pakistan (3.9% in Islamic versus 9.9% for the industry). Hanif (2014) argues that IFIs cannot claim interest on their balances with other banks and mandatory cash reserve maintained with a central bank. Islamic banks cannot invest in interest based government securities, interest based bonds. They cannot claim time value of money from defaulters and they have to bear risks in the sale.


Scholars like Khan (2014) think that critics of practiced Islamic banking do not

appreciate how important debt financing is for value creation in an economy and especially for inclusive growth and economic development through making financial services accessible for asset acquisition. Chapra (2007) argues that even if debt financing is predominantly used in Islamic banking practice, asset backed financing does not allow the debt to exceed the growth of the real economy. He argues that the introduction of such a discipline would ensure greater stability as well as efficiency and equity in the financial system.

Globally, Pakistan is widely acknowledged for its more conservative and cautious approach to Islamic banking and finance whereby, Islamic banking in Pakistan does not use Bai Inah, Organized Tawarruq and secondary market trading of Murabaha based Sukuk. Thus, it is not appropriate to disregard these differences and latest developments as substantial knowingly or due to lack of information.

Conclusion This paper is a humble attempt to discuss the minor proposals which are outside the

mainstream Islamic finance in Pakistan. Some of the minor proposals like two-tier Mudarabah are not used widely because of lack of preparation and government incentives at the practical level. Some other proposals like rationalizing bank interest through non-textual arguments (other than in Qur’an and Hadith) are not in compliance with Islamic source texts (Qur’an and Hadith). Furthermore, some minor proposals have misapplied the Islamic contracts, such as Qard-e-Hasan as in Time Multiple Counter Loan.

There are several features in conventional banking and finance which contradict with Islamic injunctions directly without any ambiguity. Islamic banking first and foremost attempts to be interest-free as well as avoid other non-permissible elements in Islamic contract law and rules of sale. In the presence of practiced Islamic banking and its growing penetration, accessibility and growth, Islamic banking should be preferred over conventional banking and finance products. The meticulous efforts of Islamic scholars, regulators, academia and industry players have contributed in instigating interest-free finance.

Islamic banking alone might not be the only solution to meet all sorts of economic and social objectives. This has increasingly been realized in the academia and the simultaneous growth of Islamic social finance in the form of Waqf and institutionalization of Zakat and Qard-e-Hasan based micro-finance has contributed in completing the access to Islamic finance to people of different economic standings. Now, people of all socio-economic sections can be served through either commercial Islamic banking and/or through Islamic social finance institutions. Thus, Islamic finance itself as a combination of commercial and social finance institutions is fast appearing to be a comprehensive and complete alternate financial system for faith conscious clients. As a result, there is no need to rationalize conventional interest based banking in part or in total.



References Ahmad, S. M. (1989). “Towards Interest-Free Banking”. Institute of Islamic Culture:

Lahore.

Bacha, I.O. (1997). “Adopting Mudarabah Financing to Contemporary Realities: A Proposed Financing Structure”, The Journal Of Accounting, Commerce & Finance, 1(1): 26 – 54.

Chapra, M. U. (2007). “The Case Against Interest: Is It Compelling?”, Thunderbird International Business Review, 49(2), pp. 161 – 186.

Choudhury, M. A. (2012). “The ‘Impossibility’ Theorems of Islamic Economics”, International Journal of Islamic and Middle Eastern Finance and Management, 5(3): 179 – 202.

Council of Islamic Ideology (1980). “Report of the Council of Islamic Ideology on the Elimination of Interest from the Economy”, CII, Pakistan.

Dar, H. A. & Presley, J. R. (2000). “Lack of Profit Loss Sharing in Islamic Banking:Management and Control Imbalances”, International Journal of Islamic Financial Services, 2(2): 1 – 9.

El-Gamal, M. A. (2005). “Limits and Dangers of Shari’ah Arbitrage”, in S. Nazim Ali, Islamic Finance: Current Legal and Regulatory Issues, Cambridge, Massachusetts: Islamic Finance Project, Islamic Legal Studies, Harvard Law School, pp. 117 – 131.

El‐Gamal, M. A. (2007). “Mutuality as an Antidote to Rent‐seeking Shari’ah Arbitrage in Islamic Finance”, Thunderbird International Business Review, 49(2): 187 – 202.

Hanif, M. (2014). “Differences and Similarities in Islamic and Conventional Banking”, International Journal of Business and Social Science, 2(2): 166 – 175.

Haniffa, R.& Hudaib, M. (2010). “Islamic Finance: From Sacred Intentions to Secular Goals?”, Journal of Islamic Accounting and Business Research, 1(2): 85 – 91.

Hassan, M. K.& Bashir, A.H. (2003). “Determinants of Islamic Banking Profitability”, ERF Paper, 10: 3 – 31.

Kayed, R. N. (2012). “The Entrepreneurial Role of Profit & Loss Sharing Modes of Finance: Theory & Practice”, International Journal of Islamic and Middle Eastern Finance and Management, 5(3): 203 – 228.

Khalil, A. F. A.; Rickwood, C. & Murinde, V. (2002). “Evidence on Agency-Contractual Problems in Mudarabah Financing Operations by Islamic Banks”. Islamic Banking and Finance: New Perspectives on Profit Sharing and Risk, 57.

Khan, T. (2014). “Comment on: Islamic Economics: Where From, Where To?”,Journal of King Abdul Aziz University: Islamic Economics, 27(2): 95 – 103.


Maududi, S. A (1961). “Sood” (Interest). Islamic Publications, Lahore.

Rahman, F. (1964). “Riba and Interest”. Islamic Studies, 3(1): 1 – 43.

Rosly, S. A. & Zaini, M. A. M. (2008). “Risk-return Analysis of Islamic Banks’ Investment Deposits and Shareholders’ Fund”, Managerial Finance, 34(10): 695 – 707.

Saeed, A. (1996). “Islamic Banking and Interest: A Study of the Prohibition of Riba and its Contemporary Interpretation”, Brill: Leiden.

Shaikh, S. A. (2013). “Islamic Banking in Pakistan: A Critical Analysis”,Journal of Islamic Economics, Banking and Finance, 9(2): 45 – 62.

Siddiqi, M. N. (2014). “Islamic Economics: Where From, Where To?”,Journal of King Abdul Aziz University: Islamic Economics, 27(2): 59 – 68.

Siddiqui, S. A. (2007). “Establishing the Need and Suggesting a Strategy to Develop Profit and Loss Sharing Islamic Banking”. In IIU Malaysia Conference on Islamic Banking and Finance at Kuala Lumpur.

Usmani, M. T. (2004). “Historic Judgement on Interest”, Karachi: Idaratul-Ma'arif.

Usmani, M. T. (2004). “An Introduction to Islamic Finance”, Karachi: Maktaba Ma’ariful Quran.

Usmani, Muhammad Taqi. (2007). “Ghair Soodi Bainkari” [Interest Free Banking], Karachi:Maktaba Ma’ariful Quran.

Uzair, M. (1978). “Interest Free Banking”, Royal Book Company: Karachi.

Warde, I. (1999). “Islamic Finance in Global Economy”, Edinburgh: Edinburgh University Press.



Medical Takaful (Insurance) Reform Models and Structures

By

Mohd Ma’Sum Billah, PhD*

Abstract Living with healthy life is among the prime natural concern of everyone regardless of one's status or background. A proper health–care requires money and today, it is one of the most expensive components of expenditure, which is not affordable to everyone thus, medical takaful1 (insurance) may be a solution. In view of creating a healthy society, several developing countries make the medical insurance compulsory. In the Kingdom of Saudi Arabia on the other hand, the health insurance has not been made mandatory yet on everyone living in the Kingdom, the native or the expatriate. The law of the Kingdom in general, is a Shari’ah (Islamic law) while its recognized insurance model is based on the cooperative (ta’awuni) principles2. In creating a healthier society by encouraging everyone to care about health, the medical takaful may be an effective step to be taken in to consideration thus, its reform is an emergence factor by allowing choices in package within the supreme law of the Kingdom. An attempt is thus made in this paper to analyze possible reformed models and structures of medical insurance appropriate for the Kingdom's environment. In establishing the idea, some experiences will be analyzed as a reference from the existing practices of the Kingdom of Saudi Arabia and also the Malaysian practices of medical takaful as the pioneer of the scheme.

Keywords: shari'ah, medical, healthcare, insurance

JEL Classification Code: G22, I13, Z4

* Professor of finance & insurance, Islamic Economics Institute, King Abdul Aziz

University, Kingdom of Saudi Arabia, blog: www.drmasumbillah.blogspot.com 1 Takaful is a Shari'ah alternative to Insurance. Some countries it (Takaful) terms as Islamic

Insurance. 2 Al-Qur’an (5:2).


Facts and Phenomena Health-care is among the prime concern of life. Everyone is equal as to one's

physical pain and suffering in no issue of one's socio-economic, legal or religious status or origin. A proper health–care requires money as at today. The rich may afford to care about health subject to own available resources, but not the poor, except as depending on own limited resources or common facility or cooperation from others in some exceptional cases. Medical insurance scheme may be a prompt solution to health-care for everyone. Medical insurance is made compulsory in many developing countries to ensure a healthy life for each citizen besides one’s education and economic wellbeing.

In the Kingdom of Saudi Arabia, the health insurance has not been taken as a mandatory level yet. Several insurance companies offer the health insurance product and services in the kingdom, but out of total 32,515,171 population in Saudi Arabia3 only 3.11 million4 (15 %) of the total 20,915,171 native Saudis5, while 7.85 million (67%) of the total 11,600,0006 expatriates have coverage7.

Based on the above data it is understood that, there are about 85% of the native Saudis uncovered by medical insurance, which might be due the following reasons:

Medical coverage for every employee along with one's dependents are undertaken by the respective employer of the Kingdom as a part of employment benefit.

The employee serves the elite corporate group of the Kingdom are along with one's dependents are covered with lavish medical benefits undertaken by the respective employer as the employment package.

The Kingdom provides free medical facilities for the rural people through the establishment of the polyclinic scheme.

Many elite groups of Saudi exercise their option to be treated in overseas hospitals using one's own financing capacity or any arrangement at choice.

Saudi students study in abroad are covered by the respective education package with standard medical facilities in the hospitals abroad.

In the Kingdom, there are many individuals or families influenced by the Fatwa and Shari'ah views against insurance thus, contributes to the declination of participation in the Medical insurance scheme.

3 Worldmeters, 2017, UN estimates as at February 11, 2017 4 As per report of the Council of Cooperative Health Insurance (CCHI), ARAB NEWS

(Saturday 19 December 2015) 5 Worldmeters, op.cit. 6 Saudi Gazette, November 28, 2016 7 the Council of the Cooperative Health Insurance (CCHI), op. cit.



Moreover, there are about 33% of expatriates living in the Kingdom are still uncovered by the medical insurance perhaps due to the following reasons:

Medical coverage is a part of employment package undertaken by the respective employer.

Diplomats along with their dependents are covered with required medical facilities by the respective employer government as a part of the employment package.

Foreign business owners or investors living in the Kingdom by holding the business visa, do exercise their choices in their health-care plan at own cost, either to be treated locally or aboard with insurance package or otherwise arrangement are totally on the individual's selection.

Expatriate children study in the kingdom are either covered by the respective guardian's health-care arrangement or by the students' health-care scheme provided by the institution concern.

Residents living in the kingdom with the refugee status are covered by the special public health-care scheme of the Kingdom or with any arrangement by NGOs or private initiative.

There are number of Illegal Immigrants (with no Iqamah) living in the Kingdom whose health-care is arranged on their own respective initiative.

The non-coverage of health-care by the medical insurance scheme may result in numerous risks as follows:

Individual and Family Risks: Physical risk due to unattended health-care.

Financial burden in bearing the medical cost on own.

Emotional damage resulting from unhealthy life.

Socio-Cultural Risks: Unhealthiness due to unattended diseases.

Unhealthy life is a social liability.

Poor physical condition may result in less creativity.

National Risks: In the absence of the medical insurance scheme may result in excessive final

burden for the public health undertaken by the government.

Less appreciation of the medical insurance scheme may place the government with humanitarian liability for unable to attend everyone living in the kingdom with reasonable public health-care.


Poor health-care may result in less productivity and thus effect the socio-

economic growth.

Therefore, to encourage a significant participation in the health-care scheme, the importance, policies, perception, products and services of health insurance may be required to be designed with more attractive existence by an appropriate reform in models with structures. Such reform may encourage everyone to participate in creating a healthier society by undertaking and appreciating medical insurance policy as part of day to day life. It is importantly noted here that, in the Kingdom of Saudi Arabia, the law of its land is a Shari’ah (Islamic law) while its present recognized insurance model is based on the Shari’ah justified cooperative principles (ta’awuny)8. By complying the spirit of law and culture of the Kingdom several alternative models with structures within the Maqasi al-Shari’ah are suggested in this paper aiming at encouraging everyone to participate in and benefit from the reformed medical insurance policy by exercising an option as to packages. In view of justifying the objective of the research, as a pioneer with Shari’ah compliant of medical insurance scheme the Malaysian experience will be analyzed besides the current practices of the Kingdom of Saudi Arabia.

Shari’ah Compliant Medical insurance Scheme: An Experience Based on a conceptual survey it has been discovered that, in the contemporary

socio-economic environment, a Shari’ah compliant medical insurance was introduced by Takaful Malaysia sometimes in 90s as among the pioneers.9 The scheme provides coverage for thirty-six types of critical illness. Through this plan, the policyholder will obtain the sufficient amount of money to cover the required cost for the medical treatment. This plan also provide the opportunity to the policyholder to choose any kind of treatment that one may intend to get10.

As per practices in Malaysia, A health insurance plan is open for participation by any individual between the ages of 18 to 55 years old and free from those 36 critical illnesses. Thus, the duration of participation depends on the package chosen. They are three packages, 10 years, 15 years and 20 years.

There are numerous products of Islamic insurance including health-care scheme offered in the market. Some of them are not available in the conventional insurance providers. Generally, Islamic insurance is categorized into two, namely: life insurance and General insurance. However, this paper attempts to provide possible practical model of Islamic health-care insurance product justified under the Shari'ah principles of cooperation. Islamic life insurance11 plan generally is a long-term based on al-Mudharabah (profit and loss sharing) contract. Basically, Islamic life insurance plan is designed to serve and provide coverage for both individual and corporate sector. It also provides mutual aid or financial assistance among its participants from the Islamic life 8 Al-Qur’an (5:2). 9 Takaful my Health Protector Simply A Better Choice for Your Health, Takaful Malaysia, at P.1 10 http://www.insuranceinfo.com.my/choose_your_takaful/things_to_note/medical_health_tak

aful.php?intPrefLangID=1&#content1 11 As practiced in some ASEAN countries (Malaysia, Brunei and Indonesia) in particular.



insurance Fund should any of its members be inflicted by a tragedy. Among the products under Islamic life insurance plan include:

Islamic life insurance Plan

Islamic life insurance Plan for Education

Employees insurance Plan

Ma'asyi insurance Plan

Health insurance Plan (Health-care insurance).12

Thus, the Health-Care insurance plan enables the individual to take preventive action from the critical illness. Under Islamic life insurance plan, the contribution paid by the participant is credited into two separate accounts namely; the Participant's Accounts (PA) and the Participant's Special Accounts (PSA). The purposes of these two types of accounts are, a proportion of the contribution will be credited into the PA only for savings and investment. While the balance of installment is credited into the PSA account and is considered as tabarru (donation) for the risk management, which is not necessarily to be fixed, but flexible with mutual arrangement.13 A health-care insurance plan is a sub-product of life insurance, which may provide two packages with option. Package one where the account is treated on a dual benefits with two accounts namely risk coverage account while the other is a saving account with investment return based on the principle of al-Mudarabah. The other option is on single tier basis to provide only the health-care coverage by having no investment return available14.

Scope of Coverage As per the practices of Bupa Arabia in the Kingdom of Saudi Arabia (KSA), a

health-care insurance plan in the covers among those of followings:

Variable overall cover with limitation

Fully paid In-patient and out-patient, including cover for General Practitioner and Specialist consultation.

Extensive network of hospitals and clinics coverage

Single room to Standard suite accommodation for in-patients

Maternity cover with benefits including neonatal care, maternity complications and treatment of premature babies

12 Brochure, Health-Care Takaful Plan, Takaful Malaysia 13 Yusof, M. F.,(1999), The Concept and Working System of insurance, Institute of Islamic

Banking & Insurance, London, 19. 14 As practiced by most of the Islamic Insurance providers in Malaysia.


Dental cover

Optical cover

Cover for cancer

Cover for diabetes

Cover for heart ailments

Life-threatening emergency treatment out of network in KSA

Emergency evacuation through International SOS Assistance when outside of KSA

Emergency treatment outside of KSA

Elective treatment outside of network inside or outside of KSA.15

Whereas in Malaysia, the health-care takaful covers among the followings:

Critical illness diagnosis

Death

Accidents

Funeral expenses

Hospitalization (Day allowances)

Cash withdrawal

Permanent Disablement.

Benefits in the Existing Health insurance Plan In the Kingdom of Saudi Arabia, the benefit under a health-care insurance plan is

ruled out under article 18 of the Kingdom of Saudi Arabia Cooperative Health Insurance Council Secretariat General as follows:

1. Diagnosis and treatment by service providers, provided that the beneficiary pays the agreed upon deductible, if any.

2. The cost of necessary and emergency medical treatment paid directly by the beneficiary, provided that the insurance company fails to urgently provide such service to the beneficiary or unjustifiably refuses to provide the service. The person bearing the expenses shall be indemnified in accordance with the limits provided

15 International health plan, Bupa Arabia (KSA).



for in the policy and the limits paid by the company to a service provider of a similar level16.

Policyholder in Malaysian practices, may have an option to choose either of the following two packages of benefits:17

Package A (coverage with saving)

Package B (coverage without saving)

Package A This package provides saving besides protecting participants from thirty-six critical

illness. Furthermore, the participant also is entitled to obtain profit sharing from the al-Mudharabah principles. However, it also depends to their age, gender, duration and level of healthiness.

For instance, let takes 20 years old participant and 40 years old participant.

20 Years old participant The risk is low

Therefore, the proportion to PSA is low and proportion for PA is high

Let say 80% in PA and 20% in PSA

40 Years old participant The risk is high

Therefore, the proportion for PSA is high and proportion for PA is high

Let say 60% in PSA and 40%in PA.

Package B This package offers protection only against thirty-six types of critical illness with a

low rate of contribution apart from profit sharing based on al–Mudharabah principle. Normally, this package is depending on the participant’s age and based on the duration of coverage. Most of participant who choose this package will contribute more proportion to the ASP account. For instance 80% of the contribution will go into ASP and the balance 20% will go into AP18.

16 Article 18, Kingdom of Saudi Arabia Cooperative Health Insurance Council Secretariat

General, Implementing Regulation of the Cooperative Health Insurance Law Approved in Session (93) Dated 11/3/1435H Approved by Ministerial Order (9/35/1/DH) Dated 13/4/1435H

17 See Takaful myHealth Protector, Takaful Malaysia. 18 This Plan does not cover pre-existing illness and pre existing symptom and all illness which

commence with a period of 30 days from certificate effective date.


Types of critical illness covered by Health-Care takaful: A Malaysian experience19

1. Heart attack 19.Motor Neuron Disease

2. Stroke 20.AIDS Due to Blood Transfusion

3.Coronary Artery Disease Requiring Surgery

21.Parkinson’s Disease

4.Cancer 22.Chronic Liver Disease

5. Kidney failure 23.Chronic Lung Disease

6.Fulminant Hepatitis 24. Head Injury Due to Accident Cause of Major Head Trauma.

7.Major Organ Transplantation 25.Aplastic Anemia

8.Paralysis 26.Muscular Dystrophy

9. Multiple Sclerosis 27.Benign Brain Tumor

10. Pulmonary Arterial Hypertension 28.Encephalitis

11.Blindness 29.Poliomyelitis

12. Heart Valve Surgery 30.Brain Surgery

13.Deafness 31.Bacterial Meningitis

14. Surgery to the Aorta 32.Others Serious Coronary Artery Disease

15.Loss of Speech 33.Apalic Syndrome

16. Major burns 34.AIDS Due from occupation

17.Alzheimer’s Disease 35.Full Blown AIDS

18.Coma 36.Terminal illness

Examples of Shari’ah Compliant Medical Scheme As practices among the takaful operators, the premium paid by the participants is

credited into two separate accounts namely; Participant's Accounts (PA) and the Participant's Special Accounts (PSA). An agreed portion of the contribution is credited into the PA for saving and duly investment while the balance is credited into the PSA account and be considered as tabarru’ (donation) for the risk coverage. The ratio of the account treatment is subjective depending on the actuarial policy and the choice of the participant as to the nature of coverage. Thus, some hypothetical experiences (examples) are shared as follows:

19 See Takaful myHealth Protector, Takaful Malaysia.



Example 1:

The distribution of contribution between Participant’s Account (PA) and Participant's Special Accounts (PSA) is made by applying several criteria as follows.20 Age - Age is regarded as an important criterion. This is because the older a

person is the higher is the risk of being diagnosed with an illness. The higher risk result in more proportion of the installment placed under PSA compared to a younger person with lesser risk.

Gender- According to studies done previously, life expectation of female is longer than male. This means the risk is lower for female. So female participants will be eligible for more proportion of installment to be placed in PA compared to male.

Duration- When a young person signs up for Health insurance, then the coverage period is longer compared to older person. The longer coverage period or duration results in more proportion placed under PA.

Health- Health condition of the participants is also considered in placing the installments. If the participant is diagnosed with illness the risk is higher which means higher proportion placed under PSA.

Package A Health insurance provides two packages for its customers. The first one is Package

A, which provides saving for the participant in addition to the coverage for the listed illness.21 The participant can enjoy with the share of profits over the saving account (PA) according to the principles of al-Mudharabah. Several coverage is provided under packages.

20 Takaful Malaysia, Health-Care Insurance Plan, Appendix (Package A) 21 Takaful Malaysia, Health-Care Insurance Plan, Appendix (Package A)


Example 2

Example 2 shows the case of a person who died of illness during the period of coverage. The person takes the insurance Plan for 20 years and died during year 10 due to an illness covered in the package. The family members are eligible to get $ 20 000 plus the balance in his Participant’s Account.

Diagnosis of Critical illness Example 3

Example 3 shows a case of a person who bought insurance policy of 20 years. He is diagnosed with an illness during year 10 which enable him to receive $10 000 for medication purpose. He died of the illness in the remaining period, which entitles the family members to receive the balance $10 000, plus the balance of his Participant’s Account.

Example 4



Example 4 relates to a case of a permanent disablement. When a person is permanently disabled due to illness then they are entitled to receive $100 monthly plus Participant’s Account balance until the person reaches 65 years old. Besides, permanent disablement coverage also depends on the percentage of part of body which is disabled.

Accident If the participant is involved in an accident then he is eligible to get $ 40 000.This

is only if it is not caused by any illness.

Hospital Allowance If a participant is diagnosed with an illness that requires hospital stay, then the person will be entitled for $100 daily as long as he stays in the hospital. Example of illness is such as dengue.

Cash Withdrawal In case of emergency, participants can withdraw their money according to the

proportion determined earlier. Participants can withdraw 50% of the total Participants Account balance after 2 years and 70% of the total Participants Account balance after 5 years.

Package B Package B is planned more toward charity. The installment is divided according to

age groups. The premium gets higher as the age increases22. All other plans are same with Package A except for critical illness plan which is different.

Example 5

Diagnosis of critical illness

Example 5 shows that in Package B, when the participant is diagnosed with an illness, the total amount which is $ 20 000 plus AP is given. As we can see this is contrast to Package A. 22 Takaful Malaysia, Health-Care Insurance Plan, Appendix (Package B)


Medical Takaful (Insurance) : The Reformed Models with Structures There are eight different medical takaful models within the Maqasid al-Shari'ah

namely:

1. Ta'awuni (Cooperative) Model 2. Wakalah (Agency) Model 3. Waqf (Endowment) Model 4. Tabarru' (Philanthropy) Model 5. Hibah (Gift) Model 6. Composite(Tabarru' & Mudharabah) Model 7. Humanitarian Health-care through Zakat Model 8. Health-care through i-Crowd Funding Model The Structure in Nutshell are as follows:

.

CoP

Operational Reserve

Management Operation Marketing Establishment

RM A/C (as per actuarial rate)

Operational Reserve Claim Reserve Re-insurance IBNR / RBNS Unearned Premium

Distribution Claims No Claim Benefit

(Subjective)

Agreed Coverage (on Claim)

No Claim Benefit (Discount / Income / Both)

5

1

Surplus Operator / Insurer

(Shareholders)

2

3

4

.

WKL

Wakalah Reserve



Wakalah Reserve Claim Reserve Re-insurance

IBNR / RBNS Unearned Premium


(as agreed)



5

1

Surplus Zakat / IT Policyholders (Subj)

Operator / Insurer

(Shareholders)

2

3

4



.

TRS

Trustee Reserve Management Operation Marketing Establishment


Trustee Reserve Claim Reserve Re-insurance IBNR / RBNS Unearned Premium



No Claim Benefit (Discount on Renewal)

5

1


(Shareholders)

2

3

4

.

DON

Tabarru’ Reserve



Tabarru’ Reserve Claim Reserve

Re-insurance IBNR / RBNS Unearned Premium



No Claim Benefit (Discount on Renewal)

5

1


(Shareholders)

2

3

4


.

GFT

Hibah Reserve Management Operation Marketing Establishment


Hibah Reserve Claim Reserve Re-insurance IBNR / RBNS Unearned Premium


(Subjective)


No Claim Benefit (Discount / Profit / Both)

5

1


(Shareholders)

Policyholders (Subjective)

2

3

4

.

Co

MP

Management Reserve



Management Reserve Claim Reserve Re-insurance IBNR / RBNS Unearned Premium Investment Reserve



No Claim Benefit (Investment Return)

6

Surplus Zakat / IT Policyholders Operator / Insurer

(Shareholders)

2

4

5

Investment3

1



.

HHI

Trustee Reserve Management Operation Marketing Establishment


Trustee Reserve Claim Reserve Re-insurance IBNR / RBNS Unearned Premium




5


(Shareholders)

Policyholders (Subjective)

2

3

4

Insured (insurable interest)

Fuqara (poor)

Masakeen (needy)

Ibni Sabeel

(including Hjji & travelers)

Types of Scheme

Group Family Individual

1

.

Nation-wide Free Quality Health-care

Government is able to Cut its (Billion) Public Health-care Cost / Budget annually

Comprehensive (Inpatient & Outpatient) Test Medicine Funeral Package (Subjective)

Any of the Followings:

GLC NGO Trustee

All Public Hospitals All Public Clinics All Public Support Groups (Laboratory etc) Required Health-care Providers to be Established

Native Saudis (all levels) Expatriates (all levels) Residents (regardless of Status) Visitors (Hajj, Umrah, Ziyarah)

Justification:

al-Qur’an 09:60 Needy Test Humanitarian Test.

The Health Care Budget for 2017 is SAR 120,419,691.000.00

(2017 Budget, KSA, P. 22)


Recommendations

Medical takaful is undoubtedly an essential component of day to day life to care about own health within the ability and afford. Thus, the following recommendation is made in view of treating health-care insurance as a life routine.

9. Public awareness has to be made on the importance and ideas of health-care insurance.

10. Health insurance operators are to increase their market share. There are numerous insurance operators in any jurisdiction of the world and no exception in the Kingdom of Saudi Arabia. Thus, in order to strengthen the operators’ competitive position, they should conduct aggressive promotional activities. Health insurance is already a growing phenomenon among the people of different levels, because of its offered benefits. This promotion is needed in order for the information to reach out for people from all walks of life.

11. The government and the industry with a joint-effort, may take an effective initiative to reduce the misconception regarding the image of the scheme. This can be done by reducing the problems of misunderstanding of the coverage provided. This has become a big issue especially when the participants complain through the media. The executives should carefully monitor the registration process so that, the participants understand the terms and conditions.

12. The term (duration) of policy may be increased. The participation period in Malaysia for example is; only limited to 10, 15 and 20 years. The period should be increased to 25 or 30 years. This is because, if a participant gets a Health insurance plan when he or she is 20 years old then the coverage is only until the person reaches the age of 40. Usually the risk of getting illness is lesser for those bellow 40 years old.

Conclusion Human being exists in this world in a state of uncertainly as we are lack of the

knowledge of the future happening. There would be no risk if we know what will happen in the future. Without risk there will be no need for protection. In reality, we can only anticipate the future based on our past experience. From the economic point of view, uncertainty relates to the fear of having to face the possibility of huge losses. Insurance emerges as a protection from this kind of mischief. Medical takaful thus, is a monetary coverage against any critical illness. It is thus, submitted that, health-care insurance is one of the strategic plans that the operators have designed to help one monetarily who unexpectedly ought to have been diagnosed with illness thus, no contradiction with the Shari’ah or cooperative principles per se.

References 1. Ali, A. Y., 2001, the Holy Quran.

2. Appendix – Brochure Health-Care Insurance, Takaful Malaysia



3. Arab News, 2015, “Only 3 million Saudis have health insurance”, Saturday 19 December, Saudi Arabia.

4. Al-Amri, K., 2015,”Takaful insurance efficiency in the GCC countries”, Humanomics, 344.

5. Billah, M.M.,2003, Islamic Insurance: Ilmiah Publisher, Malaysia. 6. Brochure, Health-Care Takaful Plan, Takaful Malaysia 7. Health Ministry aims to link insurance companies service providers with CCHI,

2010, Cooperative Health Insurance, April, Issue 9, Saudi Arabia. 8. Zohair A. Sebai, et.al.(2001),” Health Care Services In Saudi Arabia: Past, Present

And Future”, Journal of Family & Community Medicine, 8 (3), Saudi Arabia.

9. http://www.insuranceinfo.com.my/choose_your_takaful/things_to_note/medical_health_takaful.php?intPrefLangID=1&#content1

10. Health care in Saudi Arabia: https://en.wikipedia.org/wiki/Health_care_in_Saudi_Arabia#Benefits

11. https://www.hsbc.com.my/1/2/personal-banking/insurance/hbmy_healthcash_plan?WT.ac=MYH_HCP_AFP

12. International health plan, Bupa Arabia (KSA). 13. Kingdom of Saudi Arabia Cooperative Health Insurance Council Secretariat

General, Implementing Regulation of the Cooperative Health Insurance Law Approved in Session (93) Dated 11/3/1435H Approved by Ministerial Order (9/35/1/DH) Dated 13/4/1435H.

14. The Council of the Cooperative Health Insurance (CCHI), 2015, Arab News (Saturday 19 December 2015.

15. Sunan al-Tirmidhi: Sifatul Qiyamah: 2517

16. Takaful myHealth Protector, Takaful Malaysia. 17. Takaful Malaysia, Health-Care Insurance Plan, Appendix (Package A) 18. Takaful Malaysia, Health-Care Insurance Plan, Appendix (Package B) 19. Takaful my Health Protector Simply A Better Choice for Your Health, Takaful

Malaysia. 20. The Takaful Act (Malaysia) 1984 (repealed) 21. The Islamic financial Services Act (Malaysia) 2013. 22. Yusof, M. F.,1999, "The Concept and Working System of insurance" Institute of

Islamic Banking & Insurance, London. 23. Zawya, 2009, "Saudi Arabia Healthcare and Pharmaceuticals Forecast (Market

Profile)" Retrieved at: October 2, 2009. Retrieved from: http://www.zawya.com/printstory.cfm?storyid=EIU20081101211439546&l=000000080828


Combination of Contracts in Sovereign Sukuk Structure in Indonesia And A

Proposed Sharī’ah Parameters By

Muhammad Iman Sastra Mihajat** Abstract Sukuk is one of the most attractive Islamic instruments currently in Indonesian Islamic capital market. This instrument brings about the inevitable combinations of contracts in one single transaction to serve variety of demands of the Islamic investors. The fact shows that majority of contracts in Sukuk market (corporate and sovereign) are using double and multiple of contracts in their ‘aqad structure. However, based on hadith of the Prophet, it is prohibited to combine more than one contract in single transaction. Therefore, some Muslim scholars have questioned the level of compliance with Shari’ah law in Sukuk issuance. This paper provides proper understanding over the prohibited combination of contracts in Shari’ah. It can be concluded that not all combinations of contracts are prohibited as long as they follow the Shari’ah parameters guidelines. The paper laid down Shari’ah parameters to combine more than one contract in one single transaction, so as it is beneficial for Sukuk issuer (corporate and government) for future development before issuing the Sukuk.

Keywords: Combination of Contracts, Sovereign Sukuk, Shari’ah Parameters.

1. Introduction Sukuk represents a new development in global market. It is one of the fastest

growing sectors in Islamic finance and is considered by many as the most innovative

* Author: Muhammad Iman Sastra Mihajat, Head of Shari’ah Audit and Shari’ah Compliance,

Islamic Banking Islamic Banking Unit, Oman Arab Bank, Muscat, Sultanate of Oman. E-mail: [email protected]


product of Islamic finance. The impressive development of the Sukuk market from day to day has to provide innovative combination of contracts and product structures to meet the current needs of business and trade especially in the age of electronic transactions. That means the contract that is used in Islamic banking and finance particularly in Sukuk instrument is more complicated than the previous one and implies that the new Sukuk issuance shall use more than one contract in structure. Some researchers such as Al-Shadhily (1998); Abu Guddah (2000); Arbouna (2007) and Dusuki (2009) have examined the concept of combination of contract in Islamic financial instrument and its application for the purpose of product development in Islamic banking and finance. Therefore, the need for Sharīʿah guidelines and parameters for combination of contracts in Sukuk structure in order to ease the practitioners in Islamic finance industries in Indonesia is something to begin on urgent basis.

That is why, this study focuses on the Sharīʿah parameters in combination of contracts in sovereign Sukuk, that use two contracts in one transaction in Islamic commercial law (Dusuki, 2009), and understanding the prohibited ‘aqad that violate the transactions since the basic of mu’āmalah is permissible unless there is evidence that shows it is prohibited. This understanding is urgently needed to avoid non-Shari’ah compliance of the Sukuk structures since Sheikh Muhammad Taqi Usmani criticized the Sukuk structures and issuance by stating that currently 85% of Sukuk do not comply with Islamic law (Reuters, 2007).

However, combination of contracts is a controversial issue in Islamic finance because of the hadith that prohibits “two contracts in one transaction.” The wrong interpretation of the hadith may potentially defeat any attempt to allow amalgamation of contracts in Sukuk structure regardless of the nature and the feature of the contract combined and hinder the product development in Sukuk market. Nevertheless, from Sharīʿah the transaction may comprise of more than one contract and it is lawful provided the combination has to follow the Sharīʿah guidelines and parameters (Arbouna, 2007).

2. AAOIFI Versus DSN-MUI Ruling In Relation To Sukuk Sukuk issuance in Indonesia has been endorsed by National Shari’ah Board

Indonesian Council of Ulama through Fatwa No 32/DSN-MUI/IX/2002 and No 69/DSN-MUI/VI/2008 while in AAOIFI; Sukuk is regulated under AAOIFI Shari’ah Standard No 17. Definition of Sukuk that laid down by AAOIFI is more details compare to DSN-MUI. According to DSN-MUI Sukuk is:-

“Shari’ah bonds, a long term securities that based on Shari’ah, issued by the issuer to the bond holders that obliges the issuers to pay income to the Shari’ah bonds holders in the form of profit sharing / margin / fee, and pay back the Islamic bond funds as they nature.”

While AAOIFI on Shari’ah Standard No 17 2008 defines Sukuk as:

“…certificates of equal value representing, after closing subscription, receipt of the value of the certificates and putting it to use as planned, common title to shares and rights in tangible assets, usufructs and services, or equity of a given project or equity of a special investment activity.”


DSN-MUI has not put in details how structure in Shari’ah manner, it solely up to

the particular Shari’ah Supervisory Board of the issuer. However, AAOIFI has issued six recommendations on how to structure Sukuk. These recommendations are as follows:

Sukuk, in order for them to be tradable, the asset must be owned by the Sukuk holders, together with all of the rights and obligations that accompany such ownership. The manager of a Sukuk issuance must establish the transfer of ownership of the asset in its book, and must not retain them as its own asset.

Sukuk must not represent receivables or debt except in the case of a trading or financial entity selling all of its assets, or a portfolio with a standing financial obligation.

It is not permissible for the Sukuk manager to undertake to offer loans to Sukuk holders when actual earnings fall short of expected earnings. It is permissible, however, to establish a reserve for the purpose of covering such shortfalls to the extent possible, on condition that the same is mentioned in the prospectus.

It is not permissible for the investment manager, partner, or investment agent to agree to repurchase asset from Sukuk holders at nominal value when the Sukuk are extinguished at the end of their maturity. It is permissible, however, to agree to purchase the assets for their net value, or market value, or fair market value, or for a price agreed at the time of their purchase, in accordance with Shari’ah rules of partnership and modern partnership and modern partnership, and on the subject of guarantees.

It is permissible for the lessee in a Sukuk Ijarah to agree to purchase the leased assets when the Sukuk are extinguished for their nominal value, provided that the lessee is not an investment partner, investment manager, or agent.

Shari’ah supervisory board should not limit their role to the issuance of fatwa on the Sukuk structure, but should also oversee its implementation and compliance at every stage of the operation.

3. Sukuk in Indonesia

In Indonesia, Sukuk is known as “Obligasi Shari’ah or Shari’ah Bond”. Sukuk is one of the most innovative product instruments in Indonesia capital market that has big potential to be developed in terms of quantity and type of contract. Although in term of issuance amount is not as many as conventional bonds, its development since 2002 until today has increased from year to year. In improving the development of Sukuk in Indonesia, corporate and government still face some challenges.

After its debut of issuance since 2002, there are accumulatively 64 Sukuk issuance by corporate with total value of Rp 11,29 trillion. Indonesian Sovereign Sukuk has also

Combination of Contracts in Sovereign Sukuk Structure ……


recorded rapid development. As per march 2014, Government of Indonesia has issued 43 Sukuk with a total value of Rp 139.97 trillion (Otoritas Jasa Keuangan, 2013).

In 2008, Islamic capital market in Indonesia has recorded a new history after enactment of a law No. 19/2008 about Sukuk. With the enactment of Sukuk Law, this will impact into the recognition of Indonesia Sukuk in the global market and increase the investor confidence. The main issue currently face by Islamic finance industry in the Sukuk market is non-liquid of Sukuk and its tradability in the secondary market due market share of Sukuk over conventional bond is less than 5%.

4. Indonesian Sovereign Sukuk & The Combination of Contract In Indonesia, Sovereign Sukuk known as SBSN (Surat Berharga Syariah Negara),

is sovereign securities based on shariah principles issued by Indonesian government either by Indonesian Rupiah (IDR) or foreign currencies denominated (USD). The enactment of Sovereign Sukuk Law started in 2008 by issuance of Law No 19 of 2008 (Sovereign Sukuk Law) followed by its first domestic sovereign sukuk issuance. To date, Government of Indonesia (GoI) has been issuing sukuk with various structures with variety of underlying assets through Special Purpose Vehicle (SPV, called Perusahaan Penerbit SBSN, PP SBSN) to legally acting as issuer as well as trustee.

GoI has been issued Soveregin Sukuk regularly for domestic market and global

market as well. This is form of Government of Indonesia commitment to support the development of Islamic Financial Market and provide an alternative shariah compliant instrument for fast growing Islamic financial institution in Indonesia. In particular for short-term money market instrument for Islamic bank

Currently, the outstanding of Sukuk Negara issuance as of May 6th, 2013 is IDR 138.14 trillion equals USD 14.35 billion with the following details:

Table 1: Indonesian Sovereign Sukuk Issuance May 2013

Domestic Sukuk Amounts IFR (Islamic Fixed Rate) IDR 17.13 trillion SR (Retail Sukuk) IDR 35.92 trillion SDHI* (Hajj Fund Sukuk) IDR 35.78 trillion SPN-S (Islamic T-Bills) IDR 1.82 trillion PBS (Project Based Sukuk) IDR 21.97 trillion

In Indonesian market, single SPV will be used for every single issuance, series and types of Sukuk for all its domestic issuances. Through this SPV GoI has been issuing Sukuk with various structures including Ijarah, sale and lease back, asset to be leased, and Ijarah al-khadamat with different underlying asset for each transaction.

Every sovereign Sukuk issuance in Indonesian even in the global market contains several contract in every single issuance or transaction. Therefore, the need for Sharīʿah


parameters is something urgent to be developed so as every single issuance of Sukuk does not contrary to Islamic values and principles.

5. Implementation of Combination of Contract in Sukuk Structure Combination of Contracts or hybrid contract that prohibits in Islamic commercial

law particularly in Sukuk structure where each contract contradict each other (mutanāqidhah). For example, combining sale and purchase agreement with qardh or loan (bayc wa salaf). Another example is combining qardh with Ijarah contract at the same time in one transaction or combining the qardh contract with promise of reward. These combination of contracts are prohibited by the hadith (the status of hadith is hasan sahīh) narrated by al-Tirmizi that Prophet (pbuh) prohibited combining the contract of sale and loan. Imam Ibn Taymiyyah prohibits the combination between sale and loan in one transaction due to the contracting parties will benefit from sale instead from loan, unless there is return the loan at the same amount or return the goods at the same specification. (Al-Bakī, 1995; Jumcah, 2005). The prohibition of this combination of two contracts is because it opposed diametrically in the nature of contract. An example of a combination of sale and loan occurs when Ahmad says to Yasir, “Lend me Rp1 million and I will sell you my phone” or “I will sell to you my shoes at the price of Rp100.000 with the condition you have to lend me money Rp500.000” (Dusuki, 2009).

The methods of combination of contracts or combination of several caqad in one transaction shall become a special feature of Sukuk issuance in all over the world including Indonesia to develop more attractive features. In fact, the combination of the contract in the present system of economic is a necessity. The problem is, the literature on Islamic finance in Indonesia have developed the theory that Sharīʿah does not allow combining two or more contracts in one transactions. This prohibition was interpreted with narrow and wrong interpretation, thus narrowing the development of Islamic banking products and services in Indonesia. Whereas there is no explicit Qur’anic provision that directly prohibits or permits the combination of contracts. Some Sharīʿah scholars allow the combination of the contract in one transaction in a very broad scope with conditions. The provision that seem to reject the combination of contracts concept only stated in the hadith (Arbouna, 2007).

In Sharīʿah however, the combination of contracts that has been banned limited only in two cases in accordance with the sayings of the Prophet Muhammad (pbuh). Combination of contracts should not be extended to other issues that are not relevant and does not match with the context. All Islamic finance stakeholders should study in depth on view of the scholars regarding the hybrid contract in Islamic perspective to avoid wrong interpretation. Especially understanding on how to form the contract in each particular product and services, could be more comprehensive, dynamic, and not rigid. The rigidness occurs due to the shallowness of knowledge and lack of Sharīʿah literature that discusses the combination concept of caqad.

Indeed, there are four ahadith of the Prophet (pbuh) in respect to the prohibition of combination of contracts in financial transaction. These four ahadith contain four restrictions, the first prohibition is combination between bayc (sale) and salaf (loan) that is reported by Mālik (Muwatta’, Vol. 2, No. 657, ed. 2005), the second is the prohibition



of baycataini fī baycah (two contracts in one transaction or two sales in one transaction) (Mālik, Muwatta’, Vol. 2, No. 663, ed. 2005), the third prohibition is of shafqataini fī shafqah (two transactions into one transaction) (Ahmad, Musnad Imam Ahmad, Vol. 1, No. 198), and the fourth prohibition is bayc wa shart (sale with condition). These four ahadith are always used as a wrong reference with the majority of Islamic finance stakeholders in Indonesia by prohibiting combination of contracts in general to develop more attractive caqad in each issuance of Sukuk.

Pertinent to the ahadith, Dusuki (2009) highlights some opinion of the jurists such as Imam Shāfi’i interpreted that two sales in one contract occurs when one agreement puts a condition by influencing another agreement. For example, Ibn Taymiyyah and Ibn Qayyim interpreted the hadith as bayc al-cīnah that prohibited in Sharīʿah (Al-Bassam, ed. 1997). However, Imam Shāfi’i gave two interpretations. The first one, when the seller says to the buyer: “I sell you this laptop for Rp10 million in deferred payment or Rp8 million in cash”. However the buyer does the choosing of any one of it. The contract is fāsid due to the involvement the element of uncertainty. Uncertainty in terms of the modes of payment by the buyer which is by cash or in deferred payment. Second, when the seller says to the buyer that “Sell me your house with the condition that you have to sell your car” (Al-Sancāni, ed. 1960). Imam Mālik (ed. 2005) had a similar opinion pertinent to this where he explains “The meaning of two sales in one is an agreement which is binding against the purchase of one of the goods”. For example, “I will sell you my shoes for Rp1 million but you have to sell your phone at Rp1.2 million.”

6. The Views of Islamic Scholars on Combination of Contracts Majority of Hanafi’s school of law, some of Māliki’s school of law, some of

Shāfi’i’s schools of law and Hanbali’s school of law is of the opinion that the hybrid contract is valid and permissible according to Islamic law and judged in the light of its individual components. The scholars who argue that the hybrid contract is permissible on the basis of Islamic legal maxim (qawāid fiqh) on Islamic business transaction (mucāmalah) where the origin of the contract is permissible and legitimate, not forbidden and unlawful since there is no proposition of law that shows it is prohibited and banned (Al-‘Imrāni, 2006). Therefore, it is permissible to combine the contracts if the transaction comprises a number of contracts that each of them individually satisfies permissibility requirements (Al-Buhuti, ed. 1997; Ibn Qoyyim, ed. 1999). Unless combining two contracts that resembles ribā, as a combination of qardh with another contract due to the prohibition in merging the contract of sale with qardh in the hadith. Similarly, combining installment and lump sum payment in single transaction in sale contract is prohibited because it will cause gharar (uncertainly) in the contract.

According to majority of Sharīʿah scholars including Ibn Taymiyyah (ed. 1978), the origin of law on mucāmalah transaction is allowed as far as there is no explicit prohibition source in the Qur’an and the Sunnah. The contracting parties are free to conclude whatever contracts they deem necessary to meet their expectation. Za'tary (2008) stresses out that “there is no prohibition in Sharīʿah about merging the two contracts in one transaction, whether it is the exchange contract (mu’āwadhāt) or charity contract (tabarruc). This concept is based on the generality of the arguments on the validity of the caqad when it meets the terms and the conditions of the caqad.”


Hammad (2005) argues that, “the basic principle of hybrid contract in business

transactions is from Sharīʿah perspective is permissible, as long as each contract is done separately (cuqūd mustaqillah) and there is no evidence that expressly prohibits it in the Qur’an and the Sunnah.” When there is legal basis in the hadith shows the combination of contracts is prohibited, this argument does not apply in general, but excludes the cases outside the forbidden one according to the hadith. Therefore, the case was said to be the exception to the general rule applies that the freedom to make a contract and execute the agreements that have been agreed upon.

Similarly, Ibn al-Qayyim (ed. 1999) argues that the origin of forming the contract in business transaction is permissible as long as the terms and conditions are met, unless it is revoked or prohibited by Sharīʿah.

Al-Shātibi (ed. 2003) argues that in mucāmalah (business transaction) the legal origin is permissible and is based on the substance and does not lie on the practice (al iltifāt ilal macāni) and widely opens the opportunity to develop a new product and changes. According to him, the combination of contract is valid if concluded separately (cuqūd mustaqillah). For example, combining murābahah and wakalah in home financing, can also be seen when combining Ijarah, and wakalah, and so on. However, there are some prohibitions of combining contracts as an exceptional case, though they are individually permissible, such as combining sale and lending, marrying two sisters, and marrying a woman and her aunt.

This opinion is based on the text (Qur’an) that shows the permissibility of multi-contracts and contracts in general in sūrah al- Māidah Verse 1, which means: “O ye who believe please fulfill the contract agreement.”

All above arguments supported by the act of Umar bin Al-Khattāb while dispatching Ya’la bin Munyah to Yemen and his order was generally on the distribution of land. He allowed this transaction and permitted the two contracts in one contract because the original agreement occurred between both of them without knowing either one. It can be concluded that the combination of contracts is permissible as long as the contract does not influence another contract (Al-‘Asqalāni, 2007).

7. Parameters on Combination of Contracts for Sukuk Structure In general, amalgamation of several contracts in one transaction is a permissible

structure. This legality however, is circumscribed with certain parameters, criteria and conditions that need to be followed. The discussion on parameters, criteria, restrictions and conditions of combination of contracts in Sharīʿah for Sukuk structure will be highlighted as follows:

7.1 Restriction Limit and Standard Multi-Contract

In the previous discussion, it highlighted the issue of hybrid contract and how the majority of Muslim scholar allows the hybrid contract as long as there is no prohibition from the Qur’an and Hadith of the Prophet. However, Islamic scholars who allow the hybrid contract stated a number of restrictions, parameters and criteria that should be



followed such as the contract from one another should stand independently and not binding or cuqud mustaqillah that may assist one to determine whether it comply with Sharīʿah requirements (al-Shādhily, 1998; Arbouna, 2007; Dusuki, 2009). Among the Muslim scholars some agreed to this parameters and restrictions some of them disputed it. In general, the clear guideline over the combination of contract in which is expressly prohibited in the hadith is the combination between sale and loan contract in a single transaction and it is agreed upon by Muslim scholars. Other than that, such as baycatayn fi baycah, shafqatayn fi shafqah and bayc wa shart are not included in the combination of contract if it is transacted separately and followed the Sharīʿah parameters.

In general, the Sharīʿah principle in respect to formation of contracts is that any form of contract structured for Sukuk instrument is valid and acceptable in Islamic law unless explicitly prohibited and proclaimed as forbidden (Ibn Qoyyim, ed. 1999). The combination of contracts will be permissible if the subject matter, the price, and the time of transaction are known and clear to the contracting parties. If one these elements are not clear, the contract becomes unlawful.

Ibn Qayyim (ed. 1999) argues that the Prophet (pbuh) forbids combination of contracts between contract of sale and loan (qardh), even though each contract stands up individually or separated. The prohibition of combining the contract of salaf (loan contract) and sale in the contract is to avoid the forbidden ribā. This combination of contract is prohibited because if someone lends Rp1000 to his friend, then he sells the goods worth Rp800 with Rp1000 in order to get paid additional two hundred from the transaction. In this transaction he receives a surplus of two hundred in the second transaction, although it looks like he is giving a loan without any additional charges in the first contract (Ibn al-Qoyyim, ed. 1999). Majority of Muslim scholars agreed to prohibit combination of sale with loan contract in a single transaction (Ibn Rushd, ed. 1981). This argument is strengthened by Hammad (2005), where he argue that any product in Islamic banking and finance structured on the basis of hybrid contract is unacceptable in Islamic law hence it contradicts with an explicit source. For example, it is unlawful in Sharīʿah to disburse loan for investor and at the same time, the issuer sells a particular asset to the investor. This transaction falls under the category of combining loan contract with sale in order to accrue benefit (Arbouna, 2007).

Therefore, it can be concluded that all combined contracts that contain any sale element is prohibited to be combine with a qardh contract in a single transaction, such as Ijarah contract with qardh contract, salam contract with qardh contract, sharf contract with qardh contract, and so on.

Another issue in combining contracts that is expressly banned by the hadith is combining two sale contracts in a transaction (bayctayn fi baycah). Majority of Muslim scholars agreed that any product that is structured on the basis of a combination of contracts which is intended to circumvent the unlawful transaction such as ribā, gharar, and maysir is unacceptable. In other words, it implies the combination between Ijarah contract with loan in rahn product in Islamic bank in Indonesia in order to benefit from a loan contract in the name of Ijarah and combination of sale and buy back agreement in bayc al-cinah financing product in order to benefit from unintended sale is impermissible. In bayc al-cinah, there is a combination of contract between deferred payments with cash


payment which leads to ribā (Hammad, 2005). Normally, someone who sells something with credit, with the condition that the buyer shall sell it back in cash with a lower price. This kind of transaction somehow is hilah or manipulation to legalize ribā, where in fact there is no real transaction done in the contract.

Initially, contract that contains two sales in one transaction is impermissible. Although one of this sale contract was declared as valid and binding (common) before the parties separated yet it could not be determined which sale is considered as a valid and binding.

AAOIFI (No. 25/2008) laid down four Sharīʿah restrictions in combining contracts, the first combining contract that has been quoted to combine sale with lending (Mālik, al-Muwatta’, Vol. 2 No. 657, ed. 2005), or combining two sales in one deal (Mālik, al-Muwatta’, Vol. 2 No. 663, ed. 2005), or two transaction in one transaction (Ahmad. Al-Musnad, Vol. 1, No. 198). The second, it is prohibited to combine the contracts as a trick for practicing ribā, based on the directive of the Prophet (pbuh) which indicates the prohibition of bayc al-cinah and ribā fadhl. The third, it is prohibition to use the combination of contracts as an excuse for dealing in ribā, based on the hadith of the Prophet which forbids combining lending with selling. The fourth, the combination of contracts should not be contradicting with each other in terms of purpose or Sharīʿah rulings.

7.2 Combination of Contracts as Hīlah Ribawi Generally, the contemporary hybrid contracts that is commonly used in Islamic

financial institution for a hilah ribawi occurs through the contract of bayc al-‘inah and organized tawarruq (tawarruq munazzham) as backdoor to legalize ribā (Ayub, 2007; Rosly 2007; Rosly and Sanusi, 1999 and 2001; Bakar, 2009; Shaharuddin, 2009; Hanasudin, 2009). The below points highlight the combination of contracts that is commonly used as a backdoor to ribā.

1. Bayc al-cInah The contract of bayc al-cinah that has been banned by Islamic law is referring to the

majority opinion of jurists. Bayc al-cinah is a contract of a sale in a particular asset or commodity and repurchases it back at a different price; the deferred price would be higher than the cash price (Al-Nawawi, ed. 1996; Al-Zuhaili, 2007). The purpose of this transaction is to trick the transactions in order to acquire benefits from the actual loan contract given (Tuasikal, 2012). According to Imam Shafi’I (ed. 1973), bayc al-cinah is “a credit purchase of an asset which is later sold to the original owner or third party, either on cash or deferred, higher or lower than the original contract, or for an exchange of goods.”

For example selling a car on credit for Rp100 million with the condition that the buyer shall sell it back to the seller at price of Rp80 million in cash. The main objective of the buyer from this transaction is to obtain cash, whereby the seller wants to generate profit without breaking Sharīʿah principles. This motive aligns with the definition of bayc al-cinah that laid down by al-Haskafi (n.d.) he said: “It is a deferred sale of an asset with a motive to generate profit. The debtor, then, resells the asset to the original seller at a



lower price in order to settle his debt.” This kind of transaction it seems there are two sale contracts in one transaction, in fact it is just a back door (hilah) to ribā to manipulate the loan contract (qardh), because the object is not factual and the contract is a factitious contract. In fact, the main objective of a sale contract is to own a particular asset and other elements that have been specified by Islamic law cannot be found in this transaction.

In the case of the Islamic bank, it says that the customer needs cash for particular needs and wants to borrow it from Islamic bank. Since the customer needs cash not an asset, the Islamic bank will say to the customer, “I sell you this asset (an asset which is available in the Islamic bank e.g. gold bar) for Rp100 million by credit based on a monthly installment with a two years tenor, hence you do not need this asset, you can sell it back, and I will pay you in cash for Rp80 million.”

From the above transaction it can be concluded that, the Islamic bank is actually playing a trick to legalize ribā which is a loan plus additional amount of money through this fictitious transaction. In fact the Islamic bank wants to lend the money to the customer for Rp80 million and the customer will pay it back with Rp100 million. The advantage beyond the transaction to the Islamic bank is to obtain the profit from the two transactions at the same time at different prices, the difference between the cash price and installment price is the profit to the Islamic bank. Since the customer does not need any kind of an asset in the transaction, the Islamic bank then manipulates the transaction where it seems there is a sale of an asset that is why this method is called as bayc al-cinah. This contract is unlawful amongst majority of jurists such as Hanafi, Maliki, Hanbali, and some of Shafii’s follower such as Imam Nawawi, since it will lead to legalize ribā in Islamic finance industry. The bank will benefit from these two transactions from the price differentiation which is made at the same time. Where the other way around means there is profit from loan contract which violate the concept of “Any benefit transacted from loan contract is ribā” (Al-Ramli, 1984).

The other practices of bayc al-cinah in Sukuk structure normally are to finance obligor who needs the cash money to finance their overhead expense or to pay the debt. In ‘inah structure, the obligor will use a particular asset as the underlying. The obligor will promise to purchase the Sukuk asset more than the original price. The ownership of the underlying asset is not actually transferred to the investors. Ibn qayyim (ed. 1999) explains that the sale is permitted for those who are expected to give the ownership of the goods and get the price, and prohibited for those who aim for ribā fadhl and ribā nasi’ah, do not aim for the price and goods. While in the ‘inah Sukuk structure, the investors do not aim to own the Sukuk asset. Similarly, the reverse of bayc al-cinah transaction also forbidden, as someone sells something at the price of eighty in cash with the condition he buys it back for a hundred. This transaction involves the element of ribā.

The above opinion is supported by the hadith that is reported by Ibn Umar, He said that he heard the Prophet (pbuh) said “When you enter into the cinah transaction, hold the tails of oxen, are pleased with agriculture, and give up conducting jihad, Allah will make disgrace prevail over you, and will not withdraw it until you return to your original religion” (Dawud, Sunan Abu Dawud, No. 3455).


2. Tawarruq Munazzham (organized tawarruq)

The term of tawarruq is a purchase of an asset on deferred payment to a third party (other than the original seller) in cash; the deferred price would be higher than a cash price (Al-Zuhaili, 2009; Khayat, 2006). AAOIFI (No. 30/2008) defines tawarruq as “The process of purchasing a commodity for a deferred price determined through musāwamah (bargaining) or murābahah (mark-up sale), and selling it to a third party for a spot price so as to obtain cash.” Majority of jurists forbid bayc al-cinah and allow tawarruq except Ibn Taymiyyah and Ibn al-Qoyyim (Al-Zuhaili, 2009).

OIC Islamic Fiqh Academy in the 15th session in September 1998 (Rajab 1419H) permitted tawarruq subject to the condition that the customer does not sell the commodity to its original seller, to avoid bayc al-cinah as a trick legalize ribā. However, in December 2003 in the 17th session, the Academy distinguishes and classifies between the permissible (tawarruq haqīqi) and the forbidden one (tawarruq munazzam, organized tawarruq) which is widely practiced by Islamic banks is deemed to be synthetic and fictitious as bayc al-cinah and trick to circumvent the prohibition of ribā. In April 2009, at its 19th session the Academy banned the application of organized tawarruq because the transaction between Sukuk issuer and investor as it is considered a deception and resembles bayc al-cinah. The Sukuk issuer acts as an agent to the investor (mustawriq) to sell the asset to the third party who initially owned the asset (Dusuki, 2007; Dusuki 2009; Noor & Farhah, n.d.).

Similarly, Alhadad (2003) and Khayat (2006) divided tawarruq into two categories to distinguish between the permissible tawarruq (tawarruq haqīqi) with the forbidden one (organized tawarruq), the first is tawarruq munazzham (organized tawarruq), and the second is tawarruq fiqhi or haqiqi. The first tawarruq is organized tawarruq that is widely used by Islamic banks in Europe and the Middle East. This is due to the fact that Islamic banks takes part in determining the sales line and makes all arrangements to provide cash to the customer. Islamic banks will determine who is the broker for the purposes of purchase and to whom the buyer (customer) will resells the goods (Al-Zuhayli, 2006; Al-Suwaylim, 2009; Bouheraoua, 2009). The prohibition of the organized tawarruq is because its mechanism resembles bayc al-‘inah which is frowned as a form of hīlah (legal trick).

The second concept of tawarruq is where Islamic bank really buys the assets or goods from the market, and sells it to customer who needs something without no-frills to sell it to any party. The customer is free and has the right to decide to whom he wants to sell the asset. Since the ownership has been transferred from the Islamic bank to the customer, the customer has full of right pertinent to the asset. It has no hilah ghairu syar'iyyah therein that causes the product to not be Sharīʿah compliance. AAOIFI (No. 30/2008) laid down several parameters to approve tawarruq to be Sharīʿah compliant and permissible as follows:

1. The requirements of the contract for purchasing the commodity on deferred payment should be fulfilled where the commodity is real.

2. The commodity should be well identified to distinct it from other assets.



3. If the commodity is not available at the time of contract, the customer should be given a full description over the commodity such as the quantity and the place.

4. The commodity should actually be received by the customer.

5. The commodity must be sold to a party other than the original seller to avoid bayc al-cinah.

6. The contract for purchasing the commodity on deferred payment and the contract for selling it for a spot price should not be linked together in such a way that the client losses his right to receive the commodity.

7. The customer should not delegate the Islamic bank or its agent to sell the commodity on his behalf after he actually receives the commodity.

8. The Islamic bank should not arrange proxy to a third party to sell on behalf of the customer.

9. The customer should sell the commodity by himself.

10. The Islamic bank should provide the information to the customer where to sell the commodity.

3. Hīlah on ribā fadhl It has been reported that the Prophet (pbuh) instructed one of his employees to sell

his low-quality dates first and then buy the high-quality dates, instead of resorting to exchange of more quantity of low-quality dates with less quantity of high-quality dates (Bukhāri, Sahīh al-Bukhāri, Vol. 3 No. 97; Muslim, Sahīh Muslim, Vol. 3, No. 1208).

According to Ibn Qayyim (ed. 1999) this hadith indicates that the employee was directed to accomplish the first contract which is selling his low-quality dates then purchase high-quality dates while the first contract should be separated with the second contract. The hadith apparently necessitates two separate contracts that are not related to each other, much less interdependent on each other.

7.3 Sharīʿ ah Parameters of Combination of Contracts for Sukuk Structure The validity of combination of contracts for the purpose of the development of

Sukuk instruments required to structure in a way that does not conflict with an explicit source (Zactary, 2008). In other words, a product structured on the basis of combination of contracts does not intend to legalize the unlawful transaction such as ribā, gharar and maysir (Arbouna, 2007). The Sharīʿah parameters or Sharīʿah restrictions have been applied also by international Sharīʿah standard such as AAOIFI in making a limit restriction on products and services that make use of hybrid contracts.

AAOIFI in 2007 and 2008 has provided resolution No. 25 that says that the entire hybrid contract agreement is permissible provided that the contract should be separated from one another and each contract is permissible on its own, unless combination of sale


and loan contract. AAOIFI then laid down the regulations and Sharīʿah parameters on hybrid contract with the following rules:

1. The combination of contract agreements may not incorporate with the contract that has been clearly prohibited in Sharīʿah such as combination between of sale and loan in one transaction.

2. The combination of contract agreement may not be used as a trick (hīlah) to justify ribā . Like sale contracts and buy back agreements between two parties (bayc al-cīnah) or ribā fadl.

3. The combination of contract agreement may not be used as a tool for ribā such as creditor lends money in order to obtain a gift from a debtor or provides other benefits such as providing a ride or offering accommodation in his house.

4. The combination of contract agreement must not contradict to the essence of the contract. For example, like in mudhārabah contract, there should be no profit guarantee using hibah agreement in the first place or a combination between currency exchange with ju’ālah contract, or bayc al-salam with jucālah (AAOIFI No. 25, 2007; 2008).

In the meeting of Shari’ah Advisory Council Kuwait Finance House No. 23/2006 at September 19, 2006 in Kuwait, where at the time of evaluation Ijarah Rental Swap Product combined with the contract of wa’ad mulzim min tharaf wāhid (unilateral binding promise contract) on transaction of musāwamah and tawarruq, where they gave four requirements needed in order to comply with Sharīʿah conditions (Yahya, 2008; Dusuki, 2009);

1. The contract agreement in the transaction must be real, not a fictitious contract. These mean that where one transaction happens there must be a real transaction, where the desire of the seller to sell and the desire of the buyer want to buy the real subject matter. Otherwise it is the same concept with fictitious tawararruq (tawarruq mashrofi) that has been applied with many Islamic banks and Sukuk structure in the world. In fact from the data collected, only 2.7% of commodity murābahah transaction and tawarruq that really takes delivery by end user, and 97.3% used for derivative transaction for speculators.

2. Any contract that is being transacted as it has its own consequences such as once a sale contract has been transacted it has to transfer ownership of the asset from the seller to the buyer.

3. One contract to another has to be separated (‘uqūd mustaqillah)

4. This contract does not put any conditions in the transaction between the buyer and the seller.



Pertaining to the Sharīʿah parameters, Mihajat (2012) augments several parameters to make the transaction comply with Sharīʿah rules and principles which are;

1. The subject matter that is going to be transacted has to be real, not a fictitious asset which will lead into dispute in the future.

2. The subject matter that is being transacted can be delivered to the buyer if the buyer wishes. This condition is to ensure the availability of the transacted subject matter.

3. The price of the subject matter has to be based on the market price, no manipulation in term of the price.

4. The place of the subject matter should be known among the parties.

5. The subject matter that is being transacted is halal according to Sharīʿah as stated in fatwa DSN-MUI No. 82 2011 in endorsing the product of Komoditi Syariah for Islamic Money Market of Bursa Berjangka in Indonesian Islamic Banking Industry.

6. The objective of the transaction is for real sale and not for short-selling purposes.

7. The last one is the subject matter has to be ready to use not the subject matter that is still undergoing process to used.

8. Conclusion This paper highlights the development Sukuk in Indonesia in terms of quantity and

contract that are used in Sukuk structure. The paper shows that Indonesia has very big potential issuance market in particular, after the amendment of the Sukuk Act in 2008. This act will increase the global investors to invest their money in Indonesia. However, to develop the current structure of Sukuk into more innovative way and flexible in nature, the Sukuk issuers need structure with combination of contract structure basis. Therefore, in order to ease the Sukuk issuer - either government or corporate - they need to understand what are the Shari’ah parameters in structuring combination of contracts in Sukuk structure.

The paper has laid down general understanding on combination of contracts (ijtimā’ al-‘uqūd) for the purpose of development in Sukuk issuance to be more attractive to the investors which is very important following the fact that majority of Sukuk issuance in Indonesia and global markets are combining more than one contracts. The paper also laid down Sharīʿah parameters on hybrid contract in order to comply with Sharīʿah. Although the Sharīʿah compliance standard in Sukuk structure in every jurisdiction differs from one another, yet they must conform to the requirement of the agreeable fatwas and regulations. The understanding of fiqh in commercial transaction to meet the challenges of growth that may further strengthen Islamic finance industry is a must toward exploring various effective Sukuk issuances. Although some argue that the need to obtain Sharīʿah requirements is a hurdle in the path of Islamic banking product innovations (Benaissa, Parekh, and Wiegand, 2005).


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Working Model of an Islamic Bank: How different it is from conventional banking

By Muhammad Ali Shaikh*

Abstract Islamic Banking being new, there are doubts about its legitimacy. This qualitative study presents a working model of an Islamic bank (IB) and attempts to identify key differences with conventional banks (CBs) that must be maintained along with an interpretation and explanation of the apparent similarities that exist in order to remove confusion.

IBs raise deposits through a Modaraba contract and share, with the depositors, actual profits of the asset portfolio created out of deposits instead of paying interest. The assets so created are either Fixed Income (FI) using trade based or leasing modes or Profit and Loss sharing (PLS) using Modaraba and Musharaka. The basis of intermediation and relationship between parties assigns a new role to IBs as traders, investors or fund managers etc. Instead of credit risk the IB’s financing risk is a mixture of investment and credit risk with some different dimensions such as risk of lower return in case of delayed payments.

The study concludes that the IB model is legitimately a workable model and is distinctly different from conventional model. But there are issues in maintaining the different character of IBs such as partial similarity in product packaging, portfolio structures mostly based on FI income products, financial reporting, legal framework etc. Resolving these issues will improve confidence of the stake holders.

Key Words: Islamic Banking Model, Shariah Compliance, Legitimacy.

* Author: Muhammad Ali Shaikh is a retired senior banker and retired professor of

engineering economics at NED University of engineering and technology, Karachi, Pakistan. Since his retirement he is teaching subjects of financial management and Islamic finance at leading business schools in Karachi.


1. Introduction Islamic banking is now one of the fastest growing sectors of the financial market

place and is being practiced as an alternative mode of financial intermediation in many countries including non-Muslim countries of the world. Conventional banks (CBs) have also started Islamic windows to offer Sharia’h compliant financial products, to fulfill the demand of their customers. Most of the countries, including Pakistan are following a parallel system where Islamic banks (IBs) operate along with CBs.

Being new there are many questions about its legitimacy and the people wanting to shift to this system of banking must be sure that the new system being offered is really Shariah compliant and not an eyewash.

The objective of this study is to present a working model of an Islamic bank and more importantly demonstrate how it is different from CBs. The study covers a comparison of financial intermediation process, products and services as well as portfolio structures followed by both types of banks and attempts to identify key differences that must be maintained and at the same time provide interpretation and explanation of the apparent similarities that exist in order to remove confusion.

2. An over view of the main banking function Financial intermediation (FI) which is the main banking function, channels savings

into investments to ensure effective utilization of economic resources (Faruqi, 2001). It requires responsible decision making on the part of banks. The required banking products and services must be structured and implemented in accordance with underlying legal and regulatory frame work.

The IBs also perform similar functions but without indulging in receiving or paying interest. They also function through various products and services that are structured and implemented in accordance with the underlying legal and regulatory frame work which must confirm to the requirements of Shariah.

The difference lies in the underlying economic principles, financial contracts, the legal and regulatory frame work and the overall effect these institutions would have on the economy.

Table 1 gives a bird’s eye view of the methodology employed by Islamic and Conventional Banks to perform FI. A detailed description follows.

Table 1 Typical Summarized B/S of an IB and a CB

Islamic Bank Conventional Bank Assets Assets Musharika/Modaraba Loan & Advances Murabaha, etc. Ijarah Lease Finance Investments (Shariah comp.) Investments Fixed Assets Fixed Assets

Working Model of an Islamic Bank: How different it is…….


Liabilities and equity Liabilities and equity

Share Capital Share Capital

Reserves Reserves

Investment Deposits Deposits

2.1 Conventional Banks The deposits, which are the main source of funds, are credits based on debtor and

creditor relationship which makes the bank liable to return money to depositors along with interest at regular intervals or at maturity. Long and short term deposits are differentiated through premiums in interest rates. Current deposits are interest free. All deposits being loans are classified as liabilities and are not subject to sharing of the actual profits or losses. Likewise there is similar relationship b/w the bank and its borrowers who borrow from the bank on interest.

For granting loans credit-worthiness and collateral is the main criteria. In case of corporate borrowers firm’s balance sheet and profitability of the business is also considered but is not usually the main criteria except in case of limited recourse project financing.

Individuals, businesses and governments can have access to bank credits, which can be used for purposes other than productive purposes provided that the borrower has the necessary collateral to offer. Governments can use these credits to finance their budget deficits rather than avoiding wasteful expenditures. Similarly consumer credits can be used to finance personal budget deficits thus encroaching future incomes of individuals. For the business firms, since collateral rather than its profitability or rate of return is the criteria for financing, the possibility of using credits for nonproductive purposes increases, leading to unproductive financing and misallocation of economic resources and is largely responsible for non-repayable debt. One can borrow to repay his old debt. This indirectly capitalizes interest thus increasing the size of original debt –in many cases exponentially-- creating a debt trap.

2.2 Islamic Banking. IBs perform the function of FI in a different way. Deposits are raised through a

Modaraba contract where the depositor and bank act as investor and fund manager. Actual profits generated by the asset portfolio created out of deposits are shared between the bank and depositors on an agreed ratio (Meezan Bank, 2005; Bank Islami Pakistan, 2004). Long term investment deposits are differentiated from short term deposits by giving higher share of profits as their risk is higher, through a system of weightages.1 Losses will be borne by the depositors and the bank will get no compensation for its services.2 The current accounts are loans to the banks which have to be returned at face

1 The weightages are announced publicly in beginning of every month on the websites to

enable depositors to know it. See for example Meezan Bank’s website. 2 Account opening form is an agreement of modaraba b/w the bank and the depositor


value on demand (Usmani, 2001) which guarantees the principal. While the saving or investment accounts are not liabilities - the current accounts represent liabilities.

As explained later this structure points to a philosophical difference in the financial intermediation process between conventional and Islamic banks.

The returns paid to depositors depend on the earnings of asset portfolio and the fluctuations may cause serious problems for the Islamic Bank to retain customers. Different methods such as reducing the banks’ share in the profit, profit equalization reserve etc can be used to stabilize the returns on the deposits but are not fool proof methods to guarantee profit under all circumstances.

The asset portfolio created through deposits mostly consists of Fixed Income (FI) assets using trade based or leasing modes and Profit and Loss sharing (PLS) modes such as Modaraba and Musharaka.

In trade based modes financing is done by sale and purchase of goods such as Murabaha (the cost-plus profit sale method), Musawama (where profit disclosure is not necessary), Salam (where goods are purchased by the financier by paying the price in cash but delivery is deferred to make it financing) and Istisna (where goods are manufactured or processed according to the specifications of buyer (financier) and price is paid according to a mutually agreed schedule). Rules governing these contracts must be followed while using them as instruments of financing (Usmani, 1998). All of these methods require purchase and sale of goods either by deferring the sale price or the delivery of goods to make it financing. The bank as financier will act either as a buyer or seller of goods. The credit worthiness and collateral will still be used but requirement of sale /purchase of real goods must be fulfilled thus excluding pure cash loans.

Ijarah is an alternate to finance lease. The lessor transfers only the usufruct but retains ownership and corresponding rights and responsibilities throughout the period of Ijarah. At the end of Ijarah period the asset reverts back to the lessor (owner), who can either lease or sell / gift it to the same person or a different person through a separate contract or gift deed.

Investment or sharing modes are based on the principle of sharing in the return earned by the business jointly sponsored. Mushraka or full partnership gives the bank the right to take part in the management for example by taking representation on the board of directors. This right can be waived also. In Mudaraba financing, the bank (as rabulmal) entrusts funds to the entrepreneur who manages the business. Appropriate safeguards are available for the financial interests of both parties. For example the bank who delegates managerial decision-making to the entrepreneur can monitor his performance and in case the entrepreneur violates the mandate can take corrective measures such as cancelling the Modaraba contract and assuming control itself.3

A further extension of PLS financing is equity financing. However before taking a financing or investment decision the IB has to evaluate the stock against sharaih compliance criteria which requires that the main business of the investee / financed company should be shari’ah compliant, its asset and liability structure must fulfill some 3 For details see Shaikh, 2017



requirements to ensure that the target company is not involved in the receiving or paying of interest as a major activity. The relaxations are subject to disapproval at the AGM. The CBs have no such restrictions. They can finance any project or invest in the shares of any company subject to their formal business assessment.

3. Comparison of financial intermediation process The purpose of presenting an overview was to highlight the differences between the

two models. Table 2 provides a summary while these differences are explained below.

Table 2 Financial Intermediation

Islamic bank Conventional bank Basis of intermediation

Takes funds u/n modaraba and invests in income generating real assets.

Borrows funds from depositors and lends creating monetary assets.

Type of income and its sharing with depositors

Actual profit / loss of the portfolio is shared with the depositors. Principal is not guaranteed.

No sharing. Depositors get interest as per contract. Independent of the income of asset portfolio. Principal is guaranteed.

Relation with parties and role of the bank

Investor/investee or buyer/ seller. Bank is investor or trader on asset side or manager of funds on liability side.

Debtor/ creditor on both sides. Role is to deal in money and monitory assets

Financing Risk Depends on the asset portfolio PLS assets involve Investment risk while FI assets involve credit risk

Credit Risk in the entire portfolio.

Basis of financing Profitability is the main criteria.

Collateral and credit-worthiness is main criterion

Securitization Of asets

Limited possibility subject to conditions

No limit

Liquidity mgt No Borrowing / lending Allowed

3.1 Basis of intermediation Conventional banks borrow funds from depositors and lend to borrowers which

may not necessarily create new assets. Islamic banks take deposits under a Modaraba contract and invest these funds in income generating real assets as explained above. As a result the system is based on real assets instead of monetary assets. Money is used only as payment mechanism.


3.2 Type of income and its sharing with depositors

An Islamic bank does not earn interest but earns either a trading profit or a share in the actual profit/loss on investments. The overall net profit of the asset portfolio is shared with the depositors based on a predetermined profit sharing ratio. In case of loss the depositors share the loss in the proportion of deposits. This shows that the income of the asset portfolio will have a direct bearing on the income to be distributed to depositors and hence the rate paid to them. The principal is not guaranteed---an important difference between the two.

In case of CBs bank earns interest at a contracted rate which is not shared with the depositors who get interest at a contracted rate. The principal is guaranteed.

The above methodology forces IBs to be more careful in portfolio structure and efficient in decision making which would result in better allocation of economic resources.

3.3 Relationship b/w parties and role of the bank. In a conventional set up the relationship between the parties is that of a debtor and

creditor. However the contracts on either side are independent of each other and the default on asset side cannot be forced on the liability side except in case of bankruptcy.4 The role of the conventional bank is to deal in money and monetary assets. In case of Islamic Bank the role is different. While raising deposits the bank and depositor acts as fund manager and investor respectively. The Bank becomes an investor in case of PLS financing and trader / creditor in case of sale based financing. Therefore it can be forcefully argued that the assets created out of the deposit portfolio belong to the depositors who actually take the risk in these assets. Likewise the deposits (except the current accounts) are not the liabilities of the bank but funds under management. Therefore in reality neither the deposits are liabilities nor do the assets belong to the bank. At best we can call these as defacto assets.

3.4 Financing Risk Financing risk depends on the quality of asset portfolio. In case of CBs it is all

credit risk which is a function of the borrower’s ability and credit worthiness. Being collateral based the repayment is mainly influenced by its value, which is usually depressed being a distress sale and also due to deterioration in its quality over time. Therefore in spite of the loan being contractually guaranteed, credit loss can occur to the bank.

Loan defaults adversely affect bank’s overall performance. An asset portfolio loss in the short run may not force the bank to default but larger defaults and /or losses in other activities of the bank may force the banks to declare bankruptcy and consequently default on their debt obligations including obligations towards depositors. In practice the regulators and Governments try to safeguard the depositors and in many cases are able to prevent the failure of the banks, of course at the cost of tax payers’ money.

4 This form of intermediation is different from general intermediation such as a stock broker

who facilitates transactions by bringing together the buyers and sellers of stocks for a fee.



The risk profile of IBs is not only different but diverse in nature in line with the asset portfolio structure. In case of PLS financing the bank assumes investment risk5. The profit or loss of the business will be immediately absorbed by the asset portfolio of the bank affecting its income and consequently the return to the depositor requiring the financing decision is to be based purely on financial and economic viability rather than the collateral being offered. Although a more ideal method, currently banks’ lack of capacity and unpreparedness has resulted in a significantly lower proportion of PLS assets in the asset portfolio of IBs.

Sale based financing is fixed income (FI) in nature involving credit risk which is similar to the risk in the collection of the credit sales by business houses. However it is different from loans of conventional banks which do not face a risk of lower return on their loans in case of delayed payments whereas the IBs face the risk of lower return because the sale price of goods sold does not vary with the time of payment. This difference between fixed income and fixed rate financing notwithstanding, the IBs still consider credit risk more manageable than PLS risk.

To balance financing risk, the Islamic banks are structuring their asset portfolio with a greater proportion of fixed income assets. However since timely payment of sale price is important, they still have to give due weightage to profitability / cash flow of the financed firms in their decision making process, to ensure proper deployment of funds. Therefore collateral and credit worthiness cannot be the sole criteria even in case of fixed income instruments.

For similar reasons IBs will have to start recovery proceedings comparatively earlier. In this case the deterioration in the quality of collateral will be less thus improving recovery and reducing depositors’ risk.

3.5 Basis of Financing Profitability is the criteria for IBs. In case of PLS financing it cannot be otherwise.

In case of collateral based trade modes, profitability criterion is equally important. For CBs, collateral and credit-worthiness is the basic criterion and importance to profitability and business viability is less.

3.6 Securitization of assets The securitization of asset portfolio or its parts is possible only in case of illiquid or

a specified mixture of illiquid and liquid assets and subject to certain rules. In case of CBs there are no similar restrictions.

3.7 Liquidity management IBs cannot borrow funds but there are some alternate methods such as

securitization of assets to raise money, special murabaha and salam contracts between

5 Cash flow based method of lending used by modern conventional banks in project financing

also uses financial and economic viability as criteria. Collateral is taken but it is not the basis of decision making for financing. However the relationship is still based on credit rather than PLS.


banks for raising and providing money etc. More research is under way to find better alternatives.

3.8 Fee based services Like conventional banks Islamic banks can also provide fee based services such as

consultancy and advisory services, money transfers, debit cards and ATMs, etc.

4. Fundamental characteristics Based on the above discussion of the Financial Intermediation process few

fundamental characteristics of the Islamic financial system emerge.

4.1 Asset-based financing: The conventional system deals in money and monetary assets. Interest is a time

based charge for the use of money. There is no requirement for the creation of assets while granting or disbursing loans and therefore no sale / purchase or investment / partnership contracts are required

The IBs do not earn on monetary assets but put these assets in productive use which induces efficiency. Cash can only be disbursed when there are real contracts for sale and purchase of goods such as Murabaha / salam / istisna or partnership contracts such as Modaraba / Musharaka for a real business activity.

4.2 There has to be an element of risk other than credit risk Assumption of risk in a business, property or a transaction is necessary in order to

justify profit. For example in Murabaha financing ownership risk must be assumed by the seller (bank) before sale of goods to a buyer (customer)

4.3 Product development follows shariah principles Product design is based on valid contracts with some structural requirements for

example a financing product using credit Murabahah should fulfill all requirements of a credit sale as well as Murabahah. In addition there are few minimum requirements which must be met by every contract such as free consent of parties, full disclosure of information forming the basis of consent of the parties and avoidance of Gharrar ensuring that decision by either party is a fair business judgment.

4.4 Wide scope for product development The diversity in the financing methods described above indicates that IBs can

develop a large number of financing products using different contracts and their combinations making IBs superior as compared to CBs who have only one contract i.e. a loan on interest which is used in different forms to generate different products. Thus the impression that IBs have limited product choices may be incorrect.6 A wide choice for 6 PLS contracts are not presently in much use and therefore the product choices will increase

when the banks increase the use of these contracts to a reasonable level on the asset side.



product selection also provides a tool for risk diversification in addition to the conventional method such as portfolio dispersion among economic sectors, per party exposure etc. practiced by both types of banks.

4.5 Stability IBs are able to transfer losses in asset portfolio to the depositors which induces

stability whereas in case of CBs the asset portfolio losses cannot be transferred to depositors inducing instability which further aggravates with the compounding of deposits usually not done in case of advances.

4.6 Shariah Compliance Besides the prohibition of interest, Islamic banks have to operate within the

boundaries set by shariah under divine guidance. Thus, all dealings, transactions, business approach, product features, investment focus and responsibility must be derived from Shariah law. A shariah governance system (SGS) is needed to ensure shariah compliance.

5. Management and Regulation of Islamic Banks. The methodology, contracts and products used by IBs being different than the CBs,

it calls for a different system of governance, risk management and regulation. Therefore IBs require different organization structures and manpower with different skills and training. The Central Banks also have made separate rules for regulation and supervision of IBs and have established SGS which is supported by the Accounting and Auditing Association of Islamic Financial Institutions (AAOIFI)’s shariah and accounting standards.

6. Issues in maintaining the differences The discussion above clearly explains that IB model is different than the

conventional model. However the issues which usually create doubts about its legitimacy are discussed here.

6.1 Product Features and Packaging One important issue is partial similarity in product features and packaging which is

partly by default. For example in a Diminishing Musharaka progressive purchase of bank’s investment portion looks like principal repayment and payment of profit or rent looks like interest payment. But there are many structural differences between the two products7. The sale price in a Murabaha is the sum total of principal investment of the bank and its profit or mark up for the intended period of the facility is similar to payment of principal plus interest. This is there by default as the arithmetic for profit or interest calculation cannot be different8. The real issue is method of generation of profit which should not violate any shariah ruling. The SGS requires approvals from Shariah board of the bank and supervision of the contracts from the shariah advisor whose independence is also ensured under the SGS. 7 For details see Usmani 1998 8 For details see Shaikh 2011


However as pointed out by Akhtar (2008) it is mainly due to the present emphasis

on reengineering the existing products as an easy and quick solution which creates this impression that it is only a change of name to disguise it as Islamic. This focus must now shift to develop altogether new products which although may be difficult and challenging and may require lot of research and probably consumer education and awareness9 but is an ideal solution. Coordinated research by IBs instead of treating product development as a proprietary activity will help resolve this problem in addition to increasing outreach and improving market share collectively for all in a market which is mostly under banked. Reliance on the sentiments of Muslims to patronize it by virtue of being Islamic should be reduced.

6.2 Market Practices of IBs The financing products used by IBs are mainly based on the contracts of Murabaha

and Ijarah. The share of PLS products is negligible. This is despite the fact that PLS financing has many advantages. For example financing on the basis of profit and loss sharing gives maximum weight to profitability of the investment which reduces the chances of failure and thus enables the financial system to work smoothly. The reasons for FI financing could be many including lack of capacity and unpreparedness for assuming PLS financing risks, the unwillingness of business firms to share profits, the simplicity and the comfort level of the bankers with FI financing, the risk relating to return on the deposits and risk of loss to the asset portfolio. Islamic bankers seem to ignore the criticism on account of an apparent similarity with conventional products on the grounds that FI sale based products also involve charging of profit which is in consideration of taking the ownership and related risk of loss to the asset during the period of ownership till the ownership is transferred to the client (purchaser) but not in consideration of the financing provided by deferring the sale price as a debt although to maintain competitiveness with conventional banks the rate of profit may be in line with interest rates charged by conventional banks. Besides that the profit charged by Islamic bank is one time and not time related as compared to the interest charged by a conventional bank. In case of delayed payments IBs face a reduction in ROR whereas CBs will maintain their rate by continuing to charge interest.

6.3 Financial reporting International accounting standards are meant for interest based transactions and

cannot be used by IBs. They will not portray correct picture of the transactions (Hidayat, 2011). Presentation of profit and loss account and balance sheet is in a format similar to CBs in Pakistan.

As pointed out earlier, treating deposits as liability and corresponding assets as bank’s assets does not disclose true picture. Neither the deposits are the liabilities of Islamic banks nor do the assets created out of the deposit pool belong to the IBs.

9 According to one branch manager of an Islamic bank whom this author spoke to, it was his

first experience in his ten year career someone asking about wightages and methods of profit distribution. Almost everyone signs the contract (account opening form) without reading, a practice in vogue with the customers of conventional banks as well.



Therefore financial reporting needs more improvements. Interbank comparisons are necessary but these should be amongst Islamic banks. Compare apples with apples.

The return paid to depositors is also treated in the same way to calculate spread as done by conventional banks which is also incorrect. This has forced a comparative trend with CBs and the profits distributed by Islamic banks tend to be in line with the interest rates paid by the conventional banks. The interest rates paid by conventional banks can vary according to changes in policy rate and / or money market rates but the profits distributed by Islamic banks should not vary in the same way because the financing contracts will have some term and the return earned by the banks will not vary instantly. The changes could be possible only by simply varying profits distribution ratio between the bank and depositors which should be avoided. Rather in case of declining money market rates if the rates of profits are maintained in line with actual earnings it will provide good signals to the market players and increase confidence.

6.4 The legal frame work and HRD Besides financial reporting, evolution of corresponding legal frame work to fit the

new role of IBs is also essential to maintain the difference. Equally important is HRD issue. In the beginning the IBs had to rely on the available manpower in the conventional banks and retrain them. Although an organized effort has been started which includes various educational programs at universities and specialized training programs by banks themselves, the numbers lag behind the requirements.

7 Findings The important contribution of this paper is the presentation of a working model of

an Islamic bank and its comparison with the conventional model to show different working methodology and the new role an IB has to assume as a trader and an investor rather than simple financial intermediary to deal in money and monetary assets. The paper has also identified strengths of the Islamic system such as better risk management and possibility of multiple product packages by using a variety of Islamic financial contracts thus dispelling the impression that Islamic Banks have limited scope for product offering. The paper has also highlighted various issues facing the IB industry with respect to portfolio structures, product differentiation with conventional set up, legal and regulatory framework, human resource development and financial reporting which need to be solved.

8. Conclusion Notwithstanding some issues in portfolio structures, product differentiation and

financial reporting the two models are distinctly different from each other. The difficulties or handicaps must be removed. Organized and coordinated research in product development and joint market penetration strategies will help increase overall market share and acceptability and will benefit the IB industry as a whole.


References 1. Akhtar, Shamshad., 2008. Authenticity and Innovation-A regulator’s perspective.

In: Harvard law school, key note address. Harvard, Aril 20, 2008. Available at www.sbp.gov.pk accessed, August 23, 2008.

2. Bank Islami Pakistan, 2004. Product brochures. Karachi: Bank Islami Pakistan.

3. Faruqi, Shakil, 2001, Glossary of banking and finance 2nd edition, State Bank of Pakistan, 2001.

4. Hidayat, Sutan Emir, Challenges in applying conventional international accounting standards for Islamic finance, University college of Bahrain, 2011.

5. Meezan Bank Ltd: Deposit Product Training Module Version 1.1 Release Date: Rajab 14, 1426 H / September 30, 2005.

6. Shaikh, Muhammad Ali, 2011, Contemporary Islamic Banking: the issue of Murabahah, Islamic studies, 50:3-4 (2011) pp.435-448.

7. Shaikh, Muhammad Ali, 2017, Modaraba: An option for project financing, journal of Islamic Banking and Finance, 34:2 April- June, 2017. pp 74-87.

8. Usmani, Muhammad Taqi., 1998 1st edition, An Introduction to Islamic Finance, Idaaratul Maarif Karachi Pakistan.

9. Usmani, Muhammad Imran Ashraf., 2001 Shirkat wa Muzaribat asr e hazir main. Karachi: Idaratul Ma’araf.

10. Usmani, Muhammad Imran Ashraf., 2002 Meezan Bank Guide to Islamic Banking. Karachi: Daarul Ishaat.



Understanding Islamic Banking: The Perception and Thoughtfulness of

Customers about Islamic Banking in the Context of Balochistan

By Jameel Ahmed

Safia Bano, Lubaina Dawood

Abstract Islamic banking systems have been established and getting popularity not only in Muslim majority countries (Bahrain, Malaysia and Pakistan) but also in non-Muslim countries such as UK, France, China, Singapore (Ariff, 2014; Shahzad etal, 2014). The growth of the Islamic banking system is highly influenced by different factors such as level of customer awareness, acceptance patterns, religious perception, and/or preferences and economic system (Salehi and Khaksarastaneh, 2015). The aim of present research is to explore the level of understanding among customers of Islamic banking in Quetta-capital city of Balochistan. As the inclination of Islamic banking throughout the world is increasing day by day, but the growing trend of Islamic banking does not signify that people do have complete information and understanding of the basic principles of Islamic banking. Present inquiry is informed by qualitative research approach and nature of study is inductive. Qualitative interpretive tradition allows the study to construct the knowledge by including the voice of subjects of this study. In this regard semi-structured interviews were conducted from a sample of twelve account holders of Islamic banks (operating in Quetta), containing the questions relevant to the basic concepts and the functions of the Islamic banks. The results indicate that citizens are interested to be a part of Islamic banking due to religious factor, personal interest, personality

Authors: Jameel Ahmed& Safia Bano are Assistant Professors, University of Balochistan,

Quetta. Lubaina Dawood is a Lecturer, Sardar Bahadur Khan Women’s University, Quetta. E-mail: [email protected]


influence, reference groups, contribution to social welfare, faith in its name “Islamic banking” and trust in “Shariah board” (governing its functions) but these factors do not indicate the understanding of customers regarding basic principles of Islamic banking.

Keywords: Islamic banking, customer understanding, Islamic financial, Balochistan.

Introduction: The system of Islamic banking is in line with the spirit, ethos and moral standards

of Islam. It is governed by the principles of Shariah. Islamic banking not only avoids interest based transactions but it also discourages unethical and unsocial practices. Practically, it transforms the money lending component of conventional banking into transactions which are based on real assets and services (Ahmad and Shabbir, 2009).

Day by day the inclination of Islamic banking is increasing around the globe. This significant achievement of Islamic banking is the realization by the Muslims that the teachings of Islam should not be limited merely to the one aspect of life but should also extend to the other branches of life particularly with respects to financial issues. Due to the lack of clear perception regarding rules and principles of Islamic Shariah, there are some points of weaknesses in the operation of Islamic banking (Usmani, 2008). So it is necessary not only for the employees of Islamic banks to attain knowledge about different Islamic contracts used by their Islamic banks, but also for the customers to have knowledge of basic principles of Islamic banking. At this time, the customers of Islamic banks have inadequate understanding of transactions which would result in invalid transactions because of the blunders of customers. The growing trend of Islamic banking does not indicate that people do have complete information and understanding of the system of Islamic banking. Having said that, the objective of this study is to determine the level of understanding about the Islamic banking among its customers.

Literature Review: This section provides a detailed account of the concepts, scope and principles of

Islamic banking around the globe in general and specifically in Pakistan. The transactions involving interest/riba, element of gharar, maiser and any other invalid operation which is haram in Shariah, cannot be considered as part of Islamic banking. This is because the philosophy of Islamic banking is based on Islamic law i.e. Shariah (Iqbal and Mirakhor, 1987).

Philosophical Foundations of Islamic Banking The Islamic banking system derives its principles from the Holy book of Muslims

i.e. Quran and Sunnah of Holy Prophet Muhammad (Peace Be Upon Him) (Khan, 2008). The Islamic banking system is not only refraining from interested-based transaction but also is a part of overall Islamic value system. The aim of Islamic banking system is to fulfill the socio-economic objectives of society by making positive contribution in all fields such as trade, agriculture and other industries. An Islamic bank operates according to the Shariah as set by Quran and Sunnah (Siddiqui, 2008).

Understanding on Islamic Banking: The Perception …….


Prohibition of interest (riba) is one of the fundamental principles of Islamic banking. In Islam, interest is forbidden in all forms and intent. This prohibition is explicit and strict (Siddiqui, 2008). There are many verses in Quran which explicate the viewpoint of Islam on interest. It is stated by Almighty Allah on different places in Quran that:

“And whatever Riba you give so that it may increase in the wealth of the people, it does not increase with Allah” (Surah Ar-Rum, verse 39)

“O, believers, fear Allah, and give up what is still due to you from the interest (usury), if you are true believers” (Surah Al-Baqarah, Verse 278).

“If you -do not do so, then take notice of war from Allah and His Messenger. But if you repent, you can have your principal. Neither should you commit injustice nor should you be subjected to it” (Surah Al-Barqarah, Verse 279).

“And because of their charging Riba, whilst they were prohibited from it” (Surah Nisa, verse 161).

“O those who believe do not eat up Riba doubled and redoubled”. (Surah Aal-e-Imran, verse 130)

The following verses of the Holy Quran are revealed to prohibit simple interest (Sood-e-Mufrid) and compound interest (Sood-e-Murakkab) which are the two components of Riba an Nasiyah:

“O believers, take not doubled and redoubled interest, and fear God so that you may prosper” (Sura Al ‘Imran, verses 130-1).

The interest is not prohibited only in one religion, Islam. There are other major religions such as Christianity, Judaism and Hinduism which have also prohibited interest. It is strictly forbidden in the Bible which does not make any distinction between interest and usury1. It recognizes the people who take interest as wicked2. According to the Third Lateran Council (1179), ‘could not be ‘admitted to communion or receive Christian burial’3.

There is explicit message about prohibition of interest (usury) in fifth book of Herbrew Bible and of the Old Testament that is:

“Thou Shalt not lend upon usury to thy brother; usury of money, usury of victuals, usury of any thing that is lent upon usury” (Deuteronomy, 23:19).

There are several other references in the books of other major religions (for example Exodus 22:25, Leviticus 25:35-36, Deuteronomy 23:20, Psalms 15:5, Proverbs 1 For the Babylonian, Jewish and Christian views on interest, see, Johns, et.al. in Hastings,

Vol.12, pp. 548-58; and Noonan, 1957, p.20. For the Hindu view, see Bokare, 1993, p.168. 2 See the Bible - Ezekiel, 18:8, 13, 7; 22:12. See also Exodus, 22: 25-27; Leviticus, 25:36-38;

Deuteronomy, 23:19; and Luke, 6:35. 3 Johns, et.al, p.551


28:8, Nehemiah 5:7 and Ezekiel 18:8, 13, 17 and 22:12) which provide sufficient evidence about prohibition of interest:

It is stated in Leviticus that “Do not take interest of any kind from him, but fear your God, so that your countryman may continue to live among you.” (Leviticus 25:36).

Similarly, Exodus revealed that “If you lend money to one of my people among you who is needy, do not be like a moneylender; charge him no interest” (Exodus 22:25).

According to the verses dedicated to interest in Holy Quran, the definition of interest can be inferred as ‘any excess paid or received on principle is called interest’. In Islam, any capital advanced on loan basis must be repaid without the any excess amount. The lender can only receive return on his capital if he/she invests funds in purchasing equity share in a business venture or share losses, risks and rewards of the business. Therefore, in Islamic banking system, money flows to those projects which are more viable irrespective of those projects which have greatest collateral. This ensures equal distribution of wealth in society and increase in economic growth (Usmani, 2005).

On the contrary, in the capitalist system, money has an unrestrained right to a return regardless of the level of profit or losses generated by the project. The capitalist system relies on the ‘money role of commodity’. Therefore, capital flows to those projects which have greatest collateral (Usmani, 2005).

Under Islamic banking, profit can be generated via dealing in difference currencies or when any asset having intrinsic value is sold for money. Profit generated via dealing in money of the same currencies or on behalf of papers is interest (Usmani, 2007).

According to Rahman (2007), the Islamic bank is based on the following key principles:

(i) Prohibition of interest-based transactions.

(ii) Prohibition of economic activities which involve oppression.

(iii) Prohibition of economic activities which involve speculation.

(iv) Obligatory payment of Islamic tax (zakat)

(v) Restriction on production of goods which are in contradiction of Islamic value (Haram)

Islamic Financing In Shariah, Musharakah (Mutual Participation Financing) and Mudarabah

(Participation or Trust Financing) are the real and ideal instruments of Islamic financing where profit is earned without charging interest (Iqbal and Mirakhor, 1987; Usmani, 2007). Musharakah is the mode of financing based on equity participation, in which associates jointly share capital to earn profit. In Musharakah, partners share profits or losses in accordance with some agreed formula depending on equity ratio (Arif, 1988).



Another legitimate mode of financing is Mudarabah, in which financial capital is provided by the one party while the other party (entrepreneur borrower) offers the human capital i.e. ideas and expertise in order to undertake economic activity (Iqbal and Mirakhor, 1987). The party providing the financial capital shares the profit, if any, with the entrepreneur borrower, while bears the loss entire himself (Arif, 1988). It is obligatory to convert the money contributed by the financier on behalf of these two instruments into the assets having inherent value and profit is earned as result of sale of these assets (Usmani, 2007). Mudarabah is valid for the short term commercial activities while Musharakah is applicable for long run production and commercial activities (Iqbal and Mirakhor, 1987).

Salam and Istisna’ are the other two permissible modes of Islamic financing which also create real assets. Ijara (Lease Financing) and Murabahah (Cost-Plus Trade Financing) are not the original and ideal modes of Islamic financing. However, with subject to certain conditions, these are restructured to be used as modes of financing in areas where Musharakah, Mudarabah, Salam and Istisna’ are not applicable (Usmani, 2007).

There are four basic principles on which Islamic commercial law is actually based. The profit and loss sharing is the fundamental of Islamic business principle, the second is about fixed service fees and charges while third is based on free of cost and no charges. The other principles are conditional which varies with the situation of the business and its operation (Bellalah and Ellouz, 2004). Musharkah is a type of contract in which the bank and the entrepreneur contribute mutually to the capital of a project with profit motive. Profit and losses are shared between the parties on agreed term and condition of the contract. Mudarbah is a contract where the bank is responsible to provide all the capital while the other partner contributes efforts, specialized skills and experiences. The bank receives a predetermined ratio of the profits. While in the case of loss, the bank bears all the financial loss and the manufacturer remains unrewarded (Rob, 1992). So this system encourages the individual to contribute in financial activity and prove himself as an active part of society. The third principle and the free charges among the principles within the fixed charges category is Murabaha. This is a contract in which the bank informs the business person about the acquisition cost of a good and negotiates about the profit margin. In Islamic banking system it is one of the most popular modes used in different countries to promote interest-free transactions. The Bai-mua’jjal (deferred payment sale) is a deferred payment sale contract which is traded without any surplus costs. The Ijara (Leasing) is a contract in which the owner of the good rents it to another party. After that the client can purchase it and rent is reduced until the good become the possession of the client (Bellalah, and Ellouz, 2004). Nowadays Ijarah is very famous and considered a successful tool in islamic financial system, as the home Finance and Islamic mortgage are based on the concept of Ijara. In Quard Hassana the customers who are facing financial problems or unexpected expenditure approach banks who provide welfare loan without paying any fees or interest (Peter, 1992). According to Rob (1992), In Islamic banks funds can be raised through sale of shares to general public and also from three main deposit accounts such as investment deposits, saving deposits and current deposits.


Two decades ago Islamic banking appeared as a prominent player on the world

forum. Nevertheless many principles of Islamic banking system have been generally accepted all over the world for centuries rather than decades (IIBI, 1990). Islamic financial system existed in Muslim community in different forms according to situation. In fact Islamic financial system fulfills the requirement of society ina respectable way. Islamic banking is a growing sector with its multiplicity in diverse segments and spectrum. It caters to religious Muslims in Muslim’s societies as well as in countries where Muslims are in minority. In addition, it is a broad standard: non-Muslim individuals and communities that seek ethical financial solutions have also been attracted to Islamic banking. It is obvious from banking practice that Islamic banking is equally popular in all communities (Amanah, 2014).Islamic banking is not limited only to the Islamic nation but in fact it is a system that offers more ethical and moral concept of financial matters as well as it is useful to create a peaceful, economically prosperous and healthy society. Even though Islamic banking is very eminent in Muslim and non-Muslim communities and it is a system with complete financial and economic solution but still Islamic financial and banking system is not well organized in most of the countries. It is facing the challenges of lack of fund management and proper institutional setup to run this infant system. Comparatively the conventional banking system has strong financial and institutional network in all Muslim and non-Muslim countries.

The idea of Islamic banking is still a hot issue these days all over the world. Either completely new Islamic institute are emerging or recent traditional banks are opening additional branches focusing in Shariah-based financing products/services. But still clientsare uncertain that is it really Islamic banking?

Historical context of Pakistan’s Islamic banking: Pakistan has adopted the Islamic banking system since 1980s. Since then, different

Governments in Pakistan made amendments in the Banking Companies Ordinance, 1962 (BCO’62) and related laws and regulations to provide place to non-interest based banking system (BCO’62) that is strictly monitored, too .The two Government-owned mutual funds in Pakistan namely NIT and ICP, started to invest their funds in non-interest bearing securities. By this they attempted to get rid of interest from their operations. As from October 1, 1980 ICP’s investor’s scheme was substituted by new plan. The new plan applied the principle of profit and loss sharing. In addition, interest was also eliminated from the operations of the House Building Finance Corporation (HBFC) from July 1, 1979. In June 1980, a new interest-free instrument for corporate financing called Participation Term Certificate (PTC) was approved through amendment in the legal framework. A new law (i.e. the Modaraba Companies and Modarabas Ordinance, 1980 along with the Modarba Companies and Modarba Rules, 1981) was publicized to initiate Modarabas, as a two-tier fund structure, for undertaking Shariah compliant businesses.

The Banking and Financial Services Ordinance, 1984 changed several laws in 1984. As a result of these changes banks were required to adopt non-interest mode of financing and mobilize their deposits on profit and loss sharing (PLS) patterns. Since 1985, govt. at national level is directing both public and private companies for the issuance of interest free mode of financing. Therefore, mostly the commercial banks in Pakistan adopted interested free mode of finance. This interest free mode is called profit



and loss sharing (PLS) deposit which is dramatically roseisen from 9.2% at the end of 1981 to 61.6% by end of 1985. (ALM Abdul Ghafoor, 1995). After achieving certain limits of rise, PLS stopped growing due to lack of implementation and practices of commercial banks and financial institutions. To handle this situation the Federal Shariah Court challenged some emerging products and processes and offered new directions in this regard to eradicate the challenges. Now there are 4 full-fledged Islamic banks (Meezan bank, braches with overall 1200 branches are working in Pakistan (SBP, 2014).

It is observed that Islamic baking in the country has higher growth rate over conventional banks which is encouraging and it is expected to go higher in the future too. Particular attention needs to be paid by the Pakistani Government in changing the society perception about Islamic banking. Society views that there is not any difference between traditional and Islamic banks expect their names. Instead of word of interest, Islamic banks are calling it Profit and loss sharing (PLS) to attract the public. Therefore, main focus should be on this burning issue that how can we create awareness between both prevailing banking systems in the country.

Research Methodology: The aim of this paper is to examine the level of understanding of Islamic banking

among the customers of Pakistani Islamic banks. The researchers attempt to examine the basic knowledge about Shariah principles on which Islamic banking is based and to analyze the clarity of different modes of financing and offerings of Islamic banks among the customers. This inquiry is qualitative in nature and attempts to explore how people feel and what they think on any specific topic. The qualitative method is a type of research that emphasizes the quality of meaning in consumer perceptions and behaviors.

The researchers conducted an exploratory study as it is a valuable means of finding out new insights, to ask questions from customers and to examine their level of understanding and to assess phenomena in new light (Robson, 2002). It is particularly useful because the researchers wish to clarify the understanding of a problem (Saunders, 2003). The researchers have undertaken a study that includes an exploratory element; therefore researchers included qualitative interviews in research study.

Semi-structured interviews are used in this research study in order to conduct discussions not only to reveal and understand the level of understanding among customers about Islamic banking but also to exert more emphasis on explaining why people have lack of knowledge regarding different products and modes of financing (Saunders, 2003). An interview guideline was designed which contains specific interview questions relating to the level of understanding of customers about Islamic banking and its products. Also questions distinguish Islamic banking and its products with conventional banking. In addition, semi-structured interviews are used to explain and explore themes that have emerged from the use of researchers’ interview guideline (Wass and Wells, 1994).

A semi-structured interview can allow for the flexibility that may be well required. Moreover, semi structured interviews provide researchers with the opportunity to “probe” answers, where researchers want interviewees to explain and build on their responses. It also affords the interviewees an opportunity to hear their self “thinking aloud” about


mechanism of Islamic banking that they may not have previously thought about. (Saunders, 2003). However, research based on semi-structured interviews will not be able to be used to make generalization about the entire population where it is based on small and unrepresentative number of population. We conducted interviews with few of customers of Islamic banking to investigate their understanding about Islamic banking. (Yin, 1994).

For the purpose of this research, the researchers focused only on educated customers of Islamic banks who have already attained their postgraduate degrees like masters in any relevant area. This is because the educated customers can use all possible means, be it books, e-books, discussion with religious scholars and so on, to enhance their knowledge regarding Islamic banking and its products. The researchers conducted semi-structured interviews from 12 customers of Islamic banks who were conveniently available. The convenience form of sampling is most often used during exploratory research study and is the best way of getting information quickly and efficiently

Findings: The aim of paper is to determine whether the customers of Islamic banks have

understanding of the fundamentals of Islamic banking or not. Lack of awareness and level of understanding are major constraints in the development of Islamic banking system, products and market. There are plenty of constraints in creating understanding about Islamic banking among its customers. During interviews for the study the researcher asked several questions about basic principles of Islamic banking from participants to determine their level of knowledge about Islamic banking system, prevention of interest, Halal and Haram transactions, Shariah principles and its religious and ethical concepts.

As the corner stone of Islamic banking system is not only its interest free financing; number of other factors are involved to establish a proper Islamic banking system that is in compliance with Islamic laws and shariah principles. It is observed that as a minimum six principles are to be taken into consideration while executing any Islamic transaction; but most of the customers have information about two or three of these like it’s an interest free system and involves Halal transaction and they have no other information about other basic elements of the system.

“Islamic banking is free from interest and according to shariah.” Respondent A: A1-ppendix1

“Islamic banking is halal banking and its interest free banking”. Respondent E: A5-ppendix1

Customers are aware that this system is backed by Shariah principles, and Shariah board is responsible for the proper execution of its transactions; but they do not know what it’s basic elements are and what these principles are. People believed that Shariah Board governs its functions so it is purely Islamic. Furthermore, customers who are interested to investigate the fairness of its functions, visit the bank employees. But the bankers themselves didn’t have adequate knowledge and were unable to guide customers.



Some banks provide books, brochers, and other related material to enhance the knowledge of their customers.

“its according to Shariah principles bank provide books, bouchers and other material through which we come to know that it is really Islamic and we are satisfied.” Respondent B: A2-ppendix1

Islamic banking has introduced different modes of financing such as Musharkah, Mudarbah, Istisna and Salam etc: but most of the customers are aware of the two terms Mudarbah and Musharkah and only few of them know about Ijara. Furthermore, they are just aware of their names not about their working mechanism.

“Bank officers tell us about Musharkah and Mudarbah. In Mudarbah customer is investor and bank provides services and profit and loss is shared by 50/50. In Musharkah both the parties invest money and profit and loss is shared by both parties”

Respondent A: A1-ppendix1

“I know a little bit about modes of financing like Musharkah and Ijara.” Respondent H: A8-ppendix1

As profit and loss sharing is the basic principle of Islamic banking, Customers do have an idea that profit and loss sharing is involved in its functions and no rate of return is fixed earlier; but do not know how the funds are being utilized, in which business do they invest and which mechanism is used to distribute the profit and loss among its customers.

“when we opened an account with bank, the percentage of profit and loss was not fixed; and we have no exact information about the rate of return.”

Respondent C: A3-ppendix1

Some people believe that Islamic banking is growing day by day so it’s obvious that it is purely Islamic and it does not show that they have understanding of Islamic banking system.

“Not only in Pakistan other countries are also are opening Islamic banks and this shows its growth. Furthermore, in Britan there is university that has established a separate department for Islamic banking , so it is very obvious that it is working according to Islam.”

Respondent A: A1-ppendix1

The above responses of the research participants show that customers of Islamic banks have idea about the fundamentals of Islamic financial system but they do not have in depth knowledge of its working mechanism. Where it is important for development of Islamic banking that its customers as well as bankers should have complete information of its functions. The customers think that Islamic banking needs to improve information system using alternative techniques to different level of community. Such as holding customer sessions, seminars, workshops, telecasting the programs and documentaries,


publishing articles in newspapers and magazines and providing training to brief them about the mechanism and answer their queries.

Islamic banking has a potential to grow but there is need to educate the people about Islamic banking products and its functions. There is common thing in all interviews that people have not much information about the system.

Conclusion: This research study focused the level of understanding of Islamic banking among

its customers. This element is closely related to development of this new and fast growing financial system. It is concluded from the research that all users of Islamic banking have not clear on understanding about Shariah principles and Islamic financial system. They just know that Islamic banking system is based on the concept of interest free financing. All types of interest are totally prohibited in Islam because it leads the economy toward credit crises. The results indicate that citizens are interested to be a part of Islamic banking due to religious factor, personal interest, personality influence, reference group, and contribution to social welfare, faith in its name “Islamic banking” and trust in “Shariah Board” (governing its functions) but these factors do not indicate the understanding of customers regarding basic principles of Islamic banking. People having information in this regard, received it from officers of Islamic banks but it isa fact that presently the employees themselves don’t understand Islamic banking mechanism and can’t explain different methods of Islamic financing properly. Customers make product or service choices based on which combination of product attributes best meets their needs and on dimensions of value cost and prior satisfaction .So the results of this study show, there is need to develop an effective communication plan that goes beyond just marketing and advertisement to ensure the populace is aware of how Islamic banking products operate. To improve Islamic banking literacy through awareness campaigns and programs such as holding customer sessions, seminars, workshops, telecasting the programs and documentaries, publishing articles in newspapers and magazines and providing training .Institutions need to educate customers to adapt to the new ways of doing banking transactions, and understanding that Islamic finance involves the sharing of both profits and losses. However there are reasons to believe that understanding about Islamic banking among its customers is essential for its growth. This is because a bulk of literature is only focusing on its commercial and economic aspects while explaining its processing occupies back seat.

Finally, on the basis of above finding we can conclude that Islamic banking is growing day-by-day but level of understanding among the customers of Islamic banking regarding its functions is not satisfactory nevertheless with increasing experience, with cooporation of Muslim community and with proper guidance of Islamic scholars, Islamic banking can easily turned this challenge into success.

Limitation and Recommendations: According to the 12 taken interviews it was a stumbling block to get all information

from customers of Islamic banking. As Islamic banking is an emerging system in Pakistan so lack of literature in this perspective is another limitation of our research.



Moreover the relationship between the customer and the banker is confidential, so he is bound by law not to disclose any information about his customers. Therefore we were not provided with sufficient material. And our sample size was also very small that was the major limitation of our research study.

The major issue which is discussed in the Results and Discussions part of the paper, if Islamic banks overcome this challenge than there will be no hurdle in the development of Islamic banking system in Pakistan. As the first source of information for the clients are the officers of the bank; so in-depth knowledge of Islamic banking must be given to the staff of Islamic banking, so that they can convey the information in a proper way. Officers of the bank should encourage and motivate their clients to come and get knowledge about Islamic banking system and also influence them to investigate about the fairness of its functions. To enhance understanding about the Islamic banking the officers of the bank should be well trained about products and the procedures of Islamic banking. Citizens who are really interested to investigate the transactions of the Islamic banking system should acquire clarification on transactions from Shariah advisor or should seek guidance from some reputable and competent scholar who has more knowledge in this field. The banks should advertise their products and its features on television and in newspaper. They should also conduct seminars and workshops in different organizations and educational institution. As it is recognized that Islamic banking attracts a number of customers and is still rising, it is needed to arrange such activities by banks or government to enhance the understanding of customers and eliminate the existing confusions related to Islamic banking system. The cleric of mosques (imam) can be included in this activity to increase the awareness on Islamic banking and it is cost friendly method too. It is only possible if cleric or imam of mosque is trained by the officials. Workshops, seminars and certain marketing strategies can be helpful too to bring the change. Nowadays many Islamic channels are working if they start regular awareness transmission in their programs then it is really helpful to improve the understanding level of the customers.

Suggestions for further research: Present paper adopted qualitative strategy to look at the history and practice of

Islamic banking in Pakistan. In Future mixed approach can enhance the understanding on the issue by including wider number of customers. We also suggest that the further research can be done in the field of Research and development in connection with all necessary arrangements of conceptual understanding of Islamic finance and banking in Islamic financial sector in general and its impact on economy as a whole. Implication of this paper are worthy for both practitioner and academics. It would help to understand what the embedded constraints are in the current Islamic banking system that make it less successful in the economic system.

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Risk Management & Performance of Islamic Banks: Using Income of Mudharabah &

Musharakah as Moderator By

Vatimetou Mokhtar Maouloud * Ghazi Zouari

Anwar Hasan Abdullah Othman

Abstract: Risk management in banks is a crucial issue, especially in Islamic banks. This study

seeks to examine the impact of the incomes of Mudharabah and Musharakah on the relationship between risk and performance, which is measured by ROAA. This study employs unbalanced panel data regression analysis of Ordinary Least Squares method, from 16 Islamic banks from different countries over the period 2012 to 2015, which was processed by the software Stata-13. The results show that the income of PLS products (Mudharabah and Musharakah) has a moderating effect particularly on the relationships between performance and liquidity risk, and operational risk. However, it has no moderating effect on the relationship between performance and market risk. This study helps to enrich the literature with new models that can help bankers and Islamic finance students to get ideas and make relevant decisions in terms of investment.

Key Words: Bank Performance, Mudharabah, Musharakah, Islamic Banking.

1. Introduction The advances in financial engineering and some changes in the economics have

facilitated the development of financial products that integrate the requirements of Islamic finance. Because of their unique presence, Islamic institutions are recommended to apply rigorous systems to identify and manage the risks that they encounter. Islamic banks * Authors: Vatimetou Mokhtar Maouloud, A PHD student in Finance at the faculty of

Economics and management of Sfax, Tunisia. Email: [email protected] Ghazi Zouari Associate, Professor at the faculty of economics and management of Sfax, Tunisia. Email: [email protected] Anwar Hasan Abdullah Othman, Post-Doctorate researcher in the International Islamic University of Malaysia. Email: [email protected]


usually take more risk than conventional banks because of their lack of experience and lack of familiarity with all the new financial instruments.

Indeed, risk management has become a central and transversal function in Islamic and conventional financial institutions. It is a method for identifying, measuring, monitoring and managing the various risks faced by a financial institution, regardless of whether Islamic or conventional. This leads one to say that the effective risk management is a way for better performance.

This paper attempts to respond to the questions of bankers in terms of risk management of PLS (profit and lost sharing) products and performance, which form the major concerns of the Islamic banks. It has focused on the effect of the income of Mudharabah & Musharakah on the relationship between the risk and performance. To do this and within the framework of a hypothetical deductive approach, we try to answer the following problem:

Can revenues from participatory products (Mudharabah and Musharakah) moderate the relationship between the performance and risks of Islamic banks?

The main contribution of this paper is to study the relationship between risk and performance using the income of PLS products, and see whether this latter affects this relationship or not.

The remainder of the paper proceeds as follows: the next section introduces an over view of the literature, and then the model and methodology are provided in Section 3. Section 4 provides the main results. And finally, Section 5 is concludes.

2. Literature Review Iqbal and Mirakhor (2009) pointed out that ”the risk may be due to the failure of a

bank in its management, neglect in the management of companies and in compliance with contractual obligations, and also the weakness of the internal and external institutional environment including the legal framework, when banks cannot implement their contracts.”

Smith, (1995) and Schroeck, (2002) showed that there is a strong relationship between risk management and the profitability of Islamic banks.

As Islamic banks are newly established institutions, they face an operational risk that arises mainly from the lack of qualified personnel capable of effectively conducting Islamic financial operations. Moreover, the special character of Islamic banks means that the computer decision support tools in the market are not useful for Islamic banks because they are designed for conventional banks. This makes it possible to add a new type of risk related to the use of information technology at the level of Islamic banks.

Islamic banks offer financing under the principles of profit sharing and risk with their depositors. As such, investment risk arises from investment choices, since by investing in capital, the bank incurs the risk of a loss of its contributions, which it shares, with its depositors.


Bashir (2000) and Habiboullah (2009) found a positive relationship between bank

liquidity and profitability. Berger (1995) showed that the liquidity risk has a positive impact on the ROA.

Kasman et al. (2011) have studied the impact of market risk in emerging countries. They have found that market risk has a significant effect on the profitability of banks. According to Srairi (2009), Islamic banks usually take more risk than conventional banks because of their lack of experience and lack of familiarity with all financial instruments to which they should resort to.

Islamic banks do not use PLS products so much because their risks are too high, but if these products positively affect their performance or reduce the risks faced by these banks, these two possibilities can be a motivation for the banks to adopt these financial products and to integrate them into their activities.

In this research paper, we introduced a control variable that is the size of the Islamic bank, since it is a key variable in the performance of Islamic banks. Trujillo-ponce (2013) showed that a large banking size implies economies of scope in the bank, and results from the varied goods and services.

The Theoretical Framework and Hypothesis The literature review has given the basis in determining the dependent variable and

independent variables. Therefore, the theoretical framework can be presented as follows:

Generally, the moderator variable interacts with the independent variable to influence the dependent variable. The model which contains a moderator variable was has been adopted and treated by several researchers. Granted, this study focuses mainly on the work conducted by Frazier et al. (2004) and Marsh et al. (2011).

Khan and Ahmed (2001) give an example of the widespread use of the profit-and-loss-sharing contract that is perceived as the least risky, while this type of contract exposes Islamic financial institutions to a specific risk.

Izhar and Asutay (2007) found a relationship between revenues from PLS products of Islamic banks and banks' ability to generate profits.

Risk Management & Performance of Islamic Banks:……..


Rahman and Rochmanika (2012) examined the effect of Mudharabah and Musharakah on the profitability of Islamic banks. They found that they may eventually affect the profitability of Islamic banks.

In this paper, we are interested in studying the moderating effect of the income of Mudharabah and Musharakah on the relationship between risks and the performance of Islamic banks. To do this, we will include the incomes of Mudharabah and Musharakah in the model by multiplying it with each variable.

This paper uses the theory of Frazier et al. (2004) to examine and analyze the (possible) moderating effect of the income of the PLS products on the relationship between performance and risk through these assumptions:

H1: The incomes of PLS products moderate the relationship between performance and liquidity risk of Islamic banks.

H2: The incomes of PLS products moderate the relationship between the performance and market risk of Islamic banks.

H3: The incomes of PLS products moderate the relationship between performance and operational risk of Islamic banks.

3. Data And Methodology This research focuses only on Islamic banks. Moreover, the sample size of this

study includes 16 Islamic banks of 7 countries from different continents (Qatar; UAE; Bahrain; Saudi Arabia; Bangladesh; UK; Sudan). The small size of the sample is due to the unavailability of the data of other banks. The study is covering the period from 2012 to 2015 using yearly frequency unbalanced data. Thus, 53 observations were collected. The data were collected from the secondary source of Bankscope database which contains the financial statements of those banks.

3.1 Variables Measurements 3.1.1 Dependent Variable

The dependent variable is the profitability of the bank and it is measured by the ratio ROAA (average return on assets). It is calculated by dividing the net income of the bank to its total assets. Flamini et al. (2009) have demonstrated that ROA is the best indicator for measuring the performance. It is more adequate than ROE because ROE does not take into consideration the leverage effect.

3.1.2 Independent variables The data related to the operational and market risks are taken directly from the

database bankscope. However, the liquidity risk was measured by the ratio below:

LR =Liquid assetsDeposits and short term funding

This liquidity ratio can be used to measure the quality of liquidity in banks and has been used by Cihak et al. (2012).


In this empirical study, we have introduced the incomes of Musharakah and

Mudharabah as a moderator variable. These revenues were taken directly from the Bankscope. Furthermore, the size of the bank is measured by the total of its assets.

In this research, we have used the logarithm of all those variables.

3.1.3 Research Model ROAA i,t = α0 + α1 LR i,t + α2 ORi,t + α3 MRi,t + α4 MMi,t + α5 MMLR i,t + α6

MMORi,t + α7 MMMRi,t + α8 SIZE i,t + ε it

Where,

α0: is the constant;

LR i, t: is the liquidity risk; ORi, t: is the operational risk; MRi,t :is the market risk;

MMi,t: is the moderator variable;

MMLR i, t : represents the incomes of Mudharabah & Musharakah multiplied to the liquidity; risk; MMORi,t: represents the incomes of Mudharabah & Musharakah multiplied to the operational risk; MMMRi, t: represents the incomes of Mudharabah & Musharakah multiplied to the market risk and SIZE i,t is the bank size.

3.1.4 The Methodology This study employs unbalanced panel data regression analysis of Ordinary Least

Squares method, after verifying all the conditions of OLS method, from 16 Islamic banks from different countries during the period from 2012 to 2015, which was processed by the software Stata-13.

4. Results And Discussion 4.1 Descriptive Statistics

According to the table below (Table 1), the average return on assets is 1.612 for our sample of 16 Islamic banks, which corresponds to 1.599 for the poorest bank and 1.621 for the best performing bank.

On average, the liquidity risk (LR) is in the order of 1.377, which is likely to take a minimum value of -0.076 for the least risky bank and 2.382 for the most risky bank. Indeed, these values have changed when the variable ‘Moderator (MMLR)’ is introduced. The average has become 21.540, and the variable LRMM can take its minimum value which is of the order of -1.36 and its max value which is equal to 40.829. For operational risk (OR), its average is of the order of 13.997, which is likely to take a minimum value of 10.043 for the least risky bank and 21.292 for the most risky bank. Indeed, these values changed when the moderator variable (MMOR) was introduced. The average has become 222.723, and the variable ORMM can take its minimum value which is of the order of 110.996 and its maximum value, which is equal to 401.564. For market risk (MR), its average is of the order of 12.577, which is likely to take a minimum value of 8.699 for



the least risky bank and 21.177 for the most risky bank. Indeed, these values changed when the moderating variable (MMMR) was introduced. The average becomes 200.317, and the variable MRMM can take its minimum value, which is of the order of 106.793 and its max value, which is equal to 394.747. For the size of the bank (SIZE), its average is in the order of 22.628, which is likely to take a minimum value of 19.505 for the smallest bank and 25.15 for the largest bank.

Table 1: Descriptive Statistics

Variable Observation Mean Std. Dev Min Max

ROAA 53 1.612 0.003 1.599 1.621

LR 53 1.377 0.498 -0.769 2.382

OR 53 13.998 2.962 10.043 21.292

MR 53 12.578 3.323 8.699 21.177

MM 53 15.785 1.934 10.043 18.859

MMLR 53 21.540 8.081 -1.360 40.829 MMOR 53 222.723 62.293 110.996 401.564 MMMR 53 200.317 66.402 106.793 394.747 SIZE 53 2.628 1.394 19.505 25.155 4.2 Regression analysis

The Table 2 shows that the coefficient of multiple determination R², which measures the quality of the adjustment between the endogenous variable and the explanatory variables (the proportion of the variation of the dependent variable explained by the regression model), is of the order of 0.4133. The Fisher test (F = 4.53) which evaluates the quality of R² (verifies the degree of significance of the linear relationship between the dependent and independent variables) is significant at the 5% threshold. Therefore, the model is globally significant.

Table 2: Regression Results

ROAA Coef. Std. Err. t P>|t| LR 0.0203801 0.0090144 2.26 0.029 OR -0.0053966 0.0023855 -2.26 0.029 MR 0.0035928 0.0026182 1.37 0.177

MM -0.0000551 0.0015168 -0.04 0.971 MMLR -0.0012361 0.0005451 -2.27 0.028 MMOR 0.000294 0.0001566 1.88 0.067 MMMR -0.0002023 0.0001663 -1.22 0.230


SIZE 0.001067 0.0003943 2.71 0.010 _cons 1.592805 0.0276289 57.65 0.000 Number of obs = 53 F( 8, 44) = 3.87 Prob > F = 0.0016 R-squared = 0.4133

Moreover, the variables LR and MMLR are significant to the order of 5% in this model. This result allows us to say that the moderator variable has improved the relationship between the liquidity risk and the performance. Moreover, the MMLR variable is significant in the order of 1%. This confirms the hypothesis H1. We can say that the variable MM is a moderator of the relationship between liquidity risk and performance and acts negatively on this relationship.

The variables OR and MMOR are significant to the order of 10% in this model. This result allows us to say that the moderator variable reinforced the relation between the operational risk and the performance. In addition, the variable MMOR is significant to the order of 10%. This validates the hypothesis H2. The variable MM is a moderator of the relationship between operational risk and performance and acts positively on this relationship.

The variables MR and MMMR are not significant, in this model, this result allows us to say that the moderator variable has no effect on the relationship between the market risk and the performance of the Islamic banks. This shows that the hypothesis H3 is unconfirmed. Thus, we can conclude that the variable MM is not a moderator of the relationship between market risk and performance.

Table 3: Summary of the Hypothesis

Hypothesis Finding

H1: The incomes of PLS products moderate the relationship between performance and liquidity risk of Islamic banks.

Accepted

H2: The incomes of PLS products moderate the relationship between the performance and market risk of Islamic banks.

Accepted

H3: The incomes of PLS products moderate the relationship between performance and operational risk of Islamic banks.

Rejected

5. CONCLUSION

This study analyzed the impact of the income of Mudharabah and Musharakah (as a moderator variable) of the relationship between performance and risk. The study involved basically three stages: Firstly, analysis of the literature review which explains the relationship between bank’s profitability and risks; secondly, application of a suitable methodology which overcomes the classical econometric problems involved in this kind of studies; and finally, empirical testing of the hypotheses.



In order to test the validity of our hypotheses, which highlight the effect of the moderator variable (income of Mudharabah and Musharakah) on the relationship between risks and the performance of Islamic banks, we have elaborated the model based on the work of Frazier et al. (2004), focusing mainly on liquidity risk, operational risk, and market risk in Islamic banks. The estimation of this regression was done by the ordinary least squares method (OLS), on a sample of 16 Islamic banks covering the years 2012-2015. Te results highlighted the usefulness of Islamic financial products in improving the performance of Islamic banks.

Firstly, the main conclusion derived from this study is that there is an empirical effect of the moderator variable (MM) on the relationships between the bank’s profitability and liquidity risk and operational risk. Secondly, the variable (MM) does not have a moderating impact on the relationship between performance and market risk.

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Profitability of Islamic Banks: Case of Malaysia

By Huma Nawaz

Prof. Dr. Barjoyai Bardai

Abstract This study aims to investigate the performance efficiency and the differences between premier Bank Islam Malaysia Berhad and RHB Islamic Bank Berhad in Malaysia. The study uses the period of the year 2010 to until the year 2015. For data analysis, this research used linear Regression Model and Correlation. EPS and CAR were used as the dependent variables while Revenue, Total assets and total equity were used as the independent variables. The study identified that earning per share is significant factor that influence profitability of Bank Islam Malaysia Berhad. Based on Correlation analysis between independent variables and earning per share, shareholders equity of Bank Islam Malaysia Berhad has a significant relationship. The correlation test between independent variables of RHB Islamic Bank Berhad shows that equity and operating profit have positive correlation at 0.01 level of significant.

Key Words: Profitability, Efficiency, Correlation, Significant factor, Bank Islam Malaysia

1 Introduction Today’s financial market is increasingly faced with the challenge of growth for

market strength. Growing number of Islamic banking investors rely on financial statements for financial decision making instead of interacting with bank employees. Financial ratios are financial indicators that enable investors to quickly predict the financial position of an institution. Example of financial ratios include earning per Authors: Huma Nawaz, Doctoral Student, AL Madinah International University, MEDIU

(Malaysia). Supervisor: Prof.Dr.BarjoyaiBardai, AL-Madinah International University, MEDIU (Malaysia).


share(EPS), capital adequacy ratio(CAR), Return on equity(ROE), Return on asset (ROA), debt to equity ratio (D/E) and equity to net liability(EL).

A key instrument of financial system development and growth is profitability (Love & Zicchino, 2006). Previous research suggests that investors are very likely to compare and acquire information from financial ratios (Cleary, 1999). Meanwhile, a renewed ubiquity of financial ratios to capture attention of credit lenders, credit rating agencies, investors and management has generated interest in this financial disclosure (Beaver, 1966). While extensive research has been conducted on the importance of financial statement presentation (e.g. Alexander & Jermakowicz, 2006); (Ding, Stolowy, & Tenenhaus, 2003) for the importance of financial disclosures and how financial ratios predict return (Chen & Shimerda, 1981); (Fama& French, 1988). little attention has been given to the correlation among different financial ratios and more particularly, the use of regression analysis relative to fundamental financial indicators.

Previous research has examined traditional tools of profitability measurement (Eljelly, 2013) ;(Badreldin, 2009) and its significance as a critical indicator of profitability, liquidity, and solvency (Altman, 1968); (Lantto & Sahlstr¨om, 2009).

Considering the risk issue of institutions in particular, the literature is almost silent on the comparative analysis of banks profitability and its impact on stakeholders. It is increasingly evident that measurement of financial profitability and openness of financial presentation methods will continue to be a critical component of nonprofessional investors-institution interactions (Maines & McDaniel, 2000). Financial presentation methods are expected to become a key factor for investor’s judgment (Sullivan, 1988); (Ettredge, Richardson, & Scholz, 2001). The profitability of financial institutions is affected by managerial factors (Almumani, 2013). Essentially this research comparatively analyzes the profit trends of banks by financial ratios.

The main goal of this study was to investigate the factor of profitability and also to determine how these factors are related to the profitability of Islamic banks.

For further understanding, the purpose of this research is to answer the research question:

“How management controllable factors are related to bank profitability ratios”.

More specifically, this research has two objectives:

To analyze and compare the profitability of Islamic banks.

To determine and compare how revenue, total assets and total equity of the Islamic banks correlate with selected financial ratio.

The main goal of this study was to investigate the factor of profitability and also to determine how these factors are related to the profitability of Islamic banks.

After introductions, section 2 presents a brief review of literature. Section 3 deals with the methodology adopted in the paper with the description and results of findings.



While the remaining sections 4, 5, 6 present concluding remarks, references and appendix respectively.

2 Literature Review Following (Iqbal & Mirakhor, 2009) and (Bank, 2011), for the purpose of this

study, Islamic financial institutions are defined as “those whose goals and operations are based on the Principles of the Quran, basis on which can also be separated from conventional financial institutions that have no such concerns.”

2.1 An overview of the Islamic Banking The fundamental system of Islamic finance is based on set of rules and laws,

collectively referred to as shariah, governing economic, social, political, and cultural aspects of Islamic societies (Iqbal, 1997). According to El-Gamal (2000), Islamic law puts many restrictions on Islamic contracts to build a healthy financial system for an economy and attain maximum justice in financial transaction to minimize the potential for legal dispute.

2.2 Islamic banking in Malaysia Islamic banks play a key role in economic development of Malaysia. Islamic

banking has higher standard of ethics and satisfying stakeholders needs and wants. According to Anderson, Fornell, & Lehmann (1994a), economic return and profitability have positive relationship with product user satisfaction. In an operating environment of banks, the growing interest is to offer Islamic products to the large Muslim population(Sole, 2007). It is being proposed that a profitable banking sector is better able to withstand negative shocks of an economy and contribute to the stability of the financial system (Anderson, Fornell, & Lehmann, 1994b).

Akram Laldin (2008) elaborated the experience of Malaysia in developing the Islamic financial system in his paper entitled ‘Islamic financial system: the Malaysian experience and the way forward’. The author used mixed approach i.e. both qualitative and quantitative analysis to find the key focal areas of Islamic financial system. The resultant findings concluded that Malaysia has a very encouraging history of Islamic banking and domestic Islamic banking industry has been growing at an average rate of 18% per annum.

To highlight the major achievements and Islamic elements in corporate plans, Hasan 92007) studied the fifty years of Malaysian economic development. Research found that Islamic ethical norms and injunctions have been among the best policy section of Malaysia. However, he could not explained the competitive position of Islamic financial system.

(Wasiuzzaman & Tarmizi, 2010) examined the impact of bank characteristics and macroeconomic determinants on the profitability of Islamic banks in Malaysia. To measure profitability, they used internal and macroeconomic variables. This paper states that equity to total assets has negative relationship with bank profitability.

Azhar Rosly & Afandi Abu Bakar (2003a) analyzed the experience of Islamic counters of mainstream banks in Malaysia between 1996 and 2001.The empirical results shows that the ROA for Islamic banking (IB) scheme is 1.16 per cent while mainstream


banks was leveled at 0.41 per cent. Overall, this study proposed negative impact of ethics based banking products in term of efficiency. The finding contented that Islamic banks that thrive on interest-like products is less likely to outshine mainstream banks.

Ab-Rahim, Kadri, & Ismail (2013) studied performance of Islamic banks in paper entitled ‘Efficiency performance of Malaysian Islamic banks’. Authors examined the efficiency performance of the full-fledged Islamic banks in Malaysia for the period of 2006 to 2011.Data Envelopment Analysis was employed to measure the cost efficiency, technical efficiency and its decomposition. The results indicate that the average of total assets of domestic Islamic banks is RM 15 million as compared to RM 7 million for foreign Islamic banks. Moreover, on average, the main contributor of cost efficiency for Islamic domestic and foreign banks in Malaysia was allocation efficiency.

2.3 Potential indicators of Profitability The foundation for this study was the existing literature of profitability

measurement in Bank Islam Malaysia Bhd (BIMB) and RHB Islamic Bank Berhad of Malaysia. Bank Islam Malaysia Berhad (BIMB) was established in July1983 under the provisions of Islamic banking Act of 1983 (Act 276) of the Malaysian Parliament. According to Islamic banking Act of 1983, Islamic banking is defined as ‘banking business whose aims and operations do not involve any element which is not approved by the religion of Islam’ (Ahmad, 1997).

Bank Islam Malaysia Bhd (BIMB) was a single full-fledged Islamic bank in Malaysia. This Bank was established to meet demands and challenges of Muslim consumers, traders, investors, and businessmen and money market .Samad & Hassan’s (1999a) study evaluates the inter-bank performance of Islamic bank BIMB. For data analysis authors used profitability, liquidity, risk and solvency; and community involvement for the period 1984-1997. The results showed that Islamic bank made (statistically) significant progress on return on assets (ROA) and return on equity (ROE) during 1984-1997. In addition, the average ROA and ROE during this period were 0.43, 21.5 and 8.07 respectively. This study suggest that knowledgeable bankers can play an important role in development of different Islamic products.

The first local-based banking group that launched Islamic subsidiary was RHB Group, which opened RHB Islamic Bank Berhad (Mokhtar, Abdullah, & Al-Habshi, 2008). Mokhtar, Abdullah & Al-Habshi (2006) empirically investigated the efficiency of the full-fledged Islamic banks, Islamic windows and conventional banks in Malaysia. The study result showed that RHB Berhad has relatively higher average technical and cost efficiency scores as compared to the other domestic commercial banks. May bank has average technical and cost efficiency of 86.6% and 88.3% respectively, while RHB has technical and cost efficiency scores of 87.8% and 88.4% respectively.

Bidabad & Allahyarifard (2008) investigated the assets and liabilities management in Islamic banking. Research methodology was based on comparative analysis of Islamic RHB Bank and conventional banks. The result concluded that return on asset (ROA) and return on equity (ROE) in Islamic RHB Bank conventional bank at the two considered times of research are greater than conventional banking.



Hence finding of these researches conclude that authors have utilized different approaches including empirical and theoretical studies for understanding the effect of market on Islamic banking efficiency, a comparative assessment of the performance of the Bank Islam Malaysia Bhd (BIMB) and RHB Islamic Bank Berhad for evaluation of service quality, profitability and interbank performance.

Hence, in light of previous studies, the following hypotheses were proposed for this study:

H1.There is significant relationship between the profitability of Bank Islam Malaysia Bhd (BIMB) and RHB Islamic Bank Berhad.

H2.There is a significant difference between the profitability of Islamic banks of Malaysia.

H3.There is significant factor that influence profitability of Islamic banks of Malaysia.

The measuring construct in this study consist of number of variables. It has been suggested that new constructs be added for implementation, verification, and empirical analysis of the original instrument (Rao, Solis, &Raghunathan, 1999). The variables of this study are explained below:

Earning per Share (EPS) Earning per share indicates the relation between earnings and the value of the firm

(Patell, 1976), (Modigliani & Miller, 1958).

Capital adequacy ratio (CAR) Capital adequacy ratio (CAR) is a measure of a bank’s risk exposure as one of the

key measures which regulators use as a ‘buffer’ against credit risk to which banks are exposed (Ahmed Abdel Karim, 1996).

Revenue(R) Revenue indicates how well an Islamic bank is performing in terms of profit

(Bader, Mohamad, Ariff, & Hassan, 2008).

Total assets(TA) This refers to the measure of output for the financial institutions (Sealey & Lindley,

1977).

Total equity(TE) The equity is profit sharing in contracts of financial markets (Bashir, 1999a).

3 Materials and Methods The research objective implied the importance of research design and research

method. Hence, diverse types of relevant research tools and instruments, necessary for analysis of data were collected for research and significant to the accomplishment of this study objective.


The research of this study is conducted for evaluation of performance in

relationship to Islamic banking of Malaysia. According to John W. Creswell, 2003, quantitative approach is best if the problem is to identify factors that influence an outcome, the utility of an intervention or understanding the best predictors of outcomes. Thus, a quantitative approach would be more suitable to accomplish, the aim of this research.

A time series data of 5 years’ (2010-2015) internal factors specific for this study was selected to evaluate and highlight their relationship with the profitability of Bank Islam Malaysia Bhd (BIMB) and RHB Islamic Bank Berhad in Malaysia. This study, therefore, uses time series data of 5 years (2010-2015) as a particular technique based on the secondary data.

Conceptual model of relationship between Bank Islam Malaysia Bhd (BIMB) and RHB Islamic Bank Berhad to bank’s profitability based on:

Independent Variables Dependent Variables

Revenue Earning per share

Total Assets Capital adequacy ratio Total equity

Following Hamidah Ramlana & Mohd Sharrizat Adnana (2015) the statistical process for calculation and analysis was based on the following equations:

EPS = α + β1X1 + β2X2 + β3X3 + e(Model1)

CAR = α + β1X1 + β2X2 + β3X3 + e(Model2)

Where Dependent Variable are: EPS = Earning per share

CAR= Capital adequacy ratio.

Independent variables are:

X1 = Revenue

X2= Total Assets

X1= Total equity

&

e = Error term

B1 = Beta



3.1 Results and Discussion Table 1 shows the descriptive statistics for the variables of the study. It reflects

mean, standard deviation of each variable i.e. EPS, CAR, Revenue, total assets and total equity.

Descriptive statistics indicate that the earning per share of BIMB (M=19.45) is slightly higher than the earning per share of RHB (M=19.11). Hence BIMB is capable of generating a higher dividend for investors as compared to RHB. However, the mean for capital adequacy ratio of RHB is 13.40 while for BIMB the mean is 0.15.Therefore, results shows that RHB is more likely to meet its financial obligation than BIMB.

Table 1: Comparison of mean between Bank Islam Malaysia Bhd (BIMB) and RHB Islamic Bank Bhd

Variables Mean Standard Deviation

EPS(RHB) 19.11 5.14

CAR(RHB) 13.40 0.88

EPS(BIMB) 19.45 2.97

CAR(BIMB) 0.15 0.0162 3.1.1 Results for Correlation

For the RHB Islamic Bank Berhad correlation between independent variables and EPS, there is no significant relationship. The correlation tests between independent variables shows that total equity and revenue have positive correlation at 5% significant level (.975).

For the RHB Islamic Bank Berhad correlation between independent variables and CAR, there is no significant relationship. The correlation tests between independent variables shows that total equity and revenue have positive correlation at 5% significant level (.975).

Table of Bank Islam Malaysia Bhd (BIMB) EPS depicts the correlation matrix between EPS (dependent) and independent variables in this study. There is a convincing evidence of close correlation between EPS and independent variables of Bank Islam Malaysia Berhad that is specific for this research.

These are the indicators that increase in EPS of bank can bring significant part in the development of BIMB.

For the BIMB correlation between independent variables and CAR, there is no significant relationship. The correlation tests between independent variables shows that revenue, total assets and total equity have positive correlation at 5% significant level.


Table 2: Results for correlation test of RHB Islamic Bank Berhad

Variables Relationship Coefficient Sig. Hypothesis

EPS(RHB) Positive +1.00 Not. Sig. Rejected

CAR(RHB) Positive +1.00 Not Sig. Rejected

Revenue(RHB) Positive +1.00 Sig. Accepted

Total assets(RHB) Negative +1.00 Not Sig. Rejected

Total equity(RHB) Positive +1.00 Sig. Accepted Table 3: Results for correlation test of Bank Islam Malaysia Bhd

(BIMB)

Variables Relationship Coefficient Sig. Hypothesis 1

EPS Negative +1.00 Sig. Accepted

CAR Negative +1.00 Not Sig. Not accepted

Revenue Positive +1.00 Sig. Accepted

Total assets Positive +1.00 Sig. Accepted

Total equity Positive +1.00 Sig. Accepted

3.1.2 Results for Regression Table of RHB Islamic Bank Berhad regression for EPS summarizes models for

RHB Islamic Bank Berhad. By SPSS program, a regression analysis was performed on the summary data. The Durbin-Watson test results are 2.603; which implies that there is no autocorrelation among the residuals from the regression investigation.

In predicting the influence of variables on profitability, model is significant with R2=.994, which reflects that 99% variations in the variable are explained by the regression. Therefore, H3 is accepted only for EPS of RHB Islamic Bank Berhad.

Table 4: Regression for EPS of RHB Islamic Bank Berhad

Model R R Square Durbin-Watson Sig.

1 .997 .994 2.603 .009

B-coefficient (Coef.) is the specific estimation of the variables. Table for coefficient of RHB Islamic Bank Berhad EPS shows that it is 3.219 for total equity which suggests that increase in equity has positive impact on dependent variables. The percent increase in total equity leads to proportional increase in EPS of RHB Islamic Bank Berhad. In addition, all of the variables are significant at a level of 5%.



Table 5: Regression coefficient for EPS of RHB Islamic Bank Berhad

Variables Coefficient Sig. Hypothesis 3

Revenue(RHB) -2.994 .007 Accepted

Total assets(RHB) -.630 .007 Accepted

Total equity(RHB) 3.219 .006 Accepted

Table for CAR shows the estimated R square is .55, indicating that 55 % changes in CAR (dependent) is due to changing in independent variable are reliable. However, the result shows there is no significant variable that influences profitability with respect to CAR for RHB Islamic Bank Berhad. The Durbin Watson test results are 2.628; which implies that there is no autocorrelation among the residuals from the regression investigation.

Table 7: Regression for CAR of RHB Islamic Bank Berhad


2 .741 .550 2.628 .592

Table for coefficient of RHB Islamic Bank Berhad, CAR shows that it is .514 for revenue which suggests that increase in operating profit has positive impact on dependent variables. The percent increase in total revenue leads to proportional increase in CAR of RHB Islamic Bank Berhad.

So for RHB Islamic Bank Berhad,

EPS = α-2.994X1-.630X2 + 3.219X3 + e(Model1)

CAR = α + .514X1 -.121X2 + .221X3 + e(Model2)

Table 8: Regression coefficient for CAR of RHB Islamic Bank Berhad


Revenue(RHB) .514 .833 Rejected

Total assets(RHB) -.121 .823 Rejected

Total equity(RHB) .221 .928 Rejected

Table for Bank Islam Malaysia Bhd (BIMB) Regression for EPS shows that the estimated R square is .951, indicating that 95.1 % changes in EPS (dependent) is due to changing in independent. However, the result shows there is no significant variable that influences profitability with respect to EPS for BIMB. The Durbin-Watson test results are 2.851; which implies that there is no autocorrelation among the residuals from the regression investigation. Table 9: Bank Islam Malaysia Bhd (BIMB) Regression for EPS



1 .975 .951 2.851 .072

Table for B-coefficient of Bank Islam Malaysia Bhd (BIMB) EPS shows that it is 4.184 for revenue which suggests that increase in operating profit has positive impact on dependent variables. The percent increase in total revenue leads to proportional increase in CAR of Bank Islam Malaysia Bhd (BIMB)

Table 10: Bank Islam Malaysia Bhd (BIMB) coefficient for EPS


Revenue 4.184 .270 Rejected

Total assets -1.594 .591 Rejected

Total equity -1.665 .280 Rejected

Table for Bank Islam Malaysia Bhd (BIMB) regression for CAR shows the estimated R square is .841, indicating that 84.1 % changes in CAR (dependent) are due to changes in independent variable are reliable. However, the result shows there is no significant variable that influences profitability with respect to CAR for BIMB. The Durbin-Watson test results are 2.788; which implies that there is no autocorrelation among the residuals from the regression investigation.

Table 11: Bank Islam Malaysia Bhd (BIMB) Regression for CAR


2 .917 .841 2.788 .228

Table for B-coefficient of Bank Islam Malaysia Bhd (BIMB) CAR shows that it is 6.193 for total assets which suggests that increase in assets has positive impact on dependent variables. The percent increase in total assets leads to proportional increase in CAR of Bank Islam Malaysia Bhd (BIMB)

Table 12: Bank Islam Malaysia Bhd (BIMB) coefficient for CAR


Revenue -10.007 .184 Rejected

Total assets 6.193 .306 Rejected

Total equity 3.139 .266 Rejected So for Bank Islam Malaysia Bhd (BIMB),

EPS = α + 4.184X1 -1.594X2 -1.665X3 + e(Model1) CAR = α-10.007X1+6.193X2 + 3.139X3 + e(Model2)



Conclusion Based on Correlation test, for RHB Islamic Bank Berhad, the result shows there is

no significant relationship between the profitability of EPS with all independent variables and for CAR there is no close significant relationship between the profitability of CAR with all independent variables at 5 % significant level. For BIMB, H1 is accepted for one dependent variable because only dependent variable, EPS, has significant relationship with all independent variable which is revenue, total Asset and total Equity, with significance at a level 5 %.

Based on Regression model, BIMB is more profitable than RHB Islamic Bank Berhad whereas CAR of RHB Islamic Bank Berhad is higher than BIMB. H2 is accepted but inconclusive because from the three variables there is only one significant.

Based on Regression test, for RHB Islamic Bank Berhad, H3 is accepted only for EPS because the result shows there is no significant factor that influence profitability measuring CAR with independent variables and for CAR there is a significant factor that influence profitability with independent variable which is Total Equity to Revenue with significance at level 1 %. For BIMB, H3 is accepted only for BIMB because only dependent variable, EPS, is significant factor that influence profitability with all independent variable which is revenue, total asset and total equity, with significance at level 5 %.

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Book Review

Title: The Bottom Billion. Author: Paul Collier. Publisher: Oxford University Press. Reviewed by: Salman Ahmed Shaikh

Most of the five billion people in developing countries live in countries that are indeed developing. The real challenge of development is that there is a group of countries at the bottom that are falling behind, and often falling apart. The author remarks that the countries at the bottom coexist with the twenty-first century, but their reality resembles the fourteenth century. They are marred by economic underdevelopment, food insecurity, political instability and poor health and education indicators.

The author provides glaring contrasts between countries comprising the bottom billion poorest population and the rest of the developing countries. In the bottom billion countries, average life expectancy is fifty years, whereas in the other developing countries, it is sixty-seven years. Infant mortality—the proportion of children who die before their fifth birthday—is 14 percent in the bottom billion, whereas in the other developing countries, it is 4 percent. The proportion of children with symptoms of long-term malnutrition is 36 percent in the bottom billion as against 20 percent for the other developing countries.

The author argues that during the1970s, the bottom billion diverged in growth from the rest of the developing world by 2 percent a year. During the 1980s, the divergence accelerated to 4.4 percent a year, and during the 1990s, it accelerated further to an astonishing 5 percent a year.

These countries suffer from four major traps, i.e. conflict trap, natural resource trap, land-locked trap and bad governance trap. The author estimates that 73 percent of them have been through civil war,29 percent of them are in regions dominated by the politics of natural resource revenues, 30 percent are landlocked, resource-scarce, and in a bad neighborhood, and 76 percent have been through a prolonged period of bad governance and poor economic policies.

Among the instruments which can be used to change matters, the author lists aid, military intervention, trade laws and trade openness. The author estimates that aid significantly reduced capital flight. It is part of the solution rather than part of the


problem. The challenge is to complement it with other actions. The author argues that although globalization has powered the majority of developing countries toward prosperity, it is now making things harder for the latecomers.

One issue ignored by the author is the role of interest based compounded debt. Several countries in Africa face debt trap. They have to pay compound interest, which is sometimes more than the aid they receive and more than the exports and foreign investments that come in the country. In such a scenario, benefits from aid, investments and foreign exchange through trade are nullified by leakages in the form of debt servicing.

The author argues that low levels of growth are making the poorest countries to not only fall behind, but also to fall apart. Nonetheless, economic growth alone will not be a sufficient condition for development if the growth is fueled by particular sectors which are owned and managed by a tiny minority of rich elites. The focus on development shall be centered on human dignity and respect for environmental resources. Interest based finance takes away natural resource wealth which has to be sold to service debt denominated in fiat money. Real sector economic activities need to be boosted to generate inclusive growth and market-based employment. Islamic finance with its focus on real sector based activities can be more suitable in such an economic scenario, especially in Muslim majority African countries.

An important instrument to reverse these trends is social finance. In poor countries with significant Muslim population, Islamic market and non-market based institutions could be effectively utilized. Islamic microfinance is a market-based institution which can provide asset based finance and ensure asset ownership for the poor clients. Islamic non-market based institutions such as Zakat and Waqf can redistribute income to the poor. Zakat redistributes surplus wealth from the rich to the poor with a predetermined filter to separate the giver and receiver in the form of an identified quantity of wealth, known as Nisab. On the other hand, Waqf provides permanent dedication of movable and non-movable assets to the social and welfare needs of the public. This provides public goods and social safety nets at a decentralized level. In countries where governments are weak in governance and tax collection, private mobilization of charitable funds can fill the void in development finance.

Overall, the book is a welcome attempt to highlight the contrast among developing countries and to focus more attention on the bottom billion poorest population. The policy focus needs to take cognizance of the local, cultural and institutional context to help change lives. In Muslim majority regions, Islamic social finance institutions could be effectively utilized to provide solutions which not only have economic potential, but are also more locally and culturally acceptable.

Book Review


Country Model Luxembourg *

The Grand Duchy of Luxembourg, a landlocked country in Western Europe, having financial sector as leading contributor to its GDP occupies a special place in global financial market. Luxembourg is not only a leading world business centre but also the second largest investment fund centre along with being the world leader in the cross-border distribution of retail investment funds. With respect to Islamic Finance, Luxembourg is recognized as leading European Centre for Islamic finance.

History of Islamic finance in Luxembourg goes back to 1978 when it became the first country in Europe to host an Islamic finance institution (Islamic Banking System Holdings Limited Luxembourg) and since then the country has played a significant role in growth of Islamic finance; Luxembourg Stock Exchange was the first exchange to list a sukuk, the first Eurozone country issuing a sovereign sukuk and third largest Islamic fund centre with Saudi Arabia and Malaysia at first two positions. Luxembourg is the first European country that became member of the International Islamic Liquidity Management (IILM) while Luxembourg’s Central Bank (BCL) is the first European central bank to become member of the Islamic Financial Services Board (IFSB). Moreover, Luxembourg considers its wide investment treaty network with over 80 countries including Saudi Arabia, Malaysia, and Turkey etc as boosting factor to its Islamic finance credentials.

Legal & Regulatory Framework With the aim to become a global hub for Islamic finance, Luxembourg has taken

major steps to extend conducive legal and regulatory framework for Islamic finance industry. Luxembourg tax laws are considered the most efficient and dynamic laws to cater to changing needs of evolving industry like Islamic finance. All major modes of Islamic finances are realized in tax efficient manner. Contracts like fiduciary contracts also allow the distinction between legal and economic ownership ensuring the compliance with the principles of Islamic finance.

As Luxembourg tax law is based on the economic approach and substance over form principles, Islamic investment can easily be accommodated under this law. Therefore the wide range of regulated investment vehicles, semi-regulated investment vehicles and unregulated holding companies by Luxembourg accommodate the requirements of Islamic finance. Moreover, it is also allowed to appoint Shariah Board at any type of regulated vehicle while purification of income is commonly accepted by

* Source: State Bank of Pakistan, Quarterly Islamic Banking Bulletin March 2017


Luxembourg authorities and service providers. Furthermore, favourable legal framework in Luxembourg allows issuance of sukuk from all types of entities under various forms.

Sukuk: Luxembourg offers variety of investment vehicles that may be considered suitable for issuance of sukuk. The securitization has proven to be specifically beneficial for innovative sukuk structures. Favourable Securitization Law for listing of sukuk signifies Luxembourg as a prime location for listing of sukuk. Sukuk issues have a choice between two markets: a regulated market, designated as the Bourse de Luxembourg, and a multilateral trading facility, Euro multilateral trading facility (MTF).

Shariah Compliant Investment Funds Luxembourg is ranked fifth by Ernst & Young’s Islamic funds and investments

report. There are currently almost 40 Islamic funds in Luxembourg making it one of the world’s largest place of domicile outside of the Islamic world. Luxembourg has also developed alternate structures like hedge funds, private equity and real estate funds which offer Shariah compliant services.

In order to become a global hub for Islamic finance, it is of paramount importance that all related stakeholders are knowledgeable in Islamic finance and therefore Luxembourg has taken significant steps in this regard; Diploma in Islamic Finance is a proof to this which is being offered with the partnership between Luxembourg Banking Training Institute (IFBL) and the ICMA centre of the University of Reading and a further partnership between Luxembourg School of Finance (LSF) and INCEIF (Malaysian leading university in Islamic finance)

Given a business oriented environment, a proactive financial supervisory authority in addition to efficient tax system Luxembourg is spearheading global Islamic finance transaction. Despite all these efforts Luxembourg remains in the shadow of several other jurisdictions continuously favoured by Islamic investors. However, all players in Luxembourg market are committed to make the country essential for future expansion of Islamic finance.

Sources EY report (May 2016), “Luxembourg the gateway for Islamic finance and Middle

East”

Global Islamic Finance Report 2014, Edbiz Consulting Limited, UK

Global Islamic Finance Report 2011, BMB Islamic UK Limited, UK

Bataineh, S. (2010), “The Islamic finance industry in Luxembourg: Advantages, opportunities and challenges,” http://www.ifcreview.com/restricted.aspx? articleId=2096# {accessed on May 11, 2017}

Country Model


Islamic Banking Indicators --------- x ---------

Islamic Banking Assets (US$ Billion)

Region / Year 2010 2011 2012 2013 2014 GCC 333 385 455 515 606 ASEAN 93 117 143 153 159 Turkey & Rest of World 50 53 69 84 89

South Asia 14 17 20 24 28 Total 490 572 687 776 882

Source: E&Y Global Competitiveness Report 2016 --------- x ---------

Islamic Banking Share in Banking Sector (%)

Country National Global Saudi Arabia 51.2 33 Malaysia 25 15.5 UAE 21.6 15.4 Kuwait 45.2 10.1 Qatar 25.8 8.1 Turkey 5.5 5.1 Indonesia 4 2.5 Bahrain 29.3 1.6 Pakistan 11.7 1.5

Source: E&Y Global Competitiveness Report 2016 --------- x ---------

Growth Comparison in Islamic and Conventional Banking

Compound Annual Growth Rate (2010-14) (%) Country Islamic Banking Conventional Indonesia 29 11 Pakistan 27 13 Turkey 25 16 Qatar 22 7 Saudi Arabia 20 7 Malaysia 17 9 UAE 13 19 Kuwait 10 4 Bahrain 4 -1

Source: E&Y Islamic Banking Competitiveness Report 16


Note to contributors Journal of Islamic Banking and Finance is an official publication of International

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

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